INVENTORY

ACC101FINANCIAL ACCOUNTING

Week 3, Lecture

INVENTORY

Can be very significant for some

businesses. E.g. Manufacturing entities.

Impacts financial statements in two ways:

Statement of financial position (previously

known as Balance Sheet)

Potentially large balance within current assets

Income statement

Opening and closing inventories have a direct

impact on cost of sales and therefore profits.

PROBLEMS WITH INVENTORY?

Value changes over time, how should

this be accounted for? Should it be

valued at cost? Market value? Or some

other price?

Treatment of inventory is described in

“IAS 2 : Inventories”.

Inventories should be measured at the

lower of cost and net realisable value.

COST OF INVENTORY Cost comprises of 3 elements. They are:

Cost of purchase Purchases price Import dutiesBUT NOT sales tax and trade discounts

Cost of conversion Relating to productions: direct labour direct/variable overheads an allocation of fixed overheads (based on normal level of activity)

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

EXAMPLE According to IAS 2: Inventories, which of

the following should NOT be included in valuing the inventories of an entity?(1) Labour costs(2) Transport costs to deliver goods to

customers(3) Administrative overheads(4) Depreciation on factory machine

(A) All four items(B) 1 only(C) 2 and 3 only(D) 2, 3, and 4 only

EXAMPLE According to IAS 2: Inventories, which of

the following should NOT be included in valuing the inventories of an entity?(1) Labour costs(2) Transport costs to deliver goods to

customers(3) Administrative overheads(4) Depreciation on factory machine

(A) All four items(B) 1 only(C) 2 and 3 only(D) 2, 3, and 4 only

NET REALISABLE VALUE

The net realisable value of an item is essentially its net selling proceeds after all costs have been deducted.

It is calculated as:Estimated selling price XLess: estimated costs of completion

(X)Less: estimated selling and distribution costs (X)

X No netting off

The IAS 2 rule 'lower of cost and net realisable value‘ should be applied as far as possible on an item by item (or line by line) basis.

EXAMPLE

It would be incorrect to compare the total cost of $113 to the total NRV of $135 and state inventories as $113.

The comparison should be for each item, thus $107 would be attributed.Dr Inventories $107Cr Cost of goods sold $107

Inventory item

Cost

NRV

Lower of cost and NRV

1 27 32 27

2 14 8 8

3 43 55 43

4 29 40 29

113 135 107

Suppose an entity has four items of inventories on hand at the year end. Their costs and NRVs in $ are as follows:

EXAMPLE - NRV

Jessie is trying to value her inventory. She has the following information available:

Required:What is the net realisable value of Jessie's

inventory?

£

Selling price 35

Cost incurred to date 20

Cost of work to complete it

12

Selling costs per item 1

JESSIE - NRVEstimated selling Price £ 35

Less: estimated cost of completion

(£ 12)

Less: Selling costs per item (£ 1)

NRV £ 22

Cost was given as £ 20NRV calculated is £ 22Therefore, inventory must be valued at £ 20 (lower of the cost and net realisable value.

VALUATION The basic rule per IAS 2: Inventories is:'Inventories should be measured at the lower

of cost and net realisable value.' This is an example of prudence in presenting

financial information. (a) If inventory is expected to be sold at a

profit: (i) value at cost (ii) do not anticipate profit.

(b) If inventory is expected to be sold at a loss: (i) value at net realisable value (ii) do provide for the future loss.

THEORETICAL METHODS OF ESTIMATING COST

FIFO (First In First Out)

(i) first goods purchased/produced will be the

first to be sold

(ii) remaining inventories are the most recent

purchases/production.

LIFO (Last In First Out)

AVCO (Average Cost). Two averages available:

Simple average cost

Weighted average cost

AVCO

Simple average cost

The cost of all purchases/production during

the year is divided by the total number of

units purchased

Weighted average cost

The weighted average of the cost of similar

items is recalculated each time a new item

is purchased/produced during the period

(IAS 2 requires the weighted average to be

used)

EXAMPLEOn 1 January 20X2 a company held 200 units of finished

goods valued at $10 each. During January the following transactions took place.

Required

Determine the valuation of closing inventories and cost of sales using:

(a) FIFO

(b) Weighted average cost

Date

Units purchased

Cost / unit

10 Jan

300 $10.85

20 Jan

350 $11.50

25 Jan

250 $13.00

Date

Units sold

Sales price / unit

14 Jan

280 $18.00

21 Jan

400 $18.00

28 Jan

80 $18.00

SUMMARY

Inventories should be valued at the lower of cost and net

realisable value.

The cost of inventory includes the cost of purchase,

costs of conversion and any other costs necessary to

bring the inventory to its present location and

condition.

Methods available to estimate the cost of inventories are first

in, first out (FIFO) and average cost.

In times of rising prices, using FIFO will mean the financial

statements show higher inventory values and higher profits.

Net realisable value is the estimated selling price less

the costs to completion and any selling and

distribution costs.