Chapter 9 Inventories

Objectives Discuss the nature of inventories and how to measure them Explain what is included in the cost of inventory Explain cost flow assumptions and apply both FIFO and weighted average cost formulas Explain the net realizable value basis of measurement Implement the disclosure requirements of IAS

The Nature of Inventories IAS 2 defines inventories as assets that are: Held for sale In the process of production Materials or supplies to be used in production Inventories are classified as current assets Cost of goods sold (COGS) is the expense account used to record the costs of inventory once sold

Initial Recognition of Inventory ‘Inventories shall be measured at the lower of cost and net realizable value.’ (IAS 2 para 9) Cost Components: Costs of purchase Costs of conversion Costs in bringing inventory to present location & condition

Determination of Cost The cost of purchase comprises: The purchase price Import duties and other transaction taxes Transport, handling and other directly attributable costs Any discounts are to be deducted

Costs of Conversion Costs of conversion are those costs directly related to production including: Direct labor Systematic allocation of fixed and variable production overheads Variable overheads: vary with volume of production. Allocated based on actual use of production facilities Fixed overheads: remain constant regardless of the volume of production. Allocated based on normal production capacity.

Assigning Costs to Inventory on Sale IAS 2 requires the specific identification method be used where possible to assign costs to inventory Under this method costs are individually identified for each inventory item Where there are large numbers of homogenous inventory items one of the following two methods should be used: First-in first-out (FIFO) Weighted average cost method NOT Last-in First-out (LIFO)

Comparison to US GAAP US GAAP IFRS Different cost flow assumptions may be used for inventory with a similar nature and use. LIFO method is allowed. IFRS The same cost flow assumptions must be used for inventory with a similar nature and use even if inventory is held in different geographic locations and/or by different entities. LIFO method is not allowed.

Cost Flow Assumptions Analysis of companies as of 2010: Variable Mean Exxon had a reserve of $21.3 billion in 2010 and $17.1 billion in 2009. In 2010, this was 53% of Exxon’s operating income, 70% of its net income and 7% of its assets. Carpenter Technology Corp. had a reserve balance that was 28 times its operating income and 158 times its net income in 2010. Variable Mean Median Reserve balance (in millions) $294 $38 Net income (in millions) $686 $99 LIFO reserve/operating income 65% 17% LIFO reserve/net income 129% 24% LIFO reserve/assets 4% 2% LIFO reserve/inventory* 8% 14% *Inventory is the LIFO inventory with the reserve added back. Analysis of companies as of 2010 using Compustat: 6,423 companies in the sample of which 4,459 companies had inventory of which 302 companies had a LIFO reserve.

Lower of Cost or Market US GAAP IFRS Reports at the LCM: Market is defined as replacement cost with a floor (NRV less normal profit margin) and a ceiling (NRV). NRV is defined as the estimated selling price less the estimated costs of completion and sale. Reversals of prior write-downs are not allowed. IFRS Reports at the lower of cost or net realizable value (LCNRV): NRV is defined as the estimated selling price less the estimated costs of completion and sale. Since replacement cost would typically be less than NRV, IFRS will generally result in lower write-downs than US GAAP. Reversals of prior write-downs can be made and recognized in income.

Net Realizable Value (NRV) NRV may fall below cost due to: Fall in selling price Physical deterioration of inventory Obsolescence The costs and NRV of inventories should normally be compared "item by item" (IAS2). However, similar or related items may be grouped if this is appropriate.

Inventory Write-down Example Example 1 – inventory write-down Part 1: On December 31, 2012, Jets International had an inventory of five different types of airplane parts. Given the current fuel costs, airplane parts are not as valuable as they once were. The chart on the next slide provides the cost basis, net realizable value, replacement cost and net realizable value less normal profit margin as of December 31, 2012. Jets International prepares its inventory valuation comparisons on an item-by-item basis. What is the amount of write-down (if any) required using US GAAP? Please provide the necessary journal entry. What is the amount of write-down (if any) required using IFRS? Please provide the necessary journal entry.

