Lecture 5 PDF

Inventory
HI6025: Accounting Theory

and Current Issues
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
Lecture 5
financial instruments, and

biological assets
Accounting for
Inventory
Holmes Institute 2015
Inventories defined
Inventory measurement
Inventories are defined as assets (AASB 102):
Inventories must be measured at the lower of

cost and net realisable value (AASB 102)
held for sale in the ordinary course of business
on an item-by-item basis
in the process of production for such sale, or

in the form of materials or supplies to be consumed in
Cost of inventories comprises all (AASB 102):
the production process or in the rendering of services
costs of purchase (i.e. purchase price, import duties,
Cost of goods sold:
transport costs, etc.)

costs of conversion (e.g. direct labour and allocation of
is the cost of inventory sold during the financial period
overhead costs)
can be determined either on a periodic or perpetual
other costs incurred in bringing the inventories to their
basis
present location and condition (e.g. product design

costs for specific customers and installation)
Costs of inventory exclude (AASB 102):
There are two methods for dealing with fixed

production costs
abnormal amounts of wasted materials
storage costs
1. Absorption costing: fixed manufacturing costs
included in cost of inventories
administrative overheads
2. Direct costing: fixed manufacturing costs treated as
selling costs
period costs (i.e. expensed in the period incurred)
Fixed production costs:

are those costs of production that are not expected to
AASB 102 requires the use of absorption

costing
fluctuate as production levels change (e.g. building

depreciation and factory administration costs)
Net realisable value (NRV) (AASB 102)
Cost of inventory must include both fixed and

variable production overheads
Estimated selling price in the ordinary course of
business less the estimated costs of completion and

those necessary to make the sale
Indirect production costs that cannot be traced to the
goods or services
If NRV is greater than cost, inventory should be

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

written down to NRV
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 Transport
costs
costs
($,000)
($,000)
Packaging
costs
($,000)
Gidgets
20
Expected
sales
proceeds
($,000)
35
Widgets
30
30
Didgets
15
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
Gidgets
30
20
20
Widgets
22
30
22
Didgets
19.5
15
15
Sidgets
30
25
25
TOTAL
101.5
90
82
and NRV ($,000)
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.)
Variable Costs
Factory salaries
Raw materials purchased
less Closing balance
divided by Units Produced
Per unit variable costs
Fixed Costs
Factory rent
Depreciation P & E
divided by NOC
Per unit fixed costs
Total cost per unit
Net Realisable Value (NRV)
Sales price per unit
less Delivery costs
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
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)
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
$2.00
$6.50
$9.00
$1.00
$8.00
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
16
Inventory cost flow assumptions
Costs associated with borrowings (e.g. interest) can
200,000
100,000
Borrowing costs
450,000
100,000
$4.50
Discounts for early payment
So what is the closing value of inventory?
120,000
80,000
200,000
250,000
300,000
100,000
17
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
18
Inventory cost flow assumptions (contd)

Method adopted should be:
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):
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
not ordinarily interchangeable, or
first-in first-out (FIFO) (traditionally most common)
goods or services produced and segregated for specific
AASB 102 does not permit the use of:
projects
Not appropriate for large numbers of similar or

identical items (AASB 102)
last-in first-out (LIFO)
19
Weighted average method
20
FIFO method
An average cost is based on beginning

inventory and items purchased during the
period
Goods from beginning inventory and the

earliest purchases are assumed to be the
goods sold first
Various costs of individual units are weighted

by the number of units
Consistent with selling behaviour in most

entities
Cost of goods sold and ending inventory are

costed at the average cost
Ending inventory assumed to be most recent

purchases
More current value of inventory on balance sheet
21
22
LIFO method (contd)
LIFO method
Most recent purchases are assumed to be the first
goods sold
Allowed in the United States for external reporting

and tax purposes
Ending inventory assumed to be the oldest goods
US companies that elect not to adopt LIFO typically
have higher leverage and lower interest coverage ratios
Inventory could be valued at prices paid some years
Those potentially close to breaching debt covenants
earlier
adopt income-increasing and asset-increasing

accounting methods
While some methods might increase income, others
might act to reduce income
Not allowed in Australia under AASB 102
Refer to Worked Example 7.4 (p. 235) for a

comparison of the methods
23
24
Specific identification method periodic
Example of methods used

