Chapter One

Inventories

By: Mekasha T.

Prepared by Mekasha Tsegaye

 Definition and Types of Inventories
• Inventories are assets consisting of goods owned and
held either for use in manufacturing products or as
products awaiting sale.
• Widely known:
»raw materials,
»work in process,
»finished goods, and
»merchandise inventories held by retailers

Prepared by Mekasha Tsegaye

 Inventory Classifications
1. Merchandise inventory
- goods on hand purchased by a retailer or a trading Co such
as an importer or exporter for resale
- goods acquired for resale are not physically altered by the
retailer or trading Co; the goods are in finished form when
they leave the manufacturing plant
- in some instances, however, FGs are acquired and then
further assembled in to other products
2. Manufacturing Inventory
- the combined inventories of a manufacturing entity consists
of :
Prepared by Mekasha Tsegaye
 Cont’d
A. Raw material inventory
- tangible goods purchased or obtained in other ways (e.g. by
mining) and on hand for direct use in the manufacture of
goods for sale.
- parts of subassemblies manufactured prior to use are
sometimes classified as raw materials inventory or
components parts inventory.
B. Work-in-process/Goods-in-progress inventory
- goods required further processing before completion and
sale.
- usually is valued at the sum of DM, DL, and allocated MOH
costs incurred to date.
Prepared by Mekasha Tsegaye
 Cont’d
C. Finished goods inventory
- manufactured items completed and waiting for sale
- is valued at the sum of DM, DML, and allocated MOH
costs
D. Manufacturing supplies inventory
- items on hand, such as lubrication oils for the
machinery, cleaning materials, and other items, that
make up on an insignificant part of the finished
product
3. Miscellaneous inventories - items such as office
supplies, janitorial supplies, and shopping supplies.
Prepared by Mekasha Tsegaye
 IFRS
[Link] 2 – Inventories represent:
▪ Assets held for sale in the ordinary course
of business,
▪ In the process of production for such sale
or
▪ In the form of material or supplies to be
consumed:
- in the production process, or
- in the rendering of services.

Prepared by Mekasha Tsegaye

 Cont’d
2. IAS 38 – Inventory may include intangible
assets that are being developed for resale, for
example, software.
3. IAS 40 – Inventory also includes properties
that have been purchased, or are being
developed, for resale.
[Link] 41 - Agricultural produce from the point of
harvest is classified as inventory.
Prepared by Mekasha Tsegaye
 Categories
» Raw Materials - are materials:
- which are actually used in the FG, and/or
- awaiting entry into the production process.
» Work In Progress - the inventory of partially
completed products.
» Finished Goods - completed manufactured goods that
have not yet been sold.
» Packaging Material - materials consumed for the
packaging of the FG; such as Sacks & Bags

Prepared by Mekasha Tsegaye

 Cont’d
» Spare Parts, Tools & Consumables - machine parts that
are used to replace obsolete or non-useful machine parts,
tools and consumables!
» Promotional & Advertising Materials
If the ff prerequisites are met, the promotional
materials can be recorded as inventory:
i. materials are not delivered to the end-consumer.
ii. materials are directly linked to sales transaction.
iii. materials have a significant value individually.
Prepared by Mekasha Tsegaye
 Exclusions
o The ff items shall be excluded from the inventories of the
Company:
- Goods sold and awaiting delivery.
- Goods delivered and awaiting billing.
- Non-returnable packaging containers, or stationery, when their
total value is not significant.
- Major spare parts and stand-by equipment when the
entity expects to use them for more than one period
(capitalized in fixed assets)
Prepared by Mekasha Tsegaye
 Error in reporting inventory
• An inventory error causes misstatements in:
- cost of goods sold,
- gross profit,
- net income,
- current assets, and
- equity.
• It also causes misstatement in the next period’s statement
b/c ending inventory of one period is the beg inventory of
the next.
• An error carried forward causes misstatement in the next
period’s cost of goods sold, gross profit, and net income

Prepared by Mekasha Tsegaye

 Cont’d
• Income statement effect:

• Balance sheet effect:

Prepared by Mekasha Tsegaye

 Cont’d
• N.B: Error in beginning inventory does not yield
misstatement in the end-of-period balance sheet, but
they do affect the current period’s income statement.

Prepared by Mekasha Tsegaye

 Effect of ending inventory on the
following period’s financial statements
• Illustration - 1
• The following amounts were reported in X Co’s F/Ss for three
consecutive fiscal year ended December 31.

Prepared by Mekasha Tsegaye

 Cont’d
• In making the physical counts of inventory, the
following errors were made:
- Inventory on December 31, 2000, understated by Br. 12,000
- Inventory on December 31, 2001, overstated by Br. 6,000
• Required:
- Determine the correct amount of the items listed
above.

