Lecture 5(1).pdf

Lecture 5

Accounting for

Inventory

HI6025: Accounting Theory

and Current Issues

2

Inventory

Inventory often accounts for a large proportion of

total assets

Accounting methods used for inventory can have

a significant impact on reported assets and profits

AASB 102 applies to all inventories except:

work in progress under construction contracts

financial instruments, and

biological assets

Holmes Institute 2015

3

Inventories defined

Inventories are defined as assets (AASB 102):

held for sale in the ordinary course of business

in the process of production for such sale, or

in the form of materials or supplies to be consumed in

the production process or in the rendering of services

Cost of goods sold:

is the cost of inventory sold during the financial period

can be determined either on a periodic or perpetual

basis

Holmes Institute 2015 4

Inventory measurement

Inventories must be measured at the lower of

cost and net realisable value (AASB 102)

on an item-by-item basis

Cost of inventories comprises all (AASB 102):

costs of purchase (i.e. purchase price, import duties,

transport costs, etc.)

costs of conversion (e.g. direct labour and allocation of

overhead costs)

other costs incurred in bringing the inventories to their

present location and condition (e.g. product design

costs for specific customers and installation)


5


Costs of inventory exclude (AASB 102):

abnormal amounts of wasted materials

storage costs

administrative overheads

selling costs

Fixed production costs:

are those costs of production that are not expected to

fluctuate as production levels change (e.g. building

depreciation and factory administration costs)



There are two methods for dealing with fixed

production costs

1. Absorption costing: fixed manufacturing costs

included in cost of inventories

2. Direct costing: fixed manufacturing costs treated as

period costs (i.e. expensed in the period incurred)

AASB 102 requires the use of absorption

costing


7


Cost of inventory must include both fixed and

variable production overheads

Indirect production costs that cannot be traced to the

goods or services

Standard costs

Predetermined product costs based, for example, on

planned products and/or operations, planned cost and

efficiency levels and expected capacity utilisation

Only permitted for inventory costing where the

standards are realistically attainable, reviewed regularly

and revised where necessary



Net realisable value (NRV) (AASB 102) Estimated selling price in the ordinary course of

business less the estimated costs of completion and those necessary to make the sale

If NRV is greater than cost, inventory should be left at cost Upwards revaluations are not allowed by AASB 102

If NRV is less than cost, inventory should be written down to NRV Write-down treated as an expense in the period of the

write-down

Refer to Worked Examples 7.1, 7.2 and 7.3 on pp. 228, 230 and 231


Determination of “cost of inventory”

What must be considered from a list of expenses

are those costs that relate to inventory, which

would be those costs related to production such

as;

Factory utilities Factory insurance

Factory rent Purchase raw materials

R&M (factory) Wages (factory)

Freight in Raw materials

Salaries (factory staff)


Net Realisable Value (example) WE 7.2

Product

Line

Production

costs

($,000)

Transport

costs

($,000)

Packaging

costs

($,000)

Expected

sales

proceeds

($,000)

Gidgets 20 2 3 35

Widgets 30 4 4 30

Didgets 15 1 1.5 22

Sidgets 25 2.5 2.5 35

Required, what is the cost of inventory?


Net Realisable Value (example 7.2)

Product Line NRV ($,000) Cost ($,000) Lower of cost

and NRV ($,000)

Gidgets 30 20 20

Widgets 22 30 22

Didgets 19.5 15 15

Sidgets 30 25 25

TOTAL 101.5 90 82


Inventory cost determination.

Using the text example (Worked example 7.3) it

can be seen (next slides) what the value of

inventory is when disclosing it in the year-end

Balance sheet.

In this example, Scottie Thomson Ltd

commences business on 1st July 2012

manufacturing life-size dolls. The following data

is provided in order to determine value of

inventory.

Note: NOC (example) is Normal Operating

Capacity.


Inventory cost determination (cont.)

