Financial Accounting IFRS 5th Edition - Chapter 6: Inventories Complete Study Guide

Inventory Classification and Global Reporting Standards

Inventory classification varies depending on the nature of the business model, primarily distinguishing between merchandising and manufacturing entities. Despite these differences, all inventories are reported as Current Assets on the statement of financial position under International Financial Reporting Standards (IFRS).

Merchandising Companies

Merchandising companies typically utilize a single classification to encompass their inventory:

  • Merchandise Inventory: These are goods held by the company that are in a finished state and ready for sale to customers in the ordinary course of business.
Manufacturing Companies

Manufacturing companies categories inventory into three distinct classifications based on the stage of production:

  1. Raw Materials: Basic goods, materials, and substances that will be used in the production process but have not yet been placed into production.
  2. Work in Process: That portion of manufactured inventory that has begun the production process but is not yet complete.
  3. Finished Goods: Manufactured items that are completed and ready for sale.
Real-World Example: Komatsu Composition of Inventory

As of March 31, Komatsu reported the following inventory composition (figures in millions of yen):

  • Finished products (including parts for sale):
    • 2021: ¥571,103\text{¥}571,103
    • 2020: ¥586,468\text{¥}586,468
  • Work in process:
    • 2021: ¥159,515\text{¥}159,515
    • 2020: ¥153,082\text{¥}153,082
  • Materials and supplies:
    • 2021: ¥63,234\text{¥}63,234
    • 2020: ¥65,759\text{¥}65,759
  • Total Inventory:
    • 2021: ¥793,852\text{¥}793,852
    • 2020: ¥805,309\text{¥}805,309

Determining Inventory Quantities and Ownership

Companies must periodically determine the physical quantity of inventory on hand for financial reporting and internal control purposes.

Physical Inventory Rationale
  • Perpetual System: Used to check the accuracy of digital inventory records and to determine the amount of inventory lost due to factors such as wasted raw materials, shoplifting, or employee theft.
  • Periodic System: Necessary to determine the actual inventory on hand and to calculate the cost of goods sold (COGS) for the specific period.
Taking a Physical Inventory

This process involves counting, weighing, or measuring every kind of inventory on hand. It is typically performed:

  • When the business is closed or during slow operational periods.
  • At the conclusion of the accounting period.
Determining Ownership: Goods in Transit

Legal title to goods is the defining factor in determining whether goods should be included in a company's inventory count. Title is determined by the specific terms of the sale:

  • FOB (Free on Board) Shipping Point: Ownership of the goods passes to the buyer at the moment the public carrier accepts the goods from the seller. The buyer includes these goods in their inventory while in transit.
  • FOB Destination: Ownership of the goods remains with the seller until the goods physically reach the buyer. The seller continues to include these goods in their inventory until delivery is confirmed.
Consigned Goods

In a consignment arrangement, one party (the consignee) holds the goods of other parties (the consignors) to sell them for a fee without taking legal ownership. Dealers in cars, boats, and antiques often use this method. Consigned goods should be excluded from the physical inventory count of the party holding the goods (the consignee) and included in the inventory of the legal owner (the consignor).

Application of Inventory Costing and Specific Identification

Inventory is accounted for at cost, which includes all expenditures necessary to acquire the goods and place them in a condition ready for sale.

Specific Identification Method

This method tracks the actual physical flow of goods. Each item sold and each item remaining in inventory is specifically costed. While rare in practice due to the difficulty of tracking high-volume identical items, it is used for unique, high-value items.

Example: Crivitz TV Company

  • Purchases:
    • February 3: 1 TV at \text{}720
    • March 5: 1 TV at \text{}750
    • May 22: 1 TV at \text{}800
  • Sales:
    • June 1: 2 TVs sold for \text{}2,400 (at \text{}1,200 each).
  • Calculation: If the TVs purchased on Feb 3 and May 22 were sold:
    • Cost of Goods Sold = \text{}720 + \text{}800 = \text{}1,520
    • Ending Inventory = \text{}750

Cost Flow Assumptions: FIFO and Average-Cost

Since specific identification is often impractical, companies make assumptions about which units were sold. The assumed cost flow does not need to match the actual physical movement of goods.

First-In, First-Out (FIFO)
  • Logic: Assumes that the earliest goods purchased are the first ones sold.
  • Inventory Valuation: Ending inventory is determined by taking the unit cost of the most recent purchase and working backward.
  • Cost of Goods Sold: Formed by the costs of the earliest units acquired.
Average-Cost Method
  • Logic: Allocates the cost of goods available for sale based on a weighted-average unit cost.
  • Weighted-Average Unit Cost Formula:Cost of Goods Available for SaleTotal Units Available for Sale=Weighted-Average Unit Cost\frac{\text{Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}} = \text{Weighted-Average Unit Cost}
  • Application: The resulting average cost is applied to the units on hand to determine ending inventory and cost of goods sold.
Comparative Example: Lin Electronics

  • Data:

    • Jan 1: Beginning Inventory (10 units @ HK$100HK\$100) = HK$1,000HK\$1,000
    • Apr 15: Purchase (20 units @ HK$110HK\$110) = HK$2,200HK\$2,200
    • Aug 24: Purchase (30 units @ HK$120HK\$120) = HK$3,600HK\$3,600
    • Nov 27: Purchase (40 units @ HK$130HK\$130) = HK$5,200HK\$5,200
    • Total Available: 100 units at HK$12,000HK\$12,000
    • Total Units Sold: 55 units; Ending Inventory: 45 units.

