HKAS 2 - Inventories

Introduction

HKAS 2 *Inventories* replaces SSAP 22 *Inventories* (revised in 2001) and should be applied for annual periods beginning on or after 1 January 2005. Earlier application is encouraged.

Reasons for Issuing HKAS 2

The objectives of the Hong Kong Institute of Certified Public Accountants (HKICPA) in issuing HKAS 2 were to:

Reduce or eliminate alternatives, redundancies and conflicts within the Standards

Deal with some convergence issues

Make other improvements

The main objective was to reduce alternatives for the measurement of inventories. The HKICPA did not reconsider the fundamental approach to accounting for inventories contained in HKAS 2.

Main Features

Objective and Scope

The words 'held under the historical cost system' included in the scope paragraphs of SSAP 22 were removed, to clarify that the Standard applies to all inventories that are not specifically excluded from its scope.

Scope Clarification

The Standard clarifies that some types of inventories are outside its scope while certain other types of inventories are exempted only from the measurement requirements in the Standard.

Paragraph 3 establishes a clear distinction between:

Inventories that are entirely outside the scope of the Standard (described in paragraph 2)

Inventories that are outside the scope of the measurement requirements but within the scope of the other requirements in the Standard

Scope Exemptions

Producers of agricultural and forest products, agricultural produce after harvest and minerals and mineral products: The Standard does not apply to the measurement of these inventories to the extent that they are measured at net realisable value in accordance with well-established industry practices.

Inventories of commodity broker-traders: The Standard does not apply to the measurement of these inventories to the extent that they are measured at fair value less costs to sell.

Cost of Inventories

HKAS 2 does not permit exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency to be included in the costs of purchase of inventories.

Paragraph 18 clarifies that when inventories are purchased with deferred settlement terms, the difference between the purchase price for normal credit terms and the amount paid is recognised as interest expense over the period of financing.

Cost Formulas

The Standard does not permit the use of the last-in, first-out (LIFO) formula to measure the cost of inventories.

Recognition as an Expense

The Standard eliminates the reference to the matching principle.

The Standard describes the circumstances that would trigger a reversal of a write-down of inventories recognised in a prior period.

Disclosure

The Standard requires disclosure of the carrying amount of inventories carried at fair value less costs to sell.

The Standard requires disclosure of the amount of any write-down of inventories recognised as an expense in the period and eliminates the requirement to disclose the amount of inventories carried at net realisable value.

Objective (Paragraph 1)

The objective of this Standard is to prescribe the accounting treatment for inventories. A primary issue in accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised. This Standard provides guidance on:

The determination of cost and its subsequent recognition as an expense, including any write-down to net realisable value

The cost formulas that are used to assign costs to inventories

Scope (Paragraphs 2-5)

Paragraph 2 - Full Scope Exclusion

This Standard applies to all inventories, except:

(a) [deleted]

(b) Financial instruments (see HKAS 32 *Financial Instruments: Presentation* and HKFRS 9 *Financial Instruments*)

(c) Biological assets related to agricultural activity and agricultural produce at the point of harvest (see HKAS 41 *Agriculture*)

Paragraph 3 - Measurement Scope Exclusion

This Standard does not apply to the measurement of inventories held by:

(a) Producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well-established practices in those industries. When such inventories are measured at net realisable value, changes in that value are recognised in profit or loss in the period of the change.

(b) Commodity broker-traders who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognised in profit or loss in the period of the change.

Paragraph 4 - Clarification on Agricultural and Mineral Products

The inventories referred to in paragraph 3(a) are measured at net realisable value at certain stages of production. This occurs, for example, when:

Agricultural crops have been harvested or minerals have been extracted and sale is assured under a forward contract or a government guarantee, or

An active market exists and there is a negligible risk of failure to sell

These inventories are excluded from only the measurement requirements of this Standard.

Paragraph 5 - Clarification on Broker-Traders

Broker-traders are those who buy or sell commodities for others or on their own account. The inventories referred to in paragraph 3(b) are principally acquired with the purpose of:

Selling in the near future

Generating a profit from fluctuations in price or broker-traders' margin

When these inventories are measured at fair value less costs to sell, they are excluded from only the measurement requirements of this Standard.

