Intermediate Financial Accounting-I – Acfn 211

CHAPTER 5
INVENTORIES
Nature and 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.
Classification
Merchandising Company
 One inventory account.
 Purchase merchandise in a form ready for sale.
Manufacturing Company
Three accounts
 Raw Materials
 Work in Process
 Finished Goods
Goods and Costs Included an Inventory
Goods Included in Inventory
A company recognizes inventory and accounts payable at the time it controls the asset. Passage
of title is often used to determine control because the rights and obligations are established
legally.
Goods in Transit
Example: LG (KOR) determines ownership by applying the “passage of title” rule.
 If a supplier ships goods to LG f.o.b. shipping point, title passes to LG when the
supplier delivers the goods to the common carrier, who acts as an agent for LG.
 If the supplier ships the goods f.o.b. destination, title passes to LG only when it
receives the goods from the common carrier.
“Shipping point” and “destination” are often designated by a particular location, for example,
f.o.b. Seoul.
Consigned Goods
Example: Williams Art Gallery (the consignor) ships various art merchandise to Sotheby’s
Holdings (USA) (the consignee), who acts as Williams’ agent in selling the consigned goods.

1
 Intermediate Financial Accounting-I – Acfn 211

 Sotheby’s agrees to accept the goods without any liability, except to exercise due
care and reasonable protection from loss or damage, until it sells the goods to a
third party.
 When Sotheby’s sells the goods, it remits the revenue, less a selling commission
and expenses incurred, to Williams.
Goods out on consignment remain the property of the consignor (Williams).
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.
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 Assumptions to Adopt?
Cost Flow Methods
 Specific Identification
or
 Two cost flow assumptions
► First-in, First-out (FIFO) or
► Average Cost

2
 Intermediate Financial Accounting-I – Acfn 211

To illustrate the cost flow methods, assume that Call-Mart SpA had the following transactions in
its first month of operations.

Calculate Goods Available for Sale

Beginning inventory (2,000 x €4) € 8,000
Purchases:
6,000 x €4.40 26,400
2,000 x €4.75 9,500
Goods available for sale €43,900
Specific Identification
 Method may be used only in instances where it is practical to separate physically the
different purchases made. Cost 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
Illustration: Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units from the March 2
purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Compute
the amount of ending inventory and cost of goods sold

3
 Intermediate Financial Accounting-I – Acfn 211

Average-Cost
 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.

Moving-Average Method

In this method, Call-Mart computes a new average unit cost each time it makes a purchase.
First-In, First-Out (FIFO)
 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.
 Fails to match current costs against current revenues on the income statement.
Periodic Inventory System

4
 Intermediate Financial Accounting-I – Acfn 211

Determine cost of ending inventory by taking the cost of the most recent purchase and working
back until it accounts for all units in the inventory.
Perpetual Inventory System

In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the
end of the month whether a perpetual or periodic system is used.
Under IFRS, LIFO is not permitted for financial reporting purposes.
Nonetheless, LIFO is permitted for financial reporting purposes in the United States, it is
permitted for tax purposes in some countries, and its use can result in significant tax savings.
Lower-of-Cost-or-Net Realizable Value (LCNRV)
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.
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).
 Jinn-Feng Foods computes its inventory at LCNRV (amounts in thousands).

5
 Intermediate Financial Accounting-I – Acfn 211

Assume that Jinn-Feng Foods separates its food products into two major groups, frozen and
canned.

Methods of Applying LCNRV

 In most situations, companies price inventory on an item-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: Data for Ricardo SpA
Cost of goods sold (before adj. to NRV) €108,000
Ending inventory (cost) 82,000
Ending inventory (at NRV) 70,000

6
 Intermediate Financial Accounting-I – Acfn 211

Loss Method
Loss Due to Decline to NRV 12,000
Inventory (€82,000 - €70,000) 12,000
COGS Method
Cost of Goods Sold 12,000
Inventory 12,000
Partial Statement of Financial Position

Loss COGS
Method Method
Current assets:
Inventory € 70,000 € 70,000
Prepaids 20,000 20,000
Accounts receivable 350,000 350,000
Cash 100,000 100,000
Total current assets 540,000 540,000

Income Statement
Loss COGS
Method Method
Sales € 200,000 € 200,000
Cost of goods sold 108,000 120,000
Gross profit 92,000 80,000
Operating expenses:
Selling 45,000 45,000
General and administrative 20,000 20,000
Total operating expenses 65,000 65,000
Other income and expense:
Loss due to decline of inventory to NRV 12,000 -
Interest income 5,000 5,000
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

Use of an Allowance
Instead of crediting the Inventory account for NRV adjustments, companies generally use an
allowance account, often referred to as Allowance to Reduce Inventory to NRV.

