Transcription
Good day, welcome to another session of Fog Accountancy Tutorials. We are still on our study of IFRS, and today we are going to study IS2, or we are going to learn about inventories, which is being regulated by International Accounting Standard number two, Inventories.
Now, this is a very important standard that we need to understand for the sake of preparing our statement of comprehensive income and all other financial statements. We need this because the business is all about inventories, and so let us really pay attention to this.
Now, in dealing with inventories, I'm going to talk about the scope or objective. So I'm going to talk about inventories in this way: First of all, let us look at the scope of IS2, which is inventories, and then let us try to look at the definition of inventories according to the standard, and then we'll look at the fundamental principle of IS2. Very, very important, IS2 has a fundamental principle that we are going to talk about. And then from there, we look at what is meant by cost of inventory and every other thing under cost. And then we look at the net realizable value, which is NRV.
Now, you should understand that the fundamental principle of IS2 actually harps on cost and NRV, and so we're going to look at these two as part of the fundamental principle. And when we have understood that, we look at situations where we need to recognize inventory as an expense, and then finally, we look at the disclosure requirements.
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All right, so these seven will take us through everything we need to understand about inventories, and then from there, we'll begin to look at practical questions. So I really need you to pay attention because, you know, when it comes to International Accounting Standards or International Financial Reporting Standards, you cannot solve any question if you do not understand the theoretical concepts that underpin the scenarios that you are given in the question. And that is what I want you to do. So I want you to just follow as I help you to understand.
Let us begin with the scope. What is the scope of IS2, Inventories? Now, the scope is simple. It's all about what the standard is about. Now, the scope is basically the objective. And then, if I have to make you understand, the objective of IS2 is to prescribe the accounting treatment for inventories. So the focus is on inventories. But then, before we really understand what the scope is all about, you need to define what inventories are, because here we are saying that the objective of IS2 is to prescribe the accounting treatment for inventories. But what is an inventory, or what is meant by inventories? That brings us to our definition.
So I'm going to clean this, and I'm going to take you through the understanding of these step-by-step points that I have listed. So, as I was explaining, we were on the scope, okay, the scope of IS2, and I'm saying that it prescribes accounting treatment for inventories. In other words, every other thing about inventory, when it should be recognized as an expense, where, how it should be recognized, and then when it should be recognized, all those ones are spoken about in this standard. And so that is basically the scope.
Now, before we really understand the scope, because we are saying that it's about inventories, but what is inventories? That is where I want us to focus on the definition of inventory. What is an inventory, or what are inventories?
Now, according to IS2, the definition of inventory is such that it should encompass all the known types of inventory. In fact, we are going to look at categories or types of inventories, but the definition itself encompasses everything. And before you are able to define inventory in an exam to get your maximum mark, this is how it should be. So I would say that inventories are assets. Remember that inventories are non-current assets. Okay, inventories are assets. So watch this, that inventories are assets. So once you say inventories are assets, that do this, that on, and that.
Now, what kind of assets are inventory? Then you can put a colon here or a semicolon. Then you come: A. So we are going to list some assets that fall under inventory. Remember that I'm not giving you types of inventory here. What I'm doing is defining an inventory, and in an exam, exactly this way is how you should present it.
Now, inventories are assets that are used or consumed, used or consumed in the process of producing your product or rendering your services. So that is the first category. Inventories are assets that are used or consumed in production or service rendering. So that is the first category.
Now, in looking at what I have just said, this is a definition for raw materials and consumables. Now, watch this. And then, inventories are assets that are in the process of being converted to finished goods. Now, inventories are assets that are used or consumed in the production of goods or rendering of services. Then also, there are assets that are in the process of being converted. So here we are talking about work in progress. And then finally, you say that inventories are assets that are held for sale in the ordinary course of business.
