IAS-2: Inventories

IAS-2: Inventories

IAS 2 — mirrored in India as Ind AS 2 for Ind AS companies and AS 2 for companies still on the legacy framework — controls how raw materials, work-in-progress (WIP), and finished goods sit on your balance sheet. The governing rule is deceptively simple: carry inventory at the lower of cost and net realisable value (NRV). The complexity lies in execution: overhead allocation at normal capacity, consistent application of FIFO or weighted average, timely write-downs, ITC reversal under CGST, and Schedule III disclosure. For FY 2026-27, with NFRA, GST audit, and income-tax scrutiny all live, getting this right protects your gross margin, your audit opinion, and your cash.

What IAS 2 Covers — and What It Deliberately Excludes

IAS 2 applies to all inventories unless a more specific standard takes over. Carve-outs you need to know:

• Construction contract WIP → IFRS 15 / Ind AS 115 (revenue-linked completion method)
• Financial instruments → IFRS 9 / Ind AS 109
• Biological assets at point of harvest → IAS 41 / Ind AS 41
• Commodity broker-traders measuring at fair value less costs to sell → present changes in P&L, not subject to lower-of-cost-and-NRV

Within scope, "inventories" includes three categories: goods held for sale in the ordinary course of business (finished goods, traded goods), goods in the process of production for such sale (WIP), and materials or supplies to be consumed in production or service delivery (raw materials, packing materials, consumables). Service entities also bring IAS 2 into play: the cost of a service that has been incurred but for which revenue has not yet been recognised is inventory under the standard.

One edge case that trips Indian companies: real estate WIP. Under Ind AS, residential or commercial units under development that are not accounted for under Ind AS 115 as contract assets are inventory under Ind AS 2. Borrowing costs on such qualifying inventory must be capitalised under Ind AS 23 — this is addressed in the overhead section below.

The Core Measurement Rule: Lower of Cost and NRV

Inventory must be measured at the lower of its cost and its net realisable value at each reporting date. This is not a one-time election at initial recognition — you reassess at every balance sheet date. If NRV has fallen below cost, you write down. If it subsequently recovers, you reverse — but only up to the original cost.

Building Up the Cost of Inventory

Cost has three permitted components:

1. Costs of purchase. Purchase price plus import duties, non-refundable taxes, freight inward, and other directly attributable acquisition costs. Deduct trade discounts, rebates, and GST input tax credit (ITC) you are entitled to claim. Where a company is fully eligible for ITC, GST paid on purchase is not part of inventory cost — it is a balance sheet receivable (CGST/SGST input credit). Where ITC is blocked (e.g., goods used for exempt supply, or items listed under Section 17(5) of the CGST Act 2017), the blocked GST becomes part of inventory cost.

2. Costs of conversion. Direct labour applied to producing the inventory, plus a systematic allocation of fixed and variable production overheads. Variable overheads are allocated at actual. Fixed overheads use the normal capacity rate — see the next section for why this distinction creates real P&L differences.

3. Other costs. Any other cost incurred to bring inventory to its present location and condition. This can include design costs for specific customer orders and, in the real estate context, borrowing costs under Ind AS 23 for qualifying inventory that takes a substantial period to get ready for intended sale.

Excluded from cost — always:

• Abnormal amounts of wasted materials, labour, or overheads
• Storage costs (unless storage is a necessary step in the production process, e.g., aged spirits)
• Administrative overheads that do not contribute to bringing inventory to its present location and condition
• Selling costs

Determining Net Realisable Value Correctly

NRV is entity-specific, not a market price. The formula:

> NRV = Estimated selling price in ordinary course of business − Estimated costs of completion − Estimated selling costs

"Estimated selling price" means the price you expect to actually achieve, not the list price. If you have committed to sell a batch at a discount to a specific customer, use that committed price. If post-period actual sales give you evidence, use them. NRV is assessed item by item (or for similar/related items where appropriate) — you cannot net a profitable product line against a loss-making one to avoid a write-down.

For raw materials and components, NRV is assessed differently. If the finished goods into which the material will be incorporated are expected to be sold above cost, there is no NRV issue for the material. If the finished goods themselves are expected to sell below cost, you write the material down too — replacement cost is often the best available measure of NRV for raw materials in that scenario.

