Republic of the Philippines

CAGAYAN STATE UNIVERSITY

Maura,Aparri,Cagayan

CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS (AE14)

UNIT VI: INVENTORIES

Introduction

In this unit you will learn the meaning of inventories, cost of inventories,
the cost formulas, the measurement of inventory as well as accounting for
agricultural activity – the management of the biological transformation of
biological assets (living plants and animals) into agricultural produce
(harvested product of the entity's biological assets).
.

Learning Objectives

1. To understand the meaning of inventories.

2. To identify the items included in inventory cost.
3. To identify the cost formulas required by IFRS.
4. To know the measurement of inventory in the statement of financial
position.
5. To apply the lower of cost and net realizable value basis of measurement.
6. To know the accounting treatment and disclosure related to agricultural
activity.

Discussion

Definition of Inventories

IFRS defines inventories as assets that are:

 held for sale in the ordinary course of business,

 in the process of production for such sale, and
 in the form of materials or supplies to be consumed in the production
process or in the rendering of services (International Accounting
Standards, n.d., 2.6).
The key feature of inventory is that it is held for sale in the normal course of
business, which differentiates it from other tangible assets, such as property,
plant, and equipment that are only sold only when their productive capacity is
exhausted or no longer required by the business. The definition also recognizes
that for manufacturing businesses, inventory can take various forms
throughout the production process. Raw materials, work in process, and
finished goods are all considered inventory. For many businesses, inventory
can represent a significant asset.

Initial Recognition and Measurement

An obvious question that arises when considering inventory is, what costs
should be included? In answering this question, IFRS has provided some
general guidance: the cost of inventories shall include all costs of purchase,
costs of conversion, and "other costs incurred in bringing the inventories to
their present location and condition" (International Accounting Standards, n.d.,
2.10).

Costs of Purchase

Purchase costs include not only the direct purchase price of the goods but also
the costs to transport the goods to the company's premises and any
nonrecoverable taxes or import duties paid on the purchase. As well, any
discounts or rebates earned on the purchase should be deducted from the cost
of the inventory.

One issue that often needs to be considered when determining inventory costs
at the end of an accounting period is the matter of goods in transit. Goods may
be shipped by a seller before the end of an accounting period but are not
received until after the end of the purchaser's accounting period. The question
of who owns the goods while they are in transit obviously needs to be
addressed. More specifically, three issues arise from this question:

1. Who pays for the shipping costs?

2. Who is responsible for the loss if goods are damaged in transit?
3. When should the transfer of ownership be recorded in the accounting
records?

To answer these questions, the legal term free on board (FOB) needs to be
understood. When goods are shipped by a seller, the invoice will usually
indicate that the goods are shipped either FOB shipping or FOB destination. If
the goods are FOB shipping, the purchaser is assuming legal title as soon as
the goods leave the seller's warehouse. This means the purchaser is
responsible for shipping costs as well as for any damage that occurs in transit.
As well, the purchaser should record these goods in his or her inventory
accounts as soon as they are shipped, even if they don't arrive until after the
end of the accounting period. If the goods are FOB destination, the purchaser
is not assuming ownership of the goods until they are received. This means
that the seller would be responsible for shipping costs and any damage that
occurs in transit. As well, the purchaser should not include these goods in his
or her inventory until they are actually received. Likewise, the seller would still
include the goods in his or her inventory until they are actually delivered to the
purchaser. Accountants and auditors pay close attention to the FOB terms of
purchases and sales near the fiscal period end, as these terms can affect the
accurate recording of the inventory amount on the balance sheet.

