Chapter 17 Inventories

Contents Inventories Inventory systems Accounting for inventories under IFRS

Inventories for commercial companies Merchandise: goods purchased for resale without transformation

Inventories for manufacturing companies Raw materials, parts, components and consumables: goods that, once incorporated in the production process, become integrally and physically part of the product Manufacturing supplies: items used in supporting production and not part of the product

Inventories for manufacturing companies (cont’d) Work in progress (WIP): products still in the manufacturing process at the close of the day Semi-finished goods: items that are finished with regard to one stage of production but are nonetheless not sellable in that condition. Finished goods: completed products ready for sale

Inventories for service companies Work in progress: accumulated costs incurred in fulfilling a contract and not yet billed

An overview of possible methods to determine the value of the inventory Unit cost First in, first out (FIFO) Last in, last out (LIFO) Weighted average Base inventory

Inventory systems Each company needs a system to record the physical and monetary movements in the inventory. A company needs to keep track of the beginning inventory, the purchases, the goods sold and the closing inventory. Two inventory recording systems exist: the periodic inventory system the perpetual inventory system

The periodic inventory system Within this system inventory is determined by a physical count at a specific date. As long as the count is made frequently enough for reporting purposes, it is not necessary to maintain extensive inventory records. The inventory shown in the balance sheet is determined by the physical count and is priced in accordance with the inventory method used. The net charge between the beginning and ending inventories enters into the computation of costs of goods sold.

The perpetual inventory system In a perpetual system, inventory records are maintained and updated continuously as items are purchased and sold. The system has the advantage of providing inventory information on a timely basis but requires the maintenance of a full set of inventory records. Audit practice will certainly require that a physical check of perpetual inventory records be made periodically.

Accounting for inventories under IAS 2 Definitions Measurement Disclosure

IAS 2 – definitions Inventories are assets: held for sale in the ordinary course of the business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services

IAS 2 – measurement Inventories shall be measured at the lower of cost or net realisable value the cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition 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

Cost of inventory + costs of conversion Cost of purchases + costs of conversion + other costs incurred in bringing the inventory to the present location and condition

Cost of inventory (cont’d) Cost of purchase = Purchase cost + + Import duties and other non-recoverable taxes + Transport and handling costs + + Other costs directly attributable to acquisition – trade discounts/rebates

Cost of inventory (cont’d) Conversion cost includes cost directly related to the units of production, such as direct labour systematic allocation of fixed and variable production overheads that are incurred in converting materials to finished goods the allocation of fixed production overheads is based on the normal capacity of the production facilities

Cost of inventory (cont’d) Other costs are costs incurred in bringing the inventories to their present location and condition. costs which can not be included are e.g.: abnormal amounts of waste storage costs administrative overhead selling costs

Question Which can be included in the inventory costs according to IAS 2 Discounts on purchase price Travel expenses of buyers Import duties Transport insurance Storage costs for materials that are necessary in the production process Salaries of sales department Research for new products Audit and tax consultation fees Adapted from Activity 17.8 alexander et al International Financial Reporting ed. 6

Cost formulas allowed for inventory valuation by IAS 2 The cost of inventories of items that are not ordinarily interchangeable and goods and services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs The cost of other inventories shall be measured by FIFO, or weighted average cost

Lets do a question

J Jones runs a computer shop. He sells pen drives to wholesalers J Jones runs a computer shop. He sells pen drives to wholesalers. He has heard of FIFO and AVCO but is not sure what they are. During April he has the following purchases and issues from stock. Opening stock of 40 units at £3 each Bought 20 units costing £3.60 each Sold 36 units for £6 each Bought 20 units at £3.75 each sold 25 units for £6 each   Show J Jones how the stock valuations would change using each system.

2 Methods FIFO First In First Out AVCO Average Cost

FIFO What does this mean?

FIFO Definition Materials are issued out of stock in the order in which they were delivered into stock

FIFO Advantages Logical Often the reality of what happens in the stores Easy to understand and explain Stock valuation is close to replacement price

FIFO Disadvantages Time consuming if the company has received batches Managers may not understand why stocks not a current prices

AVCO What does this mean?

AVCO Definition The goods are issued at the average price of all of the goods. The price of the stock is recalculated every time a new delivery is made

AVCO Advantages Price fluctuations are smoothed out Easier to run the system

AVCO Disadvantages Price can run into several decimal places Price is rarely the actual cost of the goods

Net realisable 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 The amount of any write-down on inventories to net realisable value will be recognized as an expense in the period the write-down occurs

Question The factory has 3 distinct products in its inventories and the value of each is What according to IAS 2 should be the value of the inventories Alpha Beta Gamma Cost 25 50 20 Net realisable value 60 30

Answer As 3 distinct products each valued individually 90 Alpha Beta Gamma Cost 50 20 Net realisable value

IAS 2 disclosure The accounting policies adopted in measuring inventories, including the cost formulas used The total carrying amount of inventories and the carrying amount in classifications appropriate to the enterprise The carrying amount of inventories carried at fair value less costs to sell The amount of any write down of inventories recognized as an expense in the period in accordance with para. 34

IAS 2 disclosure (cont’d) The carrying amount of inventories pledged as security for liabilities The cost of inventories recognized as an expense during the period The amount of any reversal of any write down that is recognized as a reduction in the amount of inventories recognized as an expense in the period in accordance with para. 34 The circumstances or events that led to the reversal of a write down of inventories in accordance with para. 34

Question Which can be included in the inventory costs according to IAS 2 Discounts on purchase price Yes Travel expenses of buyers No Import duties Transport insurance Storage costs for materials that are necessary in the production process Salaries of sales department Research for new products Audit and tax consultation fees Adapted from Activity 17.8 alexander et al International Financial Reporting ed. 6