For retailing and manufacturing entities inventory is the most active asset and covers a significant share of current assets. The cost of sales during the period is generally the largest expense of such entities.
The main accounting standard for the proper inventory accounting is IAS 2 Inventories. According to para 2 of IAS 2, the standard applies in accounting for all inventories except work in progress arising under construction contracts (covered by IAS 11 Construction Contracts) and financial instruments and biological assets related to agricultural activity and agricultural produce at the point of harvest (covered by IAS 41 Agriculture).
Paragraph 6 of IAS 2 defines inventories as follows:
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.
Note the following points arising from this definition:
1. The assets are held for sale in the ordinary course of business. The accounting standards do not define ‘ordinary’, but IFRS 5 Non current Assets Held for Sale and Discontinued Operations requires that non-current assets held for sale are to be distinguished from inventories. This indicates that the term ‘inventories’ should be applied only to those assets that are always intended for sale or use in producing saleable goods or services.
2. Accounting for assets held for use by the entity is covered by other accounting standards according to their nature. IAS 16 Property, Plant and Equipment covers tangible assets such as production equipment; IAS 38 Intangible Assets covers intangible assets such as patents.
3. Supplies or materials such as stationery would not be treated as inventories unless they are held for sale or are used in producing goods for sale.
4. IAS 16, para 8, states that ‘spare parts and servicing equipment are usually carried as inventory’ unless those spare parts are expected to be used during more than one period, or can be used only in conjunction with an item of property, plant and equipment. This standard clearly envisages that spare parts as inventory are those items consumed regularly during the production process, such as bobbin winders on commercial sewing machines.
5. In the case of a service provider, inventories include the costs of the service for which the entity has not yet recognized the related revenue (IAS 2 para 8).
6. The assets are current assets because they satisfy the following criteria for classification as ‘current’ set out in para 66 of IAS 1 Presentation of Financial Statements:
• it is expected to be realized in, or is intended for sale or consumption in the entity’s normal operating cycle
• it is held primarily for the purpose of being traded
• it is expected to realize the asset within 12 months after the reporting period, or
• the asset is cash or a cash equivalent as defined in IAS 7 Statement of Cash Flows.
The operating cycle of an entity is the time between the acquisition of assets for processing and their realization in cash or cash equivalents. In some industries, such as retailing, the operating cycle may be very short, but for others, the operating cycle could cover a number of years. When the entity’s operating cycle is not clearly identifiable, its duration is assumed to be 12 months (IAS 1 para 69).