Now, you can say it is not listed in any particular order. You can decide to bring any of them first, but your explanation should reflect raw materials, work in progress, and finished goods. So inventories are assets that are used or consumed in the production of goods and services. Now, that becomes raw materials or consumables. Then they are in the process of being converted into finished goods. That is work in progress. Whether they are half completed, currently completed, or 75% completed, or whatever, once they are in the process of being converted to finished goods for sale, then they fall under the category of work in progress. Then when we are saying that inventories are assets that are held for sale, held for sale in the ordinary course of business, then they are finished goods. Whether they were bought or they were produced or manufactured by the business, the most important thing is that they are finished goods that are being sold.
So, whichever way that you list them, you need to understand that you cannot define inventory without listing these three. So imagine you have gone to an exam hall and you've been asked, "What is inventory?" and then you say that inventories are goods that are held for sale in the ordinary course of business. You are getting, if it's three marks, you are getting one out of three because the examiner expects you to mention each of these three in your definition of inventories. I hope you understand. The examiner expects that you mention each of these three. And so, anytime you are asked to define inventory, this is how you should define it. That make sure that these three components, they are key, and they are all types of inventories, and they must be there. In fact, the first one is even two in one because raw materials and consumables are all represented here.
So, inventories are assets that are used or consumed in the course of production of goods and services, in the process, or, comma, if you don't want to list ABC, you can use comma to separate them, comma, in the process of being converted to finished goods, and or held for sale in the ordinary course of business. So these is, or these are, the categories that must be present in your definition. You don't just define inventory by mentioning one of them and expect to get your complete mark because this is how the standard, IS2, wants inventory defined. So mention these three, and then you are good to go. You can't just define inventory anyhow, you're not going to get a mark. So that is the definition of inventory.
So you see that the definition itself is a big deal. It's not just a normal definition that you write a short line and you go. But I am sure that from the explanation that I have given, you see, they could have just said inventories are raw materials and consumables, work in progress, and then finished goods. But that wouldn't have been a definition. That would be listing the categories of inventory, which is the next thing we are going to do. So remember, when you go and you are asked to list the categories of inventories, we know how to list them. But when you are told to define, don't just mention defined. But when you are learning, you can learn it in that manner that you know you are going to talk about raw materials and consumables, you're going to talk about work in progress goods, and then you're going to talk about finished goods. And you are not going to mention them as we have mentioned, but rather going to explain what they are, because point A is explaining raw materials and consumables, point B is explaining what work in progress is, and point C is explaining the concept of finished goods. Combined, we get the definition for inventory according to IS2.
Okay, now the next thing we need to look at is categories of inventories. So imagine you are asked in an exam, "What are the categories of inventories?" Categories means types of inventories. Now, the definition has already highlighted on them, but here we are going to split the first two.
So, when you are talking about categories of inventories, you can talk about raw materials, okay, as the first category of inventories. You can also talk about consumable stores. So you see that the definition actually combined raw materials and consumables. However, in the categories, you are permitted to split them. So raw materials will give you a mark, and then consumable stores is another point. Meanwhile, the definition said "used or consumed." There are some consumable stores that are not the main raw materials, but they come in to help in the production, and so we try to separate consumables from raw materials. And then you can talk about work in progress. Work in progress. Now, when we say work in progress, that is what I said, that they are in the process of being converted. They are not yet done. So they are the production process on them has begun. We have started working on those raw materials, and they have left the state of raw materials, but they are not yet finished goods that are ready for the market. And therefore, they are in between the raw material stage and the finished good stage. We call them work in progress. Or you can say, you can still write them in a sentence form or in a phrase to define what is meant by raw materials if you want, and it will be given to you. So instead of writing work in progress, you can say "products or services that are in the intermediate stage of production," which will also be given to you. So, products or services that are in the intermediate stage of production. So this perfectly defines what work in progress is.
So, categories of inventories: We have raw materials, we have consumable stores, we have work in progress stock, which is products or services that are in intermediate stages of production, and then we have finished goods. Finished goods are already for the market. We are going to sell them. Now, remember that finished goods could be inbuilt by the factory, or in, let me say, in-house produced, or it could be those that are bought from external people for sale, because there are some businesses that buy and sell, okay, and there are some that produce and sell. So here, the standard can permit you to differentiate the kind of finished goods you are talking about. So, finished goods from production being one category, and then you can also say finished goods bought for resale. So that the finished goods category has also been split into two.
