Valuation of CHAPTER 8

Inventories: A Cost-
Basis Approach
FINANCIAL ACCOUNTING 1
Lecture 5: Inventory LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe inventory 3. Compare the cost flow
Intermediate Accounting IFRS Ed classifications and different assumptions used to account
inventory systems. for inventories.
3rd Ed, Chapter 8,9
2. Identify the goods and costs 4. Determine the effects of
included in inventory. inventory errors on the
financial statements.

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LEARNING OBJECTIVE 1
Inventory Issues
PREVIEW OF CHAPTER 8
Describe inventory
classifications and different
inventory systems.

Classification
Inventories are asset:
 items held for sale in the ordinary course of business, or
 goods to be used in the production of goods to be sold.

Businesses with Inventory

Merchandising or
Manufacturing
Company Company
Intermediate Accounting
IFRS 3rd Edition
Kieso ● Weygandt ● Warfield
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 Classification Classification
ILLUSTRATION 8.1 ILLUSTRATION 8.1

 One inventory Three accounts

account.
 Raw Materials
 Purchase
 Work in Process
merchandise in
a form ready  Finished Goods
for sale.

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Inventory Issues

Inventory Cost Flow ILLUSTRATION 8.3

ILLUSTRATION 8.2 Two types of systems for maintaining inventory records — perpetual
Flow of Costs through
Manufacturing and system or periodic system.
Merchandising Companies
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 Inventory Cost Flow Inventory Cost Flow

Perpetual System Periodic System

1. Purchases of merchandise are debited to Inventory. 1. Purchases of merchandise are debited to Purchases.
2. Freight-in is debited to Inventory. Purchase returns and 2. Ending Inventory determined by physical count.
allowances and purchase discounts are credited to Inventory.
3. Calculation of Cost of Goods Sold:
3. Cost of goods sold is debited and Inventory is credited for
each sale. Beginning inventory $ 100,000
Purchases, net + 800,000
4. Subsidiary records show quantity and cost of each type of
Goods available for sale 900,000
inventory on hand.
Ending inventory - 125,000
The perpetual inventory system provides a continuous record of the Cost of goods sold $ 775,000
balance in both the Inventory and Cost of Goods Sold accounts.

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Inventory Cost Flow Inventory Cost Flow ILLUSTRATION 8.4

Comparative Entries—
Perpetual vs. Periodic

Comparing Perpetual and Periodic Systems

Illustration: Fesmire Company had the following transactions
during the current year.

Record these transactions using the Perpetual and Periodic

systems.

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 Inventory Cost Flow Inventory Issues

Illustration: Assume that at the end of the reporting period, the Inventory Control
perpetual inventory account reported an inventory balance of
All companies need periodic verification of the inventory records
$4,000. However, a physical count indicates inventory of $3,800 is
actually on hand. The entry to record the necessary write-down is  by actual count, weight, or measurement, with
as follows.
 counts compared with detailed inventory records.
Inventory Over and Short 200
Companies should take the physical inventory
Inventory 200
 near the end of their fiscal year,

Note: Inventory Over and Short adjusts Cost of Goods Sold. In

 to properly report inventory quantities in their annual
practice, companies sometimes report Inventory Over and Short in accounting reports.
the “Other income and expense” section of the income statement.

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LEARNING OBJECTIVE 2
Inventory Issues Goods and Costs Identify the goods and costs
included in inventory.
Included an Inventory
Determining Cost of Goods Sold
Companies must allocate the cost of all the goods available for Goods Included in Inventory
sale (or use) between the goods that were sold or used and A company recognizes inventory and accounts payable at
those that are still on hand. the time it controls the asset.
Passage of title is often used to determine control because
the rights and obligations are established legally.

ILLUSTRATION 8.5
Computation of Cost
of Goods Sold

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 Goods Included In Inventory Goods Included In Inventory

Goods in Transit Consigned Goods

Example: LG (KOR) determines ownership by applying the Example: Williams Art Gallery (the consignor) ships various art
“passage of title” rule. merchandise to Sotheby’s Holdings (USA) (the consignee), who
 If a supplier ships goods to LG f.o.b. shipping point, title acts as Williams’ agent in selling the consigned goods.
passes to LG when the supplier delivers the goods to the  Sotheby’s agrees to accept the goods without any liability,
common carrier, who acts as an agent for LG. except to exercise due care and reasonable protection from
 If the supplier ships the goods f.o.b. destination, title passes loss or damage, until it sells the goods to a third party.
to LG only when it receives the goods from the common  When Sotheby’s sells the goods, it remits the revenue, less a
carrier. selling commission and expenses incurred, to Williams.
“Shipping point” and “destination” are often designated by a Goods out on consignment remain the property of the consignor
particular location, for example, f.o.b. Seoul. (Williams).

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Goods Included In Inventory Goods Included In Inventory

Sales with Repurchase Agreements Sales with Rights of Return

Example: Hill Enterprises transfers (“sells”) inventory to Chase, Example: Quality Publishing Company sells textbooks to Campus
Inc. and simultaneously agrees to repurchase this merchandise at Bookstores with an agreement that Campus may return for full
a specified price over a specified period of time. Chase then uses credit any books not sold. Quality Publishing should recognize
the inventory as collateral and borrows against it. a) Revenue from the textbooks sold that it expects will not be
 Essence of transaction is that Hill Enterprises is financing its returned.
inventory—and retains control of the inventory—even though it b) A refund liability for the estimated books to be returned.
transferred to Chase technical legal title to the merchandise.
c) An asset for the books estimated to be returned which reduces
 Often described in practice as a “parking transaction.” the cost of goods sold.
 Hill should report the inventory and related liability on its books. If Quality Publishing is unable to estimate the level of returns, it
should not report any revenue until the returns become predictive.
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 Costs Included In Inventory Costs Included In Inventory

Product Costs Period Costs

Costs directly connected with bringing the goods to the buyer’s Costs that are indirectly related to the acquisition or production of
place of business and converting such goods to a salable condition. goods.

Cost of purchase includes all of: Period costs such as

1. The purchase price.  selling expenses and,

2. Import duties and other taxes.  general and administrative expenses
3. Transportation costs. are not included as part of inventory cost.
4. Handling costs directly related to the acquisition of the goods.

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Costs Included In Inventory Treatment of Purchase Discounts

Treatment of Purchase Discounts

Purchase or trade discounts are reductions in the selling prices
**
granted to customers.

IASB requires these discounts to be recorded as a reduction from

the cost of inventories.
*

ILLUSTRATION 8.6 * $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

Entries under Gross and
Net Methods

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 LEARNING OBJECTIVE 3
Which Cost Flow Compare the cost flow
assumptions used to account
Cost Flow Methods
Assumptions to Adopt? for inventories.
To illustrate the cost flow methods, assume that Call-Mart SpA
had the following transactions in its first month of operations.
Cost Flow Methods
 Specific Identification
or
 Two cost flow assumptions
Calculate Goods Available for Sale
► First-in, First-out (FIFO) or
Beginning inventory (2,000 x €4) € 8,000
► Average Cost Purchases:
6,000 x €4.40 26,400
2,000 x €4.75 9,500
Goods available for sale €43,900
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Cost Flow Methods Specific Identification

Illustration: Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units
Specific Identification from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000
 Method may be used only in instances where it is practical from the March 30 purchase. Compute the amount of ending inventory
and cost of goods sold.
to separate physically the different purchases made. Cost ILLUSTRATION 8.7

of goods sold includes costs of the specific items sold.

 Used when handling a relatively small number of costly,
easily distinguishable items.

 Matches actual costs against actual revenue.

 Cost flow matches the physical flow of the goods.

 May allow a company to manipulate net income.

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 Cost Flow Methods Average-Cost
ILLUSTRATION 8.8
Average-Cost Weighted-Average Method Weighted-Average
Method—Periodic Inventory

 Prices items in the inventory on the basis of the average

cost of all similar goods available during the period.