7
 Intermediate Financial Accounting-I – Acfn 211

Using an allowance account under the loss method, Ricardo SpA makes the following entry to
record the inventory write-down to NRV.
Loss Due to Decline of Inventory to NRV 12,000
Allowance to Reduce Inventory to NRV 12,000

Recovery of Inventory Loss

 Amount of write-down is reversed.
 Reversal limited to amount of original write-down.
Continuing the Ricardo example, assume the net realizable value increases to €74,000 (an
increase of €4,000). Ricardo makes the following entry, using the loss method.
Allowance to Reduce Inventory to NRV 4,000
Recovery of Inventory Loss 4,000
LCNRV rule suffers some conceptual deficiencies:
1. A company recognizes decreases in the value of the asset and the charge to expense in the
period in which the loss in utility occurs—not in the period of sale.
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.
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 income of the subsequent period may be higher
than normal if the expected reductions in sales price do not materialize
Valuation Bases
Net Realizable Value
Departure from LCNRV rule may be justified in situations when
 cost is difficult to determine,
 items are readily marketable at quoted market prices, and
 units of product are interchangeable.
Two common situations in which NRV is the general rule:

8
 Intermediate Financial Accounting-I – Acfn 211

 Agricultural assets
 Commodities held by broker-traders.
Agricultural Inventory
Biological asset (classified as a non-current asset) is a living animal or plant, such as sheep,
cows, fruit trees, or cotton plants.
 Biological assets are measured on initial recognition and at the end of each
reporting period at fair value less costs to sell (NRV).
 Companies record gain or loss due to changes in NRV of biological assets in
income when it arises.
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.
 Agricultural produce are measured at fair value less costs to sell (NRV) at the
point of harvest.
 Once harvested, the NRV becomes cost.
Illustration: Bancroft Dairy produces milk for sale to local cheese-makers. Bancroft began
operations on January 1, 2019, by purchasing 420 milking cows for €460,000. Bancroft provides
the following information related to the milking cows.

9
 Intermediate Financial Accounting-I – Acfn 211

Bancroft makes the following entry to record the change in carrying value of the milking cows.
Biological Asset (milking cows) 33,800
Unrealized Holding Gain or Loss—Income 33,800
Biological Asset (milking cows): Reported on the Statement of financial position as a non-
current asset at fair value less costs to sell (net realizable value).
Unrealized Holding Gain or Loss—Income : Reported as “Other income and expense” on the
income statement.
Illustration: 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
Assuming the milk harvested in January was sold to a local cheese-maker for €38,500, Bancroft
records the sale as follows.
Cash 38,500
Sales Revenue 38,500
Cost of Goods Sold 36,000
Inventory (milk) 36,000
Commodity Broker-Traders
Generally measure their inventories at fair value less costs to sell (NRV), with changes in NRV
recognized in income in the period of the change.
 Buy or sell commodities (such as harvested corn, wheat, precious metals, heating
oil).
 Primary purpose is to
► sell the commodities in the near term and
generate a profit from fluctuations in price.
Purchase Commitments—A Special Problem
 Generally seller retains title to the merchandise.
 Buyer recognizes no asset or liability.
 If material, the buyer should disclose contract details in note in the financial
statements.

10
 Intermediate Financial Accounting-I – Acfn 211

 If the contract price is greater than the market price, and the buyer expects that
losses will occur when the purchase is effected, the buyer should recognize a
liability and corresponding loss in the period during which such declines in
market prices take place.
Illustration: Apres Paper AG signed timber-cutting contracts to be executed in 2020 at a price of
€10,000,000. Assume further that the market price of the timber cutting rights on December 31,
2019, dropped to €7,000,000. Apres would make the following entry on December 31, 2019.
Unrealized Holding Gain or Loss—Income 3,000,000
Purchase Commitment Liability 3,000,000
Unrealized Holding Gain or Loss—Income : Other expenses and losses in the Income statement.
Purchase Commitment Liability : Current liabilities on the balance sheet.
Illustration: When Apres cuts the timber at a cost of €10 million, it would make the following
entry.
Purchases (Inventory) 7,000,000
Purchase Commitment Liability 3,000,000
Cash 10,000,000
Assume Apres is permitted to reduce its contract price and therefore its commitment by
€1,000,000.
Purchase Commitment Liability 1,000,000
Unrealized Holding Gain or Loss—Income 1,000,000
Gross Profit Method of Estimating Inventory
Substitute Measure to Approximate Inventory
Relies on three assumptions:
1. Beginning inventory plus purchases equal total goods to be accounted for.
2. Goods not sold must be on hand.
3. The sales, reduced to cost, deducted from the sum of the opening inventory plus
purchases, equal ending inventory.
Illustration: Cetus SE has a beginning inventory of €60,000 and purchases of €200,000, both at
cost. Sales at selling price amount to €280,000. The gross profit on selling price is 30 percent.
Cetus applies the gross margin method as follows.

