1 Learning objectives After studying the material in this chapter you will be able to do the following: LO1 Explain the nature, purpose and importance of inventory to an entity. LO2 Distinguish between the perpetual and periodic methods of inventory control. LO3 Distinguish among the different cost formulas used to account for inventory and cost of sales, and understand the impact the different cost formulas have on the amounts reported in the financial statements. LO4Explain the lower of cost and NRV (net realizable value) rule. LO 5 Explain the concept of conservatism. Copyright © 2013 McGraw-Hill Ryerson Limited

2 Inventory Valuation IFRS Cost Formulas First in, first out (FIFO) Average cost Specific identification Copyright © 2013 McGraw-Hill Ryerson Limited LO3

3 First-In, First-Out (FIFO) Balance sheet values are from most recent purchases Cost of goods sold are from oldest purchases Flow of costs matches flow of goods Copyright © 2013 McGraw-Hill Ryerson Limited LO3

4 FIFO Inventory System Copyright © 2013 McGraw-Hill Ryerson Limited LO3

5 Average Cost All goods for the period have same cost No differentiation between products Particularly appropriate in process environments Copyright © 2013 McGraw-Hill Ryerson Limited LO3

6 Specific Identification Assigns the actual cost to the unit of inventory Tracks each item separately Flow of costs exactly matches flow of goods Suitable for expensive/unique inventory Opportunity for manipulation by management Copyright © 2013 McGraw-Hill Ryerson Limited LO3

7 Choice of Formula Specific identification required where inventory items are not interchangeable Choice exists between FIFO and average cost where inventory is homogeneous and interchangeable Copyright © 2013 McGraw-Hill Ryerson Limited LO3

8 Impact of Choices Choice has no effect on underlying economic activity - does not reflect or affect physical flow of inventory Cost formulas move costs from balance sheet to income statement Cost formulas allocate costs differently between ending inventory and cost of sales Copyright © 2013 McGraw-Hill Ryerson Limited LO3

9 Cash Flow and Other Impacts Cash flow is not directly affected by the cost formula used Individual values for cost of sales and inventory change with method Measures and ratios will change Economic consequences Managers have discretion Copyright © 2013 McGraw-Hill Ryerson Limited LO3

10 Which Method is Best? Depends on the objectives of the users and preparers Each has different impacts on the financial statements - it is important to be aware of consequences But remember, no effect on underlying economic activity Copyright © 2013 McGraw-Hill Ryerson Limited LO3

11 Cost Formulas and Objectives When prices are rising, Average costs yields lower income figure FIFO yields higher income figure Copyright © 2013 McGraw-Hill Ryerson Limited LO3

12 Disclosure Requirements Accounting policies adopted, including cost formula used Carrying amount of inventories Carrying amount of inventories carried at NRV Amount of inventory expensed during the period Copyright © 2013 McGraw-Hill Ryerson Limited LO3,4

13 Disclosure Requirements (Continued) Inventory writedowns and reversals of writedowns Carrying amount of inventories pledged as security for liabilities Copyright © 2013 McGraw-Hill Ryerson Limited LO3,4