Chapter 4: Inventory Valuation and Cost of Sales

4.1 IAS 2 – Inventories: Cost Formulas

Under IAS 2 Inventories, inventories should be measured at the lower of cost and net realisable value (NRV). The cost of inventories includes all costs of purchase, conversion and other costs incurred to bring the inventories to their present location and condition.

• FIFO (First-In, First-Out): assumes that the earliest goods purchased are the first to be sold, so ending inventory consists of the most recent purchases.
• Weighted Average Cost: calculates an average cost per unit after each purchase or period, then applies that cost to units sold and units in ending inventory.

4.2 Calculating COGS

The basic formula for cost of sales is:

Cost of sales = Opening inventory + Purchases – Closing inventory

Key points:

• Opening inventory: cost of unsold inventory at the beginning of the period.
• Purchases: cost of additional inventory acquired during the period (inclusive of import duties, non-refundable taxes, transport).
• Closing inventory: cost of unsold inventory at the end of the period, measured under the chosen cost formula and lower of cost or NRV test.

4.3 Obsolescence and NRV Write-downs

If the net realisable value (NRV) of inventory (selling price less costs to complete and sell) is below cost, an entity must write down inventory to NRV:

Dr Cost of sales (or loss on inventory write-down)    XX,XXX
  Cr Inventory                                           XX,XXX

When NRV subsequently increases, the write-down may be reversed, but only to the extent of the original write-down.

4.4 Worked Examples & Journal Entries

Example 1: FIFO COGS Calculation

At 1 Jan, 100 units @ \$10 = \$1,000
Purchased 200 units @ \$12 = \$2,400
Sold 250 units during period
Ending inventory = 100 + 200 – 250 = 50 units

1. Units sold (250) consist of 100 @ \$10 and 150 @ \$12 → COGS = (100×10) + (150×12) = \$1,000 + \$1,800 = \$2,800
2. Ending inventory = 50 units @ \$12 = \$600

Dr Cost of sales    2,800
  Cr Inventory         2,800

Example 2: Weighted Average Cost & NRV Write-down

At 1 Jan, 100 units @ \$8 = \$800
Purchased 100 units @ \$12 = \$1,200
Total cost = \$2,000; total units = 200 → WAC = \$2,000 ÷ 200 = \$10/unit
Sold 120 units → COGS = 120 × \$10 = \$1,200
Ending inventory = 80 units × \$10 = \$800
At period end, NRV = \$9/unit → write-down = (\$10 – \$9) × 80 = \$80

Dr Cost of sales (COGS)      1,200
  Cr Inventory                    1,200

Dr Loss on inventory write-down   80
  Cr Inventory                      80

4.5 Practice Problems

1. Using FIFO, calculate COGS and ending inventory for the following:
   Opening 150 units @ \$5; Purchase 100 units @ \$6; Purchase 100 units @ \$7; Sales 200 units.
2. At year end, 50 units remain at cost \$7/unit, but NRV is \$6. Determine the write-down and journal entry.
3. Using weighted average cost, compute COGS and ending inventory for 300 units purchased as follows:
   100 @ \$15; 200 @ \$18; Sales 180 units.

4.5 Strategic Approach: Inventory Valuation and Cost of Sales

Follow these steps to measure inventory correctly and calculate cost of sales under IAS 2:

1. Classify Inventory
   Identify all items held for sale, in process or for consumption in production.
2. Choose Cost Formula
   Select one of:
   • FIFO (First-In, First-Out)
   • Weighted Average Cost
3. Calculate Cost of Sales
   Use the basic formula: Cost of sales = Opening inventory + Purchases − Closing inventory
4. Determine Net Realisable Value (NRV)
   Compute: NRV = Estimated selling price − Costs to complete and sell
5. Measure Inventory at Lower of Cost or NRV
   For each item: Carrying amount = lower of (Cost, NRV)
6. Recognise Write-downs
   If NRV < Cost, record: Dr Cost of sales (or loss on write-down) XXX Cr Inventory XXX
7. Reverse Write-downs (if permitted)
   If NRV subsequently rises (but not above original cost): Dr Inventory XXX Cr Reversal of write-down income XXX
8. Include in Consolidation
   Eliminate any unrealised profit on intragroup inventory per Chapter 6.
9. Prepare Disclosures
   In the notes:
   • Inventory categories and cost formulas used.
   • Amount of write-downs and reversals recognised.
   • Carrying amount of inventories by classification.
10. Review & Reconcile
    Ensure:
    • Cost of sales ties to profit & loss.
    • Closing inventory ties to statement of financial position.