Prepared by Mekasha Tsegaye

 Solution – corrected amounts
2000 2001 2002
a) Cost of merchandise sold:
Reported Br. 130,000Br. 154,000 Br. 140,000
Adjustment of
2000 error (12,000) 12,000 ------
2001 error ----- 6,000 (6,000)
Corrected Br. 118,000 Br. 172,000 Br. 134,000

Prepared by Mekasha Tsegaye

 Cont’d
b)Net income:
Reported Br. 40,000 Br. 50,000 Br. 42,000
Adjustment of
2000 error 12,000 (12,000) _
2001 error _ (6,000) 6,000
Corrected Br. 52,000 Br. 32,000 Br. 48,000

Prepared by Mekasha Tsegaye

 Cont’d
c) Total current assets:
Reported Br. 210,000 Br. 230,000 Br. 200,000
Adjustment of
2000 error 12,000 _ _
2001 error _ (6,000) _
Corrected Br. 222,000 Br. 224,000 Br. 200,000

Prepared by Mekasha Tsegaye

 Cont’d
d) Owner’s equity:
Reported Br. 234,000 Br. 260,000 Br. 224,000
Adjustment of
2000 error 12,000 _ _
2001 error _ (6,000) _
Corrected Br. 246,000 Br. 254,000 Br. 224,000

Prepared by Mekasha Tsegaye

 Important points!`
NI of an entity depends directly on the valuation of ending
inventory
A merchandising Co must be sure that it has properly valued
its ending inventory. If the ending inventory is overstated:
- CGS will be understated,
- Gross margin and NI will be overstated
- CAs, TAs, and OE’s capital will be overstated

Prepared by Mekasha Tsegaye

 …Important points!
when a Co misstates its EI in the current year, the Co carries
forward that misstatement in to the next year.
this misstatement occurs b/c the ending inventory amount
of the current year is the beg inventory amount for the next
year.
an error in one’s period ending inventory automatically
causes an error in the opposite directions in the next period.
after two years, however, the error will “wash out” and
assets and owner’s capital will be properly stated.

Prepared by Mekasha Tsegaye

 Identification of Inventory Quantitates and Costs
»Determining Inventory Quantities
• Physical Inventory taken for two reasons:
- Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to waste, shoplifting, or
employee theft.
- Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.
Prepared by Mekasha Tsegaye
 … determining inventory quantities

• TAKING A PHYSICAL INVENTORY:

- Involves counting, weighing, or measuring each kind of inventory on

hand.
- Companies often “take inventory”

◆when the business is closed or business is slow.

◆at the end of the accounting period.

Prepared by Mekasha Tsegaye

 Cont’d
• When all merchandise purchased or manufactured during
a period is sold during the same period, ending inventory
remains the same as beginning inventory,
- and computation of CGS is relatively simple.
- however, such a situation rarely occurs.
- normally, a timing difference exists b/n the dates that the
merchandise is available for sale and its actual sale,
causing a change in inventory
balances.
Prepared by Mekasha Tsegaye
 Cont’d
• Thus, the CGAS during a period must be allocated b/n
- cost of goods actually sold during that period, and
- the cost of items remaining on hands
• In other words, costs must be allocated b/n amounts that
have been consumed (are to be reported on the I/S) and
amounts that represent future benefits (are to be reported
on the B/S)

Prepared by Mekasha Tsegaye

 Cont’d
• Cost of goods available for sale (CGAS)?
- need for proper allocation of costs b/n goods sold and
inventory items leads to problems in identification of:
1. physical quantities of inventory on hand.
2. types of items that should be included in inventory.
3. types of costs that should be properly included in
inventory, and
4. appropriate costs flow assumption to be used.

Prepared by Mekasha Tsegaye

 Items Identified as an Inventory
• all goods the Co owns at the inventory date should be
included, regardless of their location
• at the end of an accounting period, a business may
ohold goods that it doesn’t own or
oowns goods that it doesn’t hold (goods in transit and consignee)
• therefore, care is necessary to identify the goods properly
includable in an inventory.

Prepared by Mekasha Tsegaye

 Cont’d
• Timing errors in the recording of purchase and sales:
- When the CGAS during a specific accounting period is being
accumulated, decisions must be made as to whether certain
goods become the property of the purchaser in the current
period or in the succeeding period.
- If acquisitions of goods are not recorded in the period in
which they become the property of the purchaser,
error in the F/S will result.

Prepared by Mekasha Tsegaye

 Cont’d
• Three common types of timing errors in recording inventory
purchases may occur. The error and their effects on F/Ss are:
1. A purchase is recorded properly, but goods are not
included in the ending inventories….result is to understate
CA and NI
2. A purchase is not recorded, but goods are included in the
ending inventories….result is to state the assets properly
but to understate current liabilities and to overstate net
income

Prepared by Mekasha Tsegaye

 Cont’d
3. A purchase is not recorded, and goods are not
included in the ending inventories…. Net income in this
case unaffected because both purchase and ending
inventories are understated by the same amount, but
both current assets and current liabilities are
understated

Prepared by Mekasha Tsegaye

 Goods in transit
• Merchandise in transit b/n a buyer and seller should be
included in the inventory cost calculation of the accounting
entity that has legal title to the merchandise.
• Legal title is determined by
- all circumstances surrounding the sale and purchase and
- agreement of both parties to the transactions
• A primary consideration is whether the merchandise is
shipped F.O.B destination or F.O.B Shipping point.

