Jean Y.
Elia
ACT312 – Advanced Accounting
Chapter 8 - Valuation of Inventories: A Cost-Basis Approach
Preview
Chapter 8 investigates the intricate aspects of inventory management, addressing various
inventory classifications, perpetual and periodic systems, and different cost flow assumptions
(FIFO, LIFO, and weighted average). It emphasizes the impact of inventory errors on financial
statements, illustrating how misstatements can affect key metrics like gross profit and net
income.
Inventory Issues
Inventory Definition
Inventories are assets a company holds for sale or use in production. They represent a major
current asset, especially in retail and manufacturing, and require precise description and
measurement.
Classifications
Merchandising Inventory Accounts
Merchandising companies, like Carrefour, buy ready-for-sale items. They maintain a single
"Inventory" account on financial statements to represent unsold units on hand.
Manufacturing Inventory Accounts
Manufacturers, such as Nissan, have three inventory types:
Raw Materials (unprocessed goods),
Work in Process (partially completed items), and
Finished Goods (completed but unsold items).
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Jean Y. Elia
ACT312 – Advanced Accounting
Inventory Reporting Differences
Merchandising and manufacturing companies differ in inventory reporting; manufacturing firms
have distinct accounts for various production stages, while merchandising firms have a unified
inventory account.
The diagram shows inventory cost flow: merchandising companies record "Cost of Goods
Purchased" directly as inventory. Manufacturing companies track costs across stages—Raw
Materials, Work in Process (adding labor and overhead), and Finished Goods—before
transferring to "Cost of Goods Sold."
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Jean Y. Elia
ACT312 – Advanced Accounting
Inventory Cost Flow
Beginning Inventory
+ Cost of Goods Purchased
= Cost of Goods Available for Sale
- Ending Inventory
= Cost of Goods Sold
Two types of systems for maintaining inventory records — perpetual system and periodic
system.
Perpetual System
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and allowances and purchase discounts
are credited to Inventory.
3. Cost of goods sold is debited and Inventory is credited for each sale.
4. Subsidiary records show quantity and cost of each type of inventory on hand.
The perpetual inventory system provides a continuous record of the balance in both the Inventory
and Cost of Goods Sold accounts.
Periodic System
1. Purchases of merchandise are debited to Purchases.
2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold
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Jean Y. Elia
ACT312 – Advanced Accounting
Application 1:
Fesmire Company had the following transactions during the current year.
Required: Record these transactions under both (a) Periodic, and (b) Perpetual
inventory systems.
When a company uses a perpetual inventory system and a difference exists between the perpetual
inventory balance and the physical inventory count, it needs a separate entry to adjust the
perpetual inventory account.
Application 2:
At the end of the reporting period, the perpetual inventory account reported an inventory balance
of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand.
Required: Record the necessary entry to write down the inventory.
Inventory Control
All companies must periodically verify inventory records through physical counts, weight, or
measurement, comparing these with detailed records. Conducting this inventory check near the
fiscal year’s end ensures accurate reporting of inventory quantities in annual financial
statements.
Goods and Costs Included in Inventory
Goods Included in Inventory
Inventory Recognition:
A company recognizes inventory and accounts payable when it controls the asset. For instance,
Lee Ltd. records Apple watches as inventory once control passes to it.
Control as a Key Factor:
Control is essential for recognizing purchases and sales. The IASB defines control as the ability
to direct use and obtain benefits, preventing others from accessing the asset.
Goods in Transit:
For goods in transit, control depends on legal title.
F.O.B. shipping point means that the buyer takes ownership of the goods as soon as they
are shipped.
F.O.B. destination means that the seller retains ownership and responsibility for the
goods until they reach the buyer's location.
Consigned Goods:
Under consignment, goods remain the consignor’s property until sold. The consignee holds
physical possession but not control, so inventory remains on the consignor's records.
Costs Included In Inventory
Product Costs
Costs directly connected with bringing the goods to the buyer’s place of business and converting
such goods to a salable condition.
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Jean Y. Elia
ACT312 – Advanced Accounting
Cost of purchase includes all of:
1. The purchase price.
2. Import duties and other taxes.
3. Transportation costs.
4. Handling costs directly related to the acquisition of the goods.
Period Costs
Costs that are indirectly related to the acquisition or production of goods.
Period costs such as
selling expenses and,
general and administrative expenses
are not included as part of inventory cost.
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.
Which Cost Flow Assumption to Adopt?
Companies often purchase inventory at various prices. When specific identification isn't feasible,
they should use cost flow assumptions like FIFO or average cost to value inventory. LIFO isn't
accepted under IASB because it can distort profit reporting and does not reflect the actual flow of
inventory. LIFO increases COGS, which lowers taxable income and reduces taxes owed.
Effect of Inventory Errors
Effects of Understated Ending Inventory
If Lenovo misstates its ending inventory, it results in understated inventory and retained
earnings. The cost of goods sold (COGS) is overstated, leading to a lower net income.
Consequences of Misstated Purchases
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Jean Y. Elia
ACT312 – Advanced Accounting
Bishop Company’s failure to record certain purchases results in understated inventory and
accounts payable.
Importance of Accurate Inventory Measurement
Proper inventory measurement is crucial for accurate financial reporting. Misstatements can lead
to significant discrepancies in net income and financial position, as seen in cases where
companies inflated inventory or deflated COGS, necessitating restatements.
Exercise 1:
The stock movement of the raw material M during March 2024:
01/03/2024: Stock 4,000 kg at an average cost of 100 LBP/kg.
04/03/2024: purchase 6 000 kg for 105 LBP/kg.
08/03/2024: utilization of 3 500 kg in the workshop.
12/03/2024: purchase 2,000 kg for a total price of 210 250 LBP.
20/03/2024: utilization of 4 500 kg in the workshop.
27/03/2024: utilization of 2 000 kg in the workshop.
30/03/2024: purchase 6 000 kg for 101 LBP/kg.
Required: Prepare the stock card for the raw material M according to:
a. The weighted average method;
b. FIFO; and
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Jean Y. Elia
ACT312 – Advanced Accounting
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Jean Y. Elia
ACT312 – Advanced Accounting
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Jean Y. Elia
ACT312 – Advanced Accounting