Inventory Write-down Example Part 1 (continued): Cost NRV RC NRV-NPM Part 1 $ 10,000 $ 20,000 $ 15,000 $ 12,000 Part 2 $ 19,000 $ 18,000 $ 17,000 Part 3 $ 5,000 $ 3,000 $ 4,000 $ 2,000 Part 4 $ 8,000 $ 11,000 Part 5 $ 9,000

Inventory Write-down Example Part 1 solution: Original cost NRV RC NRV- NPM US GAAP market LCM IFRS LCNRV Part 1 $10,000 $20,000 $15,000 $12,000 Part 2 20,000 19,000 18,000 17,000 Part 3 5,000 3,000 4,000 2,000 Part 4 8,000 15,000 12,000 11,000 Part 5 9,000 Total $58,000 $50,000 $52,000

Inventory Write-down Example Part 1 solution (continued): US GAAP: IFRS: Original cost 58,000 Original cost $58,000 LCM 50,000 LCNRV 52,000 Write-down $ 8,000 Write-down $6,000 US GAAP journal entry: IFRS journal entry: COGS $8,000 Inventory write-down expense $6,000 Inventory $8,000 Inventory valuation allowance $6,000 The amount of inventory write down in this example is $8,000 using US GAAP because the LCM is less than the original cost. The amount is to be recorded in the income statement to COGS and directly to inventory because a future reversal of write-downs is not permitted. Using IFRS, the write-down is $6,000 because the LCNRV is less than the original cost. The write-down is not required to be recorded in a specific income statement account. A valuation allowance is used because future reversals of write-downs are permitted.

Inventory Write-down Reversal Example Example 1 – write-down reversal Part 2: The airline industry’s business was so terrible during 2013 that Jets International still had the same five parts in its inventory as of December 31, 2013. However, fuel prices have decreased, so the outlook is more optimistic. As of the end of the year, Jets International’s original cost basis, net realizable value, replacement cost and net realizable value less the normal profit are as shown on the next slide. What is the amount of write-down reversal (if any) required using US GAAP? Please provide the necessary journal entry. What is the amount of write-down reversal (if any) required using IFRS? Please provide the necessary journal entry.

Inventory Write-down Reversal Example Part 2 (continued): Original Cost NRV RC NRV-NPM Part 1 $ 10,000 $ 21,000 $ 16,000 $ 13,000 Part 2 $ 20,000 $ 19,000 $ 18,000 Part 3 $ 5,000 $ 4,000 $ 9,000 $ 3,000 Part 4 $ 8,000 $ 11,000 $ 12,000 Part 5 $ 15,000 $ 14,000

Inventory Write-down Reversal Example Part 2 solution: Original Cost IFRS LCNRV December 31, 2012 NRV IFRS LCNRV December 31, 2013 Part 1 $ 10,000 $10,000 $21,000 Part 2 20,000 19,000 Part 3 5,000 3,000 4,000 Part 4 8,000 16,000 Part 5 15,000 12,000 14,000 Total $ 58,000 $ 52,000 $56,000

Inventory Write-down Reversal Example Part 2 solution (continued): No reversal of a write-down is permitted using US GAAP. IFRS: December 31, 2013 LCNRV $ 56,000 December 31, 2012 LCNRV 52,000 Write-down $ 4,000 Journal entry: Inventory valuation allowance $4,000 Inventory write-down expense $4,000 Since the LCNRV at December 31, 2013 exceeds the LCNRV at December 31, 2012 by $4,000, this amount is recorded as a reversal to the previous write-down. The reversal cannot be more than the original write-down.

Disclosure IAS 2 para 36 - 37 outline requirements: Need to classify into categories Common classifications: Merchandise Production supplies Materials Work in progress Finished goods

HOMEWORK Exercise 9.11 DUE THURSDAY, SEPTEMBER 11