Prepared by Mekasha Tsegaye

 Cont’d
• F.O.B destination
- a legal title is held by the seller until the merchandise is
delivered to the buyer by the common carrier
(Transportation Company).
- the seller does not record a sale and receivables and
- the buyer does not record a purchase and payable until the
point.

Prepared by Mekasha Tsegaye

 Cont’d
• F.O.B Shipping point
- a legal title passes from the seller to the buyer when the
merchandise is transferred to the common carrier at the
shipping point.
- the seller records a sale, and the buyer records a purchase
otransportation charges:
--- expense of the seller - F.O.B destination.
--- expense of the buyer - F.O.B shipping point.

Prepared by Mekasha Tsegaye

 Goods out on consignment
• Goods shipped on consignment basis are included in the
inventory of the consignor until sold.
- the consignor retains legal titles and reports such inventory
items as the sum of their cost plus handling and
transportation charges to transfer the goods to the
consignee.
- consigned goods are not included in the inventory of the
consignee even though they are located on its premises.

Prepared by Mekasha Tsegaye

 Cont’d
- the consignee is obliged to exercises due care in protecting
the merchandise from damage, theft, and to report promptly
to the consignor any sales to third parties.
- up on notification of sale,
◙the consignor removes the merchandise from its inventory
account and
◙records a sale and receipts of cash or receivable.

Prepared by Mekasha Tsegaye

 Cont’d
• Merchandise of others held in storage is reported properly
as inventory of the owner, not as inventory of the storage
Co/agent.
• Conversely, merchandise sold on an installment basis
normally is excluded from the inventory of the seller, even
though legal tittles may not pass until the goods are fully
paid for the buyer.

Prepared by Mekasha Tsegaye

 Cont’d
• An installment sale is treated for accounting purpose in the
same manner as other regular sales.
• The cost of the merchandise is removed from the inventory
of the seller, and profits are recognized during the period of
the sale.

Prepared by Mekasha Tsegaye

 Note: determining inventory quantities
DETERMINING OWNERSHIP OF GOODS
GOODS IN TRANSIT

◆ Purchased goods not yet received.

◆ Sold goods not yet delivered.

Goods in transit should be included in the inventory of

the company that has legal title to the goods. Legal title
is determined by the terms of sale.

6-38
 DETERMINING OWNERSHIP OF GOODS

GOODS IN TRANSIT

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until the
goods reach the buyer.

6-39
 Determining Ownership of Goods

CONSIGNED GOODS
To hold the goods of other parties and try to sell the goods for
them for a fee, but without taking ownership of the goods.

Many car, boat, and antique dealers sell goods on consignment,

why?

6-40
 Sum-up!

Inventories are recognized from the date that the

entity has/takes the risks and rewards of
ownership of the inventory!
Items owned by an entity that are held on
consignment at another entity’s premises are
included as inventory of the consignor!

Prepared by Mekasha Tsegaye

Determining appropriate costs in the inventory
• After an item has been identified as properly includable in the
inventory, its appropriate cost must be determined.
• General consideration - period costs Vs product costs
• Cost - the sum of applicable expenditure and charges directly or
indirectly incurred in bringing article to its existing condition and
location.
• Product/inventorable costs
- include the purchase price of merchandise to be resold, purchase
taxes, freight charges, and/or manufacturing cost (such as direct
material, direct labor, and factory overhead), less trade discount,
rebates and subsidies

Prepared by Mekasha Tsegaye

 Cont’d
• Period costs
- include expenses that accrue with the passage of time
(interest and rent), and costs that can not be assumed to
represent future benefits to the enterprise.
- such costs are charged to expenses of the fiscal period in
which they are incurred.

Prepared by Mekasha Tsegaye

 Cont’d
- even though general and administrative costs may be
indirectly related to bringing an inventory items to its
existing condition and location, are classified as period costs
unless they are clearly related to production.
- finally, selling costs are not inventorable and should not be
included in inventory costs, b/c they are not related to
productions

Prepared by Mekasha Tsegaye

 So, cost of inventories includes…
o All costs of purchase (purchase price, transport,
handling costs, and taxes that are not
recoverable...),
o Costs of Conversion, &
o Other costs incurred in bringing the inventories
to their present condition and location.

Prepared by Mekasha Tsegaye

 Cont’d
▪ Example 1:
- A retailer imported goods at 130 Birr, including 20 Birr non-
refundable import duties and 10 Birr refundable purchase taxes.
- The risks and rewards of ownership of the imported goods were
transferred to the retailer upon collection of the goods from the port
(seller’s warehouse). The retailer was required to pay for the goods
upon collection.
- The retailer incurred 5 Birr to transport the goods to its retail outlet
and a further 2 Birr in delivering the goods to its customer. Further,
selling costs of 3 Birr were incurred in selling the goods.
- What is the cost of purchase?
Prepared by Mekasha Tsegaye
 Cont’d
• Example 1: Answer:
 The cost of purchase is 125 Birr!
- The 100 birr purchase price (130 less 20 import
duties & less 10 purchase taxes),
- The non-refundable import duties (20 Birr) &
- The transport to the retail outlet (5 Birr).

