How to Audit Inventory Valuation and Disclosure Under IAS 2

What IAS 2 requires you to test beyond existence

ISA 501.4 requires the auditor to obtain sufficient appropriate audit evidence regarding the existence and condition of inventory. Most firms execute the existence work well. Valuation is where files fall apart, because IAS 2’s cost measurement rules are more granular than many teams treat them.

The cost build-up under IAS 2.10 through IAS 2.18

IAS 2.10 states that the cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Each of these categories has specific requirements that your audit work needs to address.

Costs of purchase (IAS 2.11) include the purchase price, import duties, transport, handling, and other costs directly attributable to acquisition. Trade discounts and rebates are deducted. On a distribution or retail client, this is usually the entire cost. Your audit test is matching invoice prices (net of discounts) to the unit costs in the inventory system, then verifying that freight and handling have been allocated on a reasonable basis.

Costs of conversion (IAS 2.12) apply to manufacturing clients and are where the complexity sits. Conversion costs include direct labour and a systematic allocation of fixed and variable production overheads. IAS 2.13 is specific: fixed production overheads must be allocated based on the normal capacity of production facilities. If a factory runs at 60% capacity due to a downturn, the entity cannot load 100% of the fixed overheads into inventory cost. The unallocated overhead goes to cost of goods sold in the period.

IAS 2.13 defines normal capacity as the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity from planned maintenance. This definition matters because it prevents entities from using a single bad year’s production volume as the allocation base. On your audit, you need to understand what the entity considers “normal” and whether that figure is reasonable given the entity’s production history over the last four to five years.

On a mid-tier manufacturing audit, the overhead allocation is the single most important IAS 2 test after existence. Verify the allocation base (direct labour hours, machine hours, or units produced). Confirm the normal capacity figure the entity uses. Compare actual capacity to normal capacity and check that any unallocated overhead has been expensed rather than capitalised. If actual production significantly exceeds normal capacity, IAS 2.13 also requires that fixed overheads allocated per unit are not increased above cost. Variable overheads, by contrast, are allocated based on actual production (IAS 2.12), so they don’t present the same normal-capacity issue.

IAS 2.16 lists costs that are explicitly excluded from inventory cost: abnormal amounts of wasted materials, labour, or production costs; storage costs (unless necessary in the production process before a further production stage); administrative overheads not contributing to bringing inventory to its present condition; and selling costs. If any of these are included in the client’s cost build-up, the inventory is overstated. Check the cost build-up for each category, not just the headline number. A common error is including post-production warehouse rent in inventory cost when the storage is not part of the production process.

Cost formula selection under IAS 2.25

IAS 2.25 requires entities to use FIFO (first-in, first-out) or weighted average cost to determine the cost of inventories. LIFO is prohibited under IFRS. For items that are not ordinarily interchangeable, or goods produced and segregated for specific projects, IAS 2.23 requires specific identification of individual costs.

Your audit work on the cost formula is twofold. First, verify that the formula selected is applied consistently to all inventories with a similar nature and use to the entity (IAS 2.25). A client cannot use FIFO for finished goods and weighted average for raw materials if those categories have a similar nature. Second, reperform the cost formula calculation on a sample of inventory items and compare the result to the unit cost in the system.

A common finding: the client states they use weighted average cost, but the ERP system is configured to use FIFO, or the system uses a moving average that doesn’t match the weighted average calculation prescribed by IAS 2. Testing a sample of high-value items through the cost formula from purchase to balance sheet date resolves this. On most mid-tier ERP implementations (SAP Business One, Exact Online, Microsoft Dynamics), the cost method is a system-wide or warehouse-level setting. Checking the ERP configuration directly takes five minutes and tells you whether the accounting policy matches the system.

IAS 2.26 permits a different cost formula for inventories with a different nature or use. A construction company could use specific identification for contract-specific materials and weighted average for general supplies. But the distinction must be based on nature and use, not convenience. Document why different formulas apply to different inventory categories if this situation arises.

Net realisable value: the assessment most files get wrong

IAS 2.28 requires inventories to be written down to net realisable value on an item-by-item basis. IAS 2.6 defines net realisable value (NRV) as 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.

Most files get this wrong not at the calculation stage but at the identification stage. IAS 2.28 lists indicators: physical damage, full or partial obsolescence, a decline in selling price, and increased estimated costs of completion or sale. Most teams ask the warehouse manager whether any stock is damaged or slow-moving and document the response. They move on without running the numbers. That is not an NRV assessment.

