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Accounting for Inventories
Chapter 6
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-1
Learning objectives
• Be able to calculate the ‘cost of inventory’
pursuant to NZ IAS 2 ‘Inventories’
• Understand how to apply the ‘lower of cost
and net realisable value’ rule for measuring
inventory
• Understand why there is typically a necessity
to make inventory cost-flow assumptions
• Be able to apply the inventory cost-flow
assumptions permitted by NZ IAS 2
• Know the disclosure requirements of NZ IAS 2
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-2
Introduction
• Inventory often accounts for a large proportion
of total assets
• Accounting methods used for inventory can have
a significant impact on reported assets and profits
• NZ IAS 2 applies to all inventories except:
–
–
–
Work in progress under construction contracts
Financial instruments; and
Biological assets
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-3
Definition of inventory
• Inventories are defined as assets (NZ IAS 2):
–
–
–
Held for sale in the ordinary course of business;
In the process of production for such sale; or
In the form of materials or supplies to be consumed in
the production process or in the rendering of services
• Cost of goods sold:
–
–
Is the cost of inventory sold during the financial period
Can be determined either on a periodic or perpetual basis
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-4
The general basis of inventory
measurement
• Inventories must be measured at the lower of
cost and net realisable value (NZ IAS 2):
–
On an item-by-item basis
• Cost of inventories comprises all (NZ IAS 2):
–
–
–
Costs of purchase (e.g. purchase price, import duties,
transport costs);
Costs of conversion (e.g. direct labour and allocation of
overhead costs); and
Other costs incurred in bringing the inventories to their
present location and condition (e.g. product design costs
and installation)
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-5
The general basis of inventory
measurement (cont.)
• Costs of inventory exclude (NZ IAS 2):
–
–
–
–
Abnormal amounts of wasted materials;
Storage costs;
Administrative overheads; and
Selling costs
• Fixed production costs:
–
Are costs of production not expected to fluctuate as
production levels change (e.g. building depreciation
and factory administration costs)
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-6
The general basis of inventory
measurement (cont.)
•
There are two methods for dealing with fixed
costs:
1.
2.
•
Absorption costing: fixed manufacturing costs included
in cost of inventories
Direct costing: fixed manufacturing costs treated as
period costs (i.e. expensed in the period incurred)
NZ IAS 2 requires the use of absorption costing
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-7
The general basis of inventory
measurement (cont.)
• Cost of inventory must include both fixed and
variable production overheads
–
Indirect production costs that cannot be traced
to the goods or services
• Standard costs
–
–
Predetermined product costs based, for example, on
planned products and/or operations, planned cost and
efficiency levels and expected capacity utilisation
Only permitted for inventory costing where the standards
are realistically attainable, reviewed regularly and revised
where necessary
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-8
The general basis of inventory
measurement (cont.)
• Net realisable value (NRV) (NZ IAS 2)
–
Estimated selling price in the ordinary course of
business less the estimated costs of completion
and those necessary to make the sale
• If NRV is greater than cost, inventory should
be left at cost
–
Upwards revaluations are not allowed by NZ IAS 2
• If NRV is less than cost, inventory should be
written down to NRV
–
Write-down treated as a cost in the period of the
write-down
• Refer to Worked Examples 6.1, 6.2 and 6.3
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-9
Inventory cost-flow assumptions
• Cost-flow assumptions must be made where
cost of inventory items fluctuate
• Specific identification of items sold and on hand,
although ideal, might be impractical to apply
• Cost-flow assumptions used to determine cost
of goods sold and closing inventory
–
The actual physical flow of goods and flow according
to assumption might be different
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-10
Inventory cost-flow assumptions
(cont.)
• Method adopted should be:
– Appropriate to the circumstances; and
–
Applied consistently from period to period
• NZ IAS 2 allows the use of one or more of
the following methods:
–
–
–
Specific identification
Weighted-average cost
First-in first-out (FIFO)
• NZ IAS 2 does not permit the use of:
–
Last-in first-out (LIFO)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-11
Specific identification method
• Cost of sales calculated by determining which
item was sold and the specific cost of that item
• Ending inventory is costed at the cost of the
specific items on hand at the end of the year
• Required to be used for inventory items that
are (NZ IAS 2):
–
–
Not ordinarily interchangeable; or
Goods or services produced and segregated
for specific projects
• Not appropriate for large numbers of similar
or identical items (NZ IAS 2)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-12
Weighted-average method
• An average cost is based on beginning inventory
and items purchased during the period
• Various costs of individual units are weighted by
the number of units
• Cost of goods sold and ending inventory are
costed at the average cost
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-13
FIFO method
• Goods from beginning inventory and the earliest
purchases are assumed to be the goods sold first
• Consistent with selling behaviour in most entities
• Ending inventory assumed to be most recent
purchases
–
More current value of inventory on balance sheet
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-14
LIFO method
• Most recent purchases are assumed to be the first
goods sold
• Ending inventory assumed to be the oldest goods
–
Inventory could be valued at prices paid some years
earlier
• Not allowed in Australia under NZ IAS 2
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-15
LIFO method (cont.)
• Allowed in the United States for external reporting
and tax purposes
–
–
–
US companies that elect not to adopt LIFO typically have
higher leverage and lower interest coverage ratios
Those potentially close to breaching debt covenants
adopt income-increasing and asset-increasing accounting
methods
While some methods might increase income, others might
act to reduce income
• Refer to Worked Example 6.4
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-16
Inventory systems
• Determination of cost of sales and inventory
under each cost-flow assumption also depends
on the inventory recording system used
• Periodic inventory system
–
–
Inventory counted periodically
No continuous records kept of inventory sales
• Perpetual inventory system
–
–
Running total kept of units on hand
Increases and decreases of inventory recorded
as they occur
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-17
Disclosure requirements
• Where material, NZ IAS 2 requires the disclosure
of the following:
–
–
–
–
–
–
–
–
Accounting policies for measuring inventories,
including cost formulas used
Total carrying amount of inventories
Carrying amount of inventories carried at fair
value less costs to sell
Amount of inventories expensed during the period
Amount of any write-downs expensed in the period
Amount of any reversal of any write-down
Circumstances leading to reversals of write-downs
Carrying amount of inventories pledged as securities
for liabilities
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-18
Summary
• The chapter addresses the topic of accounting
for inventory
• Under NZ IAS 2, inventory is to be measured
at the lower of cost and net realisable value
• Absorption costing and not direct costing
should be applied
• To account for the flow of inventory, cost-flow
assumptions are necessary
–
–
Allowable methods are specific identification,
weighted-average and first-in first-out
Last-in first-out is not allowed in New Zealand
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
6-19