IAS 2 Inventories: Cost Formulas, NRV and What FIFO vs Weighted Average Means in Practice

IAS 2 Inventories: Cost Formulas, NRV and What FIFO vs Weighted Average Means in Practice

By Sai Manikanta Pedamallu (ACCA, CMA US, CSCA US, CGMA, ACMA, Dip IFRS, M.Com, MBA, MA)

Lead Instructor, Global Fin X | www.globalfinx.in/manikanta

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IAS 2 has one measurement rule that fits in nine words: inventories are measured at the lower of cost and net realisable value. Almost everything difficult about the standard sits inside the definition of those two terms.

Cost is where most errors originate, because the boundary between what must be capitalised and what must be expensed runs through the middle of a manufacturing business's overhead structure. Net realisable value is where most judgment sits, because it requires an estimate of what inventory will actually sell for, made by the people whose results depend on the answer.

The cost formula question, FIFO versus weighted average, sits between them. It is often taught as an arithmetic exercise, which it is, but the more useful framing is what each formula does to the financial statements when input prices move.

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Scope and the Measurement Exemptions

IAS 2 applies to all inventories except work in progress arising under construction contracts, financial instruments, and biological assets related to agricultural activity and agricultural produce at the point of harvest, which fall under IAS 41.

Separately, and importantly, the measurement requirements of IAS 2 do not apply to two categories of holder, even though the disclosure requirements still do:

Producers of agricultural, mineral, and forest products, to the extent that their inventories are measured at net realisable value in accordance with well-established practice in those industries.

Commodity broker-traders who measure their inventories at fair value less costs to sell.

Both exemptions exist because the ordinary lower-of-cost-and-NRV model produces unhelpful information in these specific contexts. A commodity trader holding standardised, immediately marketable inventory with an observable market price gains nothing from a historical cost measurement, and changes in fair value less costs to sell are recognised in profit or loss in the period they arise.

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Cost: The Three Components

The cost of inventories comprises all costs of purchase, all costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

Costs of purchase include the purchase price, import duties and other non-recoverable taxes, and transport, handling, and other costs directly attributable to acquisition, less trade discounts, rebates, and other similar items.

The non-recoverable qualifier matters in India. GST paid on inputs is generally recoverable as input tax credit and is therefore excluded from inventory cost. Where GST is genuinely irrecoverable, most commonly for entities making exempt supplies or where the input tax credit is blocked, the irrecoverable element forms part of the cost of the inventory.

Costs of conversion include costs directly related to the units of production, such as direct labour, plus a systematic allocation of fixed and variable production overheads incurred in converting materials into finished goods.

Other costs are included only to the extent they are incurred in bringing the inventories to their present location and condition. Borrowing costs on qualifying assets, as covered in Post 65, are included where inventory necessarily takes a substantial period to bring to a saleable condition, which is precisely the position of long-duration real estate inventory.

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What Must Be Excluded from Cost

IAS 2 lists specific costs that are excluded from inventory and recognised as expenses in the period incurred:

Abnormal amounts of wasted materials, labour, or other production costs. Normal, expected wastage is a cost of production and is absorbed into inventory. Abnormal waste is not, because it does not contribute to bringing inventory to its present condition.

Storage costs, unless those costs are necessary in the production process before a further production stage. Storage of finished goods awaiting sale is excluded. Storage of a product during a necessary maturation stage is included.

Administrative overheads that do not contribute to bringing inventories to their present location and condition. General head office costs, finance function costs, and corporate administration are excluded.

Selling costs. Marketing, distribution to customers, and sales commissions are always excluded.

The last two exclusions are where inflation of inventory carrying value most commonly occurs. A company under margin pressure has an obvious incentive to allocate a greater share of overhead into inventory, deferring the cost from this period's income statement to the next.

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The Normal Capacity Rule

Fixed production overheads are allocated to units of production based on the normal capacity of the production facilities, not on actual production.

Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the capacity lost through planned maintenance. Actual production may be used if it approximates normal capacity.

The consequence is direct and frequently misapplied. In a period of unusually low production, the fixed overhead per unit is not increased. The allocation rate remains based on normal capacity, and the unabsorbed fixed overhead is recognised as an expense in the period rather than being capitalised into a smaller number of units.

In a period of unusually high production, the allocation per unit is reduced, so that inventory is not measured above cost.

This is one of the most common audit findings on inventory. A manufacturer running at 60% of capacity during a demand slump, which allocates its full fixed overhead across the reduced output, is capitalising costs that should have been expensed, overstating both inventory and profit. Indian manufacturers with pronounced seasonal or cyclical output patterns, and those affected by demand shocks, are directly exposed to this.

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Cost Formulas: Three Options, One Prohibition

Specific identification is required for items of inventory that are not ordinarily interchangeable, and for goods or services produced and segregated for specific projects. A jeweller holding individually distinct high-value pieces, a real estate developer holding specific identified units, or a contractor holding materials allocated to a named project, all use specific identification.

FIFO or weighted average cost must be used for items that are ordinarily interchangeable, which in practice means large quantities of individually insignificant items.

LIFO is prohibited. This is one of the clearest differences between IFRS and US GAAP, which permits LIFO. An entity converting to IFRS from a framework where it applied LIFO must restate using FIFO or weighted average.

The IASB's reasoning for prohibiting LIFO is that it does not reflect the actual physical flow of inventory in most cases and, more fundamentally, that it produces a balance sheet carrying amount based on the oldest costs in the inventory pool, which can be many years out of date. LIFO's appeal was primarily its tax effect in inflationary conditions, which is not a financial reporting objective.

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FIFO Versus Weighted Average: What It Actually Does

The mechanical difference is well known. The consequential difference is what matters, and it is easiest to see with the same transactions run through both formulas.

Scenario. An Indian trading company deals in a standardised component. Opening inventory on 1 April is 1,000 units at Rs. 100 each. Purchases during the year: 2,000 units at Rs. 110 on 1 July, and 1,500 units at Rs. 125 on 1 January. Sales during the year total 3,500 units. Closing inventory is 1,000 units.

Under FIFO:

The units sold are assumed to be the oldest. The 3,500 units sold comprise 1,000 at Rs. 100, 2,000 at Rs. 110, and 500 at Rs. 125.

Cost of goods sold = (1,000 x Rs. 100) + (2,000 x Rs. 110) + (500 x Rs. 125)

= Rs. 1,00,000 + Rs. 2,20,000 + Rs. 62,500 = Rs. 3,82,500

Closing inventory = 1,000 units at Rs. 125 = Rs. 1,25,000

Under weighted average (periodic):

Total cost of goods available = (1,000 x Rs. 100) + (2,000 x Rs. 110) + (1,500 x Rs. 125)

= Rs. 1,00,000 + Rs. 2,20,000 + Rs. 1,87,500 = Rs. 5,07,500

Total units available = 4,500

Weighted average cost per unit = Rs. 5,07,500 / 4,500 = Rs. 112.78

Cost of goods sold = 3,500 x Rs. 112.78 = Rs. 3,94,730

Closing inventory = 1,000 x Rs. 112.78 = Rs. 1,12,780

Comparison:

The total is the same under both formulas, because the same total cost is being allocated between two destinations. What differs is the split.

The Practical Consequence

In a period of rising input prices, FIFO produces a lower cost of goods sold and a higher closing inventory, and therefore a higher reported profit. The oldest, cheapest costs flow through the income statement while the newest, most expensive costs sit on the balance sheet.

In a period of falling input prices, the effect reverses. FIFO produces a higher cost of goods sold and a lower closing inventory.

Weighted average dampens both effects, producing figures between the extremes and smoothing the impact of price volatility on reported margins.

