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Plain‑English explainer of HKAS 2 / IAS 2 for students, junior accountants and non‑specialists who find official standards too dense to read.
This article is based on Hong Kong Accounting Standards (HKAS / HKFRS), which are fully aligned with IAS / IFRS except for minor local tweaks, so the same principles generally apply under IAS / IFRS unless noted otherwise. The goal is to unpack HKAS 2 Presentation of Financial Statements (equivalent to IAS 2) using plain English and practical, real‑life examples instead of technical jargon. It is written for students, junior accountants, audit juniors and finance professionals who want to understand not just “what the standard says” but how to actually read and prepare financial statements in line with it.
When you see “the company” or “the entity” below, you can think of any entity that prepares general purpose financial statements under HKFRS / IFRS.
The real question: “Do we need an inventory write‑down?”
Imagine you work in a Hong Kong company selling electronics or fashion. At year‑end, you walk through the warehouse: some models are discontinued, some styles are clearly last season, and new products keep pushing prices down. Management asks: “Are these goods still worth what we show on the balance sheet? Do we need an inventory write‑down?”
HKAS 2 Inventories (equivalent to IAS 2) answers this question using the concept of net realisable value (NRV). When it looks like the cost of inventory may not be recoverable, the entity must reassess the inventory’s value: when to write it down, how much to write down, and when (and how far) to reverse it if things improve later.
What You Should Be Able to Do After Reading?
By the end, you should be able to:
- Clearly write and calculate NRV as: expected selling price − estimated costs to complete − estimated selling costs.
- Spot typical red flags that trigger an NRV test, such as damage, obsolescence, selling price drops, or rising completion and selling costs.
- Understand why NRV testing is normally done item by item, and when it is acceptable to test by group or product line.
- Apply the rule that raw materials and supplies are usually not written down if the finished goods they go into are still profitable overall.
- Deal with firm sales contracts, consider post‑year‑end price information when estimating NRV, and record write‑downs and reversals correctly in the financial statements.
1. Understand what NRV really means
HKAS 2 / IAS 2 defines net realisable value 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. In simple terms, NRV is “how much cash this inventory will actually bring back to the entity after finishing it and selling it”.
Think of the basic structure as:
NRV = estimated selling price − estimated costs to complete − estimated selling and distribution costs
Example 1 – with further processing
- Estimated selling price: HK$1,000 per unit
- Further processing needed: HK$100 per unit
- Estimated selling and distribution costs (packaging, delivery, commission): HK$50 per unit
NRV = HK$1,000 − HK$100 − HK$50 = HK$850 per unit.
If the inventory’s cost is HK$900 per unit, the entity must apply the “lower of cost and NRV” principle and write it down to HK$850 per unit.
Example 2 – no further processing
- Estimated selling price: HK$500 per unit
- No additional completion cost
- Estimated selling costs (logistics etc.): HK$30 per unit
NRV = HK$500 − HK$0 − HK$30 = HK$470 per unit.
In practice, do not stop at “How much can we sell it for?”. Always ask “After finishing and selling this inventory, how much net value actually comes back into the entity’s pocket?”.
2. Know the typical triggers for a write‑down
HKAS 2 / IAS 2 says an entity must assess whether inventory cost is recoverable and write it down if NRV falls below cost. Typical warning signs include:
- Physical damage (broken packaging, water damage, dented goods, etc.).
- Obsolescence or outdated technology (older phone models, last‑season clothing).
- A clear fall in market selling prices, making it hard to sell at or above cost even after discounts.
- Increases in costs to complete or selling costs that erode gross margin.
- Weak demand, slow‑moving stock, or the need for heavy discounts to clear inventory.
Fashion retailer mini‑case
- Original cost: HK$600 per unit
- Clearance selling price: HK$500 per unit
- Estimated selling costs (display, additional sales costs): HK$40 per unit
NRV = HK$500 − HK$40 = HK$460 per unit, which is below cost. The inventory must be written down to HK$460 per unit.
Another scenario: a product normally sells at HK$1,200 per unit. Industry‑wide cost increases mean the entity now needs to spend an extra HK$300 per unit to finish production, while the market selling price stays flat. Even with the same selling price, the higher costs may push NRV below cost, so management must reassess NRV and possibly record a write‑down.
In real life, treat these situations as “NRV alarm lights”: whenever prices fall, quality drops, or costs rise, ask “Is this inventory still worth its carrying amount on the balance sheet?”.
3. Item‑by‑item vs grouping for NRV testing
The standard’s core principle is that NRV testing is done item by item, because each SKU can have different market conditions and profitability. However, HKAS 2 / IAS 2 allows grouping in some cases where it is more realistic and still faithful to how the business is run.