Costs of Conversion

Another more complex issue arises in the determination of the cost of

manufactured inventories. As noted above, IAS 2-10 requires the inclusion of
costs to convert inventories into their current form. For a manufacturing
company, this means that inventories will include raw materials, work in
progress, and finished goods. For raw materials, the cost is fairly easy to
determine. However, for work in progress and finished goods, the
determination of which costs to include becomes more complicated. Although
labour and variable overhead costs, such as utilities consumed by operating
factory machines, are fairly easy to associate directly with the production of a
product, the treatment of other fixed overhead costs is not as clear. It can be
argued that costs such as factory rent should not be included in the inventory
cost because this cost will not vary with the level of production. However, it can
also be argued that without the payment of rent, the production process could
not occur. For management accounting purposes, a variety of methods are
used to account for overhead costs. For financial accounting purposes,
however, it is clear that all conversion costs need to be included in inventory.
Thus, the financial accountant will need to determine the best way to allocate
fixed overhead costs. In normal circumstances, the fixed overhead costs are
simply allocated to each unit of inventory produced in an accounting period.
However, if production levels are significantly higher or lower than normal
levels, then the accountant needs to apply some judgment to the situation. If
fixed overhead costs are applied to very low levels of production, the result
would be inventory that is carried at a value that may be higher than its
realizable value. For this reason, fixed overhead costs should be allocated to
low production volumes using the rate calculated on normal production levels,
with unallocated overhead being expensed in the period. This is done to avoid
reporting misleadingly high inventory levels. On the other hand, if abnormally
high production occurs, the fixed overhead costs are allocated using the actual
production level. This would result in lower per-unit costs for the inventory
produced. This situation could result in higher profits, as presumably some of
the excess production would be held in inventory at the end of the year. A
manager may be tempted to increase production strictly for the purpose of
increasing current earnings. Although this does not violate any accounting
standard, the accountant should be careful in this situation, as there may be a
risk of obsolete inventory as a result of the overproduction, or there may be
other forms of income-maximizing earnings management occurring.

Other Costs

IAS 2–15 indicates that other costs can be included in inventory only to the
extent "they are incurred in bringing the inventories to their present location
and condition." The standard provides examples such as certain non-
production overhead costs or product-design costs for specific customers.
Clearly, the accountant would need to exercise judgment in allocating these
kinds of costs to inventory. The standard also clearly defines some costs that
should not be included in inventories but rather expensed in the current
period. These costs include the following:

 Abnormal amounts of wasted materials, labour, or other production

costs
 Storage costs, unless those costs are necessary in the production process
before a further production stage
 Administrative overheads that do not contribute to bringing inventories
to their present location and condition
 Selling costs

COST FORMULAS

PAS 2 paragraph 25-The cost of inventories shall be determined by using

either:

a. First in,First out

b. Weighted average

The standard does not permit anymore the use of the last in, first out(LIFO) as
an alternative formula in measuring cost of inventories.

First in, First out (FIFO)

The FIFO method assumes that “the goods first purchased are the first
sold”and consequently the goods remaining in the inventory at the end of the
period are those recently purchased or produced.

The rule is “first come,first sold”.

Is this method there is improper matching of cost against revenue because the
goods sold are stated at earlier or older prices resulting in understatement of
cost of goods sold.

Illustration-FIFO
The following data pertain to an inventory item:

Date Particulars Units Unit cost Total cost Sales(in

unit)
Sept 1 Beginning 900 210 189,000
balance
Sept 8 Sale 600
Sept 22 Purchase 600 220 *132,000
Sept 25 Sale 800
Sept 30 Purchase 600 230 *138,000

The ending inventory is 700 units.

Date Particulars Units Unit cost Total cost

From Sept 22 Purchase 100 220 22,000
From Sept 30 Purchase 600 230 138,000
Total 700 160,000

Cost of goods sold

Inventory-Sept 1 189,000
*Purchases 270,000
Goods available for sale 459,000
Inventory-Sept 30 (160,000)
Cost of goods sold 299,000

When making an inventory cost flow assumption, what factors do managers

need to consider? Generally, the cost flow assumption should attempt to reflect
the actual physical flow of goods as much as possible. For example, a grocery
retailer selling perishable merchandise may want to use FIFO, as it is common
practice to place the oldest items at the front of the rack to encourage their sale
first. Alternatively, consider a hardware store that sells bulk nails that are
scooped from a bin. There is no way to identify the individual items specifically,
and it is likely that over time, customers scooping out nails would mix together
items stocked at different times. Weighted average costing would make the
most sense in this case, as this would likely represent the real movement of the
product. For a company selling heavy equipment, specific identification would
likely make the most sense, as each item would be unique with its own serial
number, and these items can be easily tracked.

A further consideration would be the effects on the income statement and

balance sheet. FIFO results in the inventory reported on the balance being
reported at more current costs. As there is an increasing emphasis in standard
setting on valuation concepts, this approach would result in the most useful
information for determining the value of the company. If profitability is more
important to a financial-statement reader, then weighted average cost would be
more useful, as more current costs would be averaged into income.

Income taxes may also be a consideration when choosing a cost flow formula.
This motivation must be considered carefully, however, as income will be
affected in opposite ways, depending on whether input prices are rising or
falling. As well, although taxes could be reduced in any given year through the
cost flow assumption made, this is only a temporary effect, as all inventory will
eventually be expensed through cost of goods sold.

Whatever method is chosen, it should be applied on a consistent basis. It

would be inappropriate for a company to change cost flow assumptions year to
year, simply to achieve a certain result in net income. Once the cost flow
assumption is determined, it should be applied the same way each year, unless
there has been a significant change in circumstances that warrants a change.
A company may use different cost flow assumptions for different major
inventory classes, but these choices should still be applied consistently.

WEIGHTED AVERAGE

The cost of the beginning inventory plus the total cost of purchases during the
period is divided by the total units purchased plus those in the beginning
inventory to get a weighted average unit cost.

Such weighted average unit cost is then multiplied by the units on hand to
derive the inventory value.

In other words, the average unit cost is computed by dividing the total cost of
goods available for sale by the total number of units available for sale.

The preceding illustrative data are used.

Date Particulars Units Unit Total cost

cost
Sept 1 Beginning 900 210 189,000
balance
Sept 22 Purchase 600 220 132,000
Sept 30 Purchase 600 230 138,000
Total goods available 2,100 459,000
for sale

Weighted average unit cost (459,000/2,100) 218.57

Inventory cost (700 x 218.57) 152,999

Cost of goods sold

Inventory-Sept 1 189,000
*Purchases 270,000
Goods available for sale 459,000
Inventory-Sept 30 (152,999)
Cost of goods sold 306,000

Last in, First out(LIFO)

The LIFO method assumes that the goods last purchased are first sold and
consequently the goods remaining in the inventory at the end of the period are
those first purchased or produced.

The inventory is thus expressed in terms of earlier or old prices and the cost of
goods sold is representative of recent or new prices.

Illustration-LIFO

In the preceding illustration,the cost of 700 units under the LIFO is computed
as follows:

Units Unit cost Total cost

From Sept 1 700 210 147,000
balance

Inventory-Sept 1 189,000
Purchases 270,000
Goods available 459,000
for sale
Inventory-Sept 30 (147,000)
Cost of goods sold 312,000

Specific identification

Specific identification means that specific costs are attributed to identify items
of inventory.
The cost of the inventory is determined by simply multiplying the units on
hand by the actual unit cost.

PAS 2, paragraph 23, provides that this method is appropriate for inventories
that are segregated for a specific project and inventories that are not ordinarily
interchangeable.

Measurement of inventory

PAS 2, paragraph 9, provides that inventories shall be measured at the lower of

cost and net realizable value.

The cost of inventory is determined using either FIFO cost or average cost.

The measurement of inventory at the lower of cost and net realizable value is
known as LCNRV.

What Is Net Realizable Value?

Net realizable value or NRV is the estimated selling price in the ordinary course
of business less the estimated cost of completion and the estimated cost of
disposal.

The cost of inventories may not be recoverable under the following

circumstances:

a. The inventories are damaged

b. The inventories have become wholly or partially obsolete.
c. The selling prices have declined
d. The estimated cost of completion or the estimated cost of disposal has
increased.

Inventories are usually written down to net realizable value on an item by item
or individual basis.

How Is the Lower of Cost and Net Realizable Test Applied?

In general, the lower of cost and net realizable test should be applied to the
most detailed level possible. This would normally be considered to be individual
inventory items. However, in some situations, it may be appropriate to group
inventory items together and apply the test at the group level. This would be
appropriate only when items relate to the same product line, have similar end
uses, are produced and marketed in the same geographic area, and cannot be
segregated from other items in the product line in a reasonable or cost-effective
way. If grouping is appropriate, the amount of inventory write-downs will be
less than if the test is applied on an individual-item basis. This occurs because
grouping allows for some offsetting of over- and undervalued items.

Accounting for inventory writedown

If the cost is lower than a net realizable value, there is no accounting problem
because the inventory is stated at cost and the increase in value is not
recognized.

If the net realizable value is lower than cost, the inventory is measured at net
realizable value.

The writedown of inventory to net realizable value is accounted for using the
allowance method.

Illustration-Inventory data on December 31, 2020

Inventory item Total cost NRV LCNRV

A 2,000,000 1,900,000 1,900,000
B 1,500,000 1,550,000 1,500,000
C 2,500,000 2,100,000 2,100,000
D 3,000,000 3,200,000 3,000,000
Total 9,000,000 8,750,000 8,500,000

The measurement of the inventory at LCNRV is applied on an item by item or

individual basis or 8,500,000.

Total cost 9,000,000

LCNRV 8,500,000
Inventory writedown 500,000

The loss on inventory writedown is accounted for separately.

The loss on inventory writedown is included in the computation of cost of goods

sold.