11
 Intermediate Financial Accounting-I – Acfn 211

Computation of Gross Profit Percentage

Illustration: In the previous Illustration the gross profit was a given. But how did Cetus derive
that figure? To see how to compute a gross profit percentage, assume that an article cost €15 and
sells for €20, a gross profit of €5.

Illustration: Astaire ASA uses the gross profit method to estimate inventory for monthly
reporting purposes. Presented below is information for the month of May.
Inventory, May 1 € 160,000 Sales € 1,000,000
Purchases (gross) 640,000 Sales returns 70,000
Freight-in 30,000 Purchases discounts 12,000
Instructions:
(a) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of sales.
(b) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of cost.

12
 Intermediate Financial Accounting-I – Acfn 211

Solution
a. Compute the estimated inventory at May 31, assuming that the gross profit is 25% of sales.

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000
Purchase discounts (12,000)
Freight-in 30,000
Goods available (at cost) 818,000
Sales (at selling price) € 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less: Gross profit (25% of €930,000) 232,500
Sales (at cost) 697,500
Approximate inventory, May 31 (at cost) € 120,500

Evaluation of Gross Profit Method

Disadvantages
1) Provides an estimate of ending inventory.
2) Uses past percentages in calculation.
3) A blanket gross profit rate may not be representative.
4) Normally unacceptable for financial reporting purposes because it provides
only an estimate.
IFRS requires a physical inventory as additional verification of the inventory indicated in
the records
Retail Inventory Method
Method used by retailers to compile inventories at retail prices. Retailer can use a formula to
convert retail prices to cost.
Requires retailers to keep a record of:
1) Total cost and retail value of goods purchased.
2) Total cost and retail value of the goods available for sale.
3) Sales for the period.
Methods
 Conventional Method (or LCNRV)
13
 Intermediate Financial Accounting-I – Acfn 211

 Cost Method
Illustration: The following data pertain to a single department for the month of October for
Fuque Ltd. Prepare a schedule computing retail inventory using the Conventional and Cost
methods.
COST RETAIL
Beg. inventory, Oct. 1 £ 52,000 £ 78,000
Purchases 272,000 423,000
Freight in 16,600
Purchase returns 5,600 8,000
Additional markups 9,000
Markup cancellations 2,000
Markdowns (net) 3,600
Normal spoilage and breakage 10,000
Sales 390,000

CONVENTIONAL Method: Cost to

COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
Markups, net 7,000
Current year additions 283,000 422,000
Goods available for sale 335,000 500,000 67.0%
Markdowns, net (3,600)
Normal spoilage and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

£ 96,400 x 67.0% = £ 64,588

COST Method: Cost to

COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
Markdowns, net (3,600)
Markups, net 7,000
Current year additions 283,000 418,400
Goods available for sale 335,000 496,400 67.49%
Normal spoilage and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

14
£ 96,400 x 67.49% = £ 65,060
 Intermediate Financial Accounting-I – Acfn 211

Special Items Relating to Retail Method

 Freight costs
 Purchase returns
 Purchase discounts and allowances
 Transfers-in
 Normal shortages
 Abnormal shortages
 Employee discounts
 When sales are recorded gross, companies do not recognize sales discounts.
Evaluation of Retail Inventory Method
Used for the following reasons:
1) To permit the computation of net income without a physical count of inventory.
2) Control measure in determining inventory shortages.
3) Regulating quantities of merchandise on hand.
4) Insurance information.
Some companies refine the retail method by computing inventory separately by departments or
class of merchandise with similar gross profits.
Presentation of Inventories
Accounting standards require disclosure of:
1. Accounting policies adopted in measuring inventories, including the cost formula used
(weighted-average, FIFO).
2. Total carrying amount of inventories and the carrying amount in classifications (merchandise,
production supplies, raw materials, work in progress, and finished goods).
3. Carrying amount of inventories carried at fair value less costs to sell.
4. Amount of inventories recognized as an expense during the period.
5. Amount of any write-down of inventories recognized as an expense in the period and the
amount of any reversal of write-downs recognized as a reduction of expense in the period.
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.

15