Definitions (Paragraphs 6-8)

Paragraph 6 - Key Definitions

Inventories are assets:

(a) Held for sale in the ordinary course of business

(b) In the process of production for such sale

(c) In the form of materials or supplies to be consumed in the production process or in the rendering of services

Net realisable value (NRV) 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.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (see HKFRS 13 *Fair Value Measurement*).

Paragraph 7 - NRV vs Fair Value

Aspect	Net Realisable Value	Fair Value
Nature	Entity-specific value	Market-based (not entity-specific)
Basis	Expected to realise from sale in ordinary course	Price in orderly transaction in principal market
Relationship	May not equal fair value less costs to sell	N/A

Paragraph 8 - What Inventories Encompass

Inventories encompass:

Goods purchased and held for resale (e.g., merchandise purchased by a retailer, land and other property held for resale)

Finished goods produced, or work in progress being produced, by the entity

Materials and supplies awaiting use in the production process

Costs incurred to fulfil a contract with a customer that do not give rise to inventories (or assets within the scope of another Standard) are accounted for in accordance with HKFRS 15 *Revenue from Contracts with Customers*.

Measurement of Inventories (Paragraph 9)

Paragraph 9: Inventories shall be measured at the lower of cost and net realisable value.

This is the fundamental measurement principle for inventories under HKAS 2.

Cost of Inventories (Paragraphs 10-22)

Paragraph 10 - Components of Cost

The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Costs of Purchase (Paragraph 11)

Included in costs of purchase:

Purchase price

Import duties and other taxes (other than those subsequently recoverable from taxing authorities)

Transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services

Deducted from costs of purchase:

Trade discounts

Rebates

Other similar items

Costs of Conversion (Paragraphs 12-14)

Paragraph 12 - Components of Conversion Costs

Costs of conversion include:

Direct costs: Costs directly related to the units of production, such as direct labour

Production overheads: Systematic allocation of fixed and variable production overheads

Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as:

Depreciation and maintenance of factory buildings

Equipment and right-of-use assets used in the production process

Cost of factory management and administration

Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as:

Indirect materials

Indirect labour

Paragraph 13 - Allocation of Production Overheads

Fixed Production Overheads Allocation:

Based on normal capacity of the production facilities

Normal capacity = production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account loss of capacity resulting from planned maintenance

Actual level of production may be used if it approximates normal capacity

The amount of fixed overhead allocated to each unit of production is NOT increased as a consequence of low production or idle plant

Unallocated overheads are recognised as an expense in the period in which they are incurred

In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured above cost

Variable Production Overheads Allocation:

Allocated to each unit of production on the basis of the actual use of the production facilities

Paragraph 14 - Joint Products and By-Products

When a production process results in more than one product being produced simultaneously:

Joint products: When costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis

Allocation may be based on relative sales value of each product either:

At the stage in the production process when the products become separately identifiable, or

At the completion of production

By-products: Most by-products are immaterial. When this is the case, they are often measured at net realisable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost.

Other Costs (Paragraphs 15-19)

Paragraph 15 - Costs Included

Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example:

Non-production overheads

Costs of designing products for specific customers

Paragraph 16 - Costs Excluded

Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which they are incurred:

Cost Type	Reason for Exclusion
Abnormal amounts of wasted materials, labour or other production costs	Not normal/expected
Storage costs (unless necessary in the production process before a further production stage)	Not bringing to present location/condition
Administrative overheads that do not contribute to bringing inventories to their present location and condition	Not directly attributable
Selling costs	Not production-related

Paragraph 17 - Borrowing Costs

HKAS 23 *Borrowing Costs* identifies limited circumstances where borrowing costs are included in the cost of inventories.

Paragraph 18 - Deferred Settlement Terms

When inventories are purchased on deferred settlement terms and the arrangement effectively contains a financing element, that element (e.g., the difference between the purchase price for normal credit terms and the amount paid) is recognised as interest expense over the period of the financing.

