Week 9 Student

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MIT565702

WEEK 9INVENTORY (2)

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Lecture Objectives

At the end of this lecture you should be able to:– Understand the need for cost-flow assumptions;

– Determine how ending inventory and cost of goods sold is determined under each cost-flow assumption;

– Apply each cost-flow assumption using the periodic and perpetual inventory methods; and

– Apply the lower of cost or market rule

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ExampleXYZ Company had 1500 shirts on hand at 1 July 2011. These shirts had a cost of $8 each to purchase. Throughout the year it made the following purchases:

22 August 10 000 shirts at $13 each19 October 19 000 shirts at $10 each28 January 8 000 shirts at $12 each12 March 15 000 shirts at $15 each8 June 6 000 shirts at $13 each

A physical count revealed 3500 shirts on hand as at 30 June 2012

What are Cost-flow Assumptions?

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10 000 @ $13

1500 @ $8

8000 @ $12 15000 @ $15

19 000 @ $10

6000 @ $13

Cost of goods sold56 000 @ $??

Ending inventory3500 @ $??


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Cost-flow Assumptions

• Split costs of opening inventory plus purchases into COGS and ending inventory

• Total dollar amount of goods available for sale:

• How the costs are divided between COGS and ending inventory impacts net profit and the inventory figure in the balance sheet

COGS Ending inventory

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How do we determine the value of ending inventory and COGS?– Track each individual items through the inventory flow (specific

identification) Accurate Based on physical flow of goods Time-consuming and expensive

– Technology is making specific identification easier (e.g. bar code technology)

– In cases where the costs of specific identification outweigh the benefits, cost-flow assumptions are a useful alternative

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What Cost-flow Assumptions are Permitted in Australia?

• AASB 102 (IAS 2) Inventories permits the use of three cost formulas:– Specific identification;– First-in, first-out (FIFO); and– Weighted average

• A fourth approach, last-in, first-out (LIFO) is not permitted

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Specific Identification

• Each unit sold and on hand can be identified by serial numbers or a specific purchase invoice

• Used when inventory items are not interchangeable• Small volume, high dollar value items

• Houses; motor vehicles; expensive jewellery

• Not possible or cost-effective for many entities

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FIFO

• Assumes the first units acquired are the first units sold• Beginning inventory sold first and earliest purchases

thereafter

• Ending inventory, therefore, is assumed to consist of the most recently acquired units

• Tends to understate COGS and overstate ending inventory when cost price increases during the period

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Weighted Average

Periodic Method Weighted average calculated as:

Total cost of goods available for sale for a period Total number units available for sale for a period

Perpetual Method Moving weighted average, where average price is recalculated after every purchase

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LIFO

• Assumes last units acquired are the cost of first units sold

• Not permitted in Australia (AASB 102 Inventories para 25)

• It has been popular in the United States where it is allowed for tax purposes if used for accounting purposes but currently proposed for repeal

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Perpetual vs. Periodic

Recall:– Perpetual method maintains a continuous record of

inventory and COGS– Periodic method calculates inventory and COGS once a

stocktake has occurred

Choosing the perpetual or periodic methods will influence COGS and closing inventory under some cost-flow assumptions

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Example

* For specific identification purposes assume 100 units @ $2; 150 @ $3; 400 @ $4

Details Date Units Unit cost

Total cost

Units sold

Beginning I nventory

1/ 1/ 200 $2 $400

Purchased 15/ 1/ 300 $3 $900 Sold 17/ 1/ 250 Purchased 28/ 1/ 500 $4 $2 000 Sold 30/ 1/ 400 Total 1 000 $3 300 650*

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PURCHASES COGS ENDING I NVENTORY

Date Units Unit cost

Total cost

Units Unit cost

Total cost

Units Unit cost

Total cost

1/ 1 200 2 400 15/ 1 300 3 900 200 2 400 300 3 900 17/ 1 100 2 200 100 2 200 150 3 450 150 3 450 28/ 1 500 4 2 000 100 2 200

150 500

3 4

450 2 000

30/ 1 400 4 1600 100 2 200 150

100 3 4

450 400

TOTAL 2 250 1 050

Specific identification(Perpetual Method)

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Specific identification(Periodic Method)

Specific identification traces the movement of each unit of inventory

Implies the use of the perpetual inventory method, as continuous records are maintained

Specific identification not used in conjunction with the periodic method

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PURCHASES COGS ENDI NG INVENTORY


Total cost

Units Unit cost

Total cost

Units Unit cost

Total cost

1/ 1 200 2 400 15/ 1 300 3 900 200 2 400 300 3 900 17/ 1 200 2 400 50 3 150 250 3 750 28/ 1 500 4 2 000 250 3 750 500 4 2 000 30/ 1 250 3 750 150 4 600 350 4 1 400 TOTAL 1 900 1 400

FIFO(Perpetual Method)

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FIFO(Periodic Method)

Ending InventoryStocktake of 350 units (Assume 350 units @ $4) = $1 400

Cost of Goods Available for SaleCost of goods available for sale = $3 300

Cost of Goods Sold650 units sold @ $3 300 - $1 400 = $1 900(Assume 200 units @ $2 + 300 units @ $3 + 150 @ $4 = $1900)

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Weighted Average(Perpetual Method)

Moving Weighted Average

PURCHASES COGS ENDING INV.


