School of Commerce
Fundamentals of Accounting II (IFRS By: Tewodros
Edition)
6-1 Endale 1
Chapter 2 Inventories
Learning Objectives
After studying this chapter, you should be able to:
1. Describe the steps in determining inventory quantities.
2. Explain the accounting for inventories and apply the inventory cost
flow methods.
3. Explain the financial effects of the inventory cost flow assumptions.
4. Explain the lower-of-cost-or-net realizable value basis of accounting for
inventories.
5. Indicate the effects of inventory errors on the financial statements.
6. Compute and interpret the inventory turnover ratio.
6-2
Preview of Chapter 2
6-3
Classifying Inventory
Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
◆ Inventory ◆ Raw Materials
◆ Work in Process
◆ Finished Goods
Regardless of the classification, companies report all inventories under
Current Assets on the Statement of Financial Position.
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6-5
Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted raw materials,
shoplifting, or employee theft).
Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.
6-6 LO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of
inventory on hand.
Taken,
◆ when the business is closed or business is slow.
◆ at end of the accounting period.
6-7 LO 1 Describe the steps in determining inventory quantities.
6-8
Determining Inventory Quantities
Determining Ownership of Goods
Goods in Transit
◆ Purchased goods not yet received.
◆ Sold goods not yet delivered.
Goods in transit should be included in the inventory of the company
that has legal title to the goods. Legal title is determined by the
terms of sale.
6-9 LO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Goods in Transit Illustration 6-1
Terms of sale
Ownership of the goods
passes to the buyer when the
public carrier accepts the
goods from the seller.
Ownership of the goods
remains with the seller until the
goods reach the buyer.
6-10 LO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Question
Goods in transit should be included in the inventory of the
buyer when the:
a. public carrier accepts the goods from the seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.
6-11 LO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Determining Ownership of Goods
Consigned Goods
◆ Goods held for sale by one party.
◆ Ownership of the goods is retained by another party.
6-12 LO 1 Describe the steps in determining inventory quantities.
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Inventory Costing
Unit costs can be applied to quantities on hand using the
following costing methods:
◆ Specific Identification
◆ First-in, first-out (FIFO) Cost Flow
◆ Average-cost Assumptions
6-14 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Illustration: Crivitz TV Company purchases three identical
50-inch TVs on different dates at costs of £700, £750, and
£800. During the year Crivitz sold two sets at £1,200 each.
These facts are summarized below.
Illustration 6-2
6-15 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Specific Identification
If Crivitz sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is £1,500 (£700 + £800), and its
ending inventory is £750.
Illustration 6-3
6-16 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Specific Identification
Actual physical flow costing method in which items still in
inventory are specifically costed to arrive at the total cost of
the ending inventory.
◆ Practice is relatively rare.
◆ Most companies make assumptions (Cost Flow
Assumptions) about which units were sold.
6-17 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
There are two assumed cost flow methods:
1. First-in, first-out (FIFO)
2. Average-cost
Cost flow does not need be consistent with the physical
movement of the goods.
6-18 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Illustration: Data for Lin Electronics’ Astro condensers.
Illustration 6-4
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
6-19 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
First-In-First-Out (FIFO)
◆ Earliest goods purchased are first to be sold.
◆ Often parallels actual physical flow of merchandise.
◆ Generally good business practice to sell oldest units
first.
6-20 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
First-In-First-Out (FIFO)
Illustration 6-5
6-21
LO 2
Inventory Costing
First-In-First-Out (FIFO)
Illustration 6-5
Illustration 6-6
Proof of COGS
6-22 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Average Cost
◆ Allocates cost of goods available for sale on the basis
of weighted-average unit cost incurred.
◆ Assumes goods are similar in nature.
◆ Applies weighted-average unit cost to the units on
hand to determine cost of the ending inventory.
6-23 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Average Cost
Illustration 6-8
6-24 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Average Cost
Illustration 6-8
6-25 LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Financial Statement and Tax Effects
Illustration 6-9
6-26 LO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing
Question
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. FIFO method.
b. average cost method.
c. gross profit method.
d. none of the above
6-27 LO 3 Explain the financial effects of the inventory cost flow assumptions.
6-28
Inventory Costing
Using Cost Flow Methods Consistently
◆ Method should be used consistently, enhances
comparability.
◆ Although consistency is preferred, a company may change
its inventory costing method.
6-29 LO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing
Lower-of-Cost-or-Net Realizable Value
When the value of inventory is lower than its cost
◆ Companies must “write down” the inventory to its net
realizable value in the period in which the price decline
occurs.
◆ Net realizable value refers to the net amount that a
company expects to realize (receive) from the sale of
inventory (estimated selling price in the normal course of
business, less estimated costs to complete and sell).
LO 4 Explain the lower-of-cost-or-net realizable
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value basis of accounting for inventories.
