Inventories are assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.
Inventory must be recorded at the lower of cost or net realizable value.
Cost. Includes the purchase cost and any other costs necessary in bring the inventories to their present location and condition. These may include costs incurred directly in the production of inventory such as direct labor and production overheads (i.e. conversion costs) and other expenses such as transportation and handling charges, taxes and duties that may not be recoverable from tax authorities. However, costs do not include general and administrative costs which cannot reasonable attributed to the cost of inventory. Similarly, selling and distribution expenses, storage costs and excessive expenditure resulting from abnormal wastage shall not be included in the cost of inventory.
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(IAS 2). This is simply the expected revenue from the sale of inventory after deducting any further costs that are necessary in order to sell the inventory. For example if a company has raw material costing $50, which will be sold as finished products for $80 after additional $10 of labor costs are incurred for completion, its NRV will be $70 ($80 - $10).
The need to value the inventory at the lower of cost and NRV stems from the concept of prudence which requires that the assets of the entity, which in this case is inventory, must not be stated above the amount expected to be earned from its use or sale. For example, if an inventory costs $100 but its NRV is only $70, the inventory is recorded at the year end at $70. Recording inventory at a lower amount has the effect of reducing profit because a decrease in closing inventory increases the cost of sales (expense).
Why accounting for inventory separate from purchase and sales accounting?
Every time a sale or purchase occurs, they are recorded in their respective ledger accounts. However, as we shall see in following sections, inventory is accounted for separately from purchases and sales through a single adjustment at the year end.
Theoretically, the cost of inventory sold could be determined in two ways. One is the standard way in which purchases during the period are adjusted for movements in inventory. The second way could be to adjust purchases and sales of inventory in the inventory ledger itself. The problem with this method is the need to measure value of sales every time a sale takes place (e.g. using FIFO, LIFO or AVCO methods). If accounting for sales and purchase is kept separate from accounting for inventory, the measurement of inventory need only be calculated once at the period end. This is a more practical and efficient approach to the accounting for inventory which is why it is the most common approach adopted.