Chara Charalambous CDA College 1 FINANCIAL ACCOUNTING Lecture 6

Chara Charalambous CDA College 2 Lecture learning objectives Valuation of inventory Regulation IAS 2 How companies keep record of their inventory Recording inventory in the ledger accounts Methods of calculating cost of inventory

Chara Charalambous CDA College 3 Why is Inventory Control Important Why is Inventory Control Important? Inventory is a significant asset and for many companies the largest asset. Inventory is vital to the main activity of merchandising (retail) and manufacturing companies. Mistakes in determining inventory cost can cause critical errors in financial statements. Inventory must be protected from external risks ( such as fire and theft) and internal fraud by employees.

Chara Charalambous CDA College 4 Inventory consists of: Goods purchased for resale –Consumable supplies (such as oil) –Raw materials and components used in the production process –Partly – finished goods (usually called work in progress – WIP) –Finished goods which have been manufactured by the business

Chara Charalambous CDA College 5 IAS 2: Inventory IAS 2 Inventories contains the requirements on how to account for most types of inventory. The standard requires inventories to be measured at the lower of cost and net realisable value (NRV) :

Chara Charalambous CDA College 6 IAS 2: Inventory 1.Cost: All the expenditure incurred in bringing the product or service to its present location and condition. This includes cost of purchase and cost of conversion Material costs, import duties, insurance & freight (packages, shipping, transportation) Direct costs (labor costs and conversion materials) and production overheads (factory heating and light, salaries of supervisors, depreciation of equipment) Costs which must be excluded from the cost of inventory are: -Selling costs -Storage costs -Abnormal waste of materials, of labour or of other costs -Administrative overheads

Chara Charalambous CDA College 7 2. Net realizable value (NRV) The term net realizable value (NRV) refers to the net amount that a company expects to realize from the sale of inventory. Specifically, net realizable value is the estimated selling price in the normal course of business (less estimated costs to complete and estimated costs to make a sale). WE CHOOSE THE LOWER PRICE OF THE TWO.THE COMPARISON BETWEEN COST AND NRV MUST BE MADE ITEM BY ITEM, NOT ON THE TOTAL INVENTORY VALUE. IT MAY BE ACCEPTABLE TO CONSIDER GROUPS OF ITEMS TOGETHER IF ALL ARE WORTH LESS THAN COST.

Chara Charalambous CDA College 8 Example 1: Cole’s business sells three products X,Y and Z. The following information was available at the year end: X Y Z € € € Cost per unit NRV per unit Units What is the value of the closing inventory?

Chara Charalambous CDA College 9 Solution: We choose the lower price in each case. X : € 7 * 100 = 700 Y: € 8 * 200 = 1600 Z: € 15 * 300 = 4500 TOTAL €6800

Chara Charalambous CDA College 10 Net realisable value may be less than cost because of deterioration (worsening, decline, weakening), old- fashioned, damage or changes in demand. At the accounting date, there may be a reasonable expectation that the proceeds of sale of some stock in future years will not produce enough income to cover its cost. If so, a loss on such stock should be recognised in the year under review by writing off the irrecoverable costs incurred. However most items of inventory will be stated at cost. IAS 2: Inventory

Chara Charalambous CDA College 11 IAS 2: Inventory Inventories reported at the Lower COST and NRV Why? So not reported at more than the future cash flows into the company from their sale.

Chara Charalambous CDA College 12 Product Line Quantity on Hand Unit Cost Inventory at Cost Market Value per Unit Lower of Cost or Market 1. Free Swing 1,000$190$190,000$230$190, Golf Elite , ,000 3.Hi-Flight , ,000 4.Iridescent1, , , Titanium , ,000 Based on the table, the market value is lower than cost on the Hi-Flight and Iridescent product lines. Consequently, Mulligan recognizes a loss on the Hi- Flight product line of $3,000 ($27,000 - $24,000), as well as a loss of $144,000 ($336,000 - $192,000) on the Iridescent product line. Example 2: Lower of Cost or NRV Mulligan Imports resells five major brands of golf clubs, which are noted in the following table. At the end of its reporting year, Mulligan calculates the lower of its cost or net realizable value in the following table: 1200* * 120