Permitted Cost Formulas: FIFO vs Weighted Average

For items not ordinarily interchangeable — high-value, individually identified items — specific identification is mandatory. Examples: large machinery components assembled to order, bespoke jewellery batches, project-specific spares held against a particular contract.

For all other interchangeable inventories, IAS 2 permits two formulas:

LIFO is prohibited under IAS 2 and Ind AS 2. This is a frequent exam point but also a real compliance issue: companies migrating from US GAAP to IFRS must restate opening inventories.

The consistency rule is non-negotiable. The same formula must apply to all inventories of similar nature and use. You cannot apply FIFO to finished goods and weighted average to the same product's raw materials if they share the same cost flow nature. A change in cost formula is a change in accounting policy under Ind AS 8, requiring retrospective restatement and quantitative disclosure.

Worked mini-example — impact of formula choice in FY 2026-27:

A manufacturer holds steel rods used in a single product line:

• Opening stock: 100 kg @ Rs. 80/kg = Rs. 8,000
• Purchase 1 (July 2026): 200 kg @ Rs. 90/kg = Rs. 18,000
• Purchase 2 (February 2027): 150 kg @ Rs. 95/kg = Rs. 14,250
• Total available: 450 kg | Rs. 40,250
• Consumed during year: 300 kg

Under FIFO: 100 kg @ Rs. 80 + 200 kg @ Rs. 90 = Rs. 8,000 + Rs. 18,000 = Rs. 26,000 COGS; closing stock = 150 kg @ Rs. 95 = Rs. 14,250

Under Weighted Average: Average cost = Rs. 40,250 ÷ 450 = Rs. 89.44/kg; COGS = 300 × Rs. 89.44 = Rs. 26,833; closing stock = 150 × Rs. 89.44 = Rs. 13,417

In this rising-price scenario, FIFO produces closing inventory Rs. 833 higher and gross profit Rs. 833 higher. Multiply this across thousands of SKUs or larger quantities and the GP impact is material. Neither formula is "better" — both are correct — but the choice must be consistent and disclosed.

The Normal Capacity Trap in Overhead Allocation

This is the single most commonly misstated area in inventory costing for Indian manufacturing companies.

The rule: Fixed production overheads are allocated based on normal capacity — the production level expected to be achieved on average over a number of periods under normal conditions. You do not use actual production if actual is below normal.

Why it matters: If production volume falls (plant shutdown, raw material shortage, demand slump), using actual production to absorb overheads inflates per-unit cost and overstates closing inventory. IAS 2 requires that unabsorbed fixed overhead in a low-production period is expensed in P&L, not carried in inventory.

Worked example — FY 2026-27:

A pharmaceutical company has:

• Budgeted fixed production overheads: Rs. 60,00,000 per year
• Normal capacity: 1,20,000 units per year
• Normal capacity absorption rate: Rs. 60,00,000 ÷ 1,20,000 = Rs. 50 per unit
• Actual production in FY 2026-27 (due to a machinery shutdown): 80,000 units

Fixed overhead absorbed into inventory: 80,000 × Rs. 50 = Rs. 40,00,000 Unabsorbed overhead expensed in P&L: Rs. 60,00,000 − Rs. 40,00,000 = Rs. 20,00,000

A common wrong treatment: divide Rs. 60,00,000 by 80,000 actual units = Rs. 75 per unit, inflating inventory by Rs. 20,00,000. This overstates closing inventory, understates COGS, and overstates gross profit — all three are material misstatements that auditors and NFRA will flag.

Inventory Write-Downs and Reversals

Triggering a Write-Down

Write inventory down to NRV when NRV is below carrying cost. Common triggers:

• Selling prices have declined (check recent invoices and post-year-end sales)
• Products are slow-moving or obsolete (industry norm: flag items with no movement in 180–365 days)
• Physical deterioration or damage identified at stock count
• Completed goods cost more to finish than they will realise
• Committed customer contracts at below-cost prices

The write-down is recognised as an expense in P&L, typically within cost of materials or as a separate line if material. It is not shown as an impairment of a fixed asset.

Reversal of Write-Downs

If the circumstances that caused the write-down no longer exist — NRV has recovered — the write-down is reversed. The reversal is capped at the original cost. You cannot write inventory up above cost, even if market prices have surged.

The reversal is recognised in P&L in the period in which it arises — it reduces the cost of inventories recognised as expense in that period.