Okay, so here we've been able to expand to get five categories of inventories: raw materials being one, consumable stores, work in progress stock, we have finished goods from production, and then we have finished goods bought for resale. Now, these are the categories of inventory, and I expect you to write all these in the exam when you are asked, so that regardless of what the examiner is expecting from you, you still be able to consume and get all your marks. Do not omit anything from this. It's my advice to you, and it's very easy to understand and then learn it offhand. Okay, so these are categories.
So, having understood the categories of inventories, the next thing we are going to look at is the fundamental principle of IS2. That is what we are going to look at, and then we will zoom to the cost and net realizable value that falls under the fundamental principles. So let us look at the fundamental principle.
The fundamental principle of IS2. And if you look at what I've just written, I'm saying "the fundamental." I didn't say "a fundamental principle." So, the fundamental principle, it's a definite article. It means that it's only one principle that is needed as far as inventory, accounting for inventory, is concerned. Now, this is the fundamental principle. The fundamental principle of IS2 is that we say inventory should be valued at the lower of cost and net realizable value. I repeat, inventories should be valued. So the fundamental principle is about valuation of inventory, and we are saying that in your financial statement, inventory should be valued at the lower of cost and net realizable value. I'm going to put it down, underline the keywords, and then I will explain to you.
So, inventories should be valued at the lower of cost and net realizable value. This is a fundamental principle. Inventory should be valued at the lower of cost and net realizable value. Now, I hear a lot of people say, "Inventory should be valued at the lower of cost or net." No, the word here should be "and," not "or," net realizable value. It is the lower of cost. So the keywords here are cost, and then the net realizable value, and then about it's all about valuation. But the key things that I want you to pay attention to now is cost and net realizable value. Inventory should be valued at the lower of cost and net realizable value.
What is the meaning of cost? That is the next subtopic I'm coming to from the list I made, and then I'm also going to talk about the NRV. But then, let's look at this. Let me just give a general explanation, and then we'll delve into the component of cost and then what is meant by net realizable value.
Now, assuming that I bought this duster for 200 cities. So that will be the cost. Okay, that is the only money I incurred, 200 cities or $200. Now, even though I bought it for $200 or 200 cities, if I am able to sell it, okay, when I want to sell this thing, and I'm not able to sell it for 200, or the general market condition is such that I cannot sell this for 200, if I want to sell, the maximum I can raise from this, or how much I can get, is $180. Now, look at this. This is my realizable value. Of course, there is a "net" attached to the realizable value, which I'm going to explain, okay? But let's assume this is my net realizable value. Net realizable value is how much I'm going to get from selling this inventory. And then this is how much it's worth, how much I bought it. If I'm preparing my financial statement and I want to put, or I want to incorporate the value of this inventory into the financial statement, how much should I recognize the inventory? Should I recognize the inventory as a value of having a value of 200, or having a value of 180? Even though I bought it for 200, I will be able to sell it for 180. Now, according to IS2, IS2 says inventory should be valued at the lower. So the key word here is lower, at the lower of cost and net realizable value. So if I look at my cost, the cost is 200 cities. The net realizable value is 180 cities. Which one is the lower among them? Of course, the 180 is the lower, and therefore, I have to put in my financial statement that the value of inventory is 180, not 200. That is the meaning of the fundamental principle.
Assuming that the net realizable value was supposed to be 240, even though I bought it for 200, I can sell it for 240. How much should I put into the financial statement as the value of inventory? According to the fundamental principle, it should be the lower. So comparing these two now, the lower is 200. Therefore, the value of this inventory should be 200 in my financial statements. That is the meaning. So it is not about cost should always be going, or the net realizable value should be going, but we are saying that the fundamental principle is that it should be valued at the lower. So which of the two is low? That is what we are going to use to value our closing inventory. And this is very, very understandable, and I really need you to understand this.