Prepared by Mekasha Tsegaye

 Cont’d
▪ Example 2
- A retailer buys a good priced at 500 Birr per unit.
- However, the supplier awards the retailer a 20 %
discount on orders of 100 units or more. The
retailer buys 100 units in a single order.
- What is the cost of inventory?

Prepared by Mekasha Tsegaye

 Cont’d
• Example 2: Answer:
• The retailer measures the cost of the inventory at
40,000 Birr!
• [I.e. 100 units x (500 Birr list Price less 20% of 500 Birr
volume discount)]

Prepared by Mekasha Tsegaye

 Cost Flow Assumptions
• Cost flow refers to the inflow of costs when goods are
purchased or manufactured and the out flow of costs when
goods are sold.
• the cost remaining in the inventories is the difference b/n the
inflow and out flow of costs.
• After identification is made as to:
1. which items are to be included in the inventory,
2. the types of cost to be included, and
3. the physical quantities on hand, an appropriate unit cost of
inventory items must be determined.
Prepared by Mekasha Tsegaye
 Cont’d
to assign a dollar amounts to ending inventory:
= unit cost*number of units on hand at
the end of a period
to record cost of goods sold:
= unit cost*the number of units sold (or
issued to manufacturing) during a
period or
CGS = CGAS - ending inventory
Prepared by Mekasha Tsegaye
 Cont’d
• If all inventory items were purchased at the same unit
price or manufactured for the same unit cost,
identification of unit cost would be simplified
• However, under typical condition of a changing unit
price, an assumed cost flow of cost must be
established by selecting a particular inventory “cost
flow” method

Prepared by Mekasha Tsegaye

 Cont’d
• Note
- An enterprise having several components of inventory may
find it appropriate to assume one particular cost flow for one
component of inventory and another cost flow for a different
component.
- Thus, FIFO may be used for costing certain portion of an
inventory and Average cost for other portions.
- But, once a particular cost flow has been established for a
certain component, that assumed be used consistently from
period to period.

Prepared by Mekasha Tsegaye

 Cont’d
• The most widely used methods of inventory costing
are:
1. Specific Identification
2. First-In, First-Out [FIFO] and
3. Average cost

Prepared by Mekasha Tsegaye

 Illustration
• Merchandise Transactions during January

• As shown in illustration1, 6,000 units of merchandise are available for sale

during January; 3,700 units are issued (1200+2500) and 2,300 units remain
in inventory (6,000-3,700).

Prepared by Mekasha Tsegaye

 1. Specific Identification
• It calls for identifying each items sold and each item
in inventory.
- the cost of each item sold and each item remaining in
inventory is identified specifically by its purchase price
- Note:
o the costs of the specific items sold are included in the
CGS and
o the costs of the specific items on hand are included in
the inventory

Prepared by Mekasha Tsegaye

 Cont’d
• From the previous illustration, assume the ff for the specific
identification method.
- of the January 13 issues of 1,200 units, 500 issues were
taken from the January 1, inventory (at Br 3 cost per unit)
and 700 units were taken from the January 11 (birr
3.20/unit) purchase.
- for January 27 issues of 2,500 units, 600 units were taken
from the January 1 inventory , 200 units were taken from
January 11 purchase, and 1,700 units were taken from the
January 18 purchase.
- thus, cost of merchandise issued was Br 11,960 and ending
inventory was Br 7,440 determined as follow.
Prepared by Mekasha Tsegaye
COST OF ISSUES - SPECIFIC IDENTIFICATION

Prepared by Mekasha Tsegaye

Cost of Ending Inventory - Specific Identification

Prepared by Mekasha Tsegaye

 Cont’d
• If the amount of the ending inventory had been
computed first, the cost of issue could have been
found as remainder:
Merchandise available for sale---Br 19,400
Cost of inventory (above) 7,440
Br 11,960
• Likewise, if the cost of issues had been computed first,
the cost of the ending inventory could have been
found as:

Prepared by Mekasha Tsegaye

 2. First-in, First-out (FIFO) Method
• Assumes that the costs of the first goods purchased
are the first costs charged to CGS, when the Co
actually sells the goods.
• In some Cos, thus First-In (bought) must be the first
units “out” (sold) to avoid large loss from spoilage -
such items as fresh dairy products, fruits, and vegetables should
be sold on a FIFO basis.

Prepared by Mekasha Tsegaye

 Cont’d
- FIFO flow corresponds with the actual physical flow
of goods.
- the older units to be the first units sold and the
newer units to be still on hand, the ending inventory
consists of the most recent purchases.
• Exercise; do the above problems assuming FIFO.