The allowance for inventory writedown is presented as a deduction from the

inventory

Inventory-December 31,2020,at cost 9,000,000

Allowance for inventory writedown (500,000)
Net realizable value 8,500,000

Presentation and Disclosure

Inventories are required to be disclosed as a separate item on the company's
balance sheet. As well, significant categories of inventories should be disclosed,
such as raw materials, work in process, and finished goods. As with any
significant balance sheet item, the company's accounting policies for
measuring and reporting inventories, including its chosen cost formula, should
be disclosed. The company should also disclose the amount of inventories
recognized as an expense during the period. This would normally be disclosed
as cost of goods sold, but there may be other material amounts that could be
disclosed separately, such as write-downs due to obsolescence and subsequent
reversals of those write-downs. As well, under IFRS, additional details of the
write-downs need to be disclosed, such as qualitative reasons for the write-
downs or subsequent reversal. If the inventory has been pledged as collateral
for any outstanding debt, this fact needs to be disclosed, along with the
amount pledged.
If thefair

IAS 41-Agriculture

Key definitions

 Biological asset-A living animal or plant

 Agricultural produce-The harvested product from biological assets
 Costs to sell The incremental costs directly attributable to the disposal of
an asset, excluding finance costs and income taxes

Initial recognition

 An entity recognizes a biological asset or agriculture produce only when the

entity controls the asset as a result of past events, it is probable that
future economic benefits will flow to the entity, and the fair value or cost of
the asset can be measured reliably. [IAS 41.10]

Measurement

 Biological assets within the scope of IAS 41 are measured on initial

recognition and at subsequent reporting dates at fair value less estimated
costs to sell, unless fair value cannot be reliably measured. [IAS 41.12]
 Agricultural produce is measured at fair value less estimated costs to sell
at the point of harvest. [IAS 41.13] Because harvested produce is a
marketable commodity, there is no 'measurement reliability' exception for
produce.
 The gain on initial recognition of biological assets at fair value less costs to
sell, and changes in fair value less costs to sell of biological assets during a
period, are included in profit or loss. [IAS 41.26]
 A gain on initial recognition (e.g. as a result of harvesting) of agricultural
produce at fair value less costs to sell are included in profit or loss for the
period in which it arises. [IAS 41.28]
 All costs related to biological assets that are measured at fair value are
recognized as expenses when incurred, other than costs to purchase
biological assets.
 IAS 41 presumes that fair value can be reliably measured for most
biological assets. However, that presumption can be rebutted for a
biological asset that, at the time it is initially recognized, does not have a
quoted market price in an active market and for which alternative fair value
measurements are determined to be clearly unreliable. In such a case, the
asset is measured at cost less accumulated depreciation and impairment
losses. But the entity must still measure all of its other biological assets at
fair value less costs to sell. If circumstances change and fair value becomes
reliably measurable, a switch to fair value less costs to sell is required. [IAS
41.30]
 Guidance on the determination of fair value is available in IFRS 13 Fair
Value Measurement. IFRS 13 also requires disclosures about fair value
measurements.
 Other issues
 The change in fair value of biological assets is part physical change
(growth, etc) and part unit price change. Separate disclosure of the two
components is encouraged, not required. [IAS 41.51]
 Agricultural produce is measured at fair value less costs to sell at harvest,
and this measurement is considered the cost of the produce at that time
(for the purposes of IAS 2 Inventories or any other applicable standard).
[IAS 41.13]
 Agricultural land is accounted for under IAS 16 Property, Plant and
Equipment. However, biological assets (other than bearer plants) that are
physically attached to land are measured as biological assets separate from
the land. In some cases, the determination of the fair value less costs to
sell of the biological asset can be based on the fair value of the combined
asset (land, improvements and biological assets). [IAS 41.25]
 Intangible assets relating to agricultural activity (for example, milk quotas)
are accounted for under IAS 38 Intangible Assets.
 Government grants

 Unconditional government grants received in respect of biological assets

measured at fair value less costs to sell are recognized in profit or loss
when the grant becomes receivable. [IAS 41.34]
 If such a grant is conditional (including where the grant requires an entity
not to engage in certain agricultural activity), the entity recognizes the
grant in profit or loss only when the conditions have been met. [IAS 41.35]