Now, I'm going to create another scenario that I'm sure would help you understand, so that when I start explaining the concept of cost, we just walk over it and then we'll go. I hope we understand this. I'm going to give you another complex one, but I want to finish explaining the concept, and then we will take questions. But what I want you to understand after what I have just illustrated is that with a net realizable value, it's not always giving straight away. They will tell you how much you will gain from selling it. So let's assume that the cost remains $200, but when you sell, you are getting $240. Then they will tell you that in selling, before you sell, sometimes you incur certain costs to sell. We call it cost to sell, like I taught you in IS16, fair value less cost to sell, as less realizable value. The same idea here. So even though when I sell the inventory, I'm going to get 240, but I need to incur some cost. Now, the cost that I'm going to incur could be advertising expenses and all those. So let's assume that the cost to sell is 450, oh sorry, the cost to sell is $45.
Now, what should be the value of inventory in the financial statement? The cost of the inventory is $200. Then the proceeds from sale is 240. The cost to sell is 45. So it means that you need to differentiate. Your cost remains 200, nothing has changed. But the net realizable value. Now, the sell, the proceeds from selling is the realizable value. When you deduct the cost to sell from the proceeds, then you are netting it off, then it becomes net realizable value. So the net realizable value is 240 minus 45, and that is going to give us $195. So now, looking at this, straight away you may think that this is the lower. But after netting off the cost of selling from the realizable value, you have a net realizable value of 195. And IS2's principle says that it should be valued at the lower of cost and net realizable value. And here, the lower is 195. Therefore, the value of inventory to be included in your financial statement is 195.
Now, it can get more complex. It can be more complex, and I'm just making it simple like this. So we are taking it step by step. I want to explain the other concepts that are left, and then we will look at questions where they are, especially when you are solving published accounts and you have additional information, especially on the closing inventory. Inventory can be very complex. So I'm going to take my time to explain the other concepts, and then we will start taking questions. And I really want you to follow as I will help you to solve and understand a lot of questions that are pegged on this fundamental principle, which confuses a lot of students. But I'm sure that my channel difficulty will always be made easy, as I've told you. All right, so let's move on to other concepts.
Now, the other concepts we are moving on is about cost and net realizable value. So let's go to the concept of cost. So let us look at the cost of inventory. Now, what is cost? What do we mean by cost of inventory? We are going to look at the definition, and then we'll look at the components of cost of inventory, and then we also look at the exclusions. What should not be included in the cost of inventory?
Now, cost of inventory. Cost of inventory is defined as all the amount incurred in bringing the assets into its present condition, or bringing the inventory to its present useful condition. So the amount incurred, the amount incurred in bringing the asset to its present condition, the inventory to its present condition, that is what cost is all about. So the definition of cost, cost of inventory is not a problem. It is the amount incurred in bringing the assets to its present condition. But let us look at the more important aspect, the components of costs of inventory. What makes up the cost of inventory? There are three basic components. There are three.
The first one is the purchase cost, or the, yes, the purchase price. The purchase cost or price. How much it was bought for. So, and this one, you less any trade discounts. You less any trade discount. And this purchase cost must include all direct taxes that are attributable to this. Okay, so the purchase cost or price, less any trade discount, but includes direct taxes. All right. So that is the first component of cost of inventory. So you can be given a question, and you'll be asked to calculate the cost of inventory. What you should include: the purchase cost of the inventory itself is included in the valuation or the cost of inventory. It includes all direct taxes that are attributable to the purchase. However, you take out any trade discount. If there is any trade discount, it should be net of all the trade pay discount, just as we did for property, plant, and equipment.
