1. 7-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Chapter 7 Inventory

2. 7-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Learning objectives Be able to calculate the ‘cost of inventory’ pursuant to AASB 102 ‘Inventories’ Understand how to apply the ‘lower of cost and net realisable value’ rule for measuring inventory Understand why there is typically a necessity to make inventory cost-flow assumptions Be able to apply the inventory cost-flow assumptions permitted by AASB 102 Know the disclosure requirements of AASB 102

3. 7-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Introduction Inventory often accounts for a large proportion of total assets Accounting methods used for inventory can have a significant impact on reported assets and profits AASB 102 applies to all inventories except: –work in progress under construction contracts –financial instruments; and –biological assets

4. 7-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Definition of inventory Inventories are defined as assets (AASB 102) –held for sale in the ordinary course of 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 Cost of goods sold –is the cost of inventory sold during the financial period –can be determined either on a periodic or perpetual basis

5. 7-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan The general basis of inventory measurement Inventories must be measured at the lower of cost and net realisable value (AASB 102) –on an item-by-item basis Cost of inventories comprises all (AASB 102) –costs of purchase (i.e. purchase price, import duties, transport costs, etc); –costs of conversion, (e.g. direct labour and allocation of overhead costs); and –other costs incurred in bringing the inventories to their present location and condition (e.g. product design costs and installation)

6. 7-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan The general basis of inventory measurement (cont.) Costs of inventory exclude (AASB 102) –abnormal amounts of wasted materials; –storage costs; –administrative overheads; and –selling costs Fixed production costs –are costs of production not expected to fluctuate as production levels change (e.g. building depreciation and factory administration costs)

7. 7-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan The general basis of inventory measurement (cont.) There are two methods for dealing with fixed costs 1.Absorption costing: fixed manufacturing costs included in cost of inventories 2.Direct costing: fixed manufacturing costs treated as period costs (i.e. expensed in the period incurred) AASB 102 requires the use of absorption costing

8. 7-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan The general basis of inventory measurement (cont.) Cost of inventory must include both fixed and variable production overheads –indirect production costs that cannot be traced to the goods or services Standard costs –predetermined product costs based, for example, on planned products and/or operations, planned cost and efficiency levels and expected capacity utilisation –only permitted for inventory costing where the standards are realistically attainable, reviewed regularly and revised where necessary

9. 7-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan The general basis of inventory measurement (cont.) Net realisable value (NRV) (AASB 102) –estimated selling price in the ordinary course of business less the estimated costs of completion and those necessary to make the sale If NRV is greater than cost, inventory should be left at cost –upwards revaluations are not allowed by AASB 102 If NRV is less than cost, inventory should be written down to NRV –write-down treated as an expense in the period of the write-down Refer to Worked Examples 7.1, 7.2 and 7.3

10. 7-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Discounts for early payment Discounts received for early payment for debts due to the supplier of inventory are not to be offset against the cost of inventory Discounts given to customers for early payment are not to be offset against sales Penalties for late payment are not to be added to the cost of inventory Trade discounts provided at the point of sale are to be seen as a reduction in the cost of the inventory

11. 7-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Borrowing costs Costs associated with borrowings (eg interest) can sometimes be included in the cost of inventory Governed by AASB 123 ‘Borrowing Costs’ Interest costs can be included as part of the inventory to the extent that the inventory is deemed to be a ‘qualifying asset’ Qualifying assets are those “that necessarily take a substantial period of time to get ready for its intended use or sale” Would not be applicable to most inventory being produced

12. 7-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Inventory cost-flow assumptions Cost-flow assumptions must be made where cost of inventory items fluctuate Specific identification of items sold and on hand, although ideal, might be impractical to apply Cost-flow assumptions used to determine cost of goods sold and closing inventory –the actual physical flow of goods and flow according to assumption might be different

13. 7-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Inventory cost-flow assumptions (cont.) Method adopted should be –appropriate to the circumstances; and –applied consistently from period to period AASB 102 allows the use of one or more of the following methods –specific identification –weighted-average cost –first-in first-out (FIFO) AASB 102 does not permit the use of: –last-in first-out (LIFO)

14. 7-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Specific identification method Cost of sales calculated by determining which item was sold and the specific cost of that item Ending inventory is costed at the cost of the specific items on hand at the end of the year Required to be used for inventory items that are (AASB 102) –not ordinarily interchangeable; or –goods or services produced and segregated for specific projects Not appropriate for large numbers of similar or identical items (AASB 102)

15. 7-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Weighted-average method An average cost is based on beginning inventory and items purchased during the period Various costs of individual units are weighted by the number of units Cost of goods sold and ending inventory are costed at the average cost

16. 7-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan FIFO method Goods from beginning inventory and the earliest purchases are assumed to be the goods sold first Consistent with selling behaviour in most entities Ending inventory assumed to be most recent purchases –more current value of inventory on balance sheet

17. 7-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan LIFO method Most recent purchases are assumed to be the first goods sold Ending inventory assumed to be the oldest goods –inventory could be valued at prices paid some years earlier Not allowed in Australia under AASB 102

18. 7-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan LIFO method (cont.) Allowed in the United States for external reporting and tax purposes –US companies that elect not to adopt LIFO typically have higher leverage and lower interest coverage ratios –those potentially close to breaching debt covenants adopt income-increasing and asset-increasing accounting methods –while some methods might increase income, others might act to reduce income Refer to Worked Example 7.4 (p. 255) for a comparison of the methods

19. 7-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Inventory systems Determination of cost of sales and inventory under each cost-flow assumption also depends on the inventory recording system used Periodic inventory system –inventory counted periodically –no continuous records kept of inventory sales Perpetual inventory system –running total kept of units on hand –increases and decreases of inventory recorded as they occur See worked example 7.6 (p. 258)

20. 7-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Reversals of previous write-downs As we know, inventories must be written down if the net realisable value (NRV) is less than cost If in a subsequent period, NRV increases to original cost or above, then the inventory writedown can be reversed – with a subsequent increase in income Any subsequent accounting entry to increase the carrying amount of inventory must be restricted to the amount that was previously expensed The value of inventory must not be increased above its original cost (in keeping with the lower of cost and NRV rule) See Worked Example 7.7 (p. 260)

21. 7-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Disclosure requirements Where material, AASB 102 requires the disclosure of the following –accounting policies for measuring inventories, including cost formulas used –total carrying amount of inventories –carrying amount of inventories carried at fair value less costs to sell –amount of inventories expensed during the period –amount of any write-downs expensed in the period –amount of any reversal of any write-down –circumstances leading to reversals of write-downs –carrying amount of inventories pledged as securities for liabilities

22. 7-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Summary The chapter addresses the topic of accounting for inventory Under AASB 102, inventory is to be measured at the lower of cost and net realisable value Absorption costing and not direct costing should be applied To account for the flow of inventory, cost-flow assumptions are necessary –allowable methods are specific identification, weighted- average and first-in first-out –last-in first-out is not allowed in Australia