The primary objective of inventory measurement under existing accounting principles, which are based on cost, is the appropriate determination of income through the matching of expenses to revenues.
That is, determining the amount of cost that will be recognized as an asset and presented until the point at which the income derived from that asset is recognized.
Inventory, like any other asset, must meet the requirement of the Conceptual Framework for the preparation and presentation of financial statements – namely, the generation of future economic benefits.
From this arises the guiding rule for inventory measurement: the lower of cost and net realizable value (NRV).
The accounting treatment of inventory is one of the few areas in financial accounting around which there has been little controversy.
Even the growing trend of shifting accounting standards from cost-based measurement to fair value-based measurement has so far bypassed the topic of inventory measurement.
The logic behind cost-based inventory measurement is that the act of sale represents the most difficult and unpredictable part of the business process, and reflects the most significant business risk.
Measuring inventory at fair value would result in continuous recognition of profit and would undermine the significance of the sales transaction and the revenue recognition model currently in use.
Accordingly, despite the ongoing trend toward fair value measurement of assets, accounting standards are expected to continue adopting the cost basis for inventory in the foreseeable future.
The cost of inventory includes expenses incurred during the ordinary course of business to bring the product or service to its current condition and location.
All costs incurred in relation to inventory are expensed in the period, except for costs relating to inventory that has not yet been consumed and is expected to yield future economic benefits for the reporting entity.
The deferral of such costs is intended to match them to the revenues they are expected to generate, similar to prepaid expenses.
In most businesses — especially those characterized by dynamic movement of goods and raw materials — it is not practically feasible to track the cost of each individual inventory item separately.
Therefore, certain groupings are used, and the cost of inventory that is sold, consumed, or transferred to work-in-process inventory is calculated based on the quantity used, multiplied by the amount paid per item.
However, because inventory prices frequently fluctuate, it is necessary to adopt a systematic basis for recognizing cost of sales based on certain assumptions about cost flow.
The main methods used for this purpose are: Specific Identification, First-In First-Out (FIFO), and Weighted Average Cost.
International Accounting Standard 2 (IAS 2) – Inventories (hereinafter: “the Standard”) defines which items are considered inventory and sets out rules for the recognition and measurement of inventory in the financial statements.