Lecture 12
Intermediate Corporate Reporting - BUSI2143 Lecture 12: Inventories and Biological Assets
Dr. Cuthbert Muza
Learning Outcomes
By the end of this chapter, you should be able to:
- Define inventory as specified under IAS 2.
- Explain the effect of different inventory valuation methods on profit.
- Calculate inventory value using accepted valuation techniques (e.g., FIFO, weighted average).
- Describe the key provisions of the accounting standard relating to biological assets.
Lecture Plan
Part 1: Reflection on Previous Weeks
Part 2: IAS 2 Inventory
- Attempt exercise (10 minutes)Part 3: Biological Assets
- Quiz - Multiple Choice Questions (MCQ)
Part 1: Reflection - Previous Weeks
This section aims to review key concepts and topics discussed in the previous weeks of the course.
Part 2: IAS 2 Inventory
IAS 2 Overview
Definition and Objective:
- IAS 2 Inventories prescribes the accounting treatment for inventories, including their measurement and recognition as assets until related revenues are recognized.
- The standard aims to ensure sensible accounting for inventories across different businesses.
Inventory Defined (IAS 2)
Definition:
- Inventories are defined as assets held for sale in the ordinary course of business;
- In the process of production for such sale;
- In the form of materials or supplies consumed in the production process or service rendering.
Valuation of Inventory
The valuation process involves:
- Establishing physical existence and ownership.
- Determining unit costs.
- Calculating provisions to reduce cost to net realizable value, if necessary.
Cost of Inventories (IAS 2)
Criteria for Cost:
- The cost of inventories must include all costs of purchase, conversion costs, and other costs incurred to bring the inventories to their current location and condition.
Measurement of Inventories
Cost Identification:
- IAS 2 requires that the cost of inventory items should be determined using specific identification of their individual costs.
- Each inventory item is considered separately, and its cost must be established using a chosen cost formula.
Inventory Valuation Methods
Allowed Cost Formulas:
- First-in, First-out (FIFO):
- Assumes that the inventory items purchased or produced first are sold or used first, leaving the most recently purchased/produced items remaining at the end of a period.
- Weighted Average Cost (AVCO):
- In this method, a new weighted average cost per item is computed after each acquisition, and the end-of-period inventory cost is calculated using the latest weighted average cost.
Rejection of Inventory Methods
Last-in, First-out (LIFO):
- IAS 2 rejects the LIFO method due to the following issues:
- It charges out the most recently received inventory first, which makes inventory values based on “old costs” that may not reflect current cost levels.
- Often results in lower reported profits and lower tax expenses, presenting values that are disconnected from actual costs.
Importance of Accurate Closing Stock
Effects on Profit:
- It is crucial to get the closing stock accurate due to the potential for profit smoothing, affecting financial statements significantly.
- Illustrative Example:
-
| Year | Sales | Opening Inventory | Purchases | Closing Inventory | Cost of Sales | Profit |
|------|---------|------------------|-----------|------------------|----------------|---------|
| 1 | 100,000 | 100,000 | 65,000 | 15,000 | 60,000 | 40,000 |
| 2 | 150,000 | 15,000 | 100,000 | 15,000 | 90,000 | 60,000 |
Example Problem - FIFO & AVCO
Purchases:
- January: 10 units at £15 total £150
- March: 10 units at £17 total £170
- April: 20 units at £20 total £400Sales:
- February: 8 units
- May: 2, 10, 12 unitsTasks:
- Value the Cost of Goods Sold (COGS) using FIFO and AVCO.
- Calculate the closing inventory under each method.Results of FIFO and AVCO Calculations:
- FIFO COGS: £560, Closing Inventory: £160
- AVCO COGS: £570, Closing Inventory: £150
Exercise Attempt: 10 minutes
Scenario:
- On 1 April 2022, a company has inventories of 12,000 bricks at £140 per thousand. - Calculate the cost of bricks sold and remaining inventory at 31 March 2023 using FIFO and AVCO methods.
Solutions for Attempted Exercise
FIFO Calculations:
- COGS = £5,730, Inventory = £735AVCO Calculations:
- COGS = £5,736, Inventory = £729
Net Realizable Value (NRV)
Definition (IAS 2):
- Inventories should be valued at the lower of cost and NRV.
- NRV Formula:
Examples of NRV
Numerical example with current items demonstrating respective costs, NRV, and inventory values:
| Item | Cost (£) | NRV (£) | Inventory Value (£) |
|------|----------|---------|---------------------|
| 1 | 7,000 | 9,000 | 7,000 |
| 2 | 12,000 | 12,500 | 12,000 |
| 3 | 8,000 | 4,000 | 4,000 |
| 4 | 14,000 | 8,000 | 8,000 |
| 5 | 27,000 | 33,000 | 27,000 |
Creative Accounting and Manipulations
Issues in Inventory Reporting:
- Year-end manipulation, ineffective cut-off procedures, suppression of invoices, and subjective use of NRV.
- Loading overheads onto inventory during low-profit periods, presenting an optimistic view of obsolescence, inaccuracies in physical inventory count.
Inventory Count
Audit Considerations:
- Attendance during inventory counts, ensuring ownership of items, and physical condition of items are assessed.
IAS 2: Inventories Disclosure Requirements
The disclosure requirements for IAS 2 include:
- Accounting policies regarding inventory measurement, including cost formulas.
- Total carrying amount of inventories and amount recognized as an expense during the period.
- Amount of write-downs to NRV during the period and the reversals of previous write-downs.
Part 3: Biological Assets
Objective of IAS 41
Scope of IAS 41:
- Establishes consistent accounting treatments, presentation, and disclosures for agricultural activity.
- Agricultural activity involves transforming biological assets into agricultural produce.
Initial Recognition of Biological Assets
Criteria for Recognition:
- A biological asset is recognized only if:
- The entity controls the asset due to past events.
- Economic benefits are expected to flow to the entity.
- Fair value or cost of the asset can be measured reliably.
Measurement of Biological Assets
Fair Value Requirement:
- Biological assets are generally measured at their fair value less costs to sell.
- This contradicts cost-based measurement principles outlined in IAS 2 and IAS 16.
Inventory vs Biological Assets
Distinction Based on IAS 2 and IAS 41:
- Biological Assets: Living plants/animals e.g., apple trees, lambs.
- Agricultural Produce: Products derived from biological assets such as apples or lamb meat.
Illustrative Example of Biological Assets
Scenario:
- A farmer owns a dairy herd. At the beginning of the period, the herd contains 100 animals and 50 calves.
- By the end of the period, an additional 30 calves are born, with fair value details provided.
Changes in Fair Value of Biological Assets
Reconciliation of Fair Value Change:
- Fair value at the end of the year = Calculated as:
.
- Price and physical changes computed for various animal categories.
Review
So far, we have looked at:
IAS 2 Inventory:
- Definition and effects of different inventory valuation methods.
- COGS calculation using accepted techniques: FIFO, AVCO.Biological Assets:
- IAS 41 Agriculture, initial recognition, and illustrative examples with quizzes to reinforce learning.
Quiz - MCQ
MCQ Quiz on Intermediate Corporate Reporting
- 25 Questions to test knowledge on IAS 2 and IAS 41.
Readings
Chapter 10, Inventories, from International Financial Reporting, 7th Edition by Alan Melville.
Chapter 20, Inventories, from Financial Accounting and Reporting, 19th Edition by Elliott and Elliott.