Paragraph 19 - [Deleted]

Cost of Agricultural Produce Harvested from Biological Assets (Paragraph 20)

In accordance with HKAS 41 *Agriculture*, inventories comprising agricultural produce that an entity has harvested from its biological assets are measured on initial recognition at their fair value less costs to sell at the point of harvest. This is the cost of the inventories at that date for application of this Standard.

Techniques for the Measurement of Cost (Paragraphs 21-22)

Paragraph 21 - Standard Cost Method and Retail Method

Techniques for the measurement of the cost of inventories may be used for convenience if the results approximate cost:

Standard cost method: Takes into account normal levels of materials and supplies, labour, efficiency and capacity utilisation. Standard costs are regularly reviewed and, if necessary, revised in the light of current conditions.

Retail method: Often used in the retail industry for measuring inventories of large numbers of rapidly changing items with similar margins for which it is impracticable to use other costing methods.

Paragraph 22 - Retail Method Details

Under the retail method:

The cost of the inventory is determined by reducing the sales value of the inventory by the appropriate percentage gross margin

The percentage used takes into consideration inventory that has been marked down to below its original selling price

An average percentage for each retail department is often used

Cost Formulas (Paragraphs 23-27)

Paragraph 23 - Specific Identification

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.

Paragraph 24 - Specific Identification Clarification

Specific identification of cost means that specific costs are attributed to identified items of inventory. This is the appropriate treatment for items that are segregated for a specific project, regardless of whether they have been bought or produced.

However, specific identification of costs is inappropriate when there are large numbers of items of inventory that are ordinarily interchangeable. In such circumstances, the method of selecting those items that remain in inventories could be used to obtain predetermined effects on profit or loss.

Paragraph 25 - FIFO and Weighted Average

The cost of inventories, other than those dealt with in paragraph 23, shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula.

An entity shall use the same cost formula for all inventories having a similar nature and use to the entity. For inventories with a different nature or use, different cost formulas may be justified.

Paragraph 26 - Different Cost Formulas

For example, inventories used in one operating segment may have a use to the entity different from the same type of inventories used in another operating segment. However, a difference in geographical location of inventories (or in the respective tax rules), by itself, is not sufficient to justify the use of different cost formulas.

Paragraph 27 - FIFO and Weighted Average Explained

FIFO Formula:

Assumes that the items of inventory that were purchased or produced first are sold first

Consequently, the items remaining in inventory at the end of the period are those most recently purchased or produced

Weighted Average Cost Formula:

The cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period

The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity

Summary of Cost Formulas

Cost Formula	Applicability	Description
Specific Identification	Items not ordinarily interchangeable; goods/services segregated for specific projects	Specific costs attributed to identified items
FIFO	Other inventories	First purchased/produced items sold first; ending inventory = most recent costs
Weighted Average	Other inventories	Cost determined from weighted average of beginning and period purchases/production
LIFO	NOT PERMITTED	Prohibited by HKAS 2

Net Realisable Value (Paragraphs 28-33)

Paragraph 28 - When Cost May Not Be Recoverable

The cost of inventories may not be recoverable if:

Those inventories are damaged

They have become wholly or partially obsolete

Their selling prices have declined

The estimated costs of completion or the estimated costs to be incurred to make the sale have increased

The practice of writing inventories down below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use.

Paragraph 29 - Write-Down Basis

Inventories are usually written down to net realisable value item by item. In some circumstances, however, it may be appropriate to group similar or related items. This may be the case with items of inventory relating to the same product line that:

Have similar purposes or end uses

Are produced and marketed in the same geographical area

Cannot be practicably evaluated separately from other items in that product line

It is not appropriate to write inventories down on the basis of a classification of inventory (e.g., finished goods, or all the inventories in a particular operating segment).

Paragraph 30 - Estimates of NRV

Estimates of net realisable value are based on the most reliable evidence available at the time the estimates are made, of the amount the inventories are expected to realise. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the end of the period to the extent that such events confirm conditions existing at the end of the period.

