1. 7-1 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd Accounting for inventories Chapter 7

2. Learning objectives Calculate the ‘cost’ of inventory according to NZ IAS 2 Apply the ‘lower of cost and NRV’ rule Explain the necessity of making inventory cost-flow assumptions Apply the inventory cost-flow assumptions permitted Know the disclosure requirements of NZ IAS 2. 7-2 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

3. Introduction Inventory often makes up a large proportion of total assets. Accounting for inventory has a significant impact on financial statements. Inventories are defined as assets (NZ IAS 2): –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. 7-3 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

4. Introduction NZ IAS 2 applies to all inventories except: –Work in progress under construction contracts –Financial instruments and –Biological assets. Cost of goods sold: –Is the cost of inventory sold during the financial period –Can be determined either on a periodic or perpetual (continuous) basis. 7-4 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

5. General basis of inventory measurement Inventories must be measured at the lower of cost and NRV: –Generally on an item-by-item basis. –May be appropriate to group similar or related items:  relating to the same product line that have similar purposes or end uses  produced and marketed in the same geographical area, and  cannot be practicably evaluated separately from other items in that product line. 7-5 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

6. General basis of inventory measurement Cost of inventories includes: –Costs of purchase –Costs of conversion and –Other costs to bring the inventories to their present location and condition. Costs of inventory exclude: –Abnormal amounts of wasted materials –Storage costs –Administrative overheads and –Selling costs. 7-6 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

7. General basis of inventory measurement Fixed production costs: Costs of production not expected to fluctuate as production levels change. 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). NZ IAS 2 requires the use of absorption costing: Cost of inventory must include both fixed and variable production overheads. –Indirect production costs that cannot be traced to the goods or services. 7-7 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

8. General basis of inventory measurement Standard costs: Predetermined product costs: –Based, on planned products and operations, planned cost and efficiency levels and expected capacity utilisation –Only permitted for inventory costing where standards are realistically attainable, reviewed regularly and revised where necessary. Net realisable value (NRV): Estimated selling price in ordinary course of business less estimated costs of completion and to make the sale. 7-8 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

9. General basis of inventory measurement If NRV is greater than cost, inventory should be left at cost Upwards revaluations are not allowed by NZ IAS 2 If NRV is less than cost, inventory should be written down to NRV Write-down is treated as a cost in the period. 7-9 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

10. General basis of inventory measurement Other Costs incurred in bringing inventory to their present location and condition, for example: –specialised design or packaging to meet the requirements of market segments –borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset (NZ IAS 23). Qualifying assets are assets that take a substantial period of time for completion (e.g. ships, manufacturing plants). 7-10 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

11. Inventory cost-flow assumptions Cost-flow assumptions must be made where cost of inventory items fluctuate. Specific identification, might be impractical to apply. Method adopted should be: –Appropriate to the circumstances –Applied consistently from period to period. 7-11 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

12. Inventory cost-flow assumptions NZ IAS 2 allows: –Specific identification –Weighted-average cost –First-in first-out (FIFO) –Retail method. NZ IAS 2 does not allow: –Last-in first-out (LIFO) –Base stock method. 7-12 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

13. 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: –Segregated for special projects –Not ordinarily interchangeable. Not appropriate for large numbers of similar or identical items. 7-13 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

14. 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 at a particular price. Cost of goods sold and ending inventory are costed at the average cost. 7-14 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

15. FIFO method Goods from beginning inventory and earliest purchases are assumed to be sold first. Consistent with selling behaviour in most entities. Ending inventory is assumed to be most recent purchases: –More ‘current’ value of inventory. Commonly used in NZ: –often criticised for matching old/out-dated inventory costs with current sales prices –Inflates profits relative to the amount if current up-to-date costs were used to derive COGS. 7-15 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

16. Inventory systems Determination of COS and inventory under each cost-flow assumption also depends on the inventory recording method 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. 7-16 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

17. Reversal of previous inventory write-downs Previous write downs to net realisable value may be reversed under the following conditions: –Information is available to indicate the inventory has increased in value –The write back is restricted to the amount that was previously written down –This is in keeping with the rule, ‘lower of cost and NRV’. Write-back credited to an income account: –DrInventory – Cr Reversal of previous write down 7-17 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

18. Disclosure requirements Where material, NZ IAS 2 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. 7-18 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd

19. Summary Inventory is to be measured at the lower of cost and NRV. Cost of inventory is: –Aggregate cost of purchase –Costs of conversion –Other costs to bring the inventory to be ready for sale. Absorption costing (not direct costing) should be used. Allowable methods are: –Specific identification –Weighted-average –First-in first-out –Retail method. Last-in first-out is not allowed in NZ. 7-19 PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin Slides adapted by Bob Miller, © 2011 McGraw-Hill Australia Pty Ltd