Financial Accounting IFRS Chapter 6 - Inventories Study Guide

Inventory Classification

• Merchandising Company:

  • Maintains only one inventory classification: Merchandise Inventory.

• Manufacturing Company:

  • Inventory is divided into three distinct classifications:
    1. Raw Materials: Basic goods that will be used in production but have not yet been placed into the production process.
    2. Work in Process: That portion of manufactured inventory that has begun the production process but is not yet complete.
    3. Finished Goods: Completed items that are ready for sale.

• Financial Statement Presentation:

  • Regardless of the classification, companies report all inventory types under the Current Assets section on the Statement of Financial Position (Balance Sheet).

• Case Study: Komatsu Inventory Composition (March 31):

  • This real-world example from the notes to the financial statements (expressed in yen in millions) illustrates the components of a manufacturing company's inventory.
  • 2021 Data:
    • Finished products, including finished parts held for sale: $\yen 571,103$
    • Work in process: $\yen 159,515$
    • Materials and supplies: $\yen 63,234$
    • Total Inventory (2021): $\yen 793,852$
  • 2020 Data:
    • Finished products, including finished parts held for sale: $\yen 586,468$
    • Work in process: $\yen 153,082$
    • Materials and supplies: $\yen 65,759$
    • Total Inventory (2020): $\yen 805,309$

Determining Inventory Quantities

• Physical Inventory Procedures:

  • Involves counting, weighing, or measuring every kind of inventory on hand.
  • Usually performed when the business is closed or when activity is slow.
  • Conducted at the end of the accounting period.

• Purposes based on Inventory System:

  • Perpetual System:
    1. To check the accuracy of the automated inventory records.
    2. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.
  • Periodic System:
    1. To determine the actual inventory on hand.
    2. To determine the Cost of Goods Sold (COGS) for the specific period.

Determining Ownership of Goods

• Goods in Transit:

  • Includes purchased goods not yet received and sold goods not yet delivered.
  • Inventory must be included in the records of the company that holds the legal title to the goods.
  • FOB (Free on Board) Shipping Point:
    • Ownership of the goods passes to the buyer when the public carrier (transportation company) accepts the goods from the seller.
    • The buyer includes these goods in their inventory while they are in transit.
  • FOB (Free on Board) Destination:
    • Ownership of the goods remains with the seller until the goods physically reach the buyer.
    • The seller includes these goods in their inventory while they are in transit.

• Consigned Goods:

  • Consignment involves holding the goods of other parties and attempting to sell them for a fee, without taking legal ownership of those goods.
  • Examples include car, boat, and antique dealers who often sell goods on behalf of others.

Inventory Cost Flow Methods

• Costing Basis:

  • Inventory is accounted for at cost.
  • Cost includes all expenditures necessary to acquire the goods and place them in a condition ready for sale.
  • Unit costs are applied to inventory quantities to determine the total cost of ending inventory and the cost of goods sold.

• Specific Identification:

  • Each item sold and each item remaining in inventory is specifically identified and costed.
  • Example (Crivitz TV Company):
    • Purchases: Feb 3 (1 TV at $\pounds 720$), Mar 5 (1 TV at $\pounds 750$), May 22 (1 TV at $\pounds 800$).
    • Sales: June 1 (2 TVs for $\pounds 2,400$ combined).
    • If the TVs sold were specifically the ones purchased on Feb 3 and May 22, the Cost of Goods Sold is $\pounds 1,520$ ($\pounds 720 + \pounds 800$).
    • The Ending Inventory is the remaining Mar 5 unit at $\pounds 750$.
  • This practice is relatively rare; most companies use cost flow assumptions.

• First-In, First-Out (FIFO):

  • Assumes that the costs of the earliest goods purchased are the first ones recognized in determining the cost of goods sold.
  • Often parallels the actual physical flow of merchandise.
  • Ending inventory is determined by taking the unit cost of the most recent purchase and working backward.

• Average-Cost Method:

  • Allocates the cost of goods available for sale based on a weighted-average unit cost.
  • Assumes all goods available for sale are similar in nature.
  • Weighted-Average Unit Cost Formula:
    • $\frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}} = \text{Weighted-Average Unit Cost}$

Calculations and Detailed Financial Effects

• Example Data (Lin Electronics):

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

• FIFO Allocation for Lin Electronics:

  • Ending Inventory (45 units backward from most recent):
    • 40 units at $HK\$ 130 = HK\$ 5,200$
    • 5 units at $HK\$ 120 = HK\$ 600$
    • Total Ending Inventory: $HK\$ 5,800$
  • Cost of Goods Sold (Total Available - Ending Inventory):
    • $HK\$ 12,000 - HK\$ 5,800 = HK\$ 6,200$

• Average-Cost Allocation for Lin Electronics:

  • Weighted-Average Unit Cost: $HK\$ 12,000 \div 100 = HK\$ 120$
  • Ending Inventory: $45 \text{ units} \times HK\$ 120 = HK\$ 5,400$
  • Cost of Goods Sold: $55 \text{ units} \times HK\$ 120 = HK\$ 6,600$

• Comparative Effects (Inflationary Environment):

  • FIFO Effects:
    1. Higher Ending Inventory: Costs allocated to ending inventory approximate current costs.
    2. Higher Net Income: COGS is lower because it uses older, cheaper costs.
    3. Higher Income Tax: Higher net income results in higher tax expense.
  • Average-Cost Effects:
    1. Lower Ending Inventory: Costs may be understated relative to current replacement costs.
    2. Lower Net Income: Results in lower performance compared to FIFO.
    3. Tax Savings: Lower net income results in lower taxes and better cash flow.