This has real consequences for Indian businesses exposed to volatile input costs. A jewellery retailer holding gold inventory during a period of sharply rising gold prices will report materially different gross margins under FIFO than under weighted average, from identical physical transactions. A steel fabricator, an oil refiner, or an agricultural processor faces the same exposure.

Two further points that follow:

FIFO produces a more current balance sheet. Because closing inventory is measured at the most recent purchase costs, the carrying amount is closer to current replacement cost. This is one of the stronger conceptual arguments in FIFO's favour.

Weighted average may be calculated periodically or on each delivery. IAS 2 permits both. A moving average recalculated on each receipt produces different figures from a single periodic calculation at period end, and the entity's chosen approach should be applied consistently.

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The Consistency Requirement

The same cost formula must be used for all inventories having a similar nature and use to the entity.

Different formulas may be applied to inventories of genuinely different nature or use. A manufacturer might reasonably use weighted average for bulk raw materials and specific identification for high-value bespoke components, because those inventories differ in nature.

What is not permitted is applying different formulas to similar inventories in different locations or divisions purely as a matter of local practice, or selecting a formula for a particular inventory class because of the reported outcome it produces. Where a group has inherited different formulas through acquisitions, alignment is required for inventories of similar nature and use.

A change in cost formula is a change in accounting policy under IAS 8, applied retrospectively, and requires justification that the new formula provides more reliable and relevant information.

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Net Realisable Value

Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.

Three features of this definition need emphasis.

It is entity-specific, not market-based. NRV is what this entity expects to realise, in its ordinary course of business, net of its costs to complete and sell. Fair value under IFRS 13, by contrast, is a market-based measurement reflecting what market participants would transact at. The two can differ materially, and IAS 2 requires NRV, not fair value.

It deducts costs to complete. For work in progress, NRV is the eventual selling price of the finished item less the costs still to be incurred to finish it, less selling costs. Raw materials are not written down below cost merely because their replacement cost has fallen, if the finished products in which they will be incorporated are expected to sell at or above cost.

It deducts selling costs, even though selling costs are excluded from the cost side of the comparison. This asymmetry is deliberate: cost measures what has been spent to bring inventory to its present condition, while NRV measures what will actually be realised net of what must still be spent to realise it.

The Item-by-Item Requirement

The lower of cost and NRV comparison is made item by item, not across a whole product category or the inventory balance as a whole.

This matters because it prevents offsetting. A company holding two products, one with cost of Rs. 100 and NRV of Rs. 80, and another with cost of Rs. 100 and NRV of Rs. 130, must write down the first by Rs. 20. It cannot argue that the aggregate NRV of Rs. 210 exceeds the aggregate cost of Rs. 200 and therefore no write-down is required. Unrealised gains on one item cannot absorb unrealised losses on another.

Grouping is permitted only for items that are similar or related, such as items in the same product line with similar purposes or end uses, which are produced and marketed in the same geographical area and cannot practicably be evaluated separately.

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NRV Triggers in Indian Practice

Inventory is written down when its cost may not be recoverable. The standard triggers, and where they bite in India:

Damage and physical deterioration. Directly relevant for agricultural produce, processed food, and pharmaceuticals with expiry dating.

Obsolescence. Consumer electronics, mobile handsets, and fashion apparel face compressed product cycles where a model becomes unsaleable at cost within months.

Falling selling prices. A decline in the market price of the finished product below cost triggers the test.

Increased costs of completion. Where the remaining cost to finish work in progress rises, NRV falls even if the selling price is unchanged.

Regulatory price control. This is a distinctively Indian trigger. Where the National Pharmaceutical Pricing Authority revises ceiling prices downward under the Drugs (Prices Control) Order for a scheduled formulation, the maximum realisable selling price for existing inventory falls by regulatory action. Where the revised ceiling price, net of trade margins and selling costs, falls below the carrying cost of inventory on hand, a write-down is required. Indian pharmaceutical companies with significant scheduled-formulation portfolios need to monitor NPPA notifications as an NRV trigger, not merely as a commercial matter.