Grouping can be acceptable when:
- Items are in the same product line (for example, different colours or sizes) and share similar pricing and sales patterns.
- A retail business manages and prices inventory mainly at the product category or department level, and items are largely interchangeable.
Retail example – grouping by product series
- Shoe series A: 1,000 pairs, average cost HK$400 per pair.
- Some sizes or colours sell slower, but overall expected average selling price is HK$480 per pair.
- After selling costs, NRV is about HK$430 per pair.
If the retailer typically sets prices and manages inventory at the “series A” level, then testing NRV on that series as a group can be acceptable.
But there are two important cautions:
- You cannot hide clearly loss‑making items within a profitable group to avoid recognising a write‑down.
- Grouping is only appropriate when items are similar in nature and use, and are managed as a group in the business.
In an audit or year‑end context, a practical approach is to start by reviewing gross margin and inventory balances by product line or category. Then, where necessary, drill down to more detailed levels to perform NRV testing on specific products that look problematic.
4. Raw materials and supplies – when NOT to write them down
HKAS 2 / IAS 2 has a specific rule for materials and supplies used in producing inventory. If the finished goods in which these materials will be incorporated can still be sold at or above cost, the materials themselves are generally not written down below cost, even if their market price has fallen.
The key idea: assess the materials’ value by looking at the NRV of the finished products, not the standalone scrap value of the materials.
Manufacturing example
- A manufacturer holds a large quantity of steel, costing HK$5,000 per tonne.
- Market price of steel falls to HK$4,500 per tonne.
- Products made from this steel can still be sold at their planned prices with healthy gross margins.
Even though the steel’s immediate resale price is lower than its cost, the company does not intend to sell the steel as raw material. It will use the steel to produce profitable finished goods, so no write‑down of the steel is required.
If market conditions deteriorate to a point where even the finished goods cannot be sold at cost, then the materials may need to be written down. In that case, the current replacement cost of the materials can be a useful reference when estimating NRV.
In practice, think like this:
- Materials exist to be transformed into finished goods, so their value is driven by the NRV of those finished goods.
- Only when the finished goods themselves cannot be sold at cost do you seriously consider writing down the materials.
5. Inventory held for firm sales contracts
When estimating NRV, you must consider why the entity is holding the inventory. If inventory is held to fulfil a firm sales contract, its NRV should be based on the contract price, not the general market price.
Example – inventory for a firm contract
- The entity has 10,000 units held to fulfil contract A.
- Contract price: HK$80 per unit.
- General market price for similar goods: HK$75 per unit.
- Unit cost: HK$70 per unit.
- No additional completion costs or significant selling expenses.
For the 10,000 units tied to contract A:
- NRV is based on the contract price (HK$80).
- With no major selling costs, NRV is roughly HK$80 per unit.
- NRV (HK$80) exceeds cost (HK$70), so no write‑down is needed for these contract units.
If the entity actually holds 12,000 units, with only 10,000 covered by contract A, then:
- 10,000 units: NRV based on the contract price.
- Remaining 2,000 units: NRV based on general market price (HK$75) and related selling costs.
If the contract price is itself below cost (for example, contract price HK$65, cost HK$70), then the contract units’ NRV must be based on HK$65. This may also require an onerous contract provision under HKAS 37 / IAS 37, which is a separate standard.
In practice, always ask:
- Is this batch of inventory held for a specific contract or for general sale?
- If for a contract, is the contract price above or below cost?
- Is there excess inventory above the contracted quantity that needs to be assessed using market prices?
6. Using post‑year‑end information in NRV estimates
HKAS 2 / IAS 2 acknowledges that NRV estimates can use information from shortly after the reporting date, but only if it reflects conditions that already existed at year‑end.
Examples where post‑year‑end data is relevant:
- There was already clear price pressure at the reporting date, but official list prices had not yet been reduced.
- Shortly after year‑end, actual selling prices show that the market only accepts prices below cost.
Here, post‑year‑end selling prices provide evidence about what NRV really was at year‑end, and can be used to refine the estimate.
However, if something totally new happens after year‑end (for example, sudden political events, new bans, unexpected legal changes), these are usually non‑adjusting events under HKAS 10 / IAS 10 Events after the Reporting Period. They do not change NRV at the reporting date; instead, they may require disclosure.
A practical approach:
- Review selling prices and volumes for a reasonable period after year‑end.
- Decide whether the observed changes were already “in the air” at year‑end or are entirely new events.