Worked Example: Write-Down and Reversal in Practice

A consumer electronics distributor holds 500 units of a smart speaker model at 31 March 2027.

Step 1 — March 2027 write-down:

• Cost per unit: Rs. 1,200 → Carrying value: Rs. 6,00,000
• Estimated selling price (model discontinued, clearance sale expected): Rs. 1,050
• Estimated selling costs: Rs. 75 per unit
• NRV: Rs. 1,050 − Rs. 75 = Rs. 975 per unit → NRV total: Rs. 4,87,500
• Write-down: Rs. 6,00,000 − Rs. 4,87,500 = Rs. 1,12,500 → charged to P&L FY 2026-27

Step 2 — Subsequent period recovery (say Q2 FY 2027-28):

• New selling price (cleared through online channel): Rs. 1,225
• Selling costs: Rs. 75
• Revised NRV: Rs. 1,225 − Rs. 75 = Rs. 1,150 per unit
• The lower of revised cost (Rs. 1,200) and revised NRV (Rs. 1,150) = Rs. 1,150
• Carrying amount after write-down: Rs. 975
• Reversal permitted: Rs. 1,150 − Rs. 975 = Rs. 175 per unit × 500 units = Rs. 87,500 → credited to P&L in Q2 FY 2027-28

Note: The reversal cannot take the carrying amount above Rs. 1,200 (original cost). If NRV had recovered to Rs. 1,350, the reversal would still be capped at Rs. 225 per unit (Rs. 1,200 − Rs. 975).

GST, Tax Audit, and the Inventory Reconciliation Triangle

Three external compliance points intersect with IAS 2 every year-end. Handle all three before closing.

1. GST Input Tax Credit and inventory cost. Where ITC is fully eligible and availed, GST is not part of inventory cost — it nets out through the electronic credit ledger. Where ITC is partly or fully blocked under Section 17(5) of the CGST Act 2017 (e.g., food and beverages, motor vehicles for non-business use, goods destroyed/written off), the blocked credit must be included in inventory cost or expensed. Critically, if inventory is written off or destroyed, the ITC already availed on it must be reversed under Rule 44 read with Section 17(5)(h). A write-down to NRV is different from a write-off — partial write-downs do not per se trigger ITC reversal, but total write-off does.

2. GST stock reconciliation — Section 65 audit risk. Physical inventory must reconcile with stock declared in e-way bills, GSTR-1 outward supply returns, and the GST stock register. Material unexplained discrepancies give a GST officer authority to infer suppressed sales or unaccounted purchases during a Section 65 GST audit. Run this reconciliation as part of year-end procedures — do not leave it for the GST annual return (GSTR-9) filing.

3. Tax Audit under Section 44AB — Form 3CD, Clause 18. Clause 18 of Form 3CD requires disclosure of: (a) the method of valuation of closing stock, (b) deviation, if any, from the method prescribed in any ICAI guidance or notification, and (c) the effect of such deviation on profits. Consistency of cost formula across FY 2025-26 and FY 2026-27 is tested here. A switch from FIFO to weighted average — even if legitimately disclosed as an accounting policy change under Ind AS 8 — must be quantified in the tax audit report. Clause 14 also requires disclosure of valuation of stock-in-trade in case of any change in method.

Common Pitfalls to Avoid

1. Using actual capacity rates instead of normal capacity for fixed overhead absorption. Overstates inventory in lean production years and creates a cliff-edge write-down risk.

2. Including selling costs in inventory cost. Freight outward, sales commission, and marketing spends are not inventory costs — they go straight to P&L.

3. Failing to exclude blocked GST ITC from the effective purchase price. If you cannot claim ITC (exempt supplies, Section 17(5) items), the GST must be included in cost. Treating blocked ITC as a balance sheet receivable inflates assets and understates COGS.

4. Applying NRV at category level rather than item level. Netting a profitable SKU against an obsolete SKU to avoid a write-down is not permitted. NRV is assessed line by line.

5. Not reversing write-downs when NRV recovers. This is not optional — IAS 2 requires recognition of the reversal in P&L. Omitting it understates profit in the recovery period.

6. Changing cost formula without retrospective restatement. A switch from FIFO to weighted average (or vice versa) is a change in accounting policy under Ind AS 8. It requires retrospective adjustment to opening retained earnings and comparative figures, plus quantitative disclosure. Applying it prospectively only is non-compliant.