Prepared by Mekasha Tsegaye

 Cont’d
• CGS
= 2000U*3.00 + 1000U*3.20 + 700U*3.4
= Birr 11,580
• Cost of Ending Inventory
= 2300U*3.40
= Birr 7,820

Prepared by Mekasha Tsegaye

 3. Weighted-average method
• It is based on the assumption that all goods are commingled and
that no particular batch of goods is retained in the inventories.
- inventories are valued on the basis of average prices
• When the perpetual inventory system is used, the weighted –
average method gives the result of a moving-weighted average.
• Under the perpetual system, a new weighted – average unit
cost is computed after each purchase; and for this reason is
known as the weighted average unit cost.
• Exercise; solve the above problems using weighted-average
method.
Prepared by Mekasha Tsegaye
 Cont’d
• Average Cost
= Birr19,400/6,000U
= Birr3.233/Unit
• CGS
= 3,700U*Birr3.233/U
= Birr11,962
• Cost of Ending Inventory
= 2,300U*Birr3.233/U
= Birr7,436

Prepared by Mekasha Tsegaye

Inflation and Inventory Costing Method

Prepared by Mekasha Tsegaye

 Cont’d
• At a time of inflation, most portions of the GPs is from sale of the inventory
is attributed to inflation effects, and are referred as inventory profits or
illusory profits.
• The major criticism in FIFO method is that it has a tendency to maximize
the effect of inflation and defilation trends on amounts reported as gross
profit.
• But the advantage of FIFO method is that the merchandise reported in
inventory on the B/S is usually at about the same as the current
replacement cost.
• Average cost method compromises between FIFO and LIFO. The effect of
price trend is averaged, both in CGS or cost of inventory.
• Weather in deflation or inflation period, average costing method provides
the same cost. Prepared by Mekasha Tsegaye
 Inventory Costing Methods under a
Perpetual Inventory System
»When identical units of an item are purchased at different
unit costs, an inventory cost flow method must be used.
»This is true regardless of whether the perpetual or periodic
inventory system is used

Prepared by Mekasha Tsegaye

 Illustration
• Data for Item 127B is shown below:

Prepared by Mekasha Tsegaye

 1. First-In, First-Out Method
• In FIFO method, costs are included in CGS/CMS in the order in which they
were purchased.
- this is often the same as the physical flow of the merchandise
- the oldest products (earliest purchases) are sold first
• The journal entries and the subsidiary inventory ledger for Item 127B
1. The beginning balance on January 1 is Br 2,000 (100 units at a unit cost
of Br 20).
2. On January 4, 70 units were sold at a price of Br 30 each for sales of Br
2,100 (70units × Br 30). The cost of merchandise sold is Br 1,400 (70
units at a unit cost of Br 20). After the sale, there remains Br 600 of
inventory (30 units at a unit cost of Br 20).

Prepared by Mekasha Tsegaye

 Cont’d
3. On January 10, Br 1,680 is purchased (80 units at a unit cost of Br
21). After the purchase, the inventory is reported on two lines, Br
600 (30 units at a unit cost of Br 20) from the beginning inventory
and Br 1,680 (80 units at a unit cost of Br 21) from the January 10
purchase.
4. On January 22, 40 units are sold at a price of Br 30 each for sales
of Br 1,200 (40 units × Br 30). Using FIFO, the cost of merchandise
sold of Br 810 consists of Br 600 (30 units at a unit cost of Br20)
from the beginning inventory plus Br 210 (10 units at a unit cost of
Br 21) from the January 10 purchase. After the sale, there remains
Br 1,470 of inventory (70 units at a unit cost of Br21) from the
January 10 purchase.
Prepared by Mekasha Tsegaye
 Cont’d
5. On Jan 28; 20 units are sold at a price of birr 32 each for sales of Br 640
(20U*birr32). Using FIFO, the cost of merchandise sold is Br420 (20U*birr21)
6. On Jan 30, Br 2,200 is purchased (100 units at a unit cost of Br 22).
- the January 28 sale and January 30 purchase are recorded in a similar
manner.
6. The ending balance on January 31 is Br 3,250. This balance is made up of
two layers of inventory as follows:

Prepared by Mekasha Tsegaye

Cont’d

Prepared by Mekasha Tsegaye

Perpetual Inventory Account (FIFO)

Prepared by Mekasha Tsegaye

 2. Average Cost Method
• In this method, an average unit cost for each item is
computed each time a purchase is made.
• This unit cost is then used to determine the cost of each sale
until another purchase is made and a new average is
computed.
• This averaging technique is called a moving average.
• The average cost method is rarely used in a perpetual
inventory system.

Prepared by Mekasha Tsegaye

…Illustration

Prepared by Mekasha Tsegaye

Valuation of Inventory at other than Cost
• LOWER-OF-COST-OR-NET REALIZABLE VALUE (LCNRV)
- Inventories are recorded at their cost
- However, if inventory declines in value below its original cost, a major
departure from the historical cost principle occurs
- Whatever the reason for a decline
• obsolescence,
• price-level changes, or
• damaged goods
… a Co should write down the inventory to NRV to report this loss.
- A Co abandons the historical cost principle when the future utility
(revenue-producing ability) of the asset drops below its original cost
Prepared by Mekasha Tsegaye
 Cont’d
• Net Realizable Value (NRV):
- cost is the acquisition price of inventory computed using
historical cost-based methods - specific identification,
average cost, or FIFO
- the term NRV refers to the net amount that a Co expects to
realize from the sale of inventory.
- specifically, NRV is the estimated selling price in the normal
course of business less estimated costs to complete and to
make a sale.
- NRV = ESP – Cost of completion and sale
Prepared by Mekasha Tsegaye
 Important Issues!
• When the value of inventory is lower than its cost
- companies must “write down” the inventory to its net
realizable value.

