Chapter 7
Inventory
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-1
Learning objectives
• Be able to calculate the ‘cost of inventory’
pursuant to AASB 102 ‘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 AASB 102
• Know the disclosure requirements of AASB 102
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-2
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
• AASB 102 applies to all inventories except:
– work in progress under construction contracts
– financial instruments; and
– biological assets
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-3
Definition of inventory
• Inventories are defined as assets (AASB 102)
– 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  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-4
The general basis of inventory
measurement
• Inventories must be measured at the lower of
cost and net realisable value (AASB 102)
– on an item-by-item basis
• Cost of inventories comprises all (AASB 102)
– costs of purchase (i.e. purchase price, import duties,
transport costs, etc);
– 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)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-5
The general basis of inventory
measurement (cont.)
• Costs of inventory exclude (AASB 102)
–
–
–
–
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)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-6
The general basis of inventory
measurement (cont.)
•
There are two methods for dealing with fixed
costs
1. Absorption costing: fixed manufacturing costs
included in cost of inventories
2. Direct costing: fixed manufacturing costs treated as
period costs (i.e. expensed in the period incurred)
•
AASB 102 requires the use of absorption
costing
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-7
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
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-8
The general basis of inventory
measurement (cont.)
• Net realisable value (NRV) (AASB 102)
– 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 AASB 102
• If NRV is less than cost, inventory should be
written down to NRV
– write-down treated as an expense in the period of the
write-down
• Refer to Worked Examples 7.1, 7.2 and 7.3
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-9
Discounts for early payment
• Discounts received for early payment for debts due to
the supplier of inventory are not to be offset against
the cost of inventory
• Discounts given to customers for early payment are
not to be offset against sales
• Penalties for late payment are not to be added to the
cost of inventory
• Trade discounts provided at the point of sale are to be
seen as a reduction in the cost of the inventory
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-10
Borrowing costs
• Costs associated with borrowings (eg interest) can
sometimes be included in the cost of inventory
• Governed by AASB 123 ‘Borrowing Costs’
• Interest costs can be included as part of the inventory
to the extent that the inventory is deemed to be a
‘qualifying asset’
• Qualifying assets are those “that necessarily take a
substantial period of time to get ready for its intended
use or sale”
• Would not be applicable to most inventory being
produced
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-11
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
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-12
Inventory cost-flow assumptions (cont.)
• Method adopted should be
– appropriate to the circumstances; and
– applied consistently from period to period
• AASB 102 allows the use of one or more of the
following methods
– specific identification
– weighted-average cost
– first-in first-out (FIFO)
• AASB 102 does not permit the use of:
– last-in first-out (LIFO)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-13
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
(AASB 102)
– not ordinarily interchangeable; or
– goods or services produced and segregated for specific
projects
• Not appropriate for large numbers of similar or
identical items (AASB 102)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-14
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  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-15
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  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-16
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 AASB 102
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-17
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 7.4 (p. 255) for a
comparison of the methods
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-18
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
See worked example 7.6 (p. 258)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-19
Reversals of previous write-downs
• As we know, inventories must be written down if the
net realisable value (NRV) is less than cost
• If in a subsequent period, NRV increases to original
cost or above, then the inventory writedown can be
reversed – with a subsequent increase in income
• Any subsequent accounting entry to increase the
carrying amount of inventory must be restricted to the
amount that was previously expensed
• The value of inventory must not be increased above its
original cost (in keeping with the lower of cost and
NRV rule)
• See Worked Example 7.7 (p. 260)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-20
Disclosure requirements
• Where material, AASB 102 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  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-21
Summary
• The chapter addresses the topic of accounting
for inventory
• Under AASB 102, 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, weightedaverage and first-in first-out
– last-in first-out is not allowed in Australia
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
7-22