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Financial AccountingModule code: MAN2907L

Accounting for Inventory and Contract Work-in-Progress

(Week 13)

Accounting for Inventory – Learning Objective

Inventory defined and the controversyThe requirements of IAS 2 InventoriesInventory valuationInventory controlCreative accountingAudit of year-end physical countContract work-in-progress and profit (IAS 11 Construction Contracts)Published financial statements

Inventory Defined

IAS 2 Inventories defines inventories as assets:

held for sale in the ordinary course of business (finished goods);

in the process of production for such sale (work in process);

in the form of materials or supplies to be consumed in the production process or in the rendering of services (raw materials).

Inventory Defined - Measurement

The measurement of inventory involves:

the establishment of physical existence and ownership;

the determination of unit costs;

the calculation of provisions to reduce cost to net realisable value (e.g. obsolete, slow moving or unsaleable stocks), if necessary (impairment).

Inventory Impact on ProfitExample Nissan Motor Co. Ltd – Figure 20.1

2010 Inventory reduced by 5%

% change

Pre-tax profits (mil. yen) 141,680 101,566 28%

Inventories (mil. yen) 802,278 762,164 5% 5%

40,114

Inventory (inv.) ValuationImportant to get closing stock accuratePossibility for profit smoothing

Year 1 Year 1 (with inv. inflated)Sales 100,000 100,000Opening inv. - -Purchases 65,000 65,000Less: Closing inv. 5,000 15,000Cost of sales 60,000 50,000Profit 40,000 50,000

Year 2 Year 2 (with inv. inflated)Sales 150,000 150,000Opening inv. 5,000 15,000Purchases 100,000 100,000Less: Closing inv. 15,000 15,000Cost of sales 90,000 100,000Profit 60,000 50,000 Elliott & Elliott (2012)

Figure 20.2

Inventory Valuation Methods - FIFO

Figure 20.3 First-in-first-out method (FIFO)

Receipts Issues BalanceDate Quantity Rate £ Quantity Rate £ Quantity Rate £

Jan 10 15 150 10 150Feb 8 15 120 2 30Mar 10 17 170 12 200Apr 20 20 400 32 600May 2 15 30

10 17 17012 20 240

Cost of goods sold 560Inventory 8 20 160

Inventory Valuation Methods - AVCO

Figure 20.4 Average cost method (AVCO)

Receipts Issues Balance

Date Quantity Rate £ Quantity Rate £ Quantity Rate £

Jan 10 15 150 10 150Feb 8 15 120 2 30Mar 10 17 170 12 200Apr 20 20 400 32 600May 24 18.75 450

Cost of goods sold 570

Stock 8 18.75 150

Extract from J Sainsbury plc 2008 Annual Report:

InventoriesInventories are valued at the lower of cost and net realizable value. Inventories at warehouses are valued on a first-in, first-out basis. Those at retail outlets are valued at calculated average cost prices. Cost includes all direct expenditure and other appropriate attributable costs incurred in bringing inventories to their present location and condition.

Elliott & Elliott (2012), page 533

Methods Rejected by IAS 2

Last-in-first-out (LIFO) and (by implication) replacement cost are rejected by IAS 2

Last-in-first-out (LIFO)The cost of the inventory most recently received is charged out first at the most recent ‘cost’, i.e. the inventory value is based upon an ‘old cost’, which may bear little relationship to the current ‘cost’.

Extract from Wal-Mart Stores Inc 2008 Annual Report:

Inventories The company value inventories at the lower of cost or market as determined primarily by the retail method of accounting, using the last-in, first-out (‘LIFO’) method for substantially all of the Wal-Mart Stores segment’s merchandise inventories. Sam’s Club merchandise and merchandise in our distribution warehouses are valued based on the weight average cost using the LIFO method. Inventories of foreign operations are primarily valued by the retail method of accounting, using the first-in, first-out (‘FIFO’) method. At January 31, 2008 and 2007, our inventories valued at LIFO approximate those inventories as if they were valued at FIFO.