 Not as subject to income manipulation.

 Measuring a specific physical flow of inventory is often

impossible.

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Average-Cost Cost Flow Methods

Moving-Average Method First-In, First-Out (FIFO)

ILLUSTRATION 8.9
Moving-Average Method—
Perpetual Inventory

 Assumes goods are used in the order in which they are

purchased.

 Approximates the physical flow of goods.

 Ending inventory is close to current cost.

In this method, Call-Mart computes a new average unit cost each  Fails to match current costs against current revenues on
time it makes a purchase. the income statement.

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 First-In, First-Out (FIFO) First-In, First-Out (FIFO)

Periodic Inventory System ILLUSTRATION 8.10

FIFO Method—Periodic Perpetual Inventory System ILLUSTRATION 8.11
FIFO Method—
Inventory Perpetual Inventory

In all cases where FIFO is used, the inventory and cost of goods sold
Determine cost of ending inventory by taking the cost of the most would be the same at the end of the month whether a perpetual or
recent purchase and working back until it accounts for all units in the periodic system is used.
inventory.
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Inventory Valuation Methods—Summary Inventory Valuation Methods—Summary

Comparison assumes periodic inventory procedures and the

following selected data.

ILLUSTRATION 8.12
Comparative Results of
Average-Cost and FIFO
Methods

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 Inventory Valuation Methods—Summary Inventories: CHAPTER 9

When prices are rising, average-cost results in the higher cash

Additional Valuation Issues
balance at year-end (because taxes are lower).
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe and apply the lower- 4. Determine ending
of-cost-or-net realizable value
rule. inventory by applying
2. Identify other inventory the retail inventory
valuation issues.
method.
3. Determine ending inventory by
5. Explain how to report
ILLUSTRATION 8.13
Balances of Selected Items under Alternative applying the gross profit
Inventory Valuation Methods
method.
and analyze inventory.

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LEARNING OBJECTIVE 1
Lower-of-Cost-or-Net
PREVIEW OF CHAPTER 9
Describe and apply the lower-
of-cost-or-net realizable value
Realizable Value (LCNRV) rule.

A company abandons the historical cost principle when the

future utility (revenue-producing ability) of the asset drops
below its original cost.

Net Realizable Value

Estimated selling price in the normal course of business less
 estimated costs to complete and

 estimated costs to make a sale.

Intermediate Accounting
IFRS 3rd Edition
Kieso ● Weygandt ● Warfield
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 Net Realizable Value Net Realizable Value ILLUSTRATION 9.1
Computation of Net
Realizable Value

Illustration: Assume that Mander AG has unfinished inventory with

a cost of €950, a sales value of €1,000, estimated cost of
completion of €50, and estimated selling costs of €200. Mander’s
net realizable value is computed as follows.

 Mander reports inventory on its balance sheet at €750.

 In its income statement, Mander reports a Loss on

Inventory Write-Down of €200 (€950 − €750).
ILLUSTRATION 9.1
Computation of Net Realizable Value

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Net Realizable Value Illustration of LCNRV

Jinn-Feng Foods computes its inventory

at LCNRV (amounts in thousands). ILLUSTRATION 9.3
Determining Final
Inventory Value

ILLUSTRATION 9.2
LCNRV Disclosures

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 Methods of Applying LCNRV Methods of Applying LCNRV

Assume that Jinn-Feng Foods separates its food products  In most situations, companies price inventory on an item-
into two major groups, frozen and canned. by-item basis.

 Tax rules in some countries require that companies use an

individual-item basis.

 Individual-item approach gives the lowest valuation for

statement of financial position purposes.

 Method should be applied consistently from one period to

another.

