Characteristics of Inventories
•
•
•
belong to current assets
kept in stock either to be sold to customers or to be consumed by
activities of the accounting entity
Retailer, wholesaler
– merchandise inventory
•
Manufacturer
– finished goods
– work in progress: goods not yet ready for sale
– raw materials and purchased parts
•
Most relevant standard: IAS 2
•
Aside: optimal level of inventory
– trade-off between holding costs, ordering cost, service level, customer
satisfaction, smooth production
1
The Inventory Balance Equation
•
Value of inventory at time t
= Initial inventory + inflows – outflows up to t
– initial inventory: from past period; zero at start of business
• depends on valuation method used for inflows and outflows
– inflows: valued at cost
• same as for fixed assets: „all costs incurred in order to bring the
inventories to their present location and condition“
– outflows: different approaches
• direct identification
• assumed order of depletion
• averaging
– determine market value of ending inventory and apply balance equation
2
Importance of Inventory Valuation
•
•
•
inventory valuation affects the income statement and the balance
sheet
impact on ratios used in financial statement analysis
The Gross Profit Equation:
Gross profit = Sales Revenue
⎧
-( beginning inventory
⎪
⎪
COGS ⎨ +purchases
⎪
⎪⎩
– ending inventory)
•
Effect of inventory valuation on gross profit:
– closing inventory understated (overstated)
Î gross profit for the period understated (overstated)
– opening inventory understated (overstated)
Î gross profit for the period overstated (understated).
3
Initial valuation of inventory
•
Inventories shall be measured at the lower of cost and net realizable
value
– Costs include all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and
condition
– Net realisable value is the estimated selling price in the ordinary course
of business less the estimated costs of completion and the estimated
cost necessary to make the sale
•
At initial recognition of
– Materials
– Purchased parts
– Merchandise inventory
…..purchasing costs are usually applicable
4
Initial valuation of work in progress
and finished goods inventory
•
Inventory cost includes the cost of conversion
–
This refers to direct and indirect manufacturing costs
•
Direct labor
•
Direct material cost
•
Production overhead cost
– Fixed and variable overhead
–
Fixed overhead costs should be allocated fully to inventory only to the
extent that normal capacity utilization is present
– Do not capitalize cost of idle capacity!
5
Inventory valuation – an example
•
Candy Inc. spent the fourth quarter of its fiscal year producing candy
for easter. 2.000 batches were produced at labor cost of
€ 20 per batch and € 150 for material per batch.
direct cost
•
Other cost in that quarter:
–
–
–
–
–
–
–
€ 20.000 – salary for production supervisors
€ 28.000 – depreciation of production facilities
€ 2.000 – setup cost
€ 11.250 – salary of factory manager
€ 68.750 – various manufacturing overhead
€ 250.000 – cost of headquarters
€ 40.000 – salary of sales representatives
selling
overhead
manufacturing
overhead
administrative
overhead
6
Multi-product case
•
Overhead needs to be allocated to different products
– matter of cost accounting
•
Usual method
– choose an allocation base e.g. direct cost or direct labor hrs.
– calculate the overhead rate per unit of the allocation base
– multiply units of allocation base in product times overhead rate
7
The inventory is to be valued as follows:
•
Provided normal capacity is 2000 batches
–
–
–
–
–
Direct cost:
Manufacturing overhead:
Administrative overhead:
Selling overhead:
Total:
Î Value of inventory:
•
€ 65
-----
€ 170
( 130.000 / 2.000 )
€ 235 per batch
€ 470.000
Assume normal capacity is 2500 batches
–
–
–
–
–
Direct cost:
Manufacturing overhead:
Administrative overhead:
Selling overhead:
Total:
Î Value of inventory:
€ 52
-----
€ 170
( 130.000 / 2.500 )
€ 222 per batch
€ 444.000
8
Cost flow assumptions for inventory valuation
•
If distinguishable items are purchased and sold
– Firms are required to monitor actual goods flow and record
corresponding costs (specific identification)
•
identical items of merchandise purchased and sold (at different
prices)
– usually impractical to monitor actual goods flow and record
corresponding costs
assumption about cost flow
– Average Cost
– First-In, First-Out
– Last-In, First-Out
•
Cost flow assumptions
IAS 2 allows for FIFO and average cost only
– A cost formula applied needs to be applied for all inventories similar in
nature
9
Inventory valuation –
applying different methods
•
We use the following data to calculate inventory, cost of sales, and
gross profit for the different methods:
Purchase of
Sale of
8 units @ € 2,50
(March)
4 units @ € 3,00
(April)
4 units @ € 4,00
(June)
2 units @ € 5,00
(May)
10
Specific Identification
•
items purchased and sold must be distinguishable
•
for the example:
– cost of goods sold either 5.00 or 6.00 depending on whether items out
of March‘s or April‘s purchase were used.
