CHAPTER ONE

INVENTORY AND SPECIAL

VALUATION OF INVENTORY

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 Applicable Standards

1. IAS 2 – Inventories represent:

 Assets held for sale in the ordinary
course of business,
 In the process of production for such
sale or
 In the form of material or supplies to be
consumed:
- In the production process, or
- In the rendering of services.

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 Applicable Standards(Continued)

IAS 38 - Inventory may include intangible assets

that are being developed for resale, for
example, software.
3. IAS 40 - Inventory also includes properties that
have been purchased, or are being developed,
for resale.
4. IAS 41 - Agricultural produce from the point of
harvest is classified as inventory.

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 Basic Concepts & Terminologies
 Fair Value – the amount for which an asset
could be exchanged, or a liability settled, b/n
knowledgeable, willing parties in an arm’s
length transaction.

 Net Realizable Value – the amount that is

expected to be realized from the sale of
inventory in the ordinary course of business
less the estimated costs of completion & sale.
OR
 Net realizable value is defined as the estimated selling
price less the costs necessary to make the sale.
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 Categories of Inventory

 Raw Materials- are materials:

 Which are actually used in the FG, and/or

 Awaiting entry into the production process.

 Work In Progress –The inventory of partially completed
products.
 Finished Goods – Completed manufactured goods that
have not yet been sold.
 Packaging Material- Materials consumed for the
packaging of the FG; such as Sacks & Bags.

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 Categories of Inventory (Continued)

 Spare Parts, Tools & Consumables- machine parts that

are used to replace obsolete or non-useful machine parts,
tools and consumables.
 Promotional & Advertising Materials
 If the ff prerequisites are met, the promotional
materials can be recorded as inventory:
I. Materials are not delivered to the end-consumer.
II. Materials are directly linked to sales transaction.
III. Materials have a significant value individually.

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 Exclusions

 The ff items shall be excluded from the inventories

of the Company:
 Goods sold and awaiting delivery.
 Goods delivered and awaiting billing.

 packaging
Non-returnable containers, or
stationery, when their total value is not
significant.

 Major spare parts and stand-by equipment

when the entity expects to use them for more
than one period (capitalized in fixed assets)

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 INVENTORY ISSUES

Classification
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.

Businesses with Inventory

Merchandising or Manufacturing
Company Company

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 INVENTORY ISSUES
ILLUSTRATION 5-1
Classification
 One inventory
account.
 Purchase
merchandise in
a form ready
for sale.

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 INVENTORY ISSUES
ILLUSTRATION 5-1
Classification
Three accounts
 Raw Materials
 Work in Process
 Finished Goods

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 INVENTORY ISSUES ILLUSTRATION 5-2
Flow of Costs through
Manufacturing and
Merchandising

Classification
Companies

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 INVENTORY ISSUES

Inventory Cost Flow

ILLUSTRATION 5-3

Two types of systems for maintaining inventory records — perpetual

system or periodic system.

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 Inventory Cost Flow

Perpetual System
1. Purchases of merchandise are debited to Inventory.

2. Freight-in is debited to Inventory. Purchase returns and

allowances and purchase discounts are credited to Inventory.

3. Cost of goods sold is debited and Inventory is credited for

each sale.

4. Subsidiary records show quantity and cost of each type of

inventory on hand.

The perpetual inventory system provides a

continuous record of the balance in both the
Inventory and Cost of Goods Sold accounts.
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 Inventory Cost Flow

Periodic System
1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000

Purchases, net + 800,000
Goods available for sale900,000
Ending inventory - 125,000
Cost of goods sold $ 775,000

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 Inventory Cost Flow

Comparing Perpetual and Periodic Systems

Illustration: Fesmire Company had the following transactions
during the current year.

Record these transactions using the Perpetual and Periodic

systems.

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 Inventory Cost Flow ILLUSTRATION 5-4
Comparative Entries—
Perpetual vs. Periodic

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 Inventory Cost Flow

Illustration: Assume that at the end of the reporting period, the

perpetual inventory account reported an inventory balance of
$4,000. However, a physical count indicates inventory of $3,800 is
actually on hand. The entry to record the necessary write-down is
as follows.

Inventory Over and Short 200

Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In

practice, companies sometimes report Inventory Over and Short in the
“Other income and expense” section of the income statement.

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 INVENTORY ISSUES

Inventory Control
All companies need periodic verification of the inventory records
 by actual count, weight, or measurement, with
 counts compared with detailed inventory records.

Companies should take the physical inventory

 near the end of their fiscal year,
 to properly report inventory quantities in their annual
accounting reports.

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 INVENTORY ISSUES

Basic Issues in Inventory Valuation

Companies must allocate the cost of all the goods available for
sale (or use) between the goods that were sold or used and
those that are still on hand.