• Net realizable value: amount that a company expects

to realize (receive from the sale of inventory).

Prepared by Mekasha Tsegaye

 important issues…
• Estimates of NRV of inventories:
- are based on the most reliable evidence available at
the time estimates are made of the amount on which
the inventories are expected to realize.
- when measuring the NRV for inventories
invoiced in the foreign currency the currency in
which the inventories will be sold is used!

Prepared by Mekasha Tsegaye

 important issues…
• Take into consideration the purpose for which the
inventories are held:
- for example, the NRV of inventory held to satisfy firm sales or
service contract is based on the contract price.
- if quantities specified in the contract are for less than the
inventory quantities held, the NRV of excess is based on
general selling prices.

Prepared by Mekasha Tsegaye

 Write Down of Inventories to NRV…
• Inventories are written down when the NRV of the
inventories is less than the cost of the inventories.
• Inventories are not to be carried in excess of amounts
expected to be realized from their sale or use!

Prepared by Mekasha Tsegaye

 important issues…
• The write down amount:
- is the d/c b/n the cost of the inventories and the NRV (the
present NPV) &
- is expensed immediately in profit or loss in the period the
write-down occurs
- RMs & other Supplies held for use in the production
of inventories are not written down below cost, if
 their finished products are expected to be sold
at or above cost!
Prepared by Mekasha Tsegaye
 Adjust inventory to Lower of Cost or NRV…
• To reduce the value of inventory to a NRV that is
lower than the cost recorded in the company records:

Loss on Inventory Valuation xx

Inventory xx
(Adjusting entry to write down cost to NRV)

Prepared by Mekasha Tsegaye

 Reversal of Write Down …
• When subsequent assessment of NRV indicates that
the circumstances that led to the previous write down
of inventories below cost no longer exist, the previous
write-down of inventories is reversed.
Inventory xx
Loss on Inventory Valuation xx
(Reversing entry of inventory valuation)

Prepared by Mekasha Tsegaye

 Illustration
• Assume that X Co 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. X Co’s net
realizable value is computed as follows.

Prepared by Mekasha Tsegaye

 Cont’d
• X Co reports:
- inventory on its SFP (B/S) at $750
- a loss on Inventory Write-Down in its I/S, $200 ($950 - $750).
• A departure from cost is justified b/c inventories should not
be reported at amounts higher than their expected
realization from sale or use
- In addition, a Co should charge the loss of utility against
revenues in the period in which the loss occurs, not in the
period of sale
• Cos therefore report their inventories at the lower-of-cost-
or-net realizable value (LCNRV) at each reporting date.
Prepared by Mekasha Tsegaye
 Illustration of LCNRV
• As indicated, a Co values inventory at LCNRV.
• A Co estimates NRV based on the most reliable evidence of
the inventories’ realizable amounts (expected selling price,
expected costs of completion, and expected costs to sell).
• As indicated, the final inventory value of $384,000 equals
the sum of the LCNRV for each of the inventory items.
• That is, Jinn-Feng applies the LCNRV rule to each individual
type of food.

Prepared by Mekasha Tsegaye

 Methods of Applying LCNRV
• Assume Jinn-Feng applied the LCNRV rule to each individual type of food.
However, Cos may apply the LCNRV rule to a group of similar or related
items, or to the total of the inventory. For example, in the textile industry,
it may not be possible to determine selling price for each textile
individually, and therefore it may be necessary to perform the NRV
assessment on all textiles that will be used to produce clothing for a
particular season.
• If a Co follows a similar-or-related-items or total-inventory approach in
determining LCNRV, increases in market prices tend to offset decreases in
market prices.
• To illustrate, assume that Jinn-Feng Foods separates its food products into
two major groups, frozen and canned, as shown below
Prepared by Mekasha Tsegaye
Alternative Applications of LCNRV

Prepared by Mekasha Tsegaye

 Cont’d
• If Jinn-Feng applied the LCNRV rule to:
oindividual items, the amount of inventory is ¥384,000.
omajor groups, it jumps to ¥394,000.
othe total inventory, it totals ¥415,000.
• Why this difference? When a Co uses a major group or total-
inventory approach, NRVs higher than cost offset NRVs lower
than cost.
• For Jinn-Feng, using the similar-or-related-items approach
partially offsets the high NRV for spinach. Using the total-
inventory approach totally offsets it

Prepared by Mekasha Tsegaye

 Cont’d
• In most situations, Cos price inventory on an item-by-item
basis. In fact, tax rules in some countries require that Cos use
an individual-item basis barring practical difficulties. In
addition, the individual-item approach gives the lowest
valuation for SFP purposes.
• In some cases, a Co prices inventory on a total-inventory
basis when it offers only one end product (comprised of
many different raw materials). If it produces several end
products, a Co might use a similar-or-related-items approach
instead. Whichever method a Co selects, it should apply the
method consistently from one period to another.