Inventory in Perpetual Systems

• Perpetual FIFO:

  • Results in the same ending inventory and COGS as periodic FIFO.

• Perpetual Average-Cost (Moving Average):

  • The company computes a new average cost after every purchase.
  • Example (Lin Electronics Perpetual Data):
    • Jan 1 Balance: 10 units at $HK\$ 100.00$
    • Apr 15 Purchase: 20 units at $HK\$ 110.00$. New balance: 30 units at the new average of $HK\$ 106.667$ ($HK\$ 3,200$ total).
    • Aug 24 Purchase: 30 units at $HK\$ 120.00$. New balance: 60 units at the new average of $HK\$ 113.333$ ($HK\$ 6,800$ total).
    • Sept 10 Sale: 55 units sold at $HK\$ 113.333 = HK\$ 6,233$. Remaining: 5 units at $HK\$ 567$.
    • Nov 27 Purchase: 40 units at $HK\$ 130.00$. New balance: 45 units at the average of $HK\$ 128.156$ ($HK\$ 5,767$ total).

Statement Presentation and Analysis

• Financial Statement Disclosures:

  1. Major inventory classifications (Raw materials, WIP, Finished goods).
  2. Basis of accounting: Cost or the Lower-of-Cost-or-Net Realizable Value (LCNRV).
  3. Costing method: FIFO or Average-Cost.

• Lower-of-Cost-or-Net Realizable Value (LCNRV):

  • A practice of prudence (conservatism) where companies write down inventory to its net realizable value if it is lower than the original cost.
  • Net Realizable Value (NRV): The net amount a company expects to realize (receive) from the sale of inventory.
  • Example (Gao TVs):
    • Flat-screen TVs: Cost $NT\$ 600$, NRV $NT\$ 550$. LCNRV Valuation: $100 \times NT\$ 550 = NT\$ 55,000$.
    • Wireless speakers: Cost $NT\$ 90$, NRV $NT\$ 104$. LCNRV Valuation: $500 \times NT\$ 90 = NT\$ 45,000$.
    • Bluetooth headphones: Cost $NT\$ 50$, NRV $NT\$ 48$. LCNRV Valuation: $850 \times NT\$ 48 = NT\$ 40,800$.
    • Smart watch accessories: Cost $NT\$ 5$, NRV $NT\$ 6$. LCNRV Valuation: $3,000 \times NT\$ 5 = NT\$ 15,000$.
    • Total LCNRV Inventory: $NT\$ 155,800$.

• Inventory Management Analysis:

  • High Inventory Levels: Risk high carrying costs, including investment of cash, storage costs, insurance, obsolescence, and damage.
  • Low Inventory Levels: Risk "stock-outs" and lost sales opportunities.

Questions & Discussion

• Question 1 (Ownership): Goods in transit should be included in the inventory of the buyer when the…?

  • Options: Public carrier accepts goods from seller; Goods reach the buyer; Terms are FOB destination; Terms are FOB shipping point.
  • Response: Terms of sale are FOB shipping point.

• Question 2 (Cost Flow): The cost flow method that often parallels the actual physical flow of merchandise is the…?

  • Options: FIFO; LIFO; Average-cost; Gross profit.
  • Response: FIFO method.

• DO IT! 1 (Rules of Ownership): Deng Imports count is $NT\$ 200,000$. Adjust for: 1. Consigned goods held for Falls Co. ($NT\$ 15,000$); 2. Uncounted purchase in transit FOB shipping point ($NT\$ 10,000$); 3. Uncounted sale in transit FOB shipping point ($NT\$ 12,000$).

  • Solution: Deduct consigned goods ($15,000$), Add purchase ($10,000$). Sale was correctly excluded since title passed to the customer. New total: $\yen 195,000$ ($\yen 200,000 - \yen 15,000 + \yen 10,000$).

• DO IT! 2 (Cost Flow Calculation): Shumway Implements: Beg. Inv (4,000 at $\epsilon 3$), Purchases (6,000 at $\epsilon 4$), Sales (7,000 units).

  • Solution (FIFO): Total Cost Available is $\epsilon 36,000$. Ending Inventory is 3,000 units. Under FIFO, ending inventory is $\epsilon 12,000$ ($3,000 \times \epsilon 4$). COGS = $\epsilon 36,000 - \epsilon 12,000 = \epsilon 24,000$.
  • Solution (Average): Average cost per unit is $\epsilon 3.60$ ($\epsilon 36,000 \div 10,000$). Ending inventory is $\epsilon 10,800$ ($3,000 \times \epsilon 3.60$). COGS = $\epsilon 36,000 - \epsilon 10,800 = \epsilon 25,200$.

• DO IT! 4 (LCNRV): Poon Heaters (Gas: Cost $NT\$ 84k$, NRV $NT\$ 79k$; Wood: Cost $NT\$ 250k$, NRV $NT\$ 280k$; Pellet: Cost $NT\$ 112k$, NRV $NT\$ 101k$).

  • Solution: Take the lower value for each: Gas ($79,000$) + Wood ($250,000$) + Pellet ($101,000$) = $NT\$ 430,000$.