Inventories

What are Inventories?

Inventories are assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in
the production process or in the rendering of services.

Inventories encompass:
 goods purchased and held for resale
 finished goods produced, or work in progress being
produced, and include materials and supplies awaiting
use in the production process.
 In the case of a service provider, the costs of the
service for which the entity has not yet recognized the
related revenue (see IAS 18 Revenue).
Inventory Cost Flows

Merchandising Operations

Merchandise
Inventory
Purchases C/G/Sold
Cost of goods
sold
P
Inventory Cost Flows
Manufacturing Operations

Raw Materials

Work in Process Finished

Labor Inventory Goods
P C/G/Mfd P

Manu Overhead Cost of goods

sold
P
Perpetual and Periodic Systems: Example

 Fesmire reports the following data for 2006:

 Beginning Inventory (1.1.2006): 10 units at
P10
 Purchases: (all credit)
March 12: 30 units at P10
July 6: 25 units at P10
 Sales: (all credit)
April 8: 18 units at P16
August 9: 24 units at P18
 Provide journal entries
 Perpetual System

Date Record Inventory Changes Record Sales Revenue

Mar 12 Inventory Dr 300

Accts Payable 300

Apr 8 Cost of goods sold 180 Accts Receiv 288

Inventory 180 Sales 288

Jul 6 Inventory Dr 250

Accts Payable 250

Aug 9 Cost of goods sold 240 Accts Receiv 432

Inventory 240 Sales 432
Periodic System
Date Record Inventory Changes Record Sales Revenue

Mar 12 Purchases Dr 300

Accts Payable 300

Apr 8 No entry Accts Receiv 288

Sales 288

Jul 6 Purchaees Dr 250

Accts Payable 250

Aug 9 No entry Accts Receiv 432

Sales 432

Dec 31 Cost of goods sold Dr 420

Inventory (ending) 230 Adjusting
Purchases 550 Entry
Inven (beg) 100
Measurement of Inventories

 Inventories are measured at the lower of cost

or net realizable value.
 Net realizable value is the estimated selling
price in the ordinary course of business less the
estimated costs of completion and the estimated
costs necessary to make the sale.
 Fair value is the amount for which an asset could
be exchange or a liability settled, between
knowledgeable, willing parties in an arm’s length
transaction.
Cost of Inventories

 Cost is the total expenditure that has been

incurred in bringing the product or service to its
present location and condition.
 General categories of expenditure considered as
cost:
 Costs of purchase
 Costs of conversion
 Other costs incurred in bringing the
inventories to their present location and
condition
Cost of Purchase
 Costs of purchase include:
• purchase price
• import duties and other taxes,
• transport and handling costs,
• other costs directly attributable to the
acquisition of finished goods, materials and
services.
• Discounts, rebates and other similar items
are deducted.
Cost of Conversion

 Costs of conversion include direct labor cost and

overhead.
• Allocation of overhead needs to be based on the
enterprise’s normal capacity.
• When there is a main product and a by-product
and the costs of conversion of each product are
not separately identifiable, they are allocated
between the products on a rational and consistent
basis.
• Most by-products are immaterial. Thus, they are
often measured at net realizable value and this
value is deducted from the cost of the main
product.
Other Costs
 Other costs are included only to the extent incurred in
bringing the inventories to their present location and
condition.
 Some expenses should not be included in costs of
production:
• abnormal amounts of wasted material, labor or
other production cost,
• storage costs (unless necessary in the
production process prior to a further production
stage),
• administrative overheads that do not contribute
to bringing inventories to their present location
and condition, and
• selling costs.
Other Costs
 IAS 23 Borrowing Costs, identifies the limited
circumstances where borrowing costs are
included in the cost of inventories.
 An entity may purchase inventories on deferred
settlement terms. When the arrangement
effectively contains a financing element, that
element, for example a difference between the
purchase price for normal credit terms and the
amount paid, is recognized as interest expense
over the period of the financing.
Inventories of a Service Provider
 Consist primarily of the labor and other costs
of personnel directly engaged in providing the
service, including supervisory personnel, and
attributable overheads.
 Excludes labor and other costs relating to sales
and general administrative personnel, and
profit margins or non-attributable overheads.
Techniques for
Measurement of Cost
 Techniques for the measurement of the cost of
inventories may be used for convenience if the
results approximate cost:
 Standard cost method
Cost is the pre-determined sum that is obtained
by costing the manufacturing specification of
the product at pre-determined rates for the
material, labor and overhead expenses entering
the manufacturing process.
 Retail method
Cost of the inventory is determined by reducing
the sales value of the inventory by the
appropriate percentage gross margin.
Cost Formula
Some of the principal cost bases are as follows:
1. Specific identification – appropriate when
inventories are not ordinarily interchangeable,
are segregated for specific projects or are not
comprised of a large number of homogenous
items that are ordinarily interchangeable.
2. FIFO or Weighted Average – for all other
inventories, IAS 2 permits the cost of
inventories to be assigned using either first-in,
first-out (FIFO) or weighted average.
Cost Formula
 FIFO
• assumes that the items of inventory which were
purchased or produced first are sold first, and
consequently the items remaining in inventory
at the end of the period are those most recently
purchased or produced.
 Weighted average method
• the cost of each item is determined from the
weighted average of the cost of similar items at
the beginning of a period and the cost of similar
items purchased or produced during the period.
Cost Flow Assumptions: Example