ILLUSTRATION 9.4
Alternative Applications of LCNRV

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Recording NRV Instead of Cost Recording NRV Instead of Cost

Illustration: Data for Ricardo SpA Partial Statement of Financial Position

Cost of goods sold (before adj. to NRV) €108,000 Loss COGS
Ending inventory (cost) 82,000 Method Method
Ending inventory (at NRV) 70,000 Current assets:
Inventory € 70,000 € 70,000
Prepaids 20,000 20,000
Loss Loss Due to Decline to NRV 12,000 Accounts receivable 350,000 350,000
Method Inventory (€82,000 - €70,000) 12,000 Cash 100,000 100,000
Total current assets 540,000 540,000

COGS Cost of Goods Sold 12,000

Method
Inventory 12,000

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 Recording Net Realizable Value Use of an Allowance
Loss COGS
Income Statement Method Method Instead of crediting the Inventory account for NRV adjustments,
Sales € 200,000 € 200,000 companies generally use an allowance account, often referred to
Cost of goods sold 108,000 120,000 as Allowance to Reduce Inventory to NRV.
Gross profit 92,000 80,000
Operating expenses: Using an allowance account under the loss method, Ricardo SpA
Selling 45,000 45,000 makes the following entry to record the inventory write-down to
General and administrative 20,000 20,000 NRV.
Total operating expenses 65,000 65,000
Other income and expense: Loss Due to Decline of Inventory to NRV 12,000
Loss due to decline of inventory to NRV 12,000 - Allowance to Reduce Inventory to NRV 12,000
Interest income 5,000 5,000
ILLUSTRATION 9-7
Total other (7,000) 5,000
Income from operations 20,000 20,000
Income tax expense 6,000 6,000
Net income € 14,000 € 14,000
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Use of an Allowance LCNRV

Partial Statement of Financial Position Recovery of Inventory Loss

No  Amount of write-down is reversed.
Allowance Allowance
Current assets:  Reversal limited to amount of original write-down.
Inventory € 70,000 € 82,000
Continuing the Ricardo example, assume the net realizable
Allowance to reduce inventory (12,000)
Inventory at NRV 70,000 value increases to €74,000 (an increase of €4,000). Ricardo
Prepaids 20,000 20,000 makes the following entry, using the loss method.
Accounts receivable 350,000 350,000
Cash 100,000 100,000 Allowance to Reduce Inventory to NRV 4,000
Total current assets 540,000 540,000 Recovery of Inventory Loss 4,000

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 Recovery of Inventory Loss Evaluation of LCM Rule

Allowance account is adjusted in subsequent periods, such LCNRV rule suffers some conceptual deficiencies:
that inventory is reported at the LCNRV. 1. A company recognizes decreases in the value of the asset
and the charge to expense in the period in which the loss in
Illustration shows net realizable value evaluation for Vuko Company
utility occurs—not in the period of sale.
and the effect of net realizable value adjustments on income.
2. Application of the rule results in inconsistency because a
company may value the inventory at cost in one year and at
net realizable value in the next year.
3. LCNRV values the inventory in the statement of financial
position conservatively, but its effect on the income statement
may or may not be conservative. Net income for the year in
which a company takes the loss is definitely lower. Net
ILLUSTRATION 9.8
Effect on Net Income of Adjusting income of the subsequent period may be higher than normal if
Inventory to Net Realizable Value
the expected reductions in sales price do not materialize.
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LCNRV LCNRV
P9.1: Remmers SE manufactures desks. The 2019 catalog was in Instructions: At what amount should the four desks appear in the
effect through November 2019, and the 2020 catalog is effective as of company’s December 31, 2019, inventory, assuming that the company
December 1, 2019. At December 31, 2019, the following finished has adopted a lower-of-FIFO-cost-or-net realizable value approach for
desks appear in the company’s inventory. valuation of inventories on an individual-item basis?

