Chapter Four

Inventories
Inventory Issues

Classification
Inventories are asset:
 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
Classification

 One inventory
account.
 Purchase
merchandise in
a form ready for
sale.
Classification

Three accounts
 Raw Materials
 Work in Process
 Finished Goods
Goods and Costs Included an Inventory

Goods Included in Inventory

A company recognizes inventory and accounts payable at the
time it controls the asset.
Passage of title is often used to determine control because
the rights and obligations are established legally.
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.
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).
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.
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.
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

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.
Treatment of Purchase Discounts

**

* $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

Which Cost Flow Assumptions to
Adopt?

Cost Flow Methods

 Specific Identification
or
 Two cost flow assumptions
► First-in, First-out (FIFO) or
► Average Cost
Cost Flow Methods
To illustrate the cost flow methods, assume that Call-Mart SpA
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
Cost Flow Methods

Specific Identification
 Method may be used only in instances where it is practical
to separate physically the different purchases made. 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.

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.
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.
Average-Cost

Weighted-Average Method
Average-Cost

Moving-Average Method

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

time it makes a purchase.
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.
First-In, First-Out (FIFO)

Periodic Inventory System

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.
First-In, First-Out (FIFO)

Perpetual Inventory System

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.
Inventory Valuation Methods—Summary

Comparison assumes periodic inventory procedures and the

following selected data.
Inventory Valuation Methods—Summary
Inventory Valuation Methods—Summary

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

balance at year-end (because taxes are lower).
Lower-of-Cost-or-Net Realizable
Value (LCNRV)

A company abandons the historical cost principle when

the future utility (revenue-producing ability) of the asset
drops below its original cost.

Net Realizable Value

Estimated selling price in the normal course of business
less
 estimated costs to complete and
 estimated costs to make a sale.
Net Realizable Value

Illustration: Assume that Mander AG 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. Mander’s
net realizable value is computed as follows.
Net Realizable Value

 Mander reports inventory on its balance sheet at €750.


In its income statement, Mander reports a Loss on
Inventory Write-Down of €200 (€950 − €750).
Illustration of LCNRV

Jinn-Feng Foods computes its inventory

at LCNRV (amounts in thousands).
Methods of Applying LCNRV

Assume that Jinn-Feng Foods separates its food products

into two major groups, frozen and canned.
Methods of Applying LCNRV

 In most situations, companies price inventory on an item-

by-item basis.
 Tax rules in some countries require that companies use an
individual-item basis.
 Individual-item approach gives the lowest valuation for
statement of financial position purposes.
 Method should be applied consistently from one period to
another.
Recording NRV Instead of Cost

Illustration: Data for Ricardo SpA

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 (€82,000 - €70,000) 12,000

COGS Cost of Goods Sold 12,000

Method Inventory 12,000
Recording NRV Instead of Cost

Partial Statement of Financial Position

Recording Net Realizable Value
Income Statement
Use of an Allowance

Instead of crediting the Inventory account for NRV adjustments,

companies generally use an allowance account, often referred to as
Allowance to Reduce Inventory to NRV.

Using an allowance account under the loss method, Ricardo SpA

makes the following entry to record the inventory write-down to
NRV.

Loss Due to Decline of Inventory to NRV 12,000

Allowance to Reduce Inventory to NRV 12,000
Use of an Allowance

Partial Statement of Financial Position

LCNRV

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
Recovery of Inventory Loss

Allowance account is adjusted in subsequent periods, such that

inventory is reported at the LCNRV.
Illustration shows net realizable value evaluation for Vuko Company
and the effect of net realizable value adjustments on income.
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 of Estimating Inventory

Illustration: Cetus SE 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. Cetus
applies the gross margin method as follows.
Gross Profit Method of Estimating Inventory

Computation of Gross Profit Percentage

Illustration: In Illustration 9.13, the gross profit was a given. But
how did Cetus derive that figure? To see how to compute a gross
profit percentage, assume that an article cost €15 and sells for
€20, a gross profit of €5.
Gross Profit Method
Gross Profit Method of Estimating Inventory

Astaire ASA uses the gross profit method to estimate inventory for
monthly reporting purposes. Presented below is information for the
month of May.
Inventory, May 1 € 160,000 Sales € 1,000,000
Purchases (gross) 640,000 Sales returns70,000
Freight-in 30,000Purchases discounts 12,000

Instructions:
(a) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of sales.
(b) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of cost.
Gross Profit Method of Estimating Inventory
(a) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of sales.
Gross Profit Method of Estimating Inventory
(b) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of cost.

