Chapter 7
KNOWLEDGE CHECK 7.1
 Again, consider the small shop making handcrafted wood furniture. According to
IFRS, which of the following costs would be included in the cost of inventory and
which would not? Briefly explain your answers.
○ amount paid to shipping company that delivered a shipment of fabric for a
custom order of furniture
○ salary paid to the accountant in the facility
○ cost of varnish used to finish a set of bookcases
○ shop floor supervisor who ensures all projects are proceeding as planned
Under IFRS, the cost of inventory should include all the costs incurred to produce
the finished inventory. IFRS require that the cost of inventory include the cost of
materials used plus the cost of labour directly used to produce the product, plus an
allocation of overhead incurred in the production process.
o Shipping is a cost of the fabric used in the production of furniture so its
cost would be included in inventory;
o The accountant isn’t a cost of labour directly used to produce the furniture
or overhead incurred in the production process so the cost isn’t included in
inventory;
o Varnish is a cost of producing the bookcases so the cost is included in
inventory;
o The cost of the shop floor supervisor is overhead incurred in the
production process so an allocation of the cost should be included in
inventory.
KNOWLEDGE CHECK 7.2
 Describe the three subcategories of inventory usually reported in the financial
statements of manufacturing firms.
1. Raw materials inventory: the inputs into the production process of a
manufacturer or processor.
2. Work-in-process inventory or WIP: inventory that is partially completed on
the financial statement date.
3. Finished goods inventory: inventory that has been completed and is ready for
sale.
 Describe the two inventory control systems used to keep track of inventory
transactions. How do the two differ?
A perpetual inventory control system keeps an ongoing tally of purchases and
sales of inventory, and the inventory account is adjusted to reflect changes as
they occur. With a periodic inventory control system the inventory account
isn’t adjusted whenever a transaction affects inventory. Inventory purchases
aren’t recorded directly to inventory but are accumulated in a separate
purchases account. The amount of inventory at the end of a period is
determined by counting it, not from the accounting system.
 Trenche Ltd. provides you with the following information about its inventory:
Inventory on December 31, 2017
Purchases during 2018
Inventory on December 31, 2018
$ 175,000
1,245,000
210,000
Trenche uses a periodic inventory control system. Use this information to calculate
Trenche’s cost of sales for 2018.
Cost of sales = Beginning inventory + Purchases – Ending inventory
= $175,000 + $1,245,000 – $210,000
= $1,210,000
KNOWLEDGE CHECK 7.3
 What are cost formulas and why are the necessary for inventory accounting?
Cost formulas are methods for moving costs through the inventory account to cost
of sales without regard for the actual physical movement of the inventory. Cost
formulas are necessary because it isn’t practical or even possible in many cases
for accountants to keep track of the costs associated with individual units of
inventory. Without cost formulas it wouldn’t be possible or would be very
expensive to determine ending inventory and cost of sales and therefore to prepare
financial statements.
 Identify and explain the three cost formulas allowed by IFRS.
The three main cost flow assumptions are:
1. Specific identification—assigns the actual cost of a particular unit of
inventory to that unit of inventory.
2. Average cost—the average cost of all inventory on hand during the period
is calculated and that average is used to calculate cost of sales and the balance
in ending inventory.
3. First in, first out (FIFO)—the cost associated with the inventory that was
purchased or produced first is expensed first. For raw materials that are used
in a manufacturing process, the cost associated with the raw materials that
were purchased first is the cost that is charged to the production process first.
KNOWLEDGE CHECK 7.4
 In times of rising prices, which inventory cost formula will provide the highest
inventory valuation and the highest net income? Which will provide the lowest
inventory valuation and net income? Explain.
In times of rising prices FIFO provides the highest inventory valuation and the
highest net income. Under FIFO the costs associated with the most recently
acquired, higher priced inventory is reported on the balance (and so the highest
inventory valuation). FIFO also provides the highest net income because the costs
associated with the oldest inventory (the least expensive inventory) is expensed
first so cost of goods sold will be lower and net income higher compared with
average cost. Average cost provides a lower inventory valuation and net income
because the costs used are a blend of all costs available for sale in a period. When
prices are rising this means the average cost of goods will be greater than the
FIFO cost of goods sold (the average will be larger than the older costs expensed
under FIFO) so net income will be lower than what will be obtained under FIFO.
Similarly, ending inventory under average cost will be lower than FIFO because
the average cost of all goods available for sale will be less than the cost associated
with the more recently acquired inventory (as is the case with FIFO).
 What is the lower of cost and net realizable value (LCNRV) rule, and why is it
used?
The lower of cost and net realizable value (LCNRV) rule requires that when the
net realizable value of inventory at the end of a reporting period is lower than its
cost, the inventory must be reported on the balance sheet at its net realizable
value.
 Explain the accounting concept of conservatism.
Conservatism (or prudence under IFRS) requires that measurements in financial
statements should be made to ensure that assets, revenues, and net income aren’t
overstated and that liabilities and expenses aren’t understated. Another way of
explaining conservatism is, “anticipate no profit, but anticipate all losses.”
Conservatism doesn’t mean there should be a deliberate understatement of assets,
revenues, and net income or a deliberate overstatement of liabilities and expenses,
but the uncertainty surrounding many economic events makes caution in
measurements and estimates necessary.