Chara Charalambous CDA College 13 Example 3: Which one of the following lists consists only of items which may be included in the statement of financial position, as value of inventories, according to IAS 2? A. Forman’s wages, carriage inwards, carriage outwards, raw materials B. Raw materials, carriage inwards, costs of storage of finished goods, plant depreciation C. Plant depreciation, carriage inwards, raw materials, foreman’s wages D. Carriage outwards, raw materials, Forman's wages, plant depreciation

Chara Charalambous CDA College 14 Solution: A. Forman’s wages, carriage inwards, carriage outwards, raw materials B. Raw materials, carriage inwards, costs of storage of finished goods, plant depreciation C. Plant depreciation, carriage inwards, raw materials, foreman’s wages D. Carriage outwards, raw materials, Forman's wages, plant depreciation

Chara Charalambous CDA College 15 How companies keep record of their inventory? Perpetual inventory system Periodic inventory system

Perpetual Inventory Systems  Company knows the cost of sales and ending inventory figure from their books  Advantages: 1.There is better information for inventory control 2.Less work needed to calculate inventory at the end of the accounting period. Inventory records are updated after each purchase or sale – ‘continuous basis throughout the year;

Periodic Inventory Systems  Advantages: 1.They are cheaper in most situations that the costs of maintaining continuous inventory records 2.Even if there is a continuous inventory record, there will still be a need to check the accuracy of the information recorded by having a physical check of some of the inventory lines.  Disadvantages: Reduces record keeping but also decreases the ability to track theft, break, etc., and prepare acting financial statements Inventory records are updated periodically based on physical inventory counts

Chara Charalambous CDA College 18 In order to be able to prepare a set of financial statements, inventory must be accounted for at the end of the period. Opening inventory must be included in cost of sales as these goods are available for sale along with purchases during the year. Closing inventory must be deducted from cost of sales as these goods are held at the period end and have not been sold. In some countries inventory is referred to as ‘stock’.

Chara Charalambous CDA College 19 Inventory is only recorded in the ledger accounts at the end of the accounting period. In the inventory ledger account the opening inventory will be the brought forward balance from the previous period. This must be transferred to the Income Statement ledger account with the following entry: Dr Income Statement (Ledger Account) Cr Inventory (Ledger Account)

Chara Charalambous CDA College 20 The closing inventory is entered into the ledger accounts with the following entry: Dr Inventory (Ledger Account) Cr Income Statement (Ledger Account) Once these entries have been completed, the Income Statement ledger account contains both opening and closing inventory and the inventory ledger account shows the closing inventory for the period to be shown in the Statement of Financial Position.

Chara Charalambous CDA College 21 General Ledger Inventory a/c B/ce b/d (opening) x I.S:Trading a/c x Trading a/c (closing) xx B/ce c/d xx xxx xxx B/ce b/d xx

Chara Charalambous CDA College 22 Summary The Sales account and the purchases account do not include b/ce b/d and b/ce c/d but instead they are cleared out to the trading account – their amounts are transferred to trading a/c and the accounts are closed. Opening inventory is also cleared out in the trading account and closing inventory is entered into the inventory account and the trading account. The balance on the inventory account remains at the end of the period and is listed in the balance sheet under current assets as inventory.

Chara Charalambous CDA College 23 It is not unusual for a sole trader to take inventory from their business for their own use. This type of transaction is a form of drawings. The correct double entry to account for such drawings is: Dr Drawings - Cost of Inventory taken Cr Cost of Sales – Cost of Inventory taken OR Purchases –The credit entry ensures that the cost of inventory taken is not included as part of the cost of inventory sold in the Income Statement.

Chara Charalambous CDA College 24 MethodKey Points FIFO (First in first out): for costing purposes, the first items of inventory received are assumed to be the first ones sold. The cost of closing inventory is the cost of the younger inventory. LIFO (Last in first out): for costing purposes, the last items of inventory received are assumed to be the first ones sold. The cost of closing inventory is the cost of the older inventory. AVCO (Average Cost): The cost of an item of inventory is calculated by taking the average of all inventory held. The average cost can be calculated periodically or continuously.