Total cost

Units Unit cost

Total cost

Units Unit cost

Total cost

1/ 1 200 2 400 15/ 1 300 3 900 * 500 2.60 1300 * $1 300 500 = 2.60 17/ 1 250 2.60 650 250 2.60 650 28/ 1 500 4 2 000 * 750 3.53 2 650 * $2 650 750 =$3.53 30/ 1 400 3.53 1 412 350 3.53 1 238 TOTAL 2 062 1 238

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Weighted Average(Periodic Method)

Total cost of goods available for sale for a periodTotal number units available for sale for a period

$3 300 = $3.30/unit 1 000 Ending inventory 350 x $3.30 = $1 155

COGS 650 x $3.30 = $2 145

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PURCHASES COGS ENDING STOCK/ INV.

Date Units Unitcost

Totalcost

Units Unitcost

Totalcost

Units Unitcost

Totalcost

1/ 1 200 2 40015/ 1 300 3 900 200 2 400

300 3 90017/ 1 200 2 400

250 3 750 50 3 15028/ 1 500 4 2 000 200 2 400

50 3 150500 4 2000

30/ 1 200 2 40050 3 150

400 4 1 600 100 4 400TOTAL 2 350 950

LIFO(Perpetual Method)

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LIFO(Periodic Method)

Ending InventoryStocktake of 350 units (Assume 200 units @ $2 + 150 units @ $3) = $850

Cost of Goods Available for SaleCost of goods available for sale = $3 300

Cost of Goods Sold650 units sold @ $3 300 - $850 = $2 450(Assume 500 units @ $4 + 150 units @ $3 = $2 450)

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Comparison

Assume selling price is $10 per item;

Sold 650 units x $10 = $6500;

Operating expenses $50; and

Assume there are no stock losses

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PERI ODIC PERPETUAL

FIFO LIFO Weighted

average Spec Id FIFO LIFO Moving average

SALES 6 500 6 500 6 500 6 500 6 500 6 500 6 500 Less COGS 1 900 2 450 2 145 2 250 1 900 2 350 2 062 Gross profit 4 600 4 050 4 355 4 250 4 600 4 150 4 438

Less expenses 50 50 50 50 50 50 50 Net profit 4 550 4 000 4 305 4 200 4 550 4 100 4 388 Ending inventory 1 400 850 1 155 1 050 1 400 950 1 238

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Comparison

In periods of rising prices: FIFO results in the highest ending inventory, highest

gross profit, highest net profit and the lowest COGS

LIFO results in lowest ending inventory, lowest gross profit, lowest net profit and the highest COGS

Weighted average and specific identification results fall between FIFO and LIFO

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Student Task

Have a go at practice problem 1a b and c on Pg 145-6 of the study guide for discussion in 30 minutes.

Note. In part B prepare stock cards for the FIFO, LIFO and Moving Weighted Average assumptions

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Workings – Periodic MethodDate Particulars DR CR

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Workings – Periodic MethodDate Particulars DR CR

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Income Statement (Periodic)

Income statement for the year ended 30 June

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DATE IN OUT BALANCE

Stock Card - FIFO

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DATE IN OUT BALANCE

Stock Card - LIFO

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DATE IN OUT BALANCE

Stock Card – MOVING WEIGHTED AVERAGE

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Workings – Perpetual MethodDate Particulars DR CR

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Income Statement (Perpetual)

Income statement for the year ended 30 June

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What is the Lower of Cost or Market Rule?

• Instances arise when the market price of inventory is less than the cost price• Obsolescence (perishables past their ‘use by’ date; audio

cassette players)• Damage (damaged goods basket at supermarket) • Demand (‘summer clearance sale’)

• In accordance with the principle of conservatism, this decrease in asset value is to be recognised when it occurs

• This is known as the lower of cost or market rule

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Lower of Cost or Market Rule

• AASB 102 (IAS 2) Inventories states inventory is to be valued at the lower of cost or net realisable value on an item by item basis• If not practicable, may group similar or related items

• Net realisable value is the net amount expected to be realised from the sale of inventory• Selling price less costs incurred to make the sale

• This is the value of inventory as it appears in the balance sheet

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I tem no. Units Unit cost

Total Cost

Units Market Price

Total Market Price

Lower of Cost or Market

675 5 x $ 50 = $ 250 5 x $45 = $225 $225 732 10 x $ 40 = $400 10 x $48 = $480 $400 957 15 x $ 55 = $ 825 15 x $30 = $450 $450 977 8 x $ 10 = $ 80 8 x $15 = $120 $ 80

Total 1 555 $1 275 1 155

Example

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Student Task

What would be the general journal entry from the previous example to record the lower of cost or

market rule?

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Workings

GENERAL JOURNALDate Particulars DR CR

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Lecture Outcomes

You should now be able to:– Understand the need for cost-flow assumptions;

– Determine how ending inventory and cost of goods sold is determined under each cost-flow assumption;

– Apply each cost-flow assumption using the periodic and perpetual inventory methods; and

– Apply the lower of cost or market rule

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Homework – This Week

Questions from Required Exercises?

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Homework – Next WeekCase Discussion 1

E. Knight (2001), ‘Inventiveness in inventories’, The Sydney Morning Herald, 9 August, p. 21 (Business).

Issues to consider:• How was the value of inventory determined?• How was this used to manipulate profits?

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Homework – Next WeekCase Discussion 2

L. Gettler (2005), ‘One-offs uncork the red for Evans & Tate’, The Age, 14 September, p. 2 (Business)

Issues to consider:• Why was the inventory write-down necessary?• Why were the corporate overheads expensed rather

than capitalised?

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Homework – Next Week

Required Exercises P8.2, P8.7, P8.12

Chapter 13 of textbook

Documents

Week 9 Student