ILLUSTRATION 5-5
Computation of Cost
of Goods Sold

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 Basic Issues in Inventory Valuation

Valuing inventories requires determining

1. The physical goods to include in inventory (who owns
the goods?—goods in transit, consigned goods, special
sales agreements).

2. The costs to include in inventory (product vs. period

costs).

3. The cost flow methods (specific identification, average-

cost, FIFO).

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 PHYSICAL GOODS INCLUDED IN
INVENTORY

A company should record inventory when it obtains legal title

to the goods.

ILLUSTRATION 5-6
Guidelines for Determining Ownership
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 GOODS INCLUDED IN INVENTORY

Goods in Transit
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, who acts as an agent for LG.
 If the supplier ships the goods f.o.b. destination, title
passes to LG only when it receives the goods from the
common carrier.
“Shipping point” and “destination” are often designated by a
particular location, for example, f.o.b. Seoul.

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 GOODS INCLUDED IN INVENTORY

Consigned Goods
Example: Williams Art Gallery (the consignor) ships various art
merchandise to Sotheby’s Holdings (USA) (the consignee), who
acts as Williams’ agent in selling the consigned goods.
 Sotheby’s 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 Sotheby’s sells the goods, it remits the revenue, less a
selling commission and expenses incurred, to Williams.
Goods out on consignment remain the property of the consignor
(Williams).

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 GOODS INCLUDED IN INVENTORY

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.

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 GOODS INCLUDED IN INVENTORY

Sales with Rights 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.
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 GOODS INCLUDED IN INVENTORY

Effect of Inventory Errors

ILLUSTRATION 5-7
Ending Inventory Misstated Financial Statement
Effects of Misstated
Ending Inventory

The effect of an error on net income in one year will be counterbalanced in the next,
however the income statement will be misstated for both years.

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 Ending Inventory Misstated
Illustration: Yei Chen Corp. understates its ending inventory by
HK$10,000 in 2015; all other items are correctly stated.
ILLUSTRATION 5-8
Effect of Ending Inventory
Error on Two Periods

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 GOODS INCLUDED IN INVENTORY

Effect of Inventory Errors

ILLUSTRATION 5-9
Purchases and Inventory Misstated Financial Statement
Effects of Misstated
Purchases and Inventory

The understatement does not affect cost of goods sold and net income because the
errors offset one another.

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 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.

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 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.

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 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.

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 Treatment of Purchase Discounts

**

ILLUSTRATION 5-11 * $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

Entries under Gross and
Net Methods

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 WHICH COST FLOW ASSUMPTIONS TO
ADOPT?

Cost Flow Methods

 Specific IIdentification
 First-in, First-out (FIFO) or
 Average Cost

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 Cost Flow Methods
To illustrate the cost flow methods, assume that Call-Mart Inc.
had the following transactions in its first month of operations.

Calculate Goods Available for Sale

Beginning inventory (2,000 x €4) € 8,000
Purchases:
6,000 x €4.40 26,400
2,000 x €4.75 9,500
Goods available for sale €43,900

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 Cost Flow Methods

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.

 May allow a company to manipulate net income.

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 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 5-12

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 Cost Flow Methods

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

 Not as subject to income manipulation.

 Measuring a specific physical flow of inventory is often

impossible.

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 Average-Cost
ILLUSTRATION 5-13
Weighted-Average Method Weighted-Average
Method—Periodic Inventory

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 Average-Cost
ILLUSTRATION 5-14
Moving-Average Method Moving-Average Method—
Perpetual Inventory

In this method, Call-Mart computes a new average unit cost each

time it makes a purchase.

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 Cost Flow Methods

First-In, First-Out (FIFO)

 Assumes goods are used 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.

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 First-In, First-Out (FIFO)

Periodic Inventory System ILLUSTRATION 5-15

FIFO Method—Periodic
Inventory

Determine cost of ending inventory by taking the cost of the most

recent purchase and working back until it accounts for all units in the
inventory.
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 First-In, First-Out (FIFO)

Perpetual Inventory System ILLUSTRATION 5-16

FIFO Method—
Perpetual Inventory

In all cases where FIFO is used, the inventory and cost of goods
sold would be the same at the end of the month whether a perpetual
or periodic system is used.

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 Inventory Valuation Methods—Summary

Comparison assumes periodic inventory procedures and the

following selected data.

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 Inventory Valuation Methods—Summary

ILLUSTRATION 5-17
Comparative Results of
Average-Cost and FIFO
Methods

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 Inventory Valuation Methods—Summary

When prices are rising, average-cost results in the higher cash

balance at year-end (because taxes are lower).

ILLUSTRATION 5-18
Balances of Selected
Items under Alternative
Inventory Valuation
Methods

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