7. Ignoring borrowing costs on qualifying inventory. Under Ind AS 23, borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset (including inventory that takes a substantial period to get ready) must be capitalised. Real estate developers and distillers (maturing spirit) are the most common examples. Expensing these borrowing costs understates inventory and overstates finance costs.

8. Inadequate documentation of NRV assessment. Auditors and tax officers increasingly require contemporaneous evidence: post-period sales data, customer purchase orders at reduced prices, market quotations, or independent valuations. A spreadsheet assembled after year-end without supporting documents will not hold.

Disclosure Requirements Under Ind AS 2 and Schedule III

Ind AS 2 requires the following disclosures (Schedule III of the Companies Act 2013 governs balance sheet classification):

• Accounting policies: cost formula used (FIFO or weighted average), basis of NRV assessment
• Balance sheet classification: separate disclosure of raw materials, WIP, finished goods, stock-in-trade, stores and spares — Schedule III Part I requires this on the face of the balance sheet or in notes
• Cost of inventories recognised as expense: total amount for the period, split between raw material consumption, purchase of stock-in-trade, and changes in inventories of WIP and finished goods (typically presented as part of the statement of profit and loss under Schedule III)
• Write-down amount: amount written down to NRV in the period; circumstances leading to write-down
• Reversal amount: amount of any reversal; circumstances that led to recovery
• Inventories pledged as security: carrying amount of inventory pledged against working capital facilities (cash credit, WCDL) or term loans must be disclosed as a contingent liability or under "assets pledged as security" in notes

For companies with significant inventory, NFRA and the Securities and Exchange Board of India (SEBI) LODR filings also require segment-level inventory disclosure if inventory is material to segment assets.

Year-End Inventory Procedures: A Step-by-Step Checklist

Run through these before signing off on the FY 2026-27 financial statements:

1. Physical verification: Conduct a stock count at all warehouse and factory locations (including consignment stock held by third parties). Reconcile physical counts to the inventory ledger. Investigate differences exceeding 2–3% of total inventory value.
2. Obsolescence review: Flag all inventory with no movement in 180+ days (or as per industry norms). Obtain sales team sign-off on realisable value for slow-moving items.
3. NRV assessment: Compare carrying cost to current selling prices, post-period sales realisation, or customer purchase orders. Document the assessment by SKU or batch.
4. Overhead rate review: Confirm that fixed overhead absorption rate is based on normal capacity, not actual. Calculate and expense unabsorbed overheads.
5. Cost formula consistency check: Confirm FIFO or weighted average is applied consistently with the prior year. If changed, prepare Ind AS 8 disclosures with retrospective impact quantification.
6. ITC and blocked credit reconciliation: Identify any ITC to be reversed on written-off goods. Update the GST input tax register before filing GSTR-9 for FY 2026-27.
7. GST stock register reconciliation: Match physical stock to e-way bill data and GST returns. Resolve discrepancies before the GST annual return filing.
8. Tax audit Clause 18 preparation: Document valuation method, any changes, and quantitative impact for the tax auditor.
9. Pledge disclosure: Confirm carrying value of inventory pledged to banks/NBFCs with lender statements.
10. Write-down journal and P&L disclosure: Pass the write-down entry to NRV; prepare the disclosure note with circumstances, amount, and any reversals.

Key Takeaways

• Lower of cost and NRV is assessed at each reporting date, item by item — net-off across product lines is not permitted.
• Fixed overhead allocation uses normal capacity, not actual. Unabsorbed overhead in a low-production year goes to P&L — carrying it in inventory is a misstatement.
• LIFO is prohibited under IAS 2 and Ind AS 2. The same formula (FIFO or weighted average) must apply consistently to all inventories of similar nature.
• Write-downs are mandatory when NRV falls below cost; reversals are equally mandatory when NRV recovers, capped at original cost.
• Blocked GST ITC becomes part of inventory cost; ITC on written-off goods must be reversed under Rule 44 of the CGST Rules — coordinate between the accounting team and the GST team at year-end.
• Form 3CD Clause 18 requires disclosure of valuation method and any change in method to the tax auditor — a formula change is a change in accounting policy and needs Ind AS 8 retrospective treatment and quantification.
• Documentation is not optional: NRV assessments, normal capacity workings, and write-down evidence must exist before year-end closure — not be reconstructed after audit queries arrive.