Inventory Valuation Methods - LIFO

Figure 20.5 Last-in-first-out method (LIFO)

Receipts Issues Balance

Date Quantity Rate £ Quantity Rate £ Quantity Rate £

Jan 10 15 150 10 150Feb 8 15 120 2 30Mar 10 17 170 12 200Apr 20 20 400 32 600May 20 20 400

4 17 68Cost of goods sold 588

Inventory 8 132May closing balance = (2 x 15) + (6 x 17) = 132

Procedure to Ascertain Cost

Direct material

Direct labour

Appropriate overhead

Five Types of Overhead1. Direct Subcontract, royalties

Non-routine subcontract might be expensed

2. Indirect Factory rent, ratesPowerDepreciation of plant and machineryWarehouse cost of finished goods

3. Administration Office costs easily identifiable to productionApportion wages department on head countProduction specific admin – canteen

4. Selling and distribution

advertising, delivery, sales salaries not normally included in inventory valuation sale or return basis incurs delivery costs included in inventory valuation

5. Finance cost of borrowing, fees for letters of credit may be a case for including in inventory

How Much Total Overhead to Include Important to use normal activity basis

Overhead for the year £200,00Planned activity 10,000 units Closing inventory 3,000 unitsActual activity 6,000 units Direct costs £2 per unit

Stock value based on actual activityDirect costs (6,000 – 3,000) x £2 £ 6,000Overhead (3,000/6,000) x £200,000 £100,000Closing stock value £106,000

Stock value based on planned or normal activityDirect costs (6,000 – 3,000) x £2 £ 6,000Overhead (3,000/10,000) x £200,000 £ 60,000Closing stock value £ 66,000

Net Realizable Value (NRV)Prudence requires LOWER of COST & NRV

Permanent fall in market priceExcessively priced stockHigh stock levels and liquidity problemsDeterioratingObsolescenceMarketing strategy to penetrate a market

NRV takes into account any additional costs to sell.

Net Realizable Value (NRV) – An Example

Inventory Control

Problem when inventory is taken at different date to year-end

Figure 20.6 Adjusted inventory figure

Creative AccountingYear-end manipulation

Ineffective cut-off proceduresSuppression of invoicesWindow dressingSubjective use of NRV rule Load overheads onto inventory in low profit periodsOptimistic view of obsolescenceInaccuracies in the physical inventory count

Inventory CountAudit attendance

Identification of inventory items

Ownership of Inventory items

Physical condition of inventory items

Adjustment if inventory taken after the year-end dateAfter the year-end sales made - £100,000 (@ cost plus 25%): inventory should be increased by £100,000/(1 +25%) = £80,000

After the year-end purchases received - £45,000: would reduce inventory by £45,000.

Adjustment if errors are discovered

Treatment of Inventory Items

IAS 11 - Construction ContractsFixed price contracts

Cost escalation clauseCost-plus contracts

Allowable costsPercentage

Account for individually, combined or segmentedGroup of contractsSeparate proposals for each asset

The IASB and FASB have been reviewing IAS 11 with a view to construction contracts being covered by the one Revenue Recognition standard. KPMG provides a summary on the proposed standard on Revenue from Contracts with Customers.

Recognise Net Income – When?

Completed contracts method

Percentage of completion method

Favoured by IAS 11

Identifying Contract RevenueInitial amount of revenue agreed in contract

Variations may occur– Cost escalation clauses– Customer caused delays– Errors in specification or design– Incentive payment targets reached

Variations recognised as revenue– Probably resulting in revenue– Reliable measurement

Identifying Contract Costs1. Costs directly relating to specific contract, e.g.

2. Costs that are attributable to contract activity in general & can be allocated to specific contracts

Systematic allocated based on normal level of activity. Items such as: insurance; construction overheads; cost of design and technical assistance not capable of being specifically allocated.

3. Costs specifically chargeable to customer under the contract

Contract specifies reimbursement: development costs; general administration.