 Call-Mart reports the following transactions

for 2006:

Date Purchases Purchase Cost

May 12 100 units P1,000
Aug 14 200 units P2,200
Sep 18 120 units P1,800

 On December 31, the company had 20 units

on hand. Determine the cost of goods
sold and the cost of ending inventory.
Average (weighted) method
Date Purchases Purchase Cost
May 12 100 units P1,000
Aug 14 200 units P2,200
Sep 18 120 units P1,800

420 units P5,000

Unit cost = P5,000/ 420 = P11.91
Cost of goods
available
Cost of goods sold 400 * 11.91 = 4,762
P5,000
Ending inventory 20 * 11.91 = P238
First-in, First-out method
Date Purchases Purchase Cost Cost of goods sold (FIFO)
May 12 100 units @ P10 P1,000 P1,000
Aug 14 200 units @ P11 P2,200 P2,200
Sep 18 120 units @ P15 P1,800 P1,500 (100 sold; 20 end inv)

420 units P5,000 P4,700

Cost of goods
available
Cost of goods sold P4,700
P5,000
Ending inventory 20 * P15 = P300
Net Realizable Value
 Net realizable value is the estimated selling
price in the ordinary course of business less
the estimated costs of completion and the
estimated costs necessary to make the
sale.
 Estimates of net realizable value
 are based on the most reliable evidence
available at the time the estimates are made,
and
 takes into consideration the purpose for which
the inventory is held.
Illustration
Units Unit cost NRV
Materials:
No. 1 1,000 11 10
No. 2 3,000 23 25
No. 3 2,000 30 32
Goods in process:
X 5,000 40 38
Y 3,000 50 52
Finished goods:
A 2,000 75 73
B 2,000 80 83
Illustration
Total Cost NRV Lower
Materials:
No. 1 11,000 10,000 10,000
No. 2 69,000 75,000 69,000
No. 3 60,000 64,000 60,000
Goods in process:
X 200,000 190,000 190,000
Y 150,000 156,000 150,000
Finished goods:
A 150,000 146,000 146,000
B 160,000 166,000 160,000
800,000 785,000
Lower-of-Cost-or-Net Realizable Value

Illustration 9-2
Net Realizable Value LCNRV Disclosures

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value

Illustration of LCNRV: Regner Foods computes its

inventory at LCNRV. Illustration 9-3

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value

Methods of Applying LCNRV Illustration 9-4

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value

Recording Net Realizable Value Instead of Cost

Cost of goods sold (before adj. to NRV) $ 108,000
Ending inventory (cost) 82,000
Ending inventory (at NRV) 70,000

Loss Loss due to decline to NRV 12,000

Method Inventory 12,000

COGS Cost of goods sold 12,000

Method Inventory 12,000

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value

Statement of Financial Position Presentation

Partial Statement COGS Loss

Method Method
Current assets:
Inventory $ 70,000 $ 70,000
Prepaids 20,000 20,000
Accounts receivable 350,000 350,000
Cash 100,000 100,000
Total current assets 540,000 540,000

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value
Income Statement Presentation COGS Loss
Method Method
Sales $ 200,000 $ 200,000
Cost of goods sold 108,000 120,000
Gross profit 92,000 80,000
Operating expenses:
Selling 45,000 45,000
General and administrative 20,000 20,000
Total operating expenses 65,000 65,000
Other income and expense:
Loss due to NRV on inventory 12,000 -
Interest income 5,000 5,000
Total other (7,000) 5,000
Income from operations 20,000 20,000
Income tax expense 6,000 6,000
Net income $ 14,000 $ 14,000
LO 1
Lower-of-Cost-or-Net Realizable Value

Use of an Allowance
Instead of crediting the Inventory account for net realizable
value adjustments, companies generally use an
allowance account.

