#12 INVENTORIES

FINANCIAL ACCOUNTING AND REPORTING                                                     

INVENTORIES

Key Terms and Definitions

Ø  Inventories are assets:

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

(b) In the process of production for such sale; or

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

Ø  Net realizable value 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.

Ø  Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Cost of Inventories

Ø  Costs of purchase

Ø  Costs of conversion

Ø  Other costs incurred in bringing the inventories to their present location and condition.

Costs of Purchase

Ø  The costs of purchase of inventories comprise the purchase price, import duties and other non recoverable taxes and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services.  Trade discounts, rebates and other similar items are deducted in determining the costs of purchase.

Costs of Conversion

Ø  Direct labor 

Ø  Variable production overhead is allocated to each unit using the actual use of production facilities.

Ø  Fix production overhead allocated using the normal operating capacity of production facilities.

Other Costs

Ø  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, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories.

Inventory cost should exclude:

·         Abnormal waste

·         Storage costs

·         Administrative overheads unrelated to production

·         Selling costs

·         Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency

·         Interest cost when inventories are purchased with deferred settlement terms.

Cost Formulas

Ø  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.

Ø  The cost of inventories, other than those that are not ordinarily interchangeable, 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.

FIFO Perpetual and Periodic Illustrated

			Units	Unit Cost	Total Cost
	Jan.  1	Beginning balance	8,000	70.00	560,000
	6	Purchase	3,000	81.00	243,000
	Feb.  5	Sale	10,000
	Mar.  5	Purchase	11,000	73.50	808,500
	Mar.  8	Purchase return	800	73.50	58,800
	Apr. 10	Sale	7,000
	Apr. 30	Sale return	300

Ø  If periodic FIFO is used, the ending inventory will be unit cost from the March 8 purchase and will be deducted from the accumulation of the beginning inventory and net purchase, known as the total goods available for sale.

	Beginning balance (8,000 x 70)		560,000
	Feb. 5 Purchase (3,000 x 81)		243,000
	Mar. 5 Net Purchase (10,200 x 73.50)		749,700
	Total goods available for sale		1,552,700
	Less: Ending Inventory* (4,500 x 73.50)		330,750
	Cost of goods sold		1,221,950
	*Ending inventory in units (21,200 – 16,700)		4,500
Ø  COGS computation under perpetual
	Feb. 5 Costs of goods sold:
	Jan. 1 Inventory (8,000 x 70)		560,000
	Jan. 6 Inventory (2,000 x 81)		162,000
	Total		722,000
	April 10 Net Costs of goods sold:
	Jan.6 Inventory (1,000 x 81)		81,000
	Mar. 5 Inventory (5,700 x 73.50)		418,950
	Total		499,950
	Jan.  1 Inventory			560,000
	6 Purchase			243,000
	Total			803,000
	Feb.  5 COGS			(722,000)
	Balance			81,000
	Mar.  5 Net Purchase			749,700
	Total			830,700
	Apr. 10 Net COGS			(499,950)
	Apr. 30 Inventory balance			330,750
Ø  Periodic Average or Weighted Average
	Beginning balance (8,000 x 70)			560,000
	Feb. 5 Purchase (3,000 x 81)			243,000
	Mar. 5 Net Purchase (10,200 x 73.50)			749,700
	Total goods available for sale			1,552,700
	Less: Ending Inventory* (4,500 x 73.24**)			329,580
	Cost of goods sold			1,223,120
	Total cost			1,552,700
	Divide by total number of units			21,200
	**Weighted average cost per unit			73.24
Ø  Perpetual Average or Moving Average
	Jan.  1 Inventory			560,000
	6 Purchase			243,000
	Total			803,000
	Feb.  5 COGS (10,000 x 73.00***)			(730,000)
	Balance			73,000
	Mar.  5 Net Purchase			749,700
	Total			822,700
	Apr. 10 Net COGS (6,700 * 73.46****)			(492,182)
	Apr. 30 Inventory balance			330,518
	*** Feb 5. Average cost (803,000 / 11,000)			73.00
	**** April 10 Average cost (822,700 / 11,200)			73.46

Measurement of Inventories

Ø  Inventories are required to be stated at the lower of cost and net realizable value (NRV). Inventories are usually written down to net realizable value item by item.  In some circumstances, however, it may be appropriate to group similar or related items. 

EXAMPLE:

	Cost	NRV	LCNRV
Product A	200,000	180,000	180,000
Product B	300,000	250,000	250,000
Product C	100,000	130,000	100,000
Total	600,000	560,000	530,000

Ø  The total carrying amount of inventories shall be 530,000, which is the most conservative amount by applying the LCNRV approach.

Write-Down to Net Realizable Value

Ø  If the ending inventory is recorded outright at 530,000, the writedown shall be immediately recognized in cost of goods sold.  This is the direct or cost of sales method.

Ø  If the ending inventory is recorded first at the cost of 600,000, a loss of 70,000 with a corresponding credit to an allowance account shall be recognized.  This is the loss/allowance method.

Ø  Any write-down to NRV should be recognized as an expense in the period in which the write-down occurs.

Ø  Any reversal should be recognized in the income statement in the period in which the reversal occurs.

Recognition as an Expense

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

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

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

Ø  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 recognized as an expense during the useful life of that asset.

Required disclosures:

·         Accounting policy for inventories.

·         Carrying amount, generally classified as merchandise, supplies, materials, work in progress, and finished goods. The classifications depend on what is appropriate for the enterprise.

·         Carrying amount of any inventories carried at fair value less costs to sell.

·         Amount of any write-down of inventories recognized as an expense in the period.

·         Amount of any reversal of a writedown to NRV and the circumstances that led to such reversal.

·         Carrying amount of inventories pledged as security for liabilities.

·         Cost of inventories recognized as expense (cost of goods sold).

Inventory Estimation Techniques

Ø  Gross Method – Based on the assumption that the gross profit applied by an entity to its products remains approximately the same from period to period and therefore the relationship between cost of goods sold and sales is constant.

Goods available for sale		X
Less: Estimated cost of goods sold
Net sales*	X
Less: Gross profit	X	X
Estimated ending inventory		X

The cost of goods sold can also be computed if the net sale is multiplied by 1 less the GP rate if the gross profit rate based on sales or net sales divided by 1 plus the gross profit rate if the gross profit rate is based on cost.

*Net sales shall be gross sales less “sales returns and allowance” or “sales returns” only in order for the estimate in ending inventory not to be overstated.

Ø  Retail Method – Employed by retailers dealing with numerous different items for sale with varying mark up percentages to keep track unit cost.

Goods available for sale at retail				X
Less:  Net sales	X
Employee discounts			X
Normal losses		X		X
Estimated ending inventory				X
Multiplied by the cost ratio				%
Estimated ending inventory at cost				X

Ø  Conservative Cost Ratio = GAS at cost divided by GAS at retail before net markdown

Ø  Average Cost Ratio = GAS at cost divided by GAS at retail (after net markdown)

Ø  FIFO Cost Ratio = Purchases at cost divided by Purchases at retail after net markdown

Ø  Net sales similar to the “gross profit method” of estimation is computed by ignoring the sales discount and sales allowance if it is separated from sales returns.

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