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Write-Down and Reversal

Where NRV falls below cost, inventory is written down to NRV and the write-down is recognised as an expense in the period.

Where the circumstances that caused the write-down subsequently reverse, and NRV recovers, the write-down is reversed. The reversal is limited to the amount of the original write-down, so that the inventory is never carried above its original cost, and is recognised as a reduction in the inventory expense for the period.

This reversibility is a genuine distinction from impairment of goodwill under IAS 36, where reversal is prohibited absolutely. It also means an NRV write-down taken in Q1 on an expectation of continued price weakness must be reversed in Q3 if prices recover, and cannot be retained as a cushion.

Worked Example: The NRV Test

An Indian pharmaceutical company holds the following inventory at 31 March:

Product A: NRV of Rs. 39 is below cost of Rs. 42. Write-down of Rs. 3 per unit, total Rs. 1,50,000.

Product B: NRV of Rs. 77 exceeds cost of Rs. 60. Carried at cost. No write-down.

Product C: NRV of Rs. 16 is below cost of Rs. 35. Write-down of Rs. 19 per unit, total Rs. 1,90,000.

Total write-down recognised as an expense: Rs. 3,40,000

Note that Product B's surplus of Rs. 17 per unit, amounting to Rs. 5,10,000 in aggregate, does not offset the write-downs on A and C. The item-by-item requirement prevents it.

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Indian Applications Worth Noting

Real estate developers. Units under construction held for sale are inventory under Ind AS 2, not investment property under Ind AS 40, as covered in Post 35. They are carried at the lower of cost and NRV, with cost including borrowing costs capitalised under Ind AS 23 where the development period is substantial. A market downturn that reduces achievable selling prices below accumulated development cost triggers a write-down. Given the length of Indian development cycles and the cumulative cost that builds up, this can be material.

Gold and jewellery. Titan, Kalyan Jewellers, and similar retailers hold substantial gold inventory. The choice between FIFO and weighted average materially affects reported margins during periods of gold price volatility, and the disclosed cost formula is genuinely useful information for anyone comparing these companies.

Commodity processors. Sugar, edible oil, and agricultural processing businesses face both the cost formula question and recurring NRV testing, since output prices are frequently regulated or highly volatile.

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Disclosure Requirements

IAS 2 requires disclosure of:

The accounting policies adopted in measuring inventories, including the cost formula used.

The total carrying amount of inventories and the carrying amount in classifications appropriate to the entity, typically merchandise, raw materials, work in progress, and finished goods.

The carrying amount of inventories carried at fair value less costs to sell.

The amount of inventories recognised as an expense during the period.

The amount of any write-down of inventories recognised as an expense, and the amount of any reversal of a previous write-down, together with the circumstances or events that led to the reversal.

The carrying amount of inventories pledged as security for liabilities.

The write-down and reversal disclosures are the most informative and the most frequently reduced to a single unexplained figure. A material reversal without an explanation of the circumstances that caused it is a disclosure failure.

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Ind AS 2 vs IAS 2

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What Big 4 Auditors Focus On

Fixed overhead absorption in low-production periods. Auditors recalculate the overhead absorption rate against normal capacity and test whether unabsorbed overhead in a low-output period has been expensed rather than capitalised. This is among the most frequently identified inventory findings.

Costs inappropriately capitalised. Auditors test the composition of inventory cost for administrative overheads, storage costs, selling costs, and abnormal waste, all of which must be excluded. A rising ratio of overhead to direct cost in inventory, without an operational explanation, prompts detailed testing.

NRV testing at the item level. Auditors test whether the NRV comparison has been performed item by item rather than on an aggregated basis, since aggregation systematically understates required write-downs.

