1 Inventories An Important Source of Income

2 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

3 Why inventories are so important?

4  Because the valuation of inventories directly affects the bottom line figure in the I/S by affecting COGS and thereby Gross Profit (Sales- COGS)  At the same time, it has an effect on the B/S since Inventory is usually the most significant item among the Current Assets in merchandising & manufacturing companies  The amount of inventories on hand, and the time it takes to sell them is very crucial to the performance of any firm (called Inventory Turnover – Stok Devir Hızı)

5 1.Physical count of Inventory 2. Determination of ownership of the goods, i.e. account for:  Goods in Transit  Consignment Goods Determination of Inventory Units Two Step Process:

6 Seller Buyer F.O.B. SHIPPING POINT WHO OWNS THE GOODS ON THE WAY? GOODS IN TRANSIT

7 Seller Buyer F.O.B. DESTINATION WHO OWNS THE GOODS ON THE WAY? GOODS IN TRANSIT

8 Consignment Goods  Marketing agreement btw. the consigner (owner of the goods) and the consignee (holder of the goods). Here, the consignee sells the goods on behalf of the consigner Ex: Automobile Dealer selling consignment goods. Consignee, even though he is selling it, doesn’t own the goods, so he should not include it in his inventory. On the other hand, consigner should include the goods in his inventory since he is the owner

9 Inventory Costs Beginning Inventory + Purchases - Ending Inventory = COGS (UNDER THE Cost of Goods Available for Sale PERIODIC INVENTORY SYSTEM) UNDER THE PERPETUAL INVENTORY SYSTEM: It would accumulate the cost of merchandise sold in the COGS account, and deduct the cost from the Inventory account each time a sales is made.

10  In the previous chapter, we implicitly assumed that each unit in the inventory is acquired for the same cost. However, in practice that is not the case. Even if a company sells one type of good, it buys them at varying prices  Therefore, when identical units of inventory have different unit costs, the question is: Which cost should be used to compute the amount of cost of goods sold?  Determination of the unit cost to be assigned to units sold is called the COST FLOW, i.e. how cost of units move from the Inventory account to the COGS account

11 Inventory Cost Flows According to the IAS (Int. Acc. Stds.) and TAS (Turkish Acc. Stds.), the following cost flow methods can be used, regardless of the inventory system that they are using (periodic or perpetual): 1.Specific Identification Method 2.First-in First-out (FIFO) 4.Weighted Average 3.Last-in First-out (LIFO) – not allowed by IFRS or CMB

12 Specific Identification Method Used when the actual cost of the item is tracked  When a company sells limited variety of high- priced goods, it keeps track of each item individually (generally applicable for low-volume companies, because if the volume is high, it is very difficult to keep track) Ex: A car dealer specifically knows the cost of each car, and therefore when a car is sold, COGS is debited by the cost of that specific car

13 Cost Flow vs. Physical Flow First-in First-out (FIFO), and weighted average methods assume that flow of costs may be unrelated to physical flow of goods The accounting regulations do not require that the physical flow of goods and the related cost flow to be the same

14 Illustrative Example of the Remaining 3 Cost Flow Methods: FIFO, LIFO & Weighted Avg. * The company had 1000 units available for sale for a total of TL 12 mill. during the period. * Of these available units, 550 units were sold and 450 units still remain in the inventory at the end of 2000.

15 First-in First-out Method FIFO  FIFO method assumes that the goods purchased earlier will be sold first  The cost of the first units on hand is assigned to the units sold first

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17 Beginning Inventory Ending Inventory Cost of Goods Sold Since under the Perpetual Inventory System, composition of inventory changes after every merchandising transaction, date is very important

18 Weighted Average  Goods available are homogeneous and the cost to be assigned to each unit sold is the same (under the Periodic Inventory System) Unit Cost = Total Cost of Goods Available for Sale Total Number of Units Available for Sale

19 Weighted Average Method: Periodic Inventory System Unit Cost = /1.000 = TL per unit  COGS = TL (avg. unit cost) x 550 (# of units sold) = TL  Ending Inv. = TL (avg. unit cost) x 450 (# of units remaining on hand) = TL or by using the formula COGS = Beg. Inv+Purch.–End. Inv., COST OF GOODS AVAIL. FOR SALE  End. Inv. = TL TL = TL

20 * Because the date of the purchase & sale is the deciding factor here; every time a purchase is made, a new weighted average unit cost is computed and that cost is assigned to subsequent sales until the next purchase when a new cost is computed. Ending Inventory : 450 x = 5.790

21 Summary Perpetual Inventory System

22 Lower of Cost or Market Inventories, similar to other assets are originally recorded at the historical cost However, as time passes the value of the inventories might decline in the market because of the obsolescence factor IFRS specify that the companies should use the lower-of cost-or market (LCM) valuation basis the market value is the current replacement cost of the inventory LCM rule can be applied with any of the cost flow methods, or the specific identification method LCM may be applied to individual items or major categories of inventory the decline in value is not expected to increase in the very near future

23 Example-LCM-1 Item by item What should company report on the balance sheet if it were using the total approach?

24 Example-LCM-2 on 15 August 2005, the company sold 15 units of Item W at TL 126 per unit

25 Example-LCM-3 Using item-by-item basis 31 December 2005

26 Inventory Errors COGS = Beg. Inv + Purch - End. Inv GM = Sales - COGS * If there are no other errors, the effect of the error in the ending inventory in Year 1 will be offset or counter-balanced in two consecutive years (at the end of the following year)

27 Estimating the Cost of Goods Sold and Ending Inventory Two Methods: 1.Gross Margin (Gross Profit Method) 2.Retail Method  In cases where the company is unable to take physical count of the inventory (cases of fire or other similar disasters which destroy the inventory); it has to make an estimation of the amount of inventory to file an insurance claim & get money from the insurance company.

28 Gross Profit Method (The widely used method based on the COGS formula) Gross profit percentage = 40% (from previous years), therefore : COGS percentage = 60% (100% Net Sales – 40% GM) Beginning inventory TL200 millions Purchases 1,000 Cost of Goods Available for Sale TL1,200 millions COGS : Net Sales 1,000 Gross Profit (40% of 1000) Ending Inventory TL 600 millions Main assumption: Gross Profit Percentage (Gross Profit/Net Sales) is the same or similar to the previous years. Then, the COGS ratio is calculated by deducting Gross Profit% from the Net Sales percentage of 100)

29 Inventory Management and Ethical Issues inventories are closely related with net income and thus with the shareholders’ equity, and the assets taking decisions that would affect the ending inventory and cost of goods sold amount, the management can manipulate income for example, management might decide to make a large purchase at the end of the period, in order to maximize profits in that period, and then return the goods at the beginning of the following period stating that they are not according to specifications

30 Analysis of Inventories  To check whether adequate profits are generated by the operations  To check whether inventory is adequate to meet future demands Important for two aspects:

31 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.