Inventory Costing
Lower-of-Cost-or-Net Realizable Value
Illustration: Assume that Gao TV has the following lines of
merchandise with costs and net realizable values as
indicated.
Illustration 6-10
LO 4 Explain the lower-of-cost-or-net realizable
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value basis of accounting for inventories.
Inventory Errors
Common Cause:
◆ Failure to count or price inventory correctly.
◆ Not properly recognizing the transfer of legal title to goods
in transit.
◆ Errors affect both the income statement and statement of
financial position.
6-32 LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Income Statement Effects
Inventory errors affect the computation of cost of goods sold
and net income.
Illustration 6-11
Illustration 6-12
6-33 LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Income Statement Effects
Inventory errors affect the computation of cost of goods
sold and net income in two periods.
◆ An error in ending inventory of the current period will have a
reverse effect on net income of the next accounting
period.
◆ Over the two years, the total net income is correct because
the errors offset each other.
◆ Ending inventory depends entirely on the accuracy of taking
and costing the inventory.
6-34 LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Illustration 6-13
2013 2014
Incorrect Correct Incorrect Correct
Sales € 80,000 € 80,000 € 90,000 € 90,000
Beginning inventory 20000 20000 12000 15000
Cost of goods purchased 40000 40000 68000 68000
Cost of goods available 60000 60000 80000 83000
Ending inventory 12000 15000 23000 23000
Cost of good sold 48000 45000 57000 60000
Gross profit 32000 35000 33000 30000
Operating expenses 10000 10000 20000 20000
Net income € 22,000 € 25,000 € 13,000 € 10,000
Combined income for 2- (€3,000) €3,000
year period is correct. Net Income Net Income
understated overstated
6-35 LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. equity.
6-36 LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Statement of Financial Position Effects
Effect of inventory errors on the statement of financial position
is determined by using the basic accounting equation:
Illustration 6-11
Illustration 6-14
6-37 LO 5 Indicate the effects of inventory errors on the financial statements.
LCNRV Basis; Inventory Errors
(a) Tracy Company sells three different types of home heating stoves
(wood, gas, and pellet). The cost and net realizable value value of its
inventory of stoves are as follows.
Solution
The total inventory value is the sum of these amounts, NT$430,000.
6-38 LO 5 Indicate the effects of inventory errors on the financial statements.
LCNRV Basis; Inventory Errors
(b) Visual Company overstated its 2013 ending inventory by
NT$22,000. Determine the impact this error has on ending
inventory, cost of goods sold, and equity in 2013 and 2014.
6-39 LO 5 Indicate the effects of inventory errors on the financial statements.
Statement Presentation and Analysis
Presentation
Net realizable value - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted from
sales.
There also should be disclosure of
1) major inventory classifications,
2) basis of accounting (cost or LCNRV), and
3) costing method (specific identification, FIFO, or average).
6-40 LO 5 Indicate the effects of inventory errors on the financial statements.
Statement Presentation and Analysis
Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying costs
(e.g., investment, storage, insurance, obsolescence, and
damage).
2. Low Inventory Levels – may lead to stockouts and lost
sales.
6-41 LO 6 Compute and interpret the inventory turnover ratio.
Statement Presentation and Analysis
Inventory turnover measures the number of times on average
the inventory is sold during the period.
Cost of Goods Sold
Inventory
=
Turnover
Average Inventory
Days in inventory measures the average number of days
inventory is held.
Days in Year (365)
Days in
=
Inventory
Inventory Turnover
6-42 LO 6 Compute and interpret the inventory turnover ratio.
Statement Presentation and Analysis
Illustration: Esprit Holdings (HKG) reported in a recent annual report a
beginning inventory of HK$3,170 million, an ending inventory of HK$2,997
million, and cost of goods sold for the year ended of HK$16,523 million.
The inventory turnover formula and computation for Esprit Holdings are
shown below.
Illustration 6-16
Days in Inventory: Inventory turnover of 5.4 times divided into 365
is approximately 68 days. This is the approximate time that it takes a
company to sell the inventory.
6-43 LO 6 Compute and interpret the inventory turnover ratio.
6-44
APPENDIX 6A PERPETUAL INVENTORY SYSTEMS
Illustration 6A-1
Assuming the Perpetual Inventory System, compute Cost of Goods
Sold and Ending Inventory under FIFO and average-cost.
6-45 LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6A PERPETUAL INVENTORY SYSTEMS
First-In-First-Out (FIFO) Illustration 6A-2
Cost of Goods
Ending Inventory
Sold
6-46
LO 7
APPENDIX 6A PERPETUAL INVENTORY SYSTEMS
Average Cost
Illustration 6A-3
Cost of Goods Ending Inventory
Sold
6-47 LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6B ESTIMATING INVENTORIES
Gross Profit Method
Estimates the cost of ending inventory by applying a gross profit
rate to net sales.
Illustration 6B-1
6-48 LO 8 Describe the two methods of estimating inventories.