Information provided
Date
No.
of units
1 Jul Beginning Inventory
10
Purchases made in current period:

15 Sep
Purchase
7 Dec
Purchase
Total purchases
12
15
27
Goods available for sale

Sales made in current period
20 Sep
Sales
12 Jan
Sales
Total cost of sales
30 June Ending Inventory
Unit
cost
$
10
Total
cost
$
100
11
12
132
180
312
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)
37
412
8
10
18
19
?
?
5 units from 7 December purchase ($12)
?
?
?
?
Specific identification method periodic continued
Remaining inventory:
9 units Beginning inventory
10 units 7 December
Cost of Ending Inventory
@ $ 10
12
Cost of goods available for sale

Less ending inventory 19 units
Cost of Goods Sold 18 units
First-in, first-out (FIFO) method periodic
$ 90
120
$ 210
4 units 15 September
15 units 7 December
$ 412
210
$ 202

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
$ 211.66
$ 44
180
$ 224
$ 412
224
$ 188
Weighted average method periodic

@ $ 11
12
$ 412.00
211.66
$ 200.34
Comparison of costing methods
Sales
Beginning inventory
Purchases
Goods available for sale
less: Ending inventory
Cost of Goods Sold
Gross Profit
Less: expenses
Net Profit
Specific
ID
FIFO
Weighted
Average
$360
100
312
412
210
202
158
120
$38
$360
100
312
412
224
188
172
120
$52
$360
100
312
412
212
200
160
120
$40
$210
$224
$212
Ending Inventory
in Balance Sheet
Inventory systems
Reversals of prior write-downs
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)
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

reversedwith 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
31
Journals for Inventory write-down/reverse
32
Disclosure requirements
Where material, AASB 102 requires the disclosure
of the following:
Journal for write-down

DR Inventory write-down
As we know, inventories must be written down if the
XX
accounting policies for measuring inventories, including
CR
Inventory
XX
To record the write-down value of inventory to NRV
cost formulas used

total carrying amount of inventories
carrying amount of inventories carried at fair value less
costs to sell
Journal to reverse (or partially)

DR Inventory
XX
CR
Inventory write-down
To reverse previous write-down of inventory to NRV
XX
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
34

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Inventory

HI6025: Accounting Theory

Inventory often accounts for a large proportion of

financial instruments, and

Inventories are defined as assets (AASB 102):

Inventories must be measured at the lower of

held for sale in the ordinary course of business

in the process of production for such sale, or

Cost of inventories comprises all (AASB 102):

the production process or in the rendering of services

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

Cost of goods sold:

transport costs, etc.)

is the cost of inventory sold during the financial period

can be determined either on a periodic or perpetual

other costs incurred in bringing the inventories to their

present location and condition (e.g. product design

Holmes Institute 2015

Holmes Institute 2015

Costs of inventory exclude (AASB 102):

There are two methods for dealing with fixed

abnormal amounts of wasted materials

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)

Fixed production costs:

AASB 102 requires the use of absorption

fluctuate as production levels change (e.g. building

Holmes Institute 2015

Holmes Institute 2015

Cost of inventory must include both fixed and

Estimated selling price in the ordinary course of

business less the estimated costs of completion and

Indirect production costs that cannot be traced to the

If NRV is greater than cost, inventory should be

planned products and/or operations, planned cost and

Determination of cost of inventory

Write-down treated as an expense in the period of the

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

Holmes Institute 2015

Upwards revaluations are not allowed by AASB 102

If NRV is less than cost, inventory should be

Holmes Institute 2015

Net Realisable Value (example) WE 7.2

Required, what is the cost of inventory?

Holmes Institute 2015

Net Realisable Value (example 7.2)

Cost ($,000) Lower of cost

and NRV ($,000)

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Inventory cost determination.

Inventory cost determination (cont.)

Inventory cost determination (cont.)

Normal operating capacity NOC (units)

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sometimes be included in the cost of inventory

Holmes Institute 2015

Discounts received for early payment for debts

Inventory cost flow assumptions

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

Holmes Institute 2015