The nature of inventory held by an entity does not affect its initial recognition at cost but has a significant impact when that inventory is sold. Under the perpetual system the cost of inventory items is transferred to a ‘Cost of Goods Sold’ expense account on sale, and under the periodic system a ‘Cost of Goods Sold’ figure is calculated at the end of the reporting period. This is an easy task if the nature of inventory is such that it is possible to clearly identify the exact inventory item that has been sold and its cost.
But what if it is not possible to identify exactly the cost of the item sold? How can you measure the cost of a tonne of wheat when it is extracted from a stockpile consisting of millions of tonnes acquired at different prices over the accounting period?
IAS 2 addresses this problem by mandating two different rules for assigning cost to inventory on sales. The rules differ depending on the nature of inventory held. Para 23 of IAS 2 states that the cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs.
Thus, if the inventory held consists of items that can be individually identified because of their unique nature or by some other means, or cannot be individually identified but have been acquired for a specific project, then the exact cost of the item sold must be recorded as cost of sales expense.
Para 25 states that:
The cost of inventories, other than those dealt with in para 23, shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula.
This means that, where a specific cost cannot be identified because of the nature of the item sold, then some method has to be adopted to estimate that cost. This process is known as ‘assigning’ cost. There are many methods of assigning a cost to inventory on sales but IAS 2 restricts entities to a choice between two methods — FIFO and weighted average.