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Also, while the following are within the scope of the standard, IAS 2

does not apply to the measurement of inventories held by: [IAS 2.3]

producers of agricultural and forest products, agricultural
produce after harvest, and minerals and mineral products,
to the extent that they are measured at net realizable value
(above or below cost) in accordance with well-established
practices in those industries. When such inventories are
measured at net realizable value, changes in that value are
recognized in profit or loss in the period of the change.
Commodity brokers and dealers who measure their
inventories at fair value less costs to sell. When such
inventories are measured at fair value less costs to sell,
changes in fair value less costs to sell are recognized in
profit or loss in the period of the change.

Fundamental principle of IAS 2
Inventories are required to be stated at the lower of cost and net
realizable value (NRV). [IAS 2.9]
Measurement of inventories
Cost should include all: [IAS 2.10]

costs of purchase (including taxes, transport, and handling)
net of trade discounts received

costs of conversion (including fixed and variable
manufacturing overheads) and

other costs incurred in bringing the inventories to their
present location and condition

For inventory items that are not interchangeable, specific costs are
attributed to the specific individual items of inventory. [IAS 2.23]For
items that are interchangeable, IAS 2 allows the FIFO or weighted
average cost formulas. [IAS 2.25] The LIFO formula, which had been
allowed prior to the 2003 revision of IAS 2, is no longer allowed.
The same cost formula should be used for all inventories with similar
characteristics as to their nature and use to the entity. For groups of
inventories that have different characteristics, different cost formulas
may be justified. [IAS 2.25]
Write-down to net realizable value
NRV is the estimated selling price in the ordinary course of business,
less the estimated cost of completion and the estimated costs necessary
to make the sale. [IAS 2.6] Any write-down to NRV should be
recognized as an expense in the period in which the write-down
occurs. Any reversal should be recognized in the income statement in
the period in which the reversal occurs. [IAS 2.34]
Expense recognition
IAS 18 Revenue addresses revenue recognition for the sale of goods.
When inventories are sold and revenue is recognized, the carrying
amount of those inventories is recognized as an expense (often called
cost-of-goods-sold). Any write-down to NRV and any inventory losses
are also recognized as an expense when they occur. [IAS 2.34]
Disclosure
Required disclosures: [IAS 2.36]

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
entity

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

amount of any write-down of inventories recognised as an
expense in the period

amount of any reversal of a writedown to NRV and the
circumstances that led to such reversal

IAS 23 Borrowing Costs identifies some limited circumstances where
borrowing costs (interest) can be included in cost of inventories that
meet the definition of a qualifying asset. [IAS 2.17 and IAS 23.4]
Inventory cost should not include: [IAS 2.16 and 2.18]

abnormal waste

storage costs

administrative overheads unrelated to production

selling costs

carrying amount of inventories pledged as security for
liabilities

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 of inventories recognised as expense (cost of goods
sold). IAS 2 acknowledges that some enterprises classify
income statement expenses by nature (materials, labour,
and so on) rather than by function (cost of goods sold,
selling expense, and so on). Accordingly, as an alternative
to disclosing cost of goods sold expense, IAS 2 allows an
entity to disclose operating costs recognised during the
period by nature of the cost (raw materials and
consumables, labour costs, other operating costs) and the
amount of the net change in inventories for the period).
[IAS 2.39] This is consistent with IAS 1 Presentation of
Financial Statements, which allows presentation of
expenses by function or nature.

The standard cost and retail methods may be used for the
measurement of cost, provided that the results approximate actual
cost. [IAS 2.21-22]