Disclosure

Disclosure requirements in IAS 41 include:

 aggregate gain or loss from the initial recognition of biological assets and
agricultural produce and the change in fair value less costs to sell during
the period* [IAS 41.40]
 description of an entity's biological assets, by broad group [IAS 41.41]
 description of the nature of an entity's activities with each group of
biological assets and non-financial measures or estimates of physical
quantities of output during the period and assets on hand at the end of the
period [IAS 41.46]
 information about biological assets whose title is restricted or that are
pledged as security [IAS 41.49]
 commitments for development or acquisition of biological assets [IAS 41.49]
 financial risk management strategies [IAS 41.49]

 reconciliation of changes in the carrying amount of biological assets,

showing separately changes in value, purchases, sales, harvesting,
business combinations, and foreign exchange differences* [IAS 41.50]
 * Separate and/or additional disclosures are required where biological
assets are measured at cost less accumulated depreciation [IAS 41.55]
 Disclosure of a quantified description of each group of biological assets,
distinguishing between consumable and bearer assets or between mature
and immature assets, is encouraged but not required. [IAS 41.43]

If fair value cannot be measured reliably, additional required

disclosures include: [IAS 41.54]
 description of the assets
 an explanation of why fair value cannot be reliably measured
 if possible, a range within which fair value is highly likely to lie
 depreciation method
 useful lives or depreciation rates
 gross carrying amount and the accumulated depreciation, beginning and
ending.
If the fair value of biological assets previously measured at cost
subsequently becomes available, certain additional disclosures are
required. [IAS 41.56]

Disclosures relating to government grants include the nature and

extent of grants, unfulfilled conditions, and significant decreases
expected in the level of grants. [IAS 41.57]

Chapter Summary

Inventories can be a significant asset for many businesses. The key feature of
inventory is that it is held for sale in the normal course of business, which
distinguishes it from financial instruments and long-lived assets, such as
property, plant, and equipment.

Recognition of the initial cost of purchase should include transportation,

discounts, and other nonrecoverable taxes and fees that need to be paid to
transport the goods to the place of business. FOB terms of purchase need to be
considered when applying cut-off procedures at the end of the accounting
period. This is important for determining when the responsibility for the
inventory passes from the seller to the buyer. For manufacturers, conversion
costs must also be included in inventory. For direct materials and labour, this
allocation is fairly straightforward. However certain issues with overhead
allocations can occur with low or high production levels. With abnormally low
production levels, overheads should be allocated at the rate used for normal
production levels. With abnormally high production levels, overheads should be
allocated using the actual level of production. Other costs required to bring the
inventory to the place of business and get into a saleable condition may also be
included. The accountant will need to exercise judgment when considering
other costs to include.

The cost flow formula determines how to allocate inventory costs between the
income statement and the balance sheet. Although specific identification of
individual inventory items is the most precise way to allocate these costs, this
method would only be appropriate with inventory items whose characteristics
uniquely differentiate them from other inventory units. For homogeneous
inventory products, weighted average or first in, first out (FIFO) are appropriate
choices. Weighted average (or moving average, when used with a perpetual
inventory system) recalculates the average cost of the inventory every time a
new purchase is made. This revised cost is used to determine the cost of goods
sold. With FIFO, the oldest inventory items are assumed to be sold first. Each
method has certain advantages and disadvantages, and each has a different
effect on the balance sheet and income statement. The choice of method will
depend on the actual physical movement of goods, financial reporting
objectives, tax considerations, and other factors. Whatever method is chosen, it
should be applied consistently.

When economic circumstances change, such as a shift in consumer

preferences, a company may find itself holding inventory that cannot be sold
for its carrying value. In this case, the inventory should be written-down to its
net realizable value (selling price less estimated costs required to complete and
sell the goods) in order to ensure the balance sheet is not reporting a current
asset at a value greater than the amount of cash that can be realized from its
sale. Generally, this technique should be applied on an individual-item basis,
but in certain cases where a group of products all belong to one product line,
are produced and marketed in one geographic area, have similar end uses, or
are difficult to segregate, it may be appropriate to apply the test on a grouped
basis. Judgment is required in applying this technique, as net realizable values
are estimates that may not be easy to verify.

Inventory should be described separately on the balance sheet, with separate

disclosure of major categories such as raw materials, work in process, and
finished goods. Accounting policies used should also be disclosed, as well as
the amount of any inventory that has been pledged as collateral for any
liability. The amount of inventory expensed during the period should be
disclosed as cost of goods sold on the income statement, but other categories, if
material, could be disclosed separately, such as significant write-downs or
reversals of write-downs.

References

 International Accounting Standards. (n.d.). In IAS Plus. Retrieved from

http://www.iasplus.com/en/standards/ias
 Valix, C. T., Peralta, J.F & Valix C. A. M. (2020). Conceptual Framework
and Accounting Standards. Manila, Philippines: GIC Enterprises & Co..
Inc.
 Exe https://www.iasplus.com/en/standards/ias/ias41rcises

GOD BLESS AND STAY SAFE!