Normal operating capacity NOC (units) 100,000

Goods produced (units) 100,000

OB - Finished Goods inventory Nil

CB – Finished Goods inventory 20,000

OB – Raw Materials inventory Nil

CB – Raw Materials inventory 100,000

Factory salaries 250,000

Administration salaries 90,000

Factory rent 120,000

Depreciation – Factory P&E 80,000

Rental – Office equipment 60,000

Raw materials purchased 300,000

Sales price per unit 9 per unit

Delivery costs – Finished goods 1 per unit

Note: At end of year, no partly-completed finished goods


Variable Costs

Factory salaries 250,000

Raw materials purchased 300,000

less Closing balance 100,000 200,000 450,000

divided by Units Produced 100,000

Per unit variable costs $4.50

Fixed Costs

Factory rent 120,000

Depreciation – P & E 80,000 200,000

divided by NOC 100,000

Per unit fixed costs $2.00

Total cost per unit $6.50

Net Realisable Value (NRV)

Sales price per unit $9.00

less Delivery costs $1.00 $8.00



So what is the closing value of inventory?

Is it $6.50 or $8.00?

Well if you said $6.50 being the lower, you would

be correct (as long as you remembered this

must be multiplied by the CB, being 20,000)

So 20,000 x $6.50 = $130,000 which will show in

the Statement of Financial Position (commonly

called the Balance Sheet)



Discounts for early payment

Discounts received for early payment for debts

due to the supplier of inventory are not to be

offset against the cost of inventory

Discounts given to customers for early

payment are not to be offset against sales

Penalties for late payment are not to be added

to the cost of inventory

Trade discounts provided at the point of

purchase are to be seen as a reduction in the

cost of the inventory


17

Borrowing costs

Costs associated with borrowings (e.g. interest) can

sometimes be included in the cost of inventory

Governed by AASB 123 Borrowing Costs

Interest costs can be included as part of the inventory

to the extent that the inventory is deemed to be a

‘qualifying asset’

Qualifying assets are those ‘that necessarily take a

substantial period of time to get ready for their

intended use or sale’

Would not be applicable to most inventory being

produced


Inventory cost flow assumptions

Cost-flow assumptions must be made where

cost of inventory items fluctuate

Specific identification of items sold and on

hand, although ideal, might be impractical to

apply

Cost-flow assumptions used to determine cost

of goods sold and closing inventory

The actual physical flow of goods and the flow

according to the ‘cost-flow assumption’ might be

different


19

Inventory cost flow assumptions (cont’d)

Method adopted should be:

appropriate to the circumstances

applied consistently from period to period

AASB 102 allows the use of one or more of the

following methods:

specific identification

weighted-average cost

first-in first-out (FIFO) (traditionally most common)

AASB 102 does not permit the use of:

last-in first-out (LIFO)


Specific identification method

Cost of sales calculated by determining which

item was sold and the specific cost of that item

Ending inventory is costed at the cost of the

specific items on hand at the end of the year

Required to be used for inventory items that are

(AASB 102):

not ordinarily interchangeable, or

goods or services produced and segregated for specific

projects

Not appropriate for large numbers of similar or

identical items (AASB 102)


21

Weighted average method

An average cost is based on beginning

inventory and items purchased during the

period

Various costs of individual units are weighted

by the number of units

Cost of goods sold and ending inventory are

costed at the average cost


FIFO method

Goods from beginning inventory and the

earliest purchases are assumed to be the

goods sold first

Consistent with selling behaviour in most

entities

Ending inventory assumed to be most recent

purchases

More current value of inventory on balance sheet


23

LIFO method

Most recent purchases are assumed to be the first

goods sold

Ending inventory assumed to be the oldest goods

Inventory could be valued at prices paid some years

earlier

Not allowed in Australia under AASB 102


LIFO method (cont’d)

Allowed in the United States for external reporting

and tax purposes

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

accounting methods

While some methods might increase income, others

might act to reduce income

Refer to Worked Example 7.4 (p. 235) for a

comparison of the methods


Example of methods used

Information provided No. Unit Total

Date of units cost cost

$ $

1 Jul Beginning Inventory 10 10 100

Purchases made in current period:

15 Sep Purchase 12 11 132

7 Dec Purchase 15 12 180

Total purchases 27 312

Goods available for sale 37 412

Sales made in current period

20 Sep Sales 8 ? ?

12 Jan Sales 10 ? ?

Total cost of sales 18 ?