B. For example.O.O. a third category of inventory is "raw material. Goods sold F. Why begin a discussion of inventory with this observation? The reason is that inventory measurement bears directly on the determination of income! The slightest adjustment to inventory will cause a corresponding change in an entity's reported income.O.B. All of this activity requires an accounting system capable of identifying consigned units. Consigned goods should be included in the inventory of the consignor. the consignee would keep a portion of the sales price. and remit the balance to the consignor. terms. Further. destination do not belong to the purchaser until they arrive at their final destination.B. in a company's accounting records. shipping point. In that chapter. tracking their movement. Technically. F. the inventory appears as physical units. goods in transit must be considered in light of the F. When the consignee sells consigned goods to an end user. retailers are not the only businesses that maintain inventory. the manufacturer desperately needs these units in the retail channel. Managerial accounting courses cover the specifics of accounting for manufactured inventory. In addition. In the diagram. The consignor is the party holding legal ownership/title to the consigned goods. Consigned goods describe products that are in the physical custody of one party. the party holding physical possession is not the legal owner. Thus. When examining a company's inventory on hand.B. Recall from earlier chapters this basic formulation: Notice that the goods available for sale are "allocated" to ending inventory and cost of goods sold.O. Goods completed and awaiting sale are termed "finished goods" inventory. Thus. auto parts manufacturers produce many types of parts that are very specialized and expensive. then $1 more flows into cost of goods sold (and vice versa).O. when determining the amount of inventory owned at year end. Manufacturers also have inventories related to the goods they produce. terms also determine when goods are (or are not) included in inventory. This book will focus on the general principles of inventory accounting that are applicable to most enterprises. terms. Conceptually. for instance. a buyer would need to include as inventory the goods that are being transported but not yet received. However. As a result. Practically. But. goods in transit belong to the party holding legal ownership. Inventory Costing Methods The value of a company's shares of stock often moves significantly with information about earnings. there is a significant record keeping challenge. special care must be taken to identify both goods consigned out to others (which are to be included in inventory) and goods consigned in (which are not to be included in inventory). Another inventory-related problem area pertains to goods on consignment. GOODS TO INCLUDE Recall from the merchandising chapter the discussion of freight charges. there is an opposite effect on gross profit. But. terms were introduced. A manufacturer may also have "work in process" inventory consisting of goods being manufactured but not yet completed.O. In the graphic.B. it is fairly simple to understand the accounting for consigned goods. shipping point become property of the purchaser once shipped by the seller. A retail auto parts store may not be able to afford to stock every variety. but actually belong to another party. but the sales agent does not want to pay for those goods unless resold to an end customer. Observe that if $1 less is allocated to ending inventory." consisting of goods to be used in the manufacture of products.B. as cost of goods sold is increased or decreased.Inventory for a merchandising business consists of the goods available for resale to customers. The consignee is responsible for taking care of the goods and trying to sell them to an end customer. Inventories are typically classified as current assets on the balance sheet. The following graphic illustrates this allocation process. F.B. Ownership depends on the F. the buyer or seller shown in green would "inventory" the goods in transit. Goods sold F.O. this flow must be translated into units of money. Consignments arise when the owner desires to place inventory in the hands of a sales agent. Therefore. and knowing when they are actually sold. the parts manufacturer may consign their inventory to auto parts retailers. a critical factor in determining income is the allocation of the cost of goods available for sale between ending inventory and cost of goods sold: . And. In the case of F. and the focus was on which party would bear the cost of freight. But. The person with physical possession is known as the consignee. there is the real risk of ending up with numerous obsolete units.

FIRST-OUT CALCULATIONS With first-in. (Note: FIFO and LIFO are pronounced with a long "i" and long "o" vowel sound. Importantly. first-out (FIFO)  Last-in. freight-out and sales commissions would be expensed as a selling cost rather than being included with inventory. first-out is just the reverse of FIFO. "carrying costs" like interest charges (if money was borrowed to buy the inventory). As one might expect. LAST-IN. and similar items relating to the general rule. specific costing methods must be adopted. The methods from which to choose are varied. or $136 (120 X $1. the assigned cost of inventory was always given. Mueller weighs the barrel and decides that 120 pounds of nails are on hand.. The first filling consisted of 100 pounds costing $1. The final restocking was 90 pounds at $1. To now delve deeper.13333 per pound ($306/270). The barrel was never allowed to empty completely and customers have picked all around in the barrel as they bought nails. and some from the final. Not much was said about how that cost was determined. The second filling consisted of 80 pounds costing $1. This means that inventory cost would include the invoice price. Mueller Hardware has a nail storage barrel. freight-in. The cost of goods sold was $170 (150 pounds X $1.13333 average price per pound): To deal with this very common accounting question.FIRST-IN. Conversely. and an assumption must be implemented to maintain a systematic approach to assigning costs to units on hand (and to units sold). storage costs.10 per pound. For Mueller's nails the FIFO calculations would look like this: THE COST OF ENDING INVENTORY In earlier chapters. Average cost is determined by dividing total cost of goods available for sale by total units available for sale. and insurance on goods held awaiting sale would not be included in inventory accounts. At the end of the accounting period.) Another method that will be discussed shortly is the specific identification method.30 per pound. the most recent purchases are assigned to units in ending inventory. What is the cost of the ending inventory? Remember. As its name suggests.13333 average price per pound). The barrel was filled three times. Likewise. the specific identification method does not depend on a cost flow assumption. consider a general rule: Inventory should include all costs that are "ordinary and necessary" to put the goods "in place" and "in condition" for resale.e. some from the second. In other words. FIRST-OUT CALCULATIONS Last-in. a company must adopt an inventory costing method (and that method must be applied consistently from year to year). Conversely. this question bears directly on the determination of income! WEIGHTED AVERAGE The weighted-average method relies on average unit cost to calculate cost of units sold and ending inventory. the first in) is matched against revenue and assigned to cost of goods sold. recent costs are assigned to goods sold while the oldest costs remain in inventory: COSTING METHODS Once the unit cost of inventory is determined via the preceding logic. producing an average cost of $1. It is hard to say exactly which nails are "physically" still in the barrel.01 per pound. . the oldest cost (i. first-out (LIFO)  Weighted-average Each of these methods entails certain cost-flow assumptions. instead those costs would be expensed as incurred. The ending inventory consisted of 120 pounds. Mueller Hardware paid $306 for 270 pounds. consider a simple example. the assumptions bear no relation to the physical flow of goods. first-out. some of the nails are probably from the first filling. generally consisting of one of the following:  First-in. To solidify this point. they are merely used to assign costs to inventory units. each unit of inventory will not have the exact same cost. The impact of beginning inventory Examine each of the following comparative illustrations noting how the cost of beginning inventory and purchases flow to ending inventory and cost of goods sold.