7. Accounting for write‑downs – entries and financial impact
When NRV is below cost, the entity must write down inventory to NRV. HKAS 2 / IAS 2 requires that the write‑down be recognised as an expense in the period in which it occurs, usually within cost of sales.
Example – initial write‑down
- Cost of inventory: HK$100,000
- Estimated NRV: HK$80,000
- Required write‑down: HK$20,000
One common journal entry is:
- Dr Inventory write‑down / inventory loss (or cost of sales) HK$20,000
- Cr Inventories HK$20,000
Impact:
- Statement of financial position: inventories drop from HK$100,000 to HK$80,000.
- Statement of profit or loss: the HK$20,000 write‑down is an expense, reducing gross profit and profit for the period.
HKAS 2 / IAS 2 also expects disclosure of material write‑downs and their nature, especially where they significantly affect gross margins. Auditors will typically ask:
- Were there any significant inventory write‑downs during the year? For what reasons?
- Are the write‑downs concentrated in specific product lines, regions, or types of inventory, or are they more general?
These questions relate directly to the reliability of the financial statements and the entity’s risk profile.
8. Reversing write‑downs – limits and practice points
NRV is not static. HKAS 2 / IAS 2 requires entities to review previously written‑down inventory at each reporting date. If the circumstances that caused the write‑down no longer exist, or if NRV has clearly improved, then the write‑down must be reversed – but with a strict cap:
After reversal, the carrying amount of inventory must not exceed the original cost (the cost before any write‑down).
Example – write‑down and partial reversal
- Year 1: cost HK$100,000, NRV HK$80,000 → write‑down HK$20,000, carrying amount HK$80,000.
- Year 2: NRV recovers to HK$95,000.
The entity can reverse HK$15,000 of the write‑down, raising the carrying amount from HK$80,000 to HK$95,000. It cannot go above the original cost of HK$100,000.
Year 2 journal entry:
- Dr Inventories HK$15,000
- Cr Reversal of inventory write‑down (or reduction in cost of sales) HK$15,000
HKAS 2 / IAS 2 states that such reversals are recognised as a reduction of expense (often a reduction in cost of sales), and significant reversals should be disclosed with an explanation.
Common mistakes include:
- Increasing the inventory balance above original cost when NRV improves, effectively recording unrealised profit.
- Forgetting to reverse write‑downs when NRV has clearly improved, which depresses future gross profit unnecessarily.
Auditors often ask questions like:
- How are the products that were heavily written down last year performing now?
- Does current sales performance suggest that NRV has improved enough to justify a reversal?
9. Turning NRV into a practical inventory “health check”
NRV and inventory write‑downs may look like technical calculations, but they are really a form of risk management. They help ensure assets are not overstated and that financial statements are not stuck at outdated prices when the market has moved on.
Next time you are:
- Preparing inventory schedules for management or auditors.
- Explaining a sharp drop in gross margin for the year.
- Reviewing product lines that may be obsolete or need deep discounts.
Try asking yourself these simple questions:
- Is this inventory facing pressure from damage, obsolescence, price drops, or cost increases?
- Using the best current estimates of selling price and costs, is NRV below cost?
- Should I assess NRV item by item, or is a reasonable grouping (by product series or category) appropriate?
- Is any part of this inventory held for a firm contract? How does the contract price compare with cost?
- Do post‑year‑end sales confirm that the previous NRV estimate was too high or too low?
- Have we already written this inventory down in the past? If so, should some of that write‑down now be reversed?
Once you get used to viewing inventory through an NRV lens, HKAS 2 / IAS 2 becomes less about memorising rules and more about asking the right questions. You will also naturally pay attention to “inventory write‑downs” and “NRV testing” in annual reports and notes, which often reveal early signs of business pressure or recovery.
Key takeaways for students and junior accountants
- When reviewing inventory at year‑end, always compare cost vs NRV using the simple formula (selling price − completion costs − selling costs) and document your thinking in the working papers.
- Do not forget special cases: inventory for firm contracts, raw materials used in still‑profitable finished goods, and post‑year‑end selling prices that provide evidence of conditions at the reporting date.
- In exams, watch for classic traps: including irrelevant costs in NRV, ignoring selling costs, grouping loss‑making items with profitable ones, or reversing write‑downs beyond original cost.
- When reading contracts or discussing deals with sales teams, ask whether any inventory is effectively “locked” to contract prices, and if those prices are above or below cost.
- When preparing audit or internal working papers, clearly show: the triggers for NRV testing, how each NRV was calculated, and how write‑downs or reversals flow into profit or loss and the balance sheet.
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