Prepared by Mekasha Tsegaye

Recording Net Realizable Value (NRV)
Instead of Cost
• One of the two methods may be used to record the income
effect of valuing inventory at NRV.
• Method-1- the cost-of-goods-sold method, debits CGS for
the write-down of the inventory to NRV. As a result, the Co
does not report a loss in the I/S b/c the CGS already includes
the amount of the loss.
• Method-2- the loss method, debits a loss account for the
write-down of the inventory to NRV.

Prepared by Mekasha Tsegaye

 Cont’d
•We use the following inventory data for Ricardo Co to illustrate
entries under both methods.

Cost of goods sold (before adjustment) $ 108,000

Ending inventory (at cost) 82,000
Ending inventory (at net realizable value) 70,000

• The following entries show the entries for both the CGS and
loss methods, assuming the use of a perpetual inventory
system

Prepared by Mekasha Tsegaye

 Cont’d

The cost-of-goods-sold method buries the loss in the CGS account

The loss method, by identifying the loss due to the write-down,
shows the loss separate from CGS in the income statement

Prepared by Mekasha Tsegaye

Presentation of Merchandise inventory
in the balance sheet
• Merchandise inventory is usually reported next to
receivable.
• Both the method of determining the method of
identifying the cost (Cost or Lower of Cost) and
inventory method (FIFO, Average) should be stated
either in parenthesis in the balance sheet itself or we
could attach a note to the financial statement.

Prepared by Mekasha Tsegaye

 Cont’d
Afro – Arts Company
Balance Sheet
December 31, 2002

Prepared by Mekasha Tsegaye

 Special Valuation Situations
• For the most part, Cos record inventory at LCNRV
• However, there are some situations in which Cos depart
from the LCNRV rule.
- such treatment may be justified in situations when
… cost is difficult to determine,
…the items are readily marketable at quoted market
prices, and
…units of product are interchangeable.
Prepared by Mekasha Tsegaye
 … Special Valuation Situations
• There are two common situations in which NRV is the general rule
for valuing inventory:
- Agricultural assets (including biological assets and agricultural
produce).
- Commodities held by broker-traders.
• In this section however, we only illustrate the case of agricultural
assets only.

Prepared by Mekasha Tsegaye

 AGRICULTURAL INVENTORY
• Under IFRS, NRV measurement is used for inventory when the
inventory is related to agricultural activity.
• In general, agricultural activity results in two types of agricultural
assets:
1. biological assets or
2. agricultural produce at the point of harvest.
• A biological asset (classified as a non-current asset) is a living
animal or plant, such as sheep, cows, fruit trees, or cotton plants.
• Agricultural produce is the harvested product of a biological asset,
such as wool from a sheep, milk from a dairy cow, picked fruit from
a fruit tree, or cotton from a cotton plant.
Prepared by Mekasha Tsegaye
 Cont’d
•The accounting for these assets is as follows.
• Biological assets are measured on initial recognition and at the
end of each reporting period at fair value less costs to sell (NRV).
• Cos record a gain or loss due to changes in the NRV of biological
assets in income when it arises.
- Agricultural produce are measured at fair value less costs to sell
(NRV) at the point of harvest. Once harvested, the NRV of the
agricultural produce becomes its cost, and this asset is accounted
for similar to other inventories held for sale in the normal course
of business.

Prepared by Mekasha Tsegaye

 Illustration of Agricultural Accounting
at NRV
• To illustrate the accounting at NRV for agricultural assets, assume that
Bancroft Dairy produces milk for sale to local cheese-makers. Bancroft
began operations on January 1, 2016, by purchasing 420 milking cows
for $460,000. Bancroft provides the following information related to
the milking cows.

$460,000

$36,000

Prepared by Mekasha Tsegaye

 Cont’d
• As indicated, the carrying value of the milking cows
increased during the month. Part of the change is due to
changes in market prices (less costs to sell) for milking cows
»The change in market price may also be affected by
growth—the increase in value as the cows mature and
develop increased milking capacity.
»At the same time, as mature cows are milked, their milking
capacity declines (fair value decrease due to harvest).

Prepared by Mekasha Tsegaye

 Cont’d
• Bancroft makes the following entry to record the change in carrying
value of the milking cows.
Biological Asset (milking cows) (€493,800 - €460,000) ….. 33,800
Unrealized Holding Gain or Loss—Income ……………. 33,800
• As a result of this entry, Bancroft’s SFP (B/S) reports Biological Asset
(milking cows) as a non-current asset at fair value less costs to sell
(NRV).
• In addition, the unrealized gains and losses are reported as “Other
income and expense” on the I/S.

