Chapter 6 Inventory Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-2 Objectives Be able to calculate the cost of inventory according to FRS-4 Accounting for Inventories. Be able to calculate the cost of inventory according to FRS-4 Accounting for Inventories. Understand how to apply the lower of cost and net realisable value rule for measuring inventory. Understand how to apply the lower of cost and net realisable value rule for measuring inventory. Understand why there is typically a necessity to make inventory cost-flow assumptions. Understand why there is typically a necessity to make inventory cost-flow assumptions. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-3 Objectives (cont.) Be able to assign costs to inventories as required by FRS-4. Be able to assign costs to inventories as required by FRS-4. Know the disclosure requirements of FRS-4. Know the disclosure requirements of FRS-4. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-4 Definition of inventory Assets that are: Assets that are: held for realisation in the ordinary course of business; or in the process of production for realisation in the ordinary course of business; or to be absorbed into goods and services for realisation in the ordinary course of business. FRS-4 does not apply to inventories under construction contracts; farm produce; livestock held by the producers; and financial instruments. FRS-4 does not apply to inventories under construction contracts; farm produce; livestock held by the producers; and financial instruments. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-5 General basis of inventory measurement Inventory should be measured at the lower of cost and net realisable value. Inventory should be measured at the lower of cost and net realisable value. It should be measured on an item-by-item basis. It should be measured on an item-by-item basis. It can be measured on a group basis (where item-by-item is impractical). It can be measured on a group basis (where item-by-item is impractical). Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-6 Inventory cost Aggregate of: Aggregate of: cost of purchase (including import duties, taxes, inward transportation and handling costs etc.) cost of conversion (direct labour and other production, preparation or conversion costs) other costs incurred in bringing the inventories to their present location and condition. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-7 Fixed production costs Costs of production which remain relatively constant, irrespective of variations in volume. Costs of production which remain relatively constant, irrespective of variations in volume. FRS-4 requires absorption costing FRS-4 requires absorption costing fixed manufacturing costs are included in the cost of inventories. Direct costing (fixed production costs treated as period costs) not permitted by FRS-4. Direct costing (fixed production costs treated as period costs) not permitted by FRS-4. Cost of inventory includes both variable and fixed production overheads. Cost of inventory includes both variable and fixed production overheads. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-8 Use of standard costs Predetermined product costs established on the basis of planned products and/or operations, planned cost and efficiency levels, and expected capacity utilisation. Predetermined product costs established on the basis of planned products and/or operations, planned cost and efficiency levels, and expected capacity utilisation. Only permitted where the standards are set so as to be realistically attainable, are reviewed regularly and, where necessary, are revised in the light of current conditions. Only permitted where the standards are set so as to be realistically attainable, are reviewed regularly and, where necessary, are revised in the light of current conditions. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-9 Net realisable value Defined by FRS-4 as the estimated selling price in the ordinary course of business, less costs of completion, and less costs necessarily to be incurred in order to make the sale. Defined by FRS-4 as the estimated selling price in the ordinary course of business, less costs of completion, and less costs necessarily to be incurred in order to make the sale. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-10 Applying the lower of cost and net realisable value rule If the net realisable value of an item is more than cost, it is left as cost. If the net realisable value of an item is more than cost, it is left as cost. If it is less than cost, the item must be written-down to the net realisable value. If it is less than cost, the item must be written-down to the net realisable value. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-11 Inventory cost-flow assumptions Cost-flow assumptions must be made where cost of inventory items fluctuates. Cost-flow assumptions must be made where cost of inventory items fluctuates. Used to determine cost of goods sold and closing inventory value. Used to determine cost of goods sold and closing inventory value. Method chosen should best reflect the reality of the circumstances. Method chosen should best reflect the reality of the circumstances. Method should be applied consistently across accounting periods. Method should be applied consistently across accounting periods. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-12 Available inventory cost-flow methods FRS-4 allows the use of one or more of the following methods: FRS-4 allows the use of one or more of the following methods: specific identification weighted-average cost first-in, first-out method. Not permitted: Not permitted: last-in, first-out method base-stock method of inventory valuation. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-13 Specific identification Not suitable for large numbers of similar or identical items. Not suitable for large numbers of similar or identical items. Cost of sales calculated by determining which item was sold and the specific cost of that item. Cost of sales calculated by determining which item was sold and the specific cost of that item. Required for inventory items that are: Required for inventory items that are: not ordinarily interchangeable; or goods or services produced and segregated for specific projects. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-14 Weighted average cost An average cost is based on beginning inventory and items purchased during the period. An average cost is based on beginning inventory and items purchased during the period. The various costs are weighted by the number of units. The various costs are weighted by the number of units. Cost of goods sold and ending inventory are costed at the average cost. Cost of goods sold and ending inventory are costed at the average cost. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-15 First-in, first-out method The goods from beginning inventory and the earliest purchases are assumed to be the goods sold first. The goods from beginning inventory and the earliest purchases are assumed to be the goods sold first. Consistent with selling behaviour in most entities. Consistent with selling behaviour in most entities. Ending inventory assumed to be most recent purchases. Ending inventory assumed to be most recent purchases. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-16 Last-in, first-out method The most recent purchases are assumed to be the first goods sold. The most recent purchases are assumed to be the first goods sold. Ending inventory assumed to be the oldest goods Ending inventory assumed to be the oldest goods can result in inventory being valued at prices that were paid some years before. Allowed in USA for external reporting purposes and for tax purposes Allowed in USA for external reporting purposes and for tax purposes when rising prices increase cost of goods sold, profit and, therefore, tax liability are reduced. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-17 Contractual explanations for choice of method US companies that elect not to adopt LIFO typically have higher leverage and lower interest coverage ratios. US companies that elect not to adopt LIFO typically have higher leverage and lower interest coverage ratios. Those potentially close to breaching debt covenants adopt income-increasing and asset-increasing methods. Those potentially close to breaching debt covenants adopt income-increasing and asset-increasing methods. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-18 Inventory systems Determination of cost of sales and inventory under each cost-flow assumption also depends of the recording system used. Determination of cost of sales and inventory under each cost-flow assumption also depends of the recording system used. Periodic inventory system Periodic inventory system inventory counted periodically no continuous records kept of inventory sales. Perpetual inventory system Perpetual inventory system running total kept of units on hand increases and decreases in inventory recorded as they occur. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-19 Disclosure requirements FRS-4 requires disclosure of: FRS-4 requires disclosure of: accounting policies adopted for measuring inventories including method of determining cost of inventories. amount of inventories with separate disclosure of total value of inventories; and total value of inventories; and value of each sub-classification of the total inventories classified appropriately. value of each sub-classification of the total inventories classified appropriately. Copyright 2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 6-20 Disclosure requirements (cont.) FRS-4 requires disclosure of (cont.): FRS-4 requires disclosure of (cont.): amount of inventories specifically and separately pledged as securities for liabilities. where applicable the fact that some inventories are subject to retention of title clauses.