1

InventoriesAn Important Source

of Income

2

JOIN KHALID AZIZ

ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

CONTACT:0322-3385752R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,

KARACHI, PAKISTAN.

3

Why inventories are so important?

4

Because the valuation of inventories directly affects the bottom line figure in the I/S by affecting COGS and thereby Gross Profit (Sales-COGS)

At the same time, it has an effect on the B/S since Inventory is usually the most significant item among the Current Assets in merchandising & manufacturing companies

The amount of inventories on hand, and the time it takes to sell them is very crucial to the performance of any firm (called Inventory Turnover – Stok Devir Hızı)

5

1. Physical count of

Inventory

2. Determination of

ownership of the goods, i.e. account for:

Goods in Transit

Consignment Goods

Determination of Inventory Units

Two Step Process:

6

Seller

Buyer

F.O.B. SHIPPING POINT

WHO OWNS THE GOODS ON THE

WAY?

GOODS IN TRANSITGOODS IN TRANSIT

7

Seller

Buyer

F.O.B. DESTINATION

WHO OWNS THE GOODS ON THE

WAY?

GOODS IN TRANSITGOODS IN TRANSIT

8

Consignment Goods Marketing agreement btw. the consigner (owner of

the goods) and the consignee (holder of the goods). Here, the consignee sells the goods on behalf of the consigner

Ex: Automobile Dealer selling consignment goods. Consignee, even though he is selling it, doesn’t own the goods, so he should not include it in his inventory. On the other hand, consigner should include the goods in his inventory since he is the owner

9

Inventory Costs

Beginