Ch06

Chapter 6: Inventories

Learning Objectives

• Importance of control over inventory.

• Understanding two inventory cost flow assumptions and their impact on financial statements.

• Determining inventory cost under perpetual and periodic inventory systems using FIFO and weighted average methods.

• Comparing inventory costing methods and their reporting in financial statements.

• Analyzing inventory management efficiency through turnover and days’ sales in inventory.

Importance of Control Over Inventory

• Primary Objectives:

  • Safeguarding inventory from damage or theft.

  • Accurate reporting of inventory in financial statements.

Safeguarding Inventory

• Key Control Measures:

  • Purchase orders from approved vendors authorized inventory purchases.

  • Receiving reports establish initial records of inventory received.

  • Continuous record-keeping through perpetual inventory systems ensures real-time inventory data.

  • Security measures:

    • Restricted access areas for employees only.

    • High-value items secured in cabinets.

    • Use of surveillance like cameras, two-way mirrors, and security tags.

Reporting Inventory

• Conduct a physical count of inventory at year-end to verify accuracy in financial reporting.

Inventory Cost Flow Assumptions

1. FIFO (First-in, First-out)

   • Assumes oldest inventory costs are assigned to goods sold first.

   • Ending inventory reflects costs of the most recent purchases.

2. Weighted Average Cost Method

   • Computes an average cost per unit for all items purchased.

Cost Calculation Examples

• Example of inventory cost flow based on FIFO and weighted average:

  • If one unit is sold under FIFO, calculate gross profit based on oldest costs versus average costs.

Cost of Inventory Under Perpetual System

• Methods include FIFO and weighted average; can be detailed with actual journal entries.

  • Recognizes each sale's effect on inventory and cost of goods sold immediately.

Inventory Errors

• Common reasons for errors include:

  • Miscounting during physical inventory.

  • Incorrect cost assignments.

  • Errors regarding inventory in transit.

Inventory Turnover

• Inventory Turnover Ratio: Measures how efficiently inventory is managed.

  • Formula: Inventory Turnover = Cost of Goods Sold / Average Inventory.

• Days’ Sales in Inventory:

  • Analyzes the average time inventory remains in stock before it's sold. Formula: Days’ Sales in Inventory = Average Inventory / Average Daily Cost of Goods Sold.

Comparing Inventory Cost Methods

• Presentation of comprehensive income statements illustrating effects of FIFO vs. weighted average on cost of goods sold, gross profit, and ending inventory values under various cost conditions.

Reporting Inventory in Financial Statements

• Cost is the primary basis for inventory valuation.

• Additional considerations include:

  • Lower of cost or market valuations if applicable.

Valuation at Lower of Cost or Market

• Market is defined based on replacement cost and lowest expected realizable value under the lower of cost or market principle.

• Adjustments are made for impairment and changed market conditions.

Accounting for Biological Assets

• Guided by IAS 41.

• Biological assets measured at fair value and agricultural produce upon harvest.

IFRS vs. U.S. GAAP on Inventory

• Distinctions in allowable cost methods, presentation of inventories, and rules around write-downs and reversals.

• Emphasis on the complexities of cost management and the valuation associated with diverse inventories.