Chapter 7: Inventory
Inventory is assets held for sale or assets used to produce goods that will be sold
as part of the business.
Different categories of inventory
- Raw Materials: inputs into production process
- Work-in-progress of WIP inventory: partially completed product to date
- Finished goods: inventory that has been completed and ready for sale
Requires inventory to be valued at costs on the balance sheet
Net Realizable Value (NRV) of inventory is less than costs, the inventory must be
written down to its NRV. LOWER OF COST and MARKET RULE.
Costs of inventory includes all costs incurred to ready the inventory for sale or
use: purchase price, import duties, and other taxes, shipping and handling, and any
other costs directly related to the purchase of the inventory
For manufacturers and processors:
- IFRS requires that the cost of inventory include the cost of materials, labor
costs plus an allocation of overhead incurred in the production process.
- Overhead is the costs in manufacturing process other than direct labor and
- However, IFRS does not give specific directions for determining which costs
and how much of them should be included.
- Thus, different entities can determine the cost of inventory differently, which
Perpetual and Periodic Inventory Control Systems
Perpetual Inventory control system: keeps an ongoing tally of purchases and
sales of inventory.
- For the purchase of inventory:
Cr. Accounts Payable/Cash
To record the purchase of inventory
- For the sale of inventory
To record the sale of inventory
Dr. Cost of goods sold
To record the sale of inventory in a perpetual and the
corresponding cost of sales
Periodic Inventory control system: 9K0L3;03947\,..4:39L839,/M:890/ZK030;07
www.notesolution.com Periodic Inventory control system: 9K0L3;03947\,..4:39L839,/M:890/ZK030;07
a transaction affects inventory. Purchases are accumulated in a separate purchases
account. The balance at the end of year is determined by counting the inventory.
Cost of sales = Beginning inventory + Purchases Ending Inventory
- For the purchase of inventory:
Cr. Cash/ Accounts Payable
- For when inventory is sold
At the end of the period:
Determine cost of sales using the formula above, followed after is an adjusting entry:
Dr. cost of sales
Dr. Inventory (You debit inventory because you convert the
remaining amount into an asset at the end of the year)
Under perpetual inventory, an inventory count is done to determine the amount of
inventory that maybe stolen, lost, damaged or destroyed.
If inventory is not counted at the end of the period, the amount on the b/s can be
overstated and expenses would be understated.
(Stolen inventory is an expense in the period the theft occurs or is discovered)
Information on stolen inventory is rarely, if ever reported in the f/s. It is usually
accounted for in the cost of sales.
place as there are no records to compare to the physical count.
Inventory Valuation Methods
Three cost formulas allowed by IFRS:
1. First in first out (FIFO)
2. Average cost
3. Specific identification
- When inventory is homogeneous or interchangeable then average cost or FIFO
cost formulas can be used.
- IFRS requires specific identification for inventory items that are no
models, thus each has a vehicle identification number.
- The costs associated with the inventory that was purchased for produced first is
the cost expensed first
- With FIFO, the cost of inv reported on the b/s represents the cost of inv most
www.notesolution.com - With FIFO, the cost of inv reported on the b/s represents the cost of inv most
recently purchased or produced
- The oldest costs are the first ones matched to revenues
Cost formulas address the flow of costs, not the physical flow of goods
Average Cost Method
- The average cost of the inventory on hand during the period is calculated and
the average is used to determine cost of sales and ending inventory
- Average cost simply assumes all inv units have the same cost and the cost of
individual units of inv is lost
- assigns the actual cost of a particular unit of inv to that unit of inventory
- The inventory cost reported on the b/s is the actual cost of the specific item
- Specific identification provides some opportunity for management to manipulate
F/S, if there are identical items with different costs in inv, managers could
choose sell the most expensive to lower net income and the sell the least
expensive to increase net income.
- It provides an opportunity for income management that the other two do not!
Comparison of Different Cost Formulas
- When inventory prices are rising, FIFO cost of sales will always be lower than
average cost method of cost of sales and FIFO gross margin and net income
will always be higher.
- If cost of inventory remains constant over a period of time all methods will yield
the same results.
- When FIFO is used, the inventory costs reported on the B/S are most current as
a result it gives a close approximation of the replacement cost.
- Replacement cost is the amount it would cost to replace inventory, or any
asset, at current prices.
- Stakeholders who are interested in predicting future cash flows might find a
FIFO valuation useful.
- The current ratio will be higher with FIFO when prices are rising
- On the I/S the costs associated with the oldest inventory are expensed to cost
of sales first under FIFO. This means COGS is less current
- Thus, gross margin and net income are poor indicators and the effects could be
misleading to stakeholders
- Average cost provides a b/s measure less current than FIFO but the cost of
sales is more current
- FIFO corresponds to physical flow of the goods
- Average cost used when prices are rising because it yields a lower net income
figure. (Used by businesses with tax minimization objective)
Lower of Cost and Market Rule
- According to IFRS, inventory on hand at the end of period must be evaluated
according to the lower of cost and market (LCM) rule.
- It requires inventory to be recorded at its net realizable value, is NRV is less
- NRV is the amount the entity would receive from the selling of the inventory,
less any additional costs.
www.notesolution.com - If NRV is less than its costs the inventory must be written down to NRV
- The amount write-down is the difference between the cost and the NRV, and is
reported as a loss or expense on the I/S in the period the impairment is
- A write-down is a reduction in the carrying amount of inventory to some
measure of market value
- When an asset is written down to zero is called a write off
- Journal entry:
Dr. Cost of Sales or Inventory Loss
To record write down of inventory
- A write down reduces inventory on the B/S, increases expenses, and decrease
- Can be disclosed on a separate line on the I/S or included in the COGS with
disclosure in the notes
- IFRS requires a write down to be reversed if the NRV of inventory increases in
a subsequent period
- It is written back up to its original cost
- Journal Entry:
Cr. Cost of Sales/ Inventory Loss
To reverse the write down of inventory
Valuing Inventory at Other than cost
- Replacement cost- what it would cost to replace
- Inventory worth $1000, replacement cost is $1100
- Journal entry to record at replacement cost:
Dr. Inventory $100
Cr. holding gains/loss $100
- Journal Entry to record when inventory is sold for $2500:
Dr. Cash/Accounts receivable $2500
Cr. Revenue $2500
Dr. COGS $1100
Cr. Inventory $1100
- Under IFRS
Dr. Cash $2500
Cr. Revenue $2500
Dr. COGS $1000
Cr. Inventory $1000
Financial Statement Analysis Issues
- The inventory turnover ratio
Inventory Turnover ratio= Costs of Sales/ Average Inventory
- measures how quickly the entity is able to sell its inventory
Avg = 365/ inventory turnover ratio
- indicates the number of days it takes an entity to sell its inventory