Completeness of NRV triggers. Auditors look for triggers management may not have applied: expiry dating, slow-moving and obsolete stock analysis, post-year-end selling prices below cost, and, for Indian pharmaceutical clients, NPPA ceiling price notifications affecting scheduled formulations.

Consistency of cost formula across similar inventories. Auditors test whether the same formula has been applied to inventories of similar nature and use across locations, divisions, and acquired entities.

Write-down reversals. Auditors test whether reversals are supported by a genuine change in circumstances, whether they exceed the original write-down, and whether the required disclosure of the circumstances has been provided.

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Dip IFRS Exam Angle

IAS 2 is examined reliably, usually as a calculation combining a cost formula with an NRV test.

Most tested areas:

Computing closing inventory and cost of goods sold under FIFO and weighted average from a series of purchases and sales.

Determining which costs are included in and excluded from the cost of inventories from a list.

Applying the normal capacity rule to allocate fixed production overheads, including identifying unabsorbed overhead in a low-production period.

Performing the lower of cost and NRV test item by item, computing NRV as selling price less costs to complete less selling costs.

Accounting for a write-down and a subsequent reversal, with the reversal capped at the original write-down.

Common traps:

Allocating full fixed overhead across a reduced output in a low-production period, rather than applying the normal capacity rate and expensing the unabsorbed amount.

Including selling costs or general administrative overheads in inventory cost.

Performing the NRV test on aggregate inventory rather than item by item, allowing surpluses on some items to absorb deficits on others.

Writing down raw materials because their replacement cost has fallen, without checking whether the finished products incorporating them will still sell at or above cost.

Using LIFO, or assuming it is permitted because US GAAP allows it.

Failing to deduct costs to complete when computing NRV for work in progress.

Reversing a write-down to a carrying amount above the original cost.

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FAQ

Why is LIFO prohibited under IFRS when US GAAP permits it?

Because it produces a balance sheet carrying amount based on the oldest costs in the inventory pool, which may be many years out of date, and because it does not reflect the actual physical flow of most inventories. Its principal historical appeal was its tax effect in inflationary conditions, which is not a financial reporting objective.

Does FIFO have to match the physical flow of goods?

No. FIFO is a cost formula, an assumption about which costs attach to which units, not a physical inventory management policy. An entity may operate a physical last-in-first-out warehouse and still apply FIFO for measurement, and vice versa.

Should raw materials be written down when their market price falls?

Not automatically. Materials are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. A write-down is required only where the decline indicates that the cost of the finished products will exceed their NRV.

Is net realisable value the same as fair value less costs to sell?

No. NRV is entity-specific, reflecting what this entity expects to realise in its ordinary course of business. Fair value is market-based, reflecting what market participants would transact at. The two can differ, and IAS 2's general measurement model requires NRV.

Can an entity use different cost formulas in different subsidiaries?

Only where the inventories are genuinely of different nature or use. Inventories of similar nature and use must be measured using the same formula throughout the entity, which means alignment is required where a group has inherited different practices through acquisition.

Must an NRV write-down be reversed if prices recover?

Yes, where the circumstances that caused the write-down have changed and NRV has recovered. The reversal is limited to the amount originally written down, so inventory is never carried above cost, and the circumstances leading to the reversal must be disclosed.

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Enroll with Global Fin X

IAS 2 questions reward candidates who can run both cost formulas accurately, apply the normal capacity rule correctly, and perform the NRV test at the item level without aggregating. Each is a discrete mark and each is separately lost. Our programme covers IAS 2 with detailed lectures, side-by-side FIFO and weighted average worked examples, NRV testing scenarios, exam-style MCQs, and a dedicated LMS for working professionals.

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This is Post 69 of the Global Fin X IFRS Series. Previous: IAS 12 Deferred Tax: The Most Commonly Misstated Item in Financial Statements. Next: Post 70: IAS 41 Agriculture: Biological Assets, Fair Value and Indian Agri-Business Context.