And the second component, I told you there are three key ones. The second component, which is also very important, is conversion cost. The conversion cost of inventory. Most of the time, when you buy these inventories, they will be in their raw state. You need to convert them to finished goods. So all the cost that you incurred in converting the inventory into its finished state is called conversion cost. Now, conversion cost is basically your direct labor cost, direct expenses, and factory overheads. These three make up the conversion cost. Conversion cost is the aggregate of your direct labor cost, direct expenses, and factory overheads. So I am taking my time to explain what goes into them so that when the question begins to take a twist, you understand that I said that conversion cost is a second component of cost. However, it includes direct labor cost, direct expenses, and factory overheads. So that if the question doesn't give you conversion cost as mentioned, but they will mention direct labor cost, you include it in the computation of your cost of inventory. If they mention direct expenses, you include it. If they mention any factory overheads, you include. But you will not include any non-factory overheads, and I'm going to mention those ones in the exclusions to the component of cost.
And the final component of cost is any, you say, any other cost directly attributable to bringing the assets, bringing the inventory to its useful state. So the third point is no specific, um, point. However, it's, it's like a law. It leaves room. It leaves room for any other cost that we can justify that it's directly attributable to bringing the inventory to its useful state. So these are the three key components of inventory cost. So when you are asked in any exam, "What are the components of inventory cost?" It is the purchase cost, the conversion cost, and any other cost that is directly attributable to bringing the inventory to its useful state and condition. So these are the three key components of inventory cost. However, note that the purchase cost must include direct taxes and exclude trade discounts. Conversion cost is made up of direct labor cost, direct expenses, and factory overheads. And then this is another point that you should take note of: any other cost that is incurred in bringing the inventory to its useful state. These are the components of cost of inventory. All right.
So now that I have given you what goes into the cost, let me tell you what should not be included in the cost. So we are going to look at exclusions from the components of cost of inventory. Exclusions. Those ones when you see them, you skip them. They should not be part of the cost of inventory, and that is what I'm going to list for you now. Okay, so we are going to look at exclusions from the components of costs of inventory. Exclusions.
Now, these things are not supposed to be part of the cost of inventory. The first one, abnormal waste or abnormal loss should not be included. Now, it means that normal losses are considered, but abnormal losses should not. In every production, there is an estimate of a normal waste that will come from the inventories, but the abnormal ones are due to inefficiency, and according to IS2, should not be included in the cost of inventory. But the normal waste can be included as any other cost that is attributable. Okay, so abnormal waste is the first one.
Then the next thing is storage cost. Why should storage cost be included? In fact, after producing the good or the service, or after finishing the inventory, you need to store it in a warehouse, but the cost of storing should not be part of the cost of the inventory. Storage cost should be different from the inventory cost. So anytime you see storage cost, you exclude it from computing for the cost of inventory. Very important.
And then obviously, administrative overheads. Now, administrative overheads are not production or factory overheads. Remember, remember that I said that the conversion cost includes factory overheads or production overheads. Administrative cost is not, um, factory overheads, therefore should not be there. Very important. Administrative overheads are not part. And if administrative overheads are not part, then selling overheads or selling cost should also not be there. These are all non-factory overheads, so they should be excluded from the components of the cost of inventory.
Then also, when you buy inventory from overseas, okay, you use a foreign currency. Sometimes the exchange rate differences can cause the company to incur some losses on the exchange rate. So all those foreign exchange rates differences that are related to the purchase of inventory should not be included in the cost of inventory. So I will say foreign exchange differences or losses arising from a foreign purchase of inventory with a foreign currency. So foreign exchange differences arising from a foreign purchase of inventory should not be. So any loss you incur on your foreign exchange should not be included as part of the cost of inventory. It's very tempting to do so.
And then the final thing is interest. Interest cost. Interest cost when inventories are purchased on a deferred settlement term. Interest cost that arise from buying inventories on a deferred settlement term. When we say deferred settlement term, it means that you bought the inventory today to pay later, and the supplier charged you interest on the payment. All those interest should be finance cost. They shouldn't be part of the cost of inventory. So these six items are exclusions from the cost of inventory. So make sure you are not including any of them in estimating the cost of inventory. These are exclusions. Thank you.
The next thing for me to talk about is the net realizable value, which I have already explained when I was explaining the fundamental principle. So I don't think there is much to talk about on that one. We'll come back to it when we are solving questions. Then let me talk about the recognition of an expense, inventory as expenses, and then the we look at the disclosure requirements.