Paragraph 31 - Purpose for Which Inventory is Held

Estimates of net realisable value also take into consideration the purpose for which the inventory is held:

Scenario	NRV Basis
Inventory held to satisfy firm sales or service contracts	Contract price
Sales contracts are for less than inventory quantities held	NRV of excess based on general selling prices
Firm sales contracts in excess of inventory quantities held	Provisions dealt with under HKAS 37
Firm purchase contracts	Provisions dealt with under HKAS 37

Paragraph 32 - Materials Held for Use in Production

Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost.

However, when a decline in the price of materials indicates that the cost of the finished products exceeds net realisable value, the materials are written down to net realisable value. In such circumstances, the replacement cost of the materials may be the best available measure of their net realisable value.

Paragraph 33 - Reversal of Write-Down

A new assessment is made of net realisable value in each subsequent period. When the circumstances that previously caused inventories to be written down below cost no longer exist or when there is clear evidence of an increase in net realisable value because of changed economic circumstances, the amount of the write-down is reversed (i.e., the reversal is limited to the amount of the original write-down) so that the new carrying amount is the lower of the cost and the revised net realisable value.

This occurs, for example, when an item of inventory that is carried at net realisable value, because its selling price had declined, is still on hand in a subsequent period and its selling price has increased.

Recognition as an Expense (Paragraphs 34-35)

Paragraph 34 - Recognition Rules

When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised.

The amount of any write-down of inventories to net realisable value and all losses of inventories shall be recognised as an expense in the period the write-down or loss occurs.

The amount of any reversal of any write-down of inventories, arising from an increase in net realisable value, shall be recognised as a reduction in the amount of inventories recognised as an expense in the period in which the reversal occurs.

Paragraph 35 - Allocation to Other Assets

Some inventories may be allocated to other asset accounts, for example, inventory used as a component of self-constructed property, plant or equipment. Inventories allocated to another asset in this way are recognised as an expense during the useful life of that asset.

Disclosure (Paragraphs 36-39)

Paragraph 36 - Required Disclosures

The financial statements shall disclose:

Reference	Disclosure Requirement
(a)	Accounting policies adopted in measuring inventories, including the cost formula used
(b)	Total carrying amount of inventories and the carrying amount in classifications appropriate to the entity
(c)	Carrying amount of inventories carried at fair value less costs to sell
(d)	Amount of inventories recognised as an expense during the period
(e)	Amount of any write-down of inventories recognised as an expense in the period
(f)	Amount of any reversal of any write-down recognised as a reduction in the amount of inventories recognised as expense in the period
(g)	Circumstances or events that led to the reversal of a write-down of inventories
(h)	Carrying amount of inventories pledged as security for liabilities

Paragraph 37 - Classifications of Inventories

Information about the carrying amounts held in different classifications of inventories and the extent of the changes in these assets is useful to financial statement users. Common classifications of inventories are:

Merchandise

Production supplies

Materials

Work in progress

Finished goods

Paragraph 38 - Cost of Sales

The amount of inventories recognised as an expense during the period, which is often referred to as cost of sales, consists of:

Those costs previously included in the measurement of inventory that has now been sold

Unallocated production overheads

Abnormal amounts of production costs of inventories

The circumstances of the entity may also warrant the inclusion of other amounts, such as distribution costs.

Paragraph 39 - Alternative Presentation Format

Some entities adopt a format for profit or loss that results in amounts being disclosed other than the cost of inventories recognised as an expense during the period. Under this format, an entity presents an analysis of expenses using a classification based on the nature of expenses. In this case, the entity discloses:

Costs recognised as an expense for raw materials and consumables

Labour costs

Other costs

The amount of the net change in inventories for the period

Effective Date (Paragraphs 40-40G)

Paragraph 40 - Original Effective Date

An entity shall apply this Standard for annual periods beginning on or after 1 January 2005. Earlier application is encouraged. If an entity applies this Standard for a period beginning before 1 January 2005, it shall disclose that fact.