Finished Desks A B C D Finished Desks A B C D

2019 Catalog selling price € 450 € 480 € 900 € 1,050 2019 Catalog selling price € 450 € 480 € 900 € 1,050
FIFO cost per inventory list 12/31/19 470 450 830 960 FIFO cost per inventory list 12/31/19 470 450 830 960
Estimated cost to complete and sell 50 110 260 200 Estimated cost to complete and sell 50 110 260 200
2020 catalog selling price 500 540 900 1,200 2020 catalog selling price 500 540 900 1,200

Instructions: At what amount should the four desks appear in the Net Realizable Value € 450 € 430 € 640 € 1,000
Lower-of-Cost-or-NRV 450 430 640 960
company’s December 31, 2019, inventory, assuming that the company
has adopted a lower-of-FIFO-cost-or-net realizable value approach for
valuation of inventories on an individual-item basis?
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 LEARNING OBJECTIVE 2 LEARNING OBJECTIVE 5
Valuation Bases Identify other inventory
valuation issues.
Presentation and Analysis Explain how to report and
analyze inventory.

Net Realizable Value Presentation of Inventories

Departure from LCNRV rule may be justified in situations when Accounting standards require disclosure of:

 cost is difficult to determine, 1) Accounting policies adopted in measuring inventories,

including the cost formula used (weighted-average, FIFO).
 items are readily marketable at quoted market prices, and
2) Total carrying amount of inventories and the carrying
 units of product are interchangeable.
amount in classifications (merchandise, production supplies,
Two common situations in which NRV is the general rule: raw materials, work in progress, and finished goods).
 Agricultural assets 3) Carrying amount of inventories carried at fair value less
 Commodities held by broker-traders. costs to sell.

4) Amount of inventories recognized as an expense during the

period.
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Presentation and Analysis GLOBAL ACCOUNTING INSIGHTS

Presentation of Inventories LEARNING OBJECTIVE 6

Compare the accounting for inventories under IFRS and U.S. GAAP.
Accounting standards require disclosure of:
5) Amount of any write-down of inventories recognized as Inventories
an expense in the period and the amount of any reversal In most cases, IFRS and U.S. GAAP related to inventory are the same. The
of write-downs recognized as a reduction of expense in major differences are that IFRS prohibits the use of the LIFO cost flow
the period. assumption and records market in the LCNRV differently.

6) Circumstances or events that led to the reversal of a

write-down of inventories.

7) Carrying amount of inventories pledged as security for

liabilities, if any.

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 GLOBAL ACCOUNTING INSIGHTS GLOBAL ACCOUNTING INSIGHTS

Relevant Facts Relevant Facts

Following are the key similarities and differences between U.S. GAAP and Differences
IFRS related to inventories. • U.S. GAAP provides more detailed guidelines in inventory accounting. The
Similarities requirements for accounting for and reporting inventories are more
• U.S. GAAP and IFRS account for inventory acquisitions at historical cost principles-based under IFRS.
and evaluate inventory for lower-of-cost-or-net realizable value (market) • A major difference between U.S. GAAP and IFRS relates to the LIFO cost
subsequent to acquisition. flow assumption. U.S. GAAP permits the use of LIFO for inventory
• Who owns the goods—goods in transit, consigned goods, special sales valuation. IFRS prohibits its use. FIFO and average-cost are the only two
agreements—as well as the costs to include in inventory are essentially acceptable cost flow assumptions permitted under IFRS. Both sets of
accounted for the same under U.S. GAAP and IFRS. standards permit specific identification where appropriate.

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GLOBAL ACCOUNTING INSIGHTS

Relevant Facts
Differences
• In the lower-of-cost-or-market test for inventory valuation, U.S. GAAP
defines market as replacement cost subject to the constraints of net
realizable value (the ceiling) and net realizable value less a normal markup
(the floor). IFRS defines market as net realizable value and does not use a
ceiling or a floor to determine market.
• Under U.S. GAAP, if inventory is written down under the lower-of-cost-or-
market valuation, the new basis is now considered its cost. As a result, the
inventory may not be written up back to its original cost in a subsequent
period. Under IFRS, the write-down may be reversed in a subsequent
period up to the amount of the write-down. Both the write-down
and any subsequent reversal should be reported on the income statement.

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