Chara Charalambous CDA College 25 Example 4: Periodic System. Sam started her business on 1st Jan and provides details of the following transactions : Purchases (1) Jan: 5 units at € 4 / unit (2) Jan: 5 units at € 5 / unit (3) Jan: 5 units at € 5.50 / unit Sales She then sold 7 units for € 10 per unit in 29 th of January Calculate the value of closing stock at the end of the month using the FIFO,LIFO,AVCO method under the periodic system. Also prepare the trading a/c for this month.

Chara Charalambous CDA College 26 Estimating Inventory Cost

Chara Charalambous CDA College 27 Solution: FIFO: Closing stock 3 units* 5 = 15 5 units*5.50=27.50 TOTAL €42.50 LIFO: Closing stock 3 units* 5 = 15 5 units*4 = 20 TOTAL € 35 AVCO: 5*4 + 5*5 + 5*5.50 = Closing stock 8*4.83 = 38.67

28 Trading a/c FIFO Sales (7*10) 70 Less: COS Purchases ( 5*4+5*5+5*5.50) Closing Stock (42.50) (30) GROSS PROFIT 40 LIFO Sales (7*10) 70 Less: COS Purchases ( 5*4+5*5+5*5.50) Closing Stock (35) (37.50) GROSS PROFIT AVCO Sales (7*10) 70 Less: COS Purchases ( 5*4+5*5+5*5.50) Closing Stock (38.67) (31.33) GROSS PROFIT 38.67

Chara Charalambous CDA College 29 Comparison of Costing Methods X X X X X Weighted AverageFIFO LIFO In periods of rising prices: Highest cost of goods sold? Lowest cost of goods sold? Highest gross profit? Lowest net income? Lowest income taxes? LO7

Chara Charalambous CDA College 30 In general, companies can use one accounting method for financial reporting purpose and use a different method for tax purpose. Accounting choice should be made based on which method produces most useful information.

Chara Charalambous CDA College 31 Disclosure of inventories They will be analyzed as follows in the balance sheet: Inventories: Raw Materials x Work in progress x Finished goods and goods for resale x x

Chara Charalambous CDA College 32 Example 5: Perpetual System. Sam started her business on 1st Jan and provides details of the following transactions : Transactions: Purchases and Sales Jan: 5 units purchased at € 4 / unit Jan: 2 Units sold at €10/unit Jan: 5 units purchased at € 5 / unit Jan: 5 units sold at €10/unit Jan: 5 units purchased at € 5.50 / unit Calculate the value of closing stock at the end of the month using the FIFO and LIFO method under the perpetual system.

Chara Charalambous CDA College 33 Solution: FIFO: Closing stock 3 units* 5 = 15 5 units*5.50=27.50 TOTAL €42.50 LIFO: Closing stock 3 units* 4 = 12 5 units*5.50 = TOTAL € 39.50

One important characteristic of FIFO should be noted here. Under both periodic and perpetual FIFO, ending inventory is the same and cost of goods sold is the same. The reported numbers are identical. The first cost for the period is always the first cost regardless of when the assignment to expense is made. Thus, the resulting amounts are the same when using either FIFO system. Chara Charalambous CDA College 34

Chara Charalambous CDA College 35 Example 6: Periodic System A business commenced (begin) on 1 Jan and purchases are made as follows: Month No of Units Unit Price Value € € Jan Feb Mar Apr May Jun In June 1420 units were sold for € 7000 What is the cost of closing stock and gross profit for the period using the FIFO method under the period system?

Chara Charalambous CDA College 36 Solution: Closing Stock: 130*2.75= *3= *3.25=1430 TOTAL Trading a/c Sales 7000 Less: COS Purchases 6510 Closing Sock (3077.5) ( ) GROSS PROFIT

37 Inventory Costing Methods 40% 30% 20% 10% 0% 43% 34% 19% 4% FifoLifoAverageOther APPENDIX

Chara Charalambous CDA College 38 Strangely enough, the LIFO method is the preferred inventory valuation method in the United States but is forbidden in non-US countries. The FIFO method and the weighted average cost method are used in non-US countries. In recent years there have been calls for the homogeny of accounting rules throughout the world, and talk specifically about forbidding LIFO in the US (or making the rest of the world follow the LIFO system). As of this writing the matter has not been resolved and the differences in inventory valuation still exist.