Purchases and sales are shown in the schedule.DETAILED example Accountants usually adopt the FIFO. The actual physical flow of the inventory may or may not bear a resemblance to the adopted cost flow assumption. ending inventory. and the resulting financial statements are as follows: If Gonzales uses the weighted-average method. LIFO If Gonzales uses LIFO. The dollar amount of sales will be reported in the income statement. cost of goods sold.000 units costing $12 per unit. assume that Gonzales Chemical Company had a beginning inventory balance that consisted of 4. and the resulting financial statements are as follows: Based on the information in the schedule.000 units at $22 ($154. ending inventory and cost of goods sold calculations are as follows: .000) and 6.000.000 units were actually on hand at the end of the year. Weighted average FIFO If Gonzales uses FIFO. In the following illustration. Assume that Gonzales conducted a physical count of inventory and confirmed that 5.000). cost of goods sold. How much is cost of goods sold and gross profit? The answer will depend on the cost flow assumption.000 units at $25 ($150. Gonzales will report sales of $304. or Weighted-Average cost flow assumption. LIFO. This amount is the result of selling 7. along with cost of goods sold and gross profit. ending inventory.

it would be necessary to examine the 3 cars. determine their serial numbers. this is the FIFO application.used for inventories of uniquely identifiable goods that have a fairly high per-unit cost (e. Careful study is needed to discern exactly what is occurring on each date. Lower income produces a lower tax bill. the answer is sometimes driven by income tax considerations.000 unit layer. Remember. Whichever method is used.000. Observe that the financial statement results are the same as under the periodic FIFO approach introduced earlier. Others maintain that FIFO is better because recent costs are reported in inventory on the balance sheet. changes should only be made if financial reporting is deemed to be improved. This is anticipated because the beginning inventory and early purchases are peeled away and charged to cost of goods sold in the same order. the ending inventory was counted and costs were assigned only at the end of the period. Under specific identification. depending on the inventory method selected: The preceding illustrations were based on the periodic inventory system. The following table reveals the FIFO application of the perpetual inventory system for Gonzales. The cost of goods sold could be verified by summing up the individual cost for each unit sold. Specific identification requires tedious record keeping and is typically only JOURNAL ENTRIES The table above provides information needed to record purchase and sale information. The year ended with only 3 cars in inventory.000 units remain after selling 7. LIFO companies frequently augment their reports with supplemental data about what inventory cost would be if FIFO were used instead. For example. and find the exact cost for each of those units.000 of the 6. Perpetual FIFO The results above are consistent with a general rule that LIFO produces the lowest income (assuming rising prices. one may wonder why a company would select this option. Note that there is considerable detail in tracking inventory using a perpetual approach.. automobiles. Classic has a detailed list. One may further assume that the cost of the units sold is $2. a running count of goods on hand is maintained at all times. which can be calculated as cost of goods available for sale minus ending inventory. SPECIFIC ID The specific identification method requires a business to identify each unit of merchandise with the unit's cost and retain that identification until the inventory is sold. In many countries LIFO is not permitted for tax or accounting purposes. and weighted average an amount in between. Consistency in method of application should be maintained. LIFO "conformity rules" generally require that LIFO be used for financial reporting if it is used for tax purposes. Specifically. To illustrate. and so forth).000 + 6. then ending inventory would be reported at that amount. Each car is unique and had a different unit cost. Because LIFO tends to depress profits. look at April 17 and note that 3. each purchase and sale transaction impacts the residual composition of the layers associated with the item of inventory. Inventory is debited as purchases occur . The aggregate cost of the cars is $125. However.g. and 3. financial accounting methods do not have to conform to methods chosen for tax purposes.000 units as follows: all of the 4. of each car and its cost.900. In other words.000.000. Once a specific inventory item is sold.000. Modern information systems facilitate detailed perpetual cost tracking for those goods. This does not mean that changes cannot occur. thus companies will tend to prefer the LIFO choice. and removing 7. in the United States.000 total units (4. by serial number. whether the associated calculations are done "as you go" (perpetual) or "at the end of the period" (periodic). Usually.000 unit layer. During the year. assume Classic Cars began the year with 5 units in stock. Accounting theorists may argue that financial statement presentations are enhanced by LIFO because it matches recently incurred costs with the recently generated revenues. it is important to note that the inventory method must be clearly communicated in the financial statements and related notes. however. fine jewelry. If that aggregated to $225.000 units. FIFO the highest. Perpetual Inventory Systems COMPARING METHODS The following table reveals that the amount of gross profit and ending inventory can appear quite different. In essence. and there is discussion about the USA perhaps adopting this global approach. These calculations support the following financial statement components. as was evident in the Gonzales example). so the layers are peeled away based on the chronological order of their creation. 100 additional cars are acquired at an aggregate cost of $3. With a perpetual system.000)). This is determined by looking at the preceding balance data on March 5 (consisting of 10. the cost of the unit is assigned to cost of goods sold.000. A more robust system is the perpetual system.

