Chapter 7

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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