IAS 2 — Inventories
Inventory: cost and net realisable value
What enters inventory cost, and when the carrying amount must come down.
8 min read
The idea
Inventory is measured at the lower of cost and net realisable value. The rule is short, but applying it stumbles in two places: what counts as cost, and when net realisable value falls below it.
Cost is not the supplier price alone. It includes everything spent to bring the goods to their present location and condition: purchase price, import duties, non-recoverable taxes, inbound freight, and handling. This is the landed cost, and it is among the most asked interview points because it separates those who memorise the rule from those who apply it.
The treatment
What enters cost and what stays out
In: purchase price, customs duties, non-recoverable taxes, inbound freight, cargo insurance, and conversion costs for a manufacturer. Out: recoverable taxes because they are not a final burden, abnormal waste, storage after the goods are ready, general administrative overhead, and selling costs. The exclusions matter: capitalising selling costs into inventory defers a loss and inflates an asset.
Cost formulas
For items that are not interchangeable, specific identification applies. Otherwise use first-in-first-out or weighted average, applying the same formula to all inventories of similar nature and use. Weighted average smooths price swings; first-in-first-out leaves closing stock closer to recent prices. The choice changes gross profit, not cash.
Net realisable value
It is the estimated selling price in the ordinary course of business, less the costs of completion and the costs necessary to make the sale. It is normally assessed item by item rather than for inventory as a whole, so that a surplus on one item does not mask a shortfall on another. The indicators are familiar: slow movement, damage, technical obsolescence, and falling market prices.
Reversal when the cause disappears
If the circumstances that caused the write-down cease, or net realisable value recovers, the write-down is reversed but only up to the amount previously written down, so the carrying amount never exceeds original cost. Many get this wrong: reversal is permitted here, unlike an impairment of goodwill.
Worked example
The entity imported raw materials on a supplier invoice of SAR 150,000, and paid SAR 12,000 inbound freight and SAR 18,000 customs duty. At period end, a line recorded at SAR 40,000 cannot sell for more than SAR 31,000, and the necessary selling costs are SAR 3,000.
- Landed cost = 150,000 + 12,000 + 18,000 = SAR 180,000, all of it entering inventory because it was necessary to bring the materials to their present location and condition.
- Net realisable value of the slow line = 31,000 − 3,000 = SAR 28,000, which is below the recorded cost of SAR 40,000.
- The SAR 12,000 difference is recognised as a write-down in the same period, presented in profit or loss and not as an equity adjustment.
Synthetic teaching amounts; the example does not address any tax treatment.
Record the materials at landed cost
On receipt and acceptance, with freight and duty paid in cash and the supplier balance outstanding.
| Account | Debit (SAR) | Credit (SAR) |
|---|---|---|
| Inventory — raw materials | 180,000.00 | — |
| Accounts payable — suppliers | — | 150,000.00 |
| Bank | — | 30,000.00 |
| Total | 180,000.00 | 180,000.00 |
Write down to net realisable value
When the expected selling price less selling costs falls below the recorded cost.
| Account | Debit (SAR) | Credit (SAR) |
|---|---|---|
| Inventory write-down expense | 12,000.00 | — |
| Inventory — trading goods | — | 12,000.00 |
| Total | 12,000.00 | 12,000.00 |
Common errors
- Excluding inbound freight and duties from cost and charging them to period expenses.
- Assessing net realisable value for inventory as a single pool, so a surplus on one item masks a shortfall on another.
- Forgetting to deduct the necessary selling costs when computing net realisable value.
- Capitalising storage costs after the goods are ready, or abnormal waste.
Interview question
What enters inventory cost, and does tax paid at import enter it?
The purchase price, duties, inbound freight, and everything needed to bring the goods to their present location and condition; for a manufacturer, conversion costs are added. Tax needs the distinction: non-recoverable tax enters cost because it is a final burden, while recoverable tax does not, because the entity recovers it and so bears no cost.