CHAPTER FPUR

INVENTORY

4.1.Nature and classification of inventory

– Inventories are assets:

 Items held for sale in the ordinary course of business,

or
 Goods to be used in the production of goods to be
sold.
 Classification

•. A merchandising Business

One inventory account.

Purchase merchandise
in a form ready for
sale.
Unsold units left on hand
as called merchandise
inventory
 Classification

2. Manufacturing Business

Three accounts
1. Raw Materials
2. Work in Process
3. Finished Goods
 Cont…

• Goods and materials on hand but not yet placed

into production as raw materials inventory.
• The cost of the raw material +direct labor cost
incurred +Manufacturing overhead costs applied
for unfinished units constitute the work in process
• Completed but unsold units on hand at the end of
the fiscal period as finished goods inventory.
 Physical goods and costs included in inventory

• Goods Included in Inventory

 A company should record inventory when it obtains legal
title to the goods and at the time it controls the asset.
1. Goods in Transit
•

• Are goods purchased/sold but not reached to buyers

warehouse
• E.g. LG Electronics (KOR) purchases merchandise that remains in
transit—not yet received—at the end of a fiscal period.
• Shall these inventories shall be recoded on book of LG? or supplier?
 Goods Included in Inventory

Example: LG (KOR) determines ownership by applying the―

passage of title rule.
 If a supplier ships goods to LG f.o.b. shipping point, title passes
to LG when the supplier delivers the goods to the common
carrier(at seller warehouse) and LG should report
merchandise as part of its inventory
 If the supplier ships the goods f.o.b. destination, title passes
to LG only when it receives the goods from the common
carrier at LG warehouse . The supplier should report
merchandise as part of its inventory not LG
 Goods Included in Inventory
2. Consigned Goods
Are Goods on the hand of
agent distributors

Example
Assume Coca Cola Company (the consignor) ships various soft drinks to ABC
ltd (the consignee), who acts as Coca Cola’s agent in selling the consigned
goods in Ethiopia.
 ABC agrees to accept the goods without any liability, except to
exercise due care and reasonable protection from loss or damage,
until it sells the goods to a third party.
 When ABC sells the goods, it remits the revenue, less a
selling commission and expenses incurred, to Coca Cola company
• Goods out on consignment remain the property of the consignor Coca Cola
company) and be included as part of its inventory.
 Goods Included in Inventory
3. Special Sales Agreements

•Sales with Repurchase Agreements

Example: Hill Enterprises transfers (―sells‖) inventory to Chase,
Inc. and simultaneously agrees to repurchase this merchandise
at a specified price over a specified period of time. Chase then
uses the inventory as collateral and borrows against it.
 Essence of transaction is that Hill Enterprises is financing its
inventory—and retains control of the inventory—even though it
transferred to Chase technical legal title to the merchandise.
 Often described in practice as a ―parking transaction.‖
 Hill should report the inventory and related liability on its books.
 Goods Included in Inventory

• Sales with High Rates of Return

Example: Quality Publishing Company sells textbooks to Campus
Bookstores with an agreement that Campus may return for full
credit any books not sold. Quality Publishing should recognize
a) Revenue from the textbooks sold that it expects will not be
returned.
b) A refund liability for the estimated books to be returned.
c) An asset for the books estimated to be returned which reduces
the cost of goods sold.
If Quality Publishing is unable to estimate the level of returns, it
should not report any revenue until the returns become predictive.
 Costs included in inventory
•Product Costs
– Costs directly connected with bringing the goods to
the buyer’s place of business and converting such
goods to a salable condition.
•Cost of purchase includes all of:
1. The purchase price.
2. Import duties and other taxes.
3. Transportation costs.
4. Handling costs directly related to the acquisition of
the goods.
 Costs included in inventory

• Costs of production for a manufacturing

company include
1. Cost of direct materials used,
2. Cost of direct labor incurred, and
3. Manufacturing overhead costs.
• Manufacturing overhead costs include indirect
materials, indirect labor, and various costs, such
as depreciation, taxes, insurance, and utilities.
 Costs included in inventory

• “Other costs” include those incurred to bring

the inventory to its present location and
condition ready to sell,
• such as the cost to design a product for
specific customer needs.
• For example, if a customer of Lenovo requests
that computers to be sold in Europe have an
additional power adapter that is compatible
with European power sources, the cost to
design a multisource-adapter would be
included in the cost of the computer.
 Costs included in inventory

Period Costs
Costs that are indirectly related to the acquisition or
production of goods.
•Period costs such as
 selling expenses and,
 general and administrative expenses
 Are not included as part of inventory cost.
 Costs included in inventory

Treatment of Purchase Discounts

• Purchase or trade discounts are reductions in the selling
prices granted to customers.
• IASB requires these discounts to be recorded as a
reduction from the cost of inventories.
 Costs included in inventory

• Class work
• Record the above entries
A. Using perpetual inventory system
Costs included in inventory
 Costs included in inventory

• Net method is considered better for

two reasons.
1) It provides a correct reporting of the cost of
the asset and related liability and
2) It can measure management inefficiency by
holding management responsible for
discounts not taken.
4.3. Valuation of inventories : A cost-basis approach

• During any given fiscal period, companies

typically purchase merchandise at several
different prices.
• If it made numerous purchases at different unit
costs, which cost should it use?
 WHICH COST FLOW ASSUMPTIONS TO
ADOPT?

