Chapter 7

Inventory

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-1

Objectives of this lecture

Be able to calculate the cost of inventory
pursuant to AASB 102 Inventories
Understand how to apply the lower of cost and
net realisable value rule for measuring inventory
Understand why there is typically a necessity to
make inventory cost-flow assumptions
Be able to apply the inventory cost-flow
assumptions permitted by AASB 102
Know the disclosure requirements of AASB 102

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-2

Introduction
Inventory often accounts for a large proportion
of total assets
Accounting methods used for inventory can have
a significant impact on reported assets and
profits
AASB 102 applies to all inventories except:
work in progress under construction contracts
financial instruments, and
biological assets

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-3

Definition of inventory
Inventories are defined as assets (AASB 102):
held for sale in the ordinary course of business
in the process of production for such sale, or
in the form of materials or supplies to be consumed in
the production process or in the rendering of services

Cost of goods sold:

is the cost of inventory sold during the financial period
can be determined either on a periodic or perpetual
basis

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-4

The general basis of inventory

measurement
Inventories must be measured at the lower of
cost and net realisable value (AASB 102)
on an item-by-item basis

Cost of inventories comprises all (AASB 102):

costs of purchase (i.e. purchase price, import duties,
transport costs, etc.)
costs of conversion (e.g. direct labour and allocation of
overhead costs)
other costs incurred in bringing the inventories to their
present location and condition (e.g. product design
costs for specific customers and installation)

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-5

The general basis of inventory

measurement (cont.)
Costs of inventory exclude (AASB 102):

abnormal amounts of wasted materials

storage costs
administrative overheads
selling costs

Fixed production costs:

are those costs of production that are not expected to
fluctuate as production levels change (e.g. building
depreciation and factory administration costs)

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-6

The general basis of inventory

measurement (cont.)

There are two methods for dealing with fixed

production costs
1. Absorption costing: fixed manufacturing costs
included in cost of inventories
2. Direct costing: fixed manufacturing costs treated as
period costs (i.e. expensed in the period incurred)

AASB 102 requires the use of absorption

costing

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-7

The general basis of inventory

measurement (cont.)
Cost of inventory must include both fixed and
variable production overheads
Indirect production costs that cannot be traced to the
goods or services

Standard costs
Predetermined product costs based, for example, on
planned products and/or operations, planned cost and
efficiency levels and expected capacity utilisation
Only permitted for inventory costing where the
standards are realistically attainable, reviewed
regularly and revised where necessary

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-8

The general basis of inventory

measurement (cont.)
Net realisable value (NRV) (AASB 102)
Estimated selling price in the ordinary course of
business less the estimated costs of completion and
those necessary to make the sale

If NRV is greater than cost, inventory should be

left at cost
Upwards revaluations are not allowed by AASB 102

If NRV is less than cost, inventory should be

written down to NRV
Write-down treated as an expense in the period of the
write-down

Refer to Worked Examples 7.1, 7.2 and 7.3 on

pp. 228, 230 and 231
.

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-9

Discounts for early payment

Discounts received for early payment for debts due
to the supplier of inventory are not to be offset
against the cost of inventory
Discounts given to customers for early payment are
not to be offset against sales
Penalties for late payment are not to be added to the
cost of inventory
Trade discounts provided at the point of purchase
are to be seen as a reduction in the cost of the
inventory

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-10

Borrowing costs
Costs associated with borrowings (e.g. interest) can
sometimes be included in the cost of inventory
Governed by AASB 123 Borrowing Costs
Interest costs can be included as part of the
inventory to the extent that the inventory is deemed
to be a qualifying asset
Qualifying assets are those that necessarily take a
substantial period of time to get ready for their
intended use or sale
Would not be applicable to most inventory being
produced

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-11

Inventory cost-flow assumptions

Cost-flow assumptions must be made where
cost of inventory items fluctuate
Specific identification of items sold and on hand,
although ideal, might be impractical to apply
Cost-flow assumptions used to determine cost of
goods sold and closing inventory
The actual physical flow of goods and the flow
according to the cost-flow assumption might be
different

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-12

Inventory cost-flow assumptions (cont.)

Method adopted should be:
appropriate to the circumstances
applied consistently from period to period

AASB 102 allows the use of one or more of the

following methods:
specific identification
weighted-average cost
first-in first-out (FIFO)

AASB 102 does not permit the use of:

last-in first-out (LIFO)

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-13

Specific identification method

Cost of sales calculated by determining which
item was sold and the specific cost of that item
Ending inventory is costed at the cost of the
specific items on hand at the end of the year
Required to be used for inventory items that are
(AASB 102):
not ordinarily interchangeable, or
goods or services produced and segregated for
specific projects

Not appropriate for large numbers of similar or

identical items (AASB 102)
.

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-14

Weighted-average method
An average cost is based on beginning inventory
and items purchased during the period
Various costs of individual units are weighted by
the number of units
Cost of goods sold and ending inventory are
costed at the average cost

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-15

FIFO method
Goods from beginning inventory and the earliest
purchases are assumed to be the goods sold
first
Consistent with selling behaviour in most entities
Ending inventory assumed to be most recent
purchases
More current value of inventory on balance sheet

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-16

LIFO method
Most recent purchases are assumed to be the
first goods sold
Ending inventory assumed to be the oldest
goods
Inventory could be valued at prices paid some years
earlier

Not allowed in Australia under AASB 102

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-17

LIFO method (cont.)

Allowed in the United States for external
reporting and tax purposes
US companies that elect not to adopt LIFO typically
have higher leverage and lower interest coverage
ratios
Those potentially close to breaching debt covenants
adopt income-increasing and asset-increasing
accounting methods
While some methods might increase income, others
might act to reduce income

Refer to Worked Example 7.4 (p. 235) for a

comparison of the methods
.

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-18

Inventory systems
Determination of cost of sales and inventory
under each cost-flow assumption also depends
on the inventory recording system used
Periodic inventory system
Inventory counted periodically
No continuous records kept of inventory sales

Perpetual inventory system

Running total kept of units on hand
Increases and decreases of inventory recorded as
they occur
See Worked Examples 7.5 and 7.6 (pp. 236 and 237)

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-19

Reversals of previous inventory write-downs

As we know, inventories must be written down if the
net realisable value (NRV) is less than cost
If, in a subsequent period, NRV increases to original
cost or above, the inventory write-down can be
reversedwith a subsequent increase in income
Any subsequent accounting entry to increase the
carrying amount of inventory must be restricted to
the amount that was previously expensed
The value of inventory must not be increased above
its original cost (in keeping with the lower of cost and
NRV rule)
See Worked Example 7.7 (p. 239)Reversal of a
previous inventory write-down
.

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-20

Disclosure requirements
Where material, AASB 102 requires the
disclosure of the following:
accounting policies for measuring inventories,
including cost formulas used
total carrying amount of inventories
carrying amount of inventories carried at fair value less
costs to sell
amount of inventories expensed during the period
amount of any write-downs expensed in the period
amount of any reversal of any write-down
circumstances leading to reversals of write-downs
carrying amount of inventories pledged as securities
for liabilities

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-21

Summary
The lecture addresses the topic of accounting for
inventory
Under AASB 102, inventory is to be measured at
the lower of cost and net realisable value
Absorption costing and not direct costing should
be applied
To account for the flow of inventory, cost-flow
assumptions are necessary
Allowable methods are specific identification, weightedaverage and first-in first-out
Last-in first-out is not allowed in Australia

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e

7-22