Paragraph 40a - Earlier Application

If an entity decides to apply this Standard for an earlier period, it is not required to apply all the HKASs with the effective date for that same period. However, it is required to apply the amendments set out in the appendix on amendments to other pronouncements for that earlier period.

Paragraphs 40A-40B - [Deleted]

Paragraph 40C - HKFRS 13 Amendment

HKFRS 13, issued in June 2011, amended the definition of fair value in paragraph 6 and amended paragraph 7. An entity shall apply those amendments when it applies HKFRS 13.

Paragraph 40D - [Deleted]

Paragraph 40E - HKFRS 15 Amendment

HKFRS 15 *Revenue from Contracts with Customers*, issued in July 2014, amended paragraphs 2, 8, 29 and 37 and deleted paragraph 19. An entity shall apply those amendments when it applies HKFRS 15.

Paragraph 40F - HKFRS 9 Amendment

HKFRS 9, as issued in September 2014, amended paragraphs 2 and deleted paragraphs 40A, 40B and 40D. An entity shall apply those amendments when it applies HKFRS 9.

Paragraph 40G - HKFRS 16 Amendment

HKFRS 16 *Leases*, issued in May 2016, amended paragraph 12. An entity shall apply that amendment when it applies HKFRS 16.

Withdrawal of Other Pronouncements (Paragraphs 41-42)

Paragraph 41

This Standard supersedes SSAP 22 *Inventories*, revised in 2001.

Paragraph 42 - [Not used]

Basis for Conclusions Summary

Introduction (BC1-BC3)

The Basis for Conclusions summarises the International Accounting Standards Board's considerations in reaching its conclusions on revising IAS 2 *Inventories* in 2003. The Board's intention was not to reconsider the fundamental approach to the accounting for inventories established by IAS 2.

Scope (BC4-BC8)

Reference to Historical Cost System (BC4-BC5)

The words 'in the context of the historical cost system in accounting for inventories' were deleted to clarify that the Standard applies to all inventories that are not specifically exempted from its scope.

Inventories of Broker-Traders (BC6-BC8)

The Board decided that the Standard should not apply to the measurement of inventories of:

Producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value

Commodity broker-traders when their inventories are measured at fair value less costs to sell

Cost Formulas (BC9-BC21)

Prohibition of LIFO (BC9-BC20)

The Board decided to eliminate the allowed alternative of using the LIFO method for the following reasons:

LIFO treats the newest items of inventory as being sold first, which is generally not a reliable representation of actual inventory flows

LIFO is an attempt to meet a perceived deficiency of the conventional accounting model by imposing an unrealistic cost flow assumption

LIFO use is often tax-driven

LIFO results in inventories being recognised in the balance sheet at amounts that bear little relationship to recent cost levels

LIFO can distort profit or loss, especially when 'preserved' older 'layers' of inventory are presumed to have been used when inventories are substantially reduced

Tax considerations do not provide an adequate conceptual basis for selecting an appropriate accounting treatment

FIFO and Weighted Average (BC21)

IAS 2 continues to allow the use of both the FIFO and the weighted average methods for interchangeable inventories.

Cost of Inventories Recognised as an Expense (BC22-BC23)

The Board decided to specifically require disclosure of the cost of inventories recognised as an expense in the period in IAS 2, as this information is important to understand the financial statements.

Key Takeaways Summary

Topic	Key Point
Measurement	Lower of cost and net realisable value
Cost Components	Purchase costs + conversion costs + other costs to bring to present location and condition
Fixed Overhead Allocation	Based on normal capacity; unallocated overheads expensed
Cost Formulas	Specific identification (non-interchangeable items); FIFO or weighted average (other inventories)
LIFO	Prohibited
NRV Write-Down	Item by item; reverse when circumstances improve (limited to original write-down)
Recognition	Carrying amount expensed when revenue recognised; write-downs/losses expensed immediately
Disclosure	Accounting policies, carrying amounts by classification, write-downs, reversals, pledged inventories
Scope Exclusions	Financial instruments; biological assets; certain agricultural/mineral products (measurement only); broker-trader inventories at FV less costs to sell (measurement only)
Deferred Settlement	Financing element recognised as interest expense