APPENDIX 6B ESTIMATING INVENTORIES
Illustration: Kishwaukee Company’s records for January show net
sales of $200,000, beginning inventory $40,000, and cost of goods
purchased $120,000. The company expects to earn a 30% gross profit
rate. Compute the estimated cost of the ending inventory at January 31
under the gross profit method.
Illustration 6B-2
6-49 LO 8
APPENDIX 6B ESTIMATING INVENTORIES
Retail Inventory Method
Company applies the cost-to-retail percentage to ending inventory
at retail prices to determine inventory at cost.
Illustration 6B-3
6-50 LO 8 Describe the two methods of estimating inventories.
APPENDIX 6B ESTIMATING INVENTORIES
Illustration:
Illustration 6B-4
Note that it is not necessary to take a physical inventory to estimate
the cost of goods on hand at any given time.
6-51 LO 8 Describe the two methods of estimating inventories.
APPENDIX 6C LIFO INVENTORY METHOD
Last-In-First-Out (LIFO)
◆ Under IFRS, LIFO is not permitted for financial
reporting purposes.
◆ Latest goods purchased are first to be sold.
◆ Seldom coincides with actual physical flow of
merchandise, except for goods stored in piles, such
as coal or hay.
6-52 LO 9 Apply the LIFO inventory costing method.
APPENDIX 6C LIFO INVENTORY METHOD
Last-In-First-Out (LIFO) Illustration 6C-1
6-53
LO 9
APPENDIX 6C LIFO INVENTORY METHOD
Last-In-First-Out (LIFO)
Illustration 6C-2
Proof of COGS
Illustration 6C-1
6-54 LO 9 Apply the LIFO inventory costing method.
Another Perspective
Key Points
◆ The requirements for accounting for and reporting inventories are
more principles-based under IFRS. That is, GAAP provides more
detailed guidelines in inventory accounting.
◆ The definitions for inventory are essentially similar under GAAP and
IFRS. Both define inventory as assets held-for-sale in the ordinary
course of business, in the process of production for sale (work in
process), or to be consumed in the production of goods or services
(e.g., raw materials).
◆ Who owns the goods—goods in transit or consigned goods—as well
as the costs to include in inventory, are accounted for the same
under GAAP and IFRS.
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Another Perspective
Key Points
◆ Both GAAP and IFRS permit specific identification where
appropriate. IFRS actually requires that the specific identification
method be used where the inventory items are not interchangeable
(i.e., can be specifically identified). If the inventory items are not
specifically identifiable, a cost flow assumption is used. GAAP does
not specify situations in which specific identification must be used.
◆ A major difference between IFRS and GAAP relates to the LIFO cost
flow assumption. GAAP permits the use of LIFO for inventory
valuation. IFRS prohibits its use. FIFO and average-cost are the only
two acceptable cost flow assumptions permitted under IFRS.
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Another Perspective
Key Points
◆ IFRS requires companies to use the same cost flow assumption
for all goods of a similar nature. GAAP has no specific
requirement in this area.
◆ When testing to see if the value of inventory has fallen below its
cost, IFRS defines market as net realizable value. Net realizable
value is the estimated selling price in the ordinary course of
business, less the estimated costs to complete and sell. In other
words, net realizable value is the best estimate of the net
amounts that inventories are expected to realize. GAAP, on the
other hand, defines market as essentially replacement cost. The
GAAP method of inventory valuation is often referred to as the
lower-of-cost-or-market (LCM).
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Another Perspective
Key Points
◆ Under GAAP, if inventory is written down under the lower-of-cost-
or-market valuation, the new basis is now considered its cost. As
a result, the inventory may not be written back up to its original
cost in a subsequent period. Under IFRS, the write-down may be
reversed in a subsequent period up to the amount of the previous
write-down. Both the write-down and any subsequent reversal
should be reported on the income statement.
◆ IFRS generally requires pre-harvest inventories of agricultural
products (e.g., growing crops and farm animals) to be reported at
fair value less cost of disposal. GAAP generally requires these
items to be recorded at cost.
6-58
Another Perspective
Looking to the Future
One convergence issue that will be difficult to resolve relates to the use
of the LIFO cost flow assumption. As indicated, IFRS specifically
prohibits its use. Conversely, the LIFO cost flow assumption is widely
used in the United States because of its favorable tax advantages. In
addition, many argue that LIFO from a financial reporting point of view
provides a better matching of current costs against revenue and,
therefore, enables companies to compute a more realistic income.
6-59
Another Perspective
GAAP Self-Test Questions
Which of the following should not be included in the inventory of a
company using GAAP?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB shipping
point.
d) None of the above.
6-60
Another Perspective
GAAP Self-Test Questions
Which method of inventory costing is prohibited under IFRS?
a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.
6-61
Another Perspective
GAAP Self-Test Questions
Specific identification:
a) must be used under IFRS if the inventory items are not
interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most
conservative net income.
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Question or Comment ?
6-63