  • FIFO Allocation:

    • Ending Inventory (based on latest costs): 40 units @ HK$130HK\$130 + 5 units @ HK$120HK\$120 = HK$5,800HK\$5,800
    • Cost of Goods Sold (COGS) = Total Available−Ending Inventory=HK$12,000−HK$5,800=HK$6,200\text{Total Available} - \text{Ending Inventory} = HK\$12,000 - HK\$5,800 = HK\$6,200

  • Average-Cost Allocation:

    • Weighted Average Cost = HK$12,000/100=HK$120HK\$12,000 / 100 = HK\$120
    • Ending Inventory = 45×HK$120=HK$5,40045 \times HK\$120 = HK\$5,400
    • COGS = 55×HK$120=HK$6,60055 \times HK\$120 = HK\$6,600

Financial and Tax Effects of Cost Flow Methods

The choice of cost flow method significantly impacts financial statements, particularly during periods of inflation (rising prices).

Income Statement Effects
  • FIFO: Results in lower COGS and higher net income because older, cheaper costs are matched against current revenues.
  • Average-Cost: Results in higher COGS and lower net income compared to FIFO during inflation.
Statement of Financial Position Effects
  • FIFO: Provides a major advantage as ending inventory costs approximate current replacement costs.
  • Average-Cost: Ending inventory may be understated relative to current market costs during inflation.
Tax Effects
  • In periods of rising prices, the average-cost method results in lower net income and, consequently, lower income taxes. This provides a cash flow advantage by making more cash available for business operations.

Advanced Cost Flow: Perpetual Inventory Application

Under a perpetual inventory system, cost flow methods are applied continuously as purchases and sales occur.

Perpetual FIFO

The allocation of costs to goods sold and ending inventory remains consistent with the periodic system.

Moving-Average Method

Under a perpetual system, a new average is computed after every purchase.

  • Example (Lin Electronics Perpetual Data):
    • After Aug 24 purchase (Total cost HK$6,800HK\$6,800 for 60 units), the average is HK$113.333HK\$113.333 per unit.
    • Sept 10 sale of 55 units is costed at HK$113.333HK\$113.333 (Total COGS = HK$6,233HK\$6,233).
    • Nov 27 purchase (40 units @ HK$130HK\$130) added to remaining 5 units (@ HK$113.333HK\$113.333) results in a new weighted average of HK$128.156HK\$128.156
    • Ending Inventory = 45×HK$128.156=HK$5,76745 \times HK\$128.156 = HK\$5,767

Statement Presentation and Inventory Analysis

Reporting and Disclosure
  • Statement of Financial Position: Inventory is a current asset.
  • Income Statement: COGS is subtracted from net sales.
  • Required Disclosures:
    1. Major inventory classifications.
    2. Basis of accounting (Cost or Lower-of-Cost-or-Net Realizable Value).
    3. Costing method used (FIFO or Average-Cost).
Lower-of-Cost-or-Net Realizable Value (LCNRV)

When the value of inventory drops below its original cost, companies must perform an inventory "write-down" to the net realizable value (NRV). This practice embodies the principle of Prudence (Conservatism).

  • Net Realizable Value: The amount the company expects to receive from the sale of the inventory.

LCNRV Example (Gao TVs):

  • Flat-screen TVs: 100 units, Cost NT$600NT\$600, NRV NT$550NT\$550. Value = 100×NT$550=NT$55,000100 \times NT\$550 = NT\$55,000
  • Wireless speakers: 500 units, Cost NT$90NT\$90, NRV NT$104NT\$104. Value = 500×NT$90=NT$45,000500 \times NT\$90 = NT\$45,000 (Cost is lower)
  • Bluetooth headphones: 850 units, Cost NT$50NT\$50, NRV NT$48NT\$48. Value = 850×NT$48=NT$40,800850 \times NT\$48 = NT\$40,800
  • Smart watch accessories: 3,000 units, Cost NT$5NT\$5, NRV NT$6NT\$6. Value = 3,000×NT$5=NT$15,0003,000 \times NT\$5 = NT\$15,000
  • Total Inventory Value: NT$155,800NT\$155,800
Inventory Management Dynamics

Inventory levels represent a trade-off:

  • High Inventory Levels: Lead to high carrying costs, including storage, insurance, investment, damage, and obsolescence.
  • Low Inventory Levels: Might result in "stock-outs," leading to lost sales and customer dissatisfaction.

Questions & Discussion

  • Q: In what situation should goods in transit be included in the buyer's inventory?

  • A: Goods in transit should be included in the inventory of the buyer when the terms of sale are FOB shipping point, specifically once the public carrier accepts the goods from the seller.

  • Q: Which cost flow method often parallels the actual physical flow of merchandise?

  • A: The FIFO method often parallels the actual physical flow, as most businesses attempt to sell their oldest stock first.

  • Practice Problem (Shumway Implements):

    • Beginning Inventory: 4,000 units @  3\text{ }3
    • Purchases: 6,000 units @  4\text{ }4
    • Sales: 7,000 units @  12\text{ }12
    • Total Available: 10,000 units ( 36,000\text{ }36,000)
    • Ending Inventory Units: 10,000−7,000=3,00010,000 - 7,000 = 3,000
    • FIFO COGS:  36,000−(3,000× 4)= 24,000\text{ }36,000 - (3,000 \times \text{ }4) = \text{ }24,000
    • Average-Cost COGS: Weighted average =  36,000/10,000= 3.60\text{ }36,000 / 10,000 = \text{ }3.60. COGS =  36,000−(3,000× 3.60)= 25,200\text{ }36,000 - (3,000 \times \text{ }3.60) = \text{ }25,200