Now, with the disclosure requirements, we can even look at that in the next video after we have solved a question. But let us, um, quickly look at recognition of inventory as an expense. Now, I just want you to follow as I put it on your screen right now, and you look at what I have there, and then I'll read for you and I will explain. According to the standard, the current amount of inventory sold should be recognized as an expense in the period in which the related, in which the related revenue is recognized.
Now, this is the meaning: if I buy any inventory, I'll recognize the inventory as an expense only in the period that I generated revenue from the inventory. Other than that, it will continue to be an asset. For example, if I buy goods for resale, I'll recognize it as inventory in my statement of financial position until I have sold it. The moment I sold it, it becomes revenue, sales revenue. And once it becomes revenue, then that particular inventory that I have sold comes as a cost of sales, of course, that is an expense. But mostly, it's up there because it's a direct expense. So we only expense inventory when the related revenue has been generated, and we only expense the portion of inventory that we have generated revenue from. So that is something you should be very mindful of.
Then the amount of write down of inventories to net realizable value and other losses of inventory should be recognized as expense in the period the write down or losses occur. Now, let me read the third point and let me explain both together. The amount of reinstatement of cost of inventories arising from an increase in net realizable value should be recognized as a reduction of expense in the period the reinstatement occurs.
Now, what we are trying to say is that we know that the fundamental principle of IS2 says that inventory should be valued at the lower of cost and net realizable value. So if I have the cost of inventory to be 1,000 and my net realizable value to be 1,200, now what it means is that I'm going to recognize the value of inventory as 1,000 because that is the lower of the two. Now, in any period where the market conditions change such that the net realizable value reduces to 900, when the net realizable value reduces to 900 in a particular period, it means that I have to no more recognize inventory as 1,000. I have to now recognize inventory as 900. There's going to be a 100 short for which is going to be expensed. Okay, this is going to be an expense in the statement of financial position in the year that that reduction occurred. Forget about the big English you just read. This is a simple explanation.
Now, it also means that in another period, that the net realizable value goes up to, let's say, 1,100 or 1,200, then I need to now shift and recognize the value of inventory to 1,000 again. When that happens, instead of the normal 900 I used to recognize, there has been an increase of 100 again, which will come as other income. So I also recognize it in the same period that it changes. That is what we are trying to see. Okay, so we need to understand the practicability of it more than the theoretical aspect. But if you don't understand the theory, you cannot understand the practical.
And then finally, we are seeing that some inventories may be allocated to other asset accounts. For example, inventory used as a component of self-constructed property. Inventories allocated to other assets in this way are recognized as expense during the useful life of the asset. Okay, so this is very clear. Once you allocate an inventory to a self-constructed asset, then that inventory will be recognized as an expense throughout the useful life of the asset, and that is what we want you to understand.
Now, the, the, the most important thing that is left to talk about is a disclosure requirement. And so we want to look at what the accounting or financial statements must disclose relating to inventory. These are the disclosure requirements:
1. The financial statement, according to IS2, must disclose the accounting policy adopted, including the cost formula used. So the financial statements should disclose the accounting policy adopted.
2. And then the total carrying amount, classified appropriately.
3. And then you should also disclose the amount of inventories carried at net realizable value. So you should show which of them is carried at cost and which of them is carried at net realizable value.
4. And then the amount of inventories pledged as securities for liabilities should also be disclosed.
5. And then finally, the amount recognized as an expense of income during the period in respect of inventories written down to the net realizable value, net of reinstatement of, of course, the circumstances or events that led to the reversals or write down. So you disclose.
Like I was explaining, these are the disclosure requirements for IS2. Now, those two that I just put on your screens are theories for you to learn. I have really explained the fundamental principle that you need to understand. Now, I am bringing this video to an end. In the part two of this video, that is where I'm going to actually solve practical questions that relate to IS2. Remember to subscribe to this channel if it's your first time, share this video, and let others also have the benefit. And until we meet again for part two, it's bye for now. Thank you.