and the moving-average fell in between. The journal entries are not repeated here but would be the same as with FIFO. The resulting ledger accounts and financial statements are shown below: MOVING AVERAGE The average method can be applied on a perpetual basis. Conversely. ledgers. and financial statements reveal the application of moving average. . and financial statements reveal the application of perpetual LIFO.and credited as sales occur. observe that the perpetual system also produced the lowest gross profit via LIFO. The following table. This is not a hardened rule. as a new average unit cost must be computed with each purchase transaction. This technique is involved. PERPETUAL LIFO Lower of Cost or Market Adjustments The following table. The journal entries are below. only the amounts would change. Conservatism dictates that accountants avoid overstatement of assets and income. ledgers. the highest with FIFO. just a general principle of measurement. accountants do employ a degree of conservatism. As with the periodic system. Although every attempt is made to prepare and present financial data that are free from bias. earning it the name moving average. liabilities would tend to be presented at higher amounts in the face of uncertainty. Note that the results usually differ from the periodic LIFO approach.

Once reduced. Sales for the year. APPLICATION OF LCM Despite the apparent focus on detail. Obsolescence. In the latter case. The beginning inventory totaled $200. In the case of inventory. not to exceed the ceiling nor be less than the floor. consider the following four different inventory items.000. and a write-down is only needed if the overall market is less than the overall cost.000 in purchases had occurred prior to the date of the fire. Crock Buster sells pots that cost $7. and Tiki usually sells goods at a 40% gross profit rate. a company's normal gross profit rate (i. which is the net realizable value less a normal profit margin. and similar problems can contribute to uncertainty about the "realization" (conversion to cash) for inventory items. a physical count may not be possible or is not cost effective. In other words. however. or for the aggregate of all the inventory. Step 1: Determine market . GROSS PROFIT METHOD One such estimation technique is the gross profit method.000. sales might be subtracted from goods available for sale at retail. The reason is that "replacement cost" for some items can be very high even though there is no market in which to sell the item (e. applicable accounting rules define "market" as the replacement cost (not sales price!) of the goods. Very simply. Therefore.000 (at cost). In any event. and any differences should result in an adjustment of the accounting records. and note that the "cost" is shaded in yellow and the appropriate "market value" is shaded in red. This debit would be reported in the income statement as a charge against (reduction in) income. Inventory Estimation Techniques Whether a company uses a periodic or perpetual inventory system. For instance.000. it is noteworthy that the lower-ofcost-or-market adjustments can be made for each item in inventory. the Inventory account would be credited. These three data points are manipulated by the cost-to-retail percentage to solve for ending inventory cost of $155. prior to the date of the fire were $1. a company may find itself holding inventory that has an uncertain future. "market" for purposes of the lower of cost or market test should not exceed the net realizable value. over supply.000 (at retail). the concepts of "ceiling and floor" are usually not applicable. Additionally. a write-down from the recorded cost to the lower market value would be made. This simply means that if inventory is carried on the accounting records at greater than its market value.g. Or.000. once a write-down is deemed necessary. Instead.. the international standards speak to net realizable value as the only benchmark for assessing market. Be careful to note when the percentage factors are divided and when they are multiplied. the Inventory account becomes the new basis for valuation and reporting purposes going forward. Tiki can readily estimate that cost of goods sold was $600. meaning the company does not know if or when it will sell. The quantities determined via the physical count are presumed to be correct. the good offsets the bad. accountants evaluate inventory and employ lower of cost or market considerations. Therefore. and sales totaled $460. The cost-to-retail percentage is multiplied times ending inventory at retail.000. Therefore. at their retail value. defects. gross profit as a percentage of sales) would be used to estimate the amount of gross profit and cost of sales. Write-ups of previous write-downs for any recovery in value would not be permitted under United States GAAP. The only"givens"are highlighted in yellow. What arises then.000 (at cost). purchases were $300. Tiki's beginning of