25%
= 20% of sales
100% + 25%
Gross Profit Method of Estimating Inventory

Evaluation of Gross Profit Method

Disadvantages
1) Provides an estimate of ending inventory.
2) Uses past percentages in calculation.
3) A blanket gross profit rate may not be representative.
4) Normally unacceptable for financial reporting purposes
because it provides only an estimate.

IFRS requires a physical inventory as additional verification of

the inventory indicated in the records.
Retail Inventory Method

Method used by retailers to compile inventories at retail prices.

Retailer can use a formula to convert retail prices to cost.
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.

Methods
 Conventional Method (or LCNRV)
 Cost Method
Retail Inventory Method
Illustration: The following data pertain to a single department for
the month of October for Fuque Ltd. Prepare a schedule computing
retail inventory using the Conventional and Cost methods.

CO ST R E T A IL
B e g . in v e n to r y , O c t. 1 £ 52,000 £ 78,000
P u rch ase s 272,000 423,000
F r e ig h t in 16,600
P u r c h a s e r e tu r n s 5,600 8,000
A d d itio n a l m a r k u p s 9,000
M a r k u p c a n c e lla tio n s 2,000
M a r k d o w n s (n e t) 3,600
N o r m a l s p o ila g e a n d b r e a k a g e 10,000
S a le s 390,000
Retail Inventory Method
Retail Inventory Method
Retail Inventory Method

Special Items Relating to Retail Method

 Freight costs
 Purchase returns
 Purchase discounts and allowances
 Transfers-in
 Normal shortages When sales are recorded
gross, companies do not
 Abnormal shortages recognize sales discounts.
 Employee discounts
 Retail Inventory Method

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.

Some companies refine the retail method by computing inventory separately by

departments or class of merchandise with similar gross profits.
 GLOBAL ACCOUNTING INSIGHTS

LEARNING OBJECTIVE 6
Compare the accounting for inventories under IFRS and U.S. GAAP.

Inventories
In most cases, IFRS and U.S. GAAP related to inventory are the same. The
major differences are that IFRS prohibits the use of the LIFO cost flow
assumption and records market in the LCNRV differently.
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Following are the key similarities and differences between U.S. GAAP and IFRS
related to inventories.
Similarities
• U.S. GAAP and IFRS account for inventory acquisitions at historical cost and
evaluate inventory for lower-of-cost-or-net realizable value (market)
subsequent to acquisition.
• Who owns the goods—goods in transit, consigned goods, special sales
agreements—as well as the costs to include in inventory are essentially
accounted for the same under U.S. GAAP and IFRS.
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• U.S. GAAP provides more detailed guidelines in inventory accounting. The
requirements for accounting for and reporting inventories are more
principles-based under IFRS.
• A major difference between U.S. GAAP and IFRS relates to the LIFO cost
flow assumption. U.S. 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. Both sets of standards permit
specific identification where appropriate.
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• In the lower-of-cost-or-market test for inventory valuation, U.S. GAAP
defines market as replacement cost subject to the constraints of net
realizable value (the ceiling) and net realizable value less a normal markup
(the floor). IFRS defines market as net realizable value and does not use a
ceiling or a floor to determine market.
• Under U.S. 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 up back 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.
 GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• IFRS requires both biological assets and agricultural produce at the point of
harvest to be reported at net realizable value. U.S. GAAP does not require
companies to account for all biological assets in the same way. Furthermore,
these assets generally are not reported at net realizable value. Disclosure
requirements also differ between the two sets of standards.
 GLOBAL ACCOUNTING INSIGHTS

On the Horizon
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.