Cost Flow Methods

 Specific
Identification
or
 Two cost flow
assumptions
► First-in,
First-out
(FIFO) or
► Average
 Cost Flow Method

Specific Identification
 IASB requires in cases where inventories are not ordinarily
interchangeable or for goods and services produced or
segregated for specific projects.
 Cost of goods sold includes costs of the specific items sold.
 Used when handling a relatively small number of costly,
easily distinguishable items.
 Matches actual costs against actual revenue.
 Cost flow matches the physical flow of the goods.
 Cost Flow Methods
To illustrate the cost flow methods, assume that Call-Mart
Inc.
had the following transactions in its first month of operations.
 Specific Identification
•Illustration: Call-Mart Inc.’s 6,000 units of inventory
consists of 1,000 units from the March 2 purchase, 3,000 from
the March 15 purchase, and 2,000 from the March 30
purchase.Compute the amount of ending inventory and cost of
goods sold.
ILLUSTRATION 4.1.1

8-22 LO 5
 Cost Flow Assumptions

Average-Cost
 Prices items in the inventory on the basis of the
average cost of all similar goods available
during the period.

 Measuring a specific physical flow of inventory is

often impossible.

8-23 LO 5
 Cont…

 Step 1: Compute the Weighted Average Unit Cost

(WAUC) as follows:
 WAUC = Total cost of merchandise available for sale (CMAS)
Total units available for sale
 Step 2: Applying the weighted average unit cost on
both units on hand and units sold.

EI = WAUC*Qty on hand
CMS = WAUC* Qty sold
 Average-Cost method

• To illustrate use of the periodic inventory method (amount of

inventory computed at the end of the period), Call-Mart
computes the ending inventory and cost of goods sold using a
weighted-average method as shown in illustration 4:2
•
 Average-Cost
• Moving-Average Method

• Companies use the moving-average method

with perpetual inventory records
• In this method, Call-Mart computes a new
average unit cost each time it makes a
purchase
 Average-Cost

• Moving-Average Method
 Cost Flow Assumptions

First-In, First-Out (FIFO)

 Assumes goods are used/sold in the order
in which they are purchased.

 Approximates the physical flow of goods.

 Ending inventory is close to current cost.

 Fails to match current costs against current

revenues on the income statement.
 FIFO Method—Periodic Inventory
• To illustrate, assume that Call-Mart uses the periodic inventory system. It
determines its cost of the ending inventory by taking the cost of the most
recent purchase and working back until it accounts for all units in the
inventory. Call-Mart determines its ending inventory and cost of goods
sold as shown in Illustration 4.4.
 • If Call-Mart instead uses a perpetual inventory system in
quantities and euros, it attaches a cost figure to each
withdrawal. Illustration 8.11 shows the inventory on a FIFO
basis perpetual system for Call-Mart.

Here, the ending inventory is €27,100, and the cost of goods sold is €16,800 [(2,000 @
€4.00) + (2,000
N.B. In all cases where FIFO is used, the amount reported for ending inventory and cost
of goods sold would be the same at the end of the month whether a perpetual or periodic
system is used.
 4.4 Special inventory valuation methods

•4.4.1. Lower-of-cost-or-net realizable

value (LCNRV) method

• A company abandons the historical cost

principle when the future utility (revenue-
producing ability) of the asset drops below its
original cost.
4.4.1. Lower-of-cost-or-net realizable value (LCNRV) method

• Net Realizable Value

• Estimated selling price in the normal course of
business less
 Estimated costs to complete and
 Estimated costs to make a sale.
 Cont…
• To illustrate, assume that ABC has unfinished
inventory with a cost of €950, a sales value of €1,000,
estimated cost of completion of €50, and estimated
selling costs of €200. ABC’s net realizable value is
computed as shown in Illustration 4.6:
 Cont…
• Companies therefore report their inventories
at the lower-of-cost-or-net realizable value
(LCNRV) at each reporting date.
• ABC reports inventory on its statement of
financial position at €750.
• In its income statement, It reports a Loss on
Inventory Write-Down of €200 (€950 − €750).
 Cont…
• Recording Net Realizable Value Instead of Cost
• One of two methods may be used to record the income effect of
valuing inventory at net realizable value
cost-of-goods-sold method,
 Debits cost of goods sold for the write-down of the inventory
to net realizable value.