11
Inventory valued at average cost:
Average Cost
March
•
•
•
Inventory
in numbers
Inventory
value
8 units @ 2,5
=
20
April
4 units @ 3
=
12
June
4 units @ 4
=
16
June end total
16 units @ 3
48
Sale of 2 items (May)
- 2 units @ 3
-6
Ending inventory
Cost of sales
14 units @ 3
42
Cost of
Sales
6
6
units in inventory are valued at the average cost of the goods available for
sale, i.e. total cost of inventory over number of items
method easy to handle
objective in nature, less room for manipulation
12
Inventory valued using FIFO
First-In, First-Out
(FIFO)
March
Inventory
value
8 units @ 2,5
=
20
April
4 units @ 3
=
12
June
4 units @ 4
=
16
June end total
Sale of 2 items (May)
Ending inventory
Cost of sales
•
•
•
•
Inventory
in numbers
16
- 2 units @ 2,5 (March)
14
Cost of
Sales
48
=
-5
=
43
5
5
cost of the first items purchased is assigned to the first items sold
ending inventory valued at most recent cost
disadvantage: „old“ costs are matched with current revenues
no manipulation of income figures
13
Inventory valued using LIFO
Last-In, First-Out
(LIFO)
March
Inventory
value
8 units @ 2,5
=
20
April
4 units @ 3
=
12
June
4 units @ 4
=
16
June end total
Sale of 2 units (May)
Ending inventory
Cost of sales
•
•
•
•
•
Inventory
in numbers
16
-2@4
14
Cost of
Sales
48
(June)
=
-8
=
40
8
8
cost of items purchased last is assigned to items sold first
items from the earliest purchases rest in ending inventory
advantage: most recent costs are matched with current revenues
disadvantage: possible distortion of inventory figure
(again) no manipulation of income figures?
14
Comparison of the effects on gross profit
Average Cost
Sales
Purchases
Closing Inventory
Cost of sales
10
LIFO
Sales
Purchases
Closing Inventory
Cost of sales
Gross profit
6
Purchases
Closing Inventory
Cost of sales
4
Gross profit
48
42
Gross profit
FIFO
Sales
10
48
40
8
2
10
48
43
5
5
Gross profit highest under FIFO and
lowest under LIFO, (only in a period of
rising prices. The reverse would be true
if prices decline.)
This year‘s closing inventory is next
year‘s opening inventory!
15
Summary of Income Effects - When Inventory Costs (Prices) are Increasing
Ending
inventory,
gross profit,
and net income
LIFO
Averagecost
FIFO
Summary of Income Effects - When Inventory Costs (Prices) are Decreasing
Ending
inventory,
gross profit,
and net income
LIFO
Averagecost
FIFO
16
Impact of accounting principles on
inventory valuation
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•
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Consistency principle Æ stick to one method for inventory valuation
Relevance, reliability Æ if valuation method is changed, disclose
that
Comparability Æ if two companies use different methods, effects of
valuation methods need to be determined for purposes of
comparison
17
Subsequent inventory valuation
•
Inventory to be measured at the lower of cost and net realizable
value
– Impairment test at the end of a financial year
– If net realizable value is below book value impairment is required
•
Net realizable value is the estimated selling price in the ordinary
course of business less the estimated costs of completion and the
estimated cost necessary to make the sale
– This refers to the selling price of a finished good rather than an input
factor
– Inventory valuation ensures that assets or income figures are not
overstated
•
Possible reasons why market value may be lower:
– physical deterioration, obsolescence, market downturn
18
Example: lower of
cost and net realizable value
19