A proper NRV test on a mid-tier engagement involves running an aged inventory report and identifying items with no movement for a defined period (90 days, 180 days, or whatever is appropriate for the client’s industry cycle). For those items, you compare the carrying cost per unit to the most recent selling price less costs to sell. If the client is a manufacturer, you also need to estimate costs of completion for any work-in-progress items. Connect this analysis to the ISA 520 Analytical Review Calculator if you’re running margin analysis on inventory categories. A year-on-year decline in gross margin on a product line is an indicator that NRV may be below cost.

IAS 2.31 adds a requirement specific to raw materials. Raw materials 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. But if a decline in raw material prices indicates that the cost of the finished products will exceed NRV, the raw materials must be written down. The NRV assessment for raw materials requires you to look through to the finished product margin, not just the replacement cost of the raw material itself.

IAS 2.33 permits reversal of a previous write-down when the circumstances that caused the NRV impairment no longer exist. If market prices have recovered, the inventory can be written back up to cost (but never above original cost). Your working paper should check whether any prior-year write-downs are now eligible for reversal. This is a check that appears on almost no mid-tier engagement files, but IAS 2.33 explicitly requires it.

For your working paper, document the NRV assessment as a two-step process. Step one: identify inventory lines at risk (using the aged inventory report, margin analysis, and management inquiry combined). Step two: for each identified line, calculate NRV per unit and compare to carrying cost. The working paper should show both the population tested and the conclusion per item, not just the aggregate result.

Disclosure requirements under IAS 2.36

IAS 2.36 requires specific disclosures that your disclosure checklist should capture, but the ones that generate findings most often are worth flagging separately.

IAS 2.36(a) requires disclosure of the accounting policies adopted in measuring inventories, including the cost formula used. If the client uses different formulas for different categories (per IAS 2.26), each formula must be disclosed. IAS 2.36(b) requires disclosure of the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity. “Inventory EUR 4.8M” on the balance sheet is insufficient if the entity holds raw materials, work-in-progress, and finished goods. Each category needs separate disclosure, either on the face or in the notes.

IAS 2.36(d) requires disclosure of the amount of inventories recognised as an expense during the period. This is the cost of goods sold figure. IAS 2.36(e) requires disclosure of the amount of any write-down recognised as an expense in the period and (under IAS 2.36(f)) any reversal of a write-down. If your NRV assessment identified write-downs, verify the disclosure exists and the amounts agree. IAS 2.36(g) requires disclosure of the circumstances that led to the reversal, if applicable.

One disclosure that’s often missing on mid-tier files: IAS 2.36(h) requires disclosure of the carrying amount of inventories pledged as security for liabilities. If the client has a revolving credit facility secured against inventory, this disclosure is required. Cross-reference to the borrowings note to check for consistency.

Worked example: Dijkstra Logistics B.V.

Client: Dijkstra Logistics B.V., a Dutch distributor of industrial cleaning products. Revenue: EUR 22M | Total assets: EUR 14M | Reporting framework: IFRS as adopted by the EU. Inventory carrying value: EUR 4.8M (raw materials EUR 1.2M, finished goods EUR 3.6M). Overall materiality: EUR 330K (1.5% of revenue) | Performance materiality: EUR 248K.

1. Cost build-up verification

Dijkstra is a distributor, not a manufacturer. Conversion costs do not apply. Cost of purchase comprises invoice price net of trade discounts, plus inbound freight. The auditor selects 25 inventory items (covering 68% of the finished goods balance by value) and traces the unit cost in the system back to the most recent purchase invoice and freight allocation.

Two items (industrial degreaser concentrate, unit cost EUR 14.20) include a EUR 0.80 per unit allocation for warehouse storage after receipt. IAS 2.16(b) excludes storage costs that are not necessary before a further production stage. Since Dijkstra stores these products in a general warehouse pending sale (not pending a further production step), the EUR 0.80 must be removed from inventory cost.

Total adjustment: 3,200 units at EUR 0.80 = EUR 2,560. Below performance materiality but noted on the summary of unadjusted differences.

2. Cost formula verification

Dijkstra states in its accounting policies that it uses weighted average cost. The auditor selects five high-value product lines and reperforms the weighted average calculation using purchase records from the prior twelve months. Four of the five match the system. The fifth (product line: anti-bacterial surface spray, 8,400 units on hand) shows a system unit cost of EUR 6.10 but a recalculated weighted average of EUR 5.85.