Prepared by Mekasha Tsegaye

 Cont’d
• In subsequent periods at each reporting date, Bancroft continues to
report Biological Asset at NRV and records any related unrealized
gains or losses in income. B/c there is a ready market for the
biological assets (milking cows), valuation at NRV provides more
relevant information about these assets.
• In addition to recording the change in the biological asset, Bancroft
makes the following summary entry to record the milk harvested for
the month of January.
Inventory (milk) ………… 36,000
Unrealized Holding Gain or Loss—Income …. 36,000

Prepared by Mekasha Tsegaye

 Cont’d
• The milk inventory is recorded at NRV at the time it is
harvested and Unrealized Holding Gain or Loss—Income is
recognized in income.
• As with the biological assets, NRV is considered the most
relevant for purposes of valuation at harvest. What happens
to the milk inventory that Bancroft recorded upon harvesting
the milk from the cows?
• Assuming the milk harvested in January was sold to a local
cheese-maker for €38,500, Bancroft records the sale as
follows.

Prepared by Mekasha Tsegaye

 Cont’d
Cash ………….……………38,500
Cost of Goods Sold …36,000
Inventory (milk) ………. 36,000
Sales Revenue …..……… 38,500
• Thus, once harvested, the NRV of the harvested milk
becomes its cost, and the milk is accounted for similar
to other inventories held for sale in the normal course
of business.

Prepared by Mekasha Tsegaye

 Cont’d
• A final note:
- Some animals or plants may not be considered biological
assets but would be classified and accounted for as other
types of assets (not at NRV).
- For example:
- a pet shop may hold an inventory of dogs purchased from
breeders that it then sells. B/c the pet shop is not breeding
the dogs, these dogs are not considered biological assets. As
a result, the dogs are accounted for as inventory held for sale
(at LCNRV).
Prepared by Mekasha Tsegaye
 Estimating inventory cost
•A Co using periodic inventory procedures may wish to estimate its inventory
for any of the following reasons.
✓ To obtain an inventory cost for use monthly or quarterly F/S without taking
physical inventory. The effort taking a physical inventory can be very
expensive and disrupts normal business operations.
✓ To compare with physical inventories to determine whether shortage exist.
✓ To determine the amount recoverable from an insurance Co when fires
has destroyed inventory or the inventory has been stolen.
•There are two widely used method of estimating inventories
1. The gross profit method and
2. The retail inventory method.

Prepared by Mekasha Tsegaye

 1. Gross Profit (Margin) Method
• It is one method of estimating an inventory when a Co has not taken a
physical inventory. The steps in calculating ending inventory under the
gross margin method are:
- Estimate gross margin (based on net sales) using the same gross margin
rate experienced in prior accounting periods.
- Determine estimated CGS by deducting estimated gross margin from net
sales.
- Determine estimated ending inventory by deducting estimated CGS from
CGAS.
• Thus, the gross margin method estimates ending inventory by deducting
estimated CGS from CGAS.

Prepared by Mekasha Tsegaye

 Example
• Assume that the inventory on January 01 is Br 57,000.00, that net
purchases during the month are Br 180,000.00, that net sales during
the month are Br 250,000.00, and finally that the gross profit is
estimated to be 30% of net sales. The inventory on January 31 may be
estimated as follows:

Prepared by Mekasha Tsegaye

 Cont’d
• Inventories estimated in this manner are useful in preparing interim
statements, and is also useful in establishing an estimate of the cost
of merchandise destroyed by fire or other disaster.
• Example 1: The merchandise inventory was destroyed by Fire on July
20. The following data were obtained from the accounting records.
- January 1 Merchandise Inventory Br 172,250
- January 1-July 20 Purchase (net) 812,250
Sales (net) 1,080,000
Estimated gross profit 35%
• Estimate the cost of merchandise destroyed
Prepared by Mekasha Tsegaye
 2. Retail Method of Inventory
Estimation
• A retail method of inventory estimation is based on the r/ship of the
cost of merchandise available for sale to the retail price of the same
merchandise.
• The retail price of all merchandise acquired is accumulated in
supplementary records, and the inventory at retail is identified by
deducting the sales at retail price form retail price of the goods
available for sale during the period.
• The procedures to estimate the cost of inventory are discussed as
follows:
- 1st: Determine merchandise available for sale at both cost and retail prices
- 2nd: Determine cost to retail ratio

Prepared by Mekasha Tsegaye

Cont’d

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Example

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 Cont’d
• This method is used mostly by department stores. Its main
advantage is it will provide inventory figure for use in
preparing interim statements (With in the accounting period
statement).
• This method could also be used in periodic inventory system
to identify the cost of inventory. This is done, when physical
inventory is done, inventories will be recorded at their retail
price and to convert these inventories stated at retail we will
multiply it by the cost %age.
Prepared by Mekasha Tsegaye
 Exercise
• 1. Consider the following data

• 2. On the basis of the following data, estimate the cost of the

merchandise inventory at April 30 by retail method.

Prepared by Mekasha Tsegaye