Loss Loss due to decline to NRV 12,000

Method Allowance to reduce
inventory to NRV 12,000

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value

Statement of Financial Position Presentation

Partial Statement COGS Loss
Method Method
Current assets:
Inventory $ 70,000 $ 82,000
Allowance to reduce inventory (12,000)
Inventory at NRV 70,000
Prepaids 20,000 20,000
Accounts receivable 350,000 350,000
Cash 100,000 100,000
Total current assets 540,000 540,000

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value

Recovery of Inventory Loss

►Amount of write-down is reversed.

►Reversal limited to amount of original write-down.

Continuing the Ricardo example, assume the net realizable

value increases to $74,000 (an increase of $4,000). Ricardo
makes the following entry, using the loss method.

Allowance to reduce inventory to NRV 4,000

Recovery of inventory loss 4,000

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value

Recovery of Inventory Loss

Allowance account is adjusted in subsequent periods,
such that inventory is reported at the LCNRV.
Illustration 9-8

Inventory should not be reported at a value above original cost.

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value
Evaluation of LCNRV Rule
Some Deficiencies:
 Decreases in the value of the asset and the charge to expense are
recognized in the period in which the loss in utility occurs—not in the
period of sale.
 Increases in the value of the asset (in excess of original cost)
recognized only at the point of sale.
 Inconsistency because a company may value inventory at cost in one
year and at net realizable value in the next year.
 LCNRV values inventory conservatively. Net income for the year in
which a company takes the loss is definitely lower. Net income of the
subsequent period may be higher than normal if the expected
reductions in sales price do not materialize.

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Lower-of-Cost-or-Net Realizable Value
P9-1: Remmers Company manufactures desks. Most of the
company’s desks are standard models and are sold on the basis of
catalog prices. At December 31, 2010, the following finished desks
appear in the company’s inventory.

Finished Desks A B C D
FIFO cost inventory at 12/31/10 $ 470 $ 450 $ 830 $ 960
Est. cost to complete and sell 50 110 260 200
Catalog selling price 500 540 900 1,200

Instructions: At what amount should the desks appear in the company’s

December 31, 2010, inventory, assuming that the company has adopted
a lower-of-FIFO-cost-or-net realizable value approach for valuation of
inventories on an individual-item basis?
LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.
Lower-of-Cost-or-Net Realizable Value
P9-1: Remmers Company manufactures desks. Most of the
company’s desks are standard models and are sold on the basis of
catalog prices. At December 31, 2010, the following finished desks
appear in the company’s inventory.

Finished Desks A B C D
FIFO cost inventory at 12/31/10 $ 470 $ 450 $ 830 $ 960
Est. cost to complete and sell 50 110 260 200
Catalog selling price 500 540 900 1,200

Net realizable value 450 430 640 1,000

Lower-of-cost-or-NRV 450 430 640 960

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

Valuation Bases
Valuation Using Relative Sales Value

Permitted by GAAP under the following conditions:

(1) a controlled market with a quoted price applicable to all
quantities, and
(2) no significant costs of disposal (rare metals and
agricultural products)

or
(3) too difficult to obtain cost figures (meatpacking).

LO 3 Explain when companies use the relative sales

value method to value inventories.
Valuation Bases
Valuation Using Relative Sales Value
Used when buying varying units in a single lump-sum purchase.

E9-9: Larsen Realty Corporation purchased a tract of unimproved land for

$55,000. This land was improved and subdivided into building lots at an
additional cost of $30,000. These building lots were all of the same size
but owing to differences in location were offered for sale at different prices
as follows. Operating expenses allocated to this project total $18,200.

No. of Price Lots Unsold Instructions: Calculate the

Group Lots per Lot at Year-End net income realized on this
1 9 $ 3,000 5 operation to date.
2 15 4,000 7
3 19 2,000 2

LO 3 Explain when companies use the relative sales

value method to value inventories.