year inventory was $500. Additionally. the rules stipulate that "market" should not be less than a floor amount.e. Assume that Tiki's inventory was destroyed by fire. This yields a cost-toretail percentage of 75%.. . what would it cost for the company to acquire or reproduce the inventory? However. the loss should be recognized in income and inventory should be reduced.50 for $10. is the following decision process: The application of lower-of-cost-or-market principles varies under IFRS (international financial reporting standards). Step 2: Report inventory at the lower of its cost or market (as determined in step 1).In the case of inventory. recoveries of previous write downs are recognized under IFRS.Replacement cost. In essence. MEASURING MARKET VALUE Market values are very subjective. Ending inventory at retail can be determined by a physical count of goods on hand. To illustrate. out of date cell phones still in the inventory of a phone store). the lower-of-cost-or-market rule can become complex because accounting rules specify that market not exceed a ceiling amount known as "net realizable value" (NRV = selling price minus completion and disposal costs). and certainly would come into play if a fire or other catastrophe destroyed the inventory. This method would only work where a category of inventory has a consistent mark-up. a physical count of goods on hand should occur from time to time. and a Loss for Decline in Market Value would be the offsetting debit. Sometimes. The reported value is in the final row. Such items are unlikely to produce much net value when sold. and corresponds to the lower of cost or market: Retail METHOD A method that is widely used by merchandising firms to value or estimate ending inventory is the retail method. and $800. major price declines. This method might be used to estimate inventory on hand for purposes of preparing monthly or quarterly financial statements. The inventory destroyed by fire can be estimated via the gross profit method. and estimates are employed. as shown.

where the only difference is an overstatement of ending inventory by $1. That is. general assessments are not in order.000 = $14. count goods twice.000. It is calculated by dividing cost of sales by the average inventory level: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory If a company's average inventory was $1. In the alternative. The general rule of thumb is that overstatements of beginning inventory cause that year's income to be understated.000 + $12. or a worsening economy.000. one would deduce that inventory turned over 8 times (approximately once every 45 days).000 instead of the correct $4. one must be clever enough to recognize that the choice of inventory method affects the results. slow moving goods.Inventory Management In the process of maintaining inventory records and the physical count of goods on hand. but a lumber yard might view this as good. if the company was a baker it would be very bad news. A general rule is that overstatements of ending inventory cause overstatements of income. compare the following correct and incorrect scenario. being out of stock may result in lost customers. and the annual cost of goods sold was $8. Careful attention must be paid to the inventory levels.000).000 + $13.000 (note that this general rule is only valid when purchases are correctly recorded): The best run companies will minimize their investment in inventory. This ratio shows the number of times that a firm's inventory balance was turned ("sold") during a year. the amount for each year is critically flawed. A declining turnover rate might indicate poor management. so a delicate balance must be maintained. This could be good or bad depending on the particular business. In making such comparisons. So. Examine the following table where the only error relates to beginning inventory balances: . For instance. However. Inventory is costly and involves the potential for loss and spoilage. What is important is to monitor the turnover against other companies in the same line of business. errors may occur. It is vital that accountants and business owners fully understand the effects of inventory errors and grasp the need to be careful to get these numbers as correct as possible. INVENTORY ERRORS Hence. one year's ending inventory error becomes the next year's beginning inventory error. Had the above inventory error been an understatement ($3.000.000). then the ripple effect would have caused an understatement of income by $1. and vice versa. the total income would be correct ($13. or simply make mathematical mistakes. It is quite easy to overlook goods on hand. One ratio that is often used to monitor inventory is the Inventory Turnover Ratio. if the above illustrations related to two consecutive years. Inventory errors tend to be counterbalancing. and against prior years' results for the same company.000. while understatements of ending inventory cause understatements of income.000.