30 June Ending Inventory 19 ?


Units sold and on hand are identified with a

specific invoice

If 18 units sold (per previous slide), assume:

1 unit from beginning inventory ($10)

12 units from 15 September purchase ($11)

5 units from 7 December purchase ($12)

Specific identification method – periodic


Remaining inventory:

9 units Beginning inventory @ $ 10 $ 90

10 units 7 December 12 120

Cost of Ending Inventory $ 210

Cost of goods available for sale $ 412

Less ending inventory – 19 units 210

Cost of Goods Sold – 18 units $ 202

Specific identification method – periodic continued


First-in, first-out (FIFO) method – periodic


4 units 15 September @ $ 11 $ 44

15 units 7 December 12 180

Cost of Ending Inventory $ 224

Cost of goods available for sale $ 412

Less ending inventory – 19 units 224

Cost of Goods Sold – 18 units $ 188


Weighted average method – periodic

Average cost per unit of ending inventory

= Total cost of goods available for sale Number of units available for sale

= $412 / 37 units = $11.14 per unit


19 units @ $11.14 $ 211.66

Cost of Ending Inventory $ 211.66

Cost of goods available for sale $ 412.00

Less ending inventory – 19 units 211.66

Cost of Goods Sold – 18 units $ 200.34


Comparison of costing methods

Specific FIFO Weighted

ID Average

Sales $360 $360 $360

Beginning inventory 100 100 100

Purchases 312 312 312

Goods available for sale 412 412 412

less: Ending inventory 210 224 212

Cost of Goods Sold 202 188 200

Gross Profit 158 172 160

Less: expenses 120 120 120

Net Profit $38 $52 $40

Ending Inventory

in Balance Sheet $210 $224 $212


31

Inventory systems

Determination of cost of sales and inventory under

each cost-flow assumption also depends on the

inventory recording system used

Periodic inventory system

– Inventory counted periodically

– No continuous records kept of inventory sales

Perpetual inventory system

– Running total kept of units on hand

– Increases and decreases of inventory recorded as they

occur

See Worked Examples 7.5 and 7.6 (pp. 236 and 237)


Reversals of prior write-downs

As we know, inventories must be written down if the net realisable value (NRV) is less than cost

If, in a subsequent period, NRV increases to original cost or above, the inventory write-down can be reversed—with a subsequent increase in income

Any subsequent accounting entry to increase the carrying amount of inventory must be restricted to the amount that was previously expensed

The value of inventory must not be increased above its original cost (in keeping with the lower of cost and NRV rule)

See Worked Example 7.7 (p. 239)—Reversal of a previous inventory write-down


Journals for Inventory write-down/reverse

Journal for write-down

DR Inventory write-down XX

CR Inventory XX

To record the write-down value of inventory to NRV

Journal to reverse (or partially)

DR Inventory XX

CR Inventory write-down XX

To reverse previous write-down of inventory to NRV


Disclosure requirements

Where material, AASB 102 requires the disclosure of the following: accounting policies for measuring inventories, including

cost formulas used

total carrying amount of inventories

carrying amount of inventories carried at fair value less costs to sell

amount of inventories expensed during the period

amount of any write-downs expensed in the period

amount of any reversal of any write-down

circumstances leading to reversals of write-downs

carrying amount of inventories pledged as securities for liabilities


Lecture 5(1).pdf

Documents

Transcript of Lecture 5(1).pdf