Does not report a loss in the income statement because the

cost of goods sold already includes the amount of the loss

The loss method,

•Debits a loss account for the write-down of the inventory to

net realizable value.
 Cont…

• ABC in Illustration 4.6: record the write down

of inventory using the following entries under
both methods.
Cost of goods … 200
Inventory…………200
Loss due to decline of inventory
to net realizable value ……..…..200

Inventory…….…………………….200
 4.4.2. Gross profit method

• Companies take a physical inventory to verify

the accuracy of the perpetual inventory records
or, if no records exist, to arrive at an inventory
amount.
• Sometimes, however, taking a physical
inventory is impractical.
• In such cases, companies use substitute measures to
approximate inventory on hand.
• One substitute method of verifying or determining the
inventory amount is the gross profit method
GROSS PROFIT METHOD OF ESTIMATING INVENTORY

Substitute Measure to Approximate Inventory

Relies on three assumptions:

1. Beginning inventory plus purchases equal total goods to be
accounted for.

2. Goods not sold must be on hand.

3. The sales, reduced to cost, deducted from the sum of the

opening inventory plus purchases, equal ending inventory.
 GROSS PROFIT METHOD
Illustration: Smart ltd.. has a beginning inventory of €60,000
and purchases of €200,000, both at cost. Sales at selling price
amount to €280,000. The gross profit on selling price is 30
percent. Smart Ltd. applies the gross margin method as
follows.

Illustration 4.7: Application of

Gross Profit Method
 4.4.3. Retail-inventory method

• For most Retailers to use the specific identification

method to value their inventories will be challenging
due to nature and variety of inventory they hold
• An alternative is to compile the inventories at retail
prices.
• For most retailers, an observable pattern between cost
and selling price exists.
• The retailer can then use a formula to convert retail
prices to cost.
 RETAIL INVENTORY METHOD

Requires retailers to keep a record of:

1) Total cost and retail value of goods purchased.

2) Total cost and retail value of the goods available for sale.

3) Sales for the period.

 RETAIL INVENTORY METHOD

• Illustration 4.8: shows the retail inventory

method calculations using assumed data.

Retail-Method Concepts
 The amounts shown in the “Retail” column of Illustration 4.8 represent the
original retail prices, assuming no price changes.
 Retail-Method Concepts

• In practice, though, retailers frequently mark up or mark down the

prices they charge buyers.
• The term markup means an additional markup of the original
retail price
• Markup cancellations are decreases in prices of merchandise
that the retailer had marked up above the original retail price.
• markdowns, which are decreases in the original sales prices
• Markdown cancellations occur when the markdowns are
later offset by increases in the prices of goods that the retailer had
marked down

• N.B. Neither a markup cancellation nor a markdown

cancellation can exceed the original markup or markdown.
Cont.….
 Cont…

• To illustrate the different possibilities, consider the data

for In-Fusion SA shown in Illustration 9.18. In-Fusion can
calculate its ending inventory at cost under two
assumptions, A and B. (We’ll explain the reasons for the
two later.
– Assumption A: Computes a cost ratio after markups
(and markup cancellations) but before markdowns.
(Conventional method)
– Assumption B: Computes a cost ratio after both
markups and markdowns (and cancellations) (Cost
method)
 Conventional Method (or LCNRV)

• This method calculate a cost ratio using markups but

not markdowns.
• It approximates the lower-of-average-cost-or-net
realizable value.
• We will refer to this approach as the conventional
retail inventory method or the LCNRV.
• It consider markdowns a current loss and so would
not include them in calculating the cost-to-retail ratio.
• Omitting the markdowns would make the cost-to-
retail ratio lower, which leads to an approximate
LCNRV.
 Cont…

Conventional
Method

Cost
method)

Markdowns and mark down cancelation are included the cost-to-retail ratio
Cont….
 Special Items Relating to Retail Method
• The retail inventory method becomes more complicated when
we consider such items as freight-in, purchase returns and
allowances, and purchase discounts.
1. Freight costs are part of the purchase cost.
2. Purchase returns are ordinarily considered as a reduction of the
price at both cost and retail.
3. Purchase discounts and allowances usually are considered as a
reduction of the cost of purchases.
4. sales returns and allowances are considered as proper adjustments
to gross sales.
• Transfers-in from another department are reported in
the same way as purchases from an outside enterprise.
• Normal shortages (breakage, damage, theft, shrinkage)
companies do not consider this amount in computing
the cost-toretail percentage. Rather, to arrive at
ending inventory at retail, they show normal shortages
as a deduction similar to sales.
• Abnormal shortages, on the other hand, are deducted
from both the cost and retail columns and reported as a
special inventory amount or as a loss.
 Cont….
• Employee discounts (given to employees to
encourage loyalty and better performance) are
deducted from the retail column in the
same way as sales.
• These discounts should not be considered in
the cost-to-retail percentage because they do
not reflect an overall change in the selling
price.
Cont.…
 Evaluation of Retail Inventory Method

 Used for the following reasons:

1. To permit the computation of net income
without a physical count of inventory.
2. Control measure in determining inventory
shortages.
3. Regulating quantities of merchandise on hand.
4. Insurance information.