Investigation reveals the ERP system (Exact Online) uses a moving average that recalculates on each purchase rather than a periodic weighted average. The difference per unit is EUR 0.25 across 8,400 units (EUR 2,100 total). Below performance materiality individually, but the auditor extends the test to all product lines above EUR 50K in value to assess whether the systematic difference is material in aggregate. Extended testing across 14 product lines shows a total overstatement of EUR 8,700, still below performance materiality.

3. Net realisable value assessment

The aged inventory report shows EUR 620K of finished goods with no sales in the past 180 days (42 product lines). For each of these lines, the auditor obtains the most recent selling price per unit and deducts estimated costs to sell (average 4% based on Dijkstra’s sales commission structure).

Of the 42 product lines, seven (carrying value EUR 184K) have an NRV below cost. The largest is a discontinued line of citrus-based degreasers (EUR 89K carrying value, NRV of EUR 31K based on the liquidation price agreed with a secondary buyer in January). The required write-down across all seven lines totals EUR 127K. This is below overall materiality (EUR 330K) but above performance materiality (EUR 248K when assessed as a risk of aggregate misstatement on inventory).

Management agrees to book the write-down of EUR 127K to cost of goods sold.

The file shows a cost build-up verification with a storage cost finding, a cost formula reperformance that identified an ERP configuration issue (extended to confirm immateriality), and an NRV assessment grounded in the aged inventory report with corroborating third-party evidence for the largest write-down. Each finding includes the specific IAS 2 paragraph that governs it.

Practical checklist for your current engagement

1. For distribution and retail clients, trace a sample of high-value inventory items from the system unit cost back to the purchase invoice net of trade discounts and rebates (IAS 2.11). Verify that no excluded costs under IAS 2.16 (storage, administrative overheads, selling costs, abnormal waste) are included in the cost build-up.
2. For manufacturing clients, obtain the overhead allocation methodology and verify the normal capacity figure used for fixed overhead allocation (IAS 2.13). Compare actual production to normal capacity and confirm that unallocated overhead has been expensed, not capitalised.
3. Check the ERP system configuration to confirm the cost formula (FIFO or weighted average) matches the accounting policy (IAS 2.25). Reperform the cost calculation on a sample and compare to the system unit cost.
4. Run the aged inventory report and identify items with no movement beyond the client’s normal sales cycle. For each identified line, calculate NRV per unit (estimated selling price less costs of completion and costs to sell) and compare to carrying cost (IAS 2.28, IAS 2.6).
5. For raw materials held by a manufacturer, assess NRV by looking through to the finished product. If finished product margins are under pressure, the raw material NRV test cannot stop at replacement cost (IAS 2.31, IAS 2.32). Also check whether any prior-year write-downs should be reversed under IAS 2.33.
6. Verify the disclosures required by IAS 2.36: accounting policy and cost formula used (IAS 2.36(a)), carrying amount by category (IAS 2.36(b)), cost of goods sold (IAS 2.36(d)), write-downs recognised (IAS 2.36(e)), and any inventories pledged as security (IAS 2.36(h)).

Common mistakes regulators flag

• Insufficient overhead allocation testing: The PCAOB’s 2023 inspection findings report identified inventory valuation as a recurring deficiency area. The most common finding was insufficient testing of the cost build-up, particularly the allocation of production overheads at manufacturing entities. Auditors accepted management’s allocation methodology without testing the normal capacity assumption or verifying the allocation base.
• NRV assessments relying solely on management inquiry: The AFM has flagged NRV assessments that rely solely on management inquiry without corroborating evidence. An NRV working paper that documents “per discussion with the warehouse manager, no slow-moving items identified” without an aged inventory report or margin analysis does not meet the evidence threshold under ISA 500.
• Cost formula mismatch between policy and ERP: The FRC’s thematic review on inventory (2019) found that auditors frequently failed to test whether the cost formula stated in the accounting policies matched the calculation performed by the entity’s system. The discrepancy between a stated weighted average policy and an ERP configured for moving average or FIFO was a recurring finding.

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Further reading and source references

• IAS 2, Inventories: the source standard governing inventory measurement, cost formulas, NRV assessment, and disclosure requirements.
• ISA 501, Audit Evidence – Specific Considerations for Selected Items: the audit standard requiring sufficient appropriate evidence on the existence and condition of inventory.
• ISA 500, Audit Evidence: governs the evidence threshold for all audit assertions, including valuation evidence that must go beyond management inquiry alone.
• IAS 1, Presentation of Financial Statements: relevant to the disaggregation of inventory categories on the face of the balance sheet or in the notes.