Site labourCosts of materialsDepreciation of plant used on contractCost of moving plant & materials

Cost of hiring P&ECost of design and technical assistanceEstimated costs of rectification

Recognition of Contract Revenue and Expenses

Recognise in income statement as soon as outcome can be reliably estimated

– Total revenue reliably measurable– Total costs reliably measurable– Stage of completion accurately identified

• External expert – e.g. Architect• Contract cost as % of total cost• Physical proportion of work completed

Income Statement Entry

Credited with this % of the net income

UNLESS too early

Debited (charged) immediately if a loss

Statement of Financial Position Entry

Asset/liability‘Gross amounts due from/to customers’

ComprisesTotal cost incurred to datePlus attributable profits (or less foreseeable losses)Less any progress billings.

Advances - liability

Proposed New Accounting RulesRecognise revenue when control passes

IF the revenue recognition rules change as proposed, then it is likely that construction contracts will be altered in the future to more clearly specify when ‘control’ of components of the construction contracts pass to the clients

It may mean that proportionate revenue recognition as a percentage of work completed is no longer permitted unless that percentage is linked to the completion of major milestones.

Approach when a contract can be separated into components

Keep track of the construction contracts: costs are accumulated by job;

Distinct components of the job: separate records may be required for each component as a basis for invoicing.

Records needed to account fora) Total costs incurred on the contract to dateb) The amount of revenue recognised in the accounts to datec) The costs incurred in relation to the revenue which has been

recognisedd) The amount of the profit or loss recorded on the contract so fare) The amount invoiced to the customer so far andf) The amount unpaid by the customer.

An Example Using A Step ApproachYear to 30 Jun 20X0 (Stage 1 of the contract) Contract £000Total contract price 25,000Costs incurred to date 5,500Anticipated future costs 14,500Progress billings -Architect’s estimate of % completed 30.6.X0 28%Agreed price for the component completed 7,000

Further Information:ABC recognised revenue £7m and costs £5.5m on the contract.

Factors indicating that control has passed:Unconditional obligation to payCustomer has legal titlePhysical possession by the customerDesign is customer-specific: has no alternative use

Step 1 Overall Anticipated ResultTotal expected cost to complete the contract: £000Costs incurred to date 5,500Anticipated future costs 14,500Expected total costs 20,000Contract price 25,000Forecast profit on the contract 5,000

The contract is expected to be profitable Profit on the component completed to date of £7m – £5.5m = £1.5m can be fully realised.

If forecast total cost is greater than revenue: anticipated cost overrun need to be recorded as an expense/loss in the current period.

All anticipated loss on contract needs to be recorded in the current period, not just those related to the current stage of completion.

Step 2 Income Statement

Step 3 Statement of Financial Position Entries

Statement of financial position is a cumulative statementGross work done for the customer = Cost incurred to date + profit recognised to date

– losses recognised to dateGross amount due from customers= Gross work done for the customer – amount billed to the customer

£000Costs incurred to date 5,500

Add profits to date 1,500

Less recognised loss to date -

Gross work done for the customer 7,000Less: amount billed to the customer -

Gross amount due from customer 7,000

Year 2 of Contract – 30 June 20X1Year to 30 Jun 20X0 Contract £000Total contract price 25,000Costs incurred to date 14,000Anticipated future costs to complete the contract 6,000Architect’s estimate of % completed 30.6.X1 60%Agreed contract price for stages 1 & 2 15,000Progress billings 12,000Advance payments 4,000

Step 1 Overall Anticipated Result for the ContractTotal expected cost to complete the contract: £000Costs incurred to date 14,000Anticipated future costs 6,000Expected total costs 20,000Contract price 25,000Forecast profit on the contract 5,000

Stage 2 Comprehensive Income StatementTotal expected cost to complete the contract: £000 £000Total revenue for stages 1 & 2 15,000Less revenue already recognised 7,000Revenue for the period 8,000Less expenses: Additional expenses incurred in the period (14,000 – 5,500) 8,500Additional anticipated loss accrual - Total expenses 8,500Loss for the year (500)

Step 3 Statement of Financial Position Entries£000

Costs incurred to date 14,000

Add profits recognised to date 1,500

Less recognised loss to date (500)

Work performed for the customer 15,000Less: progress billings 12,000

Gross amount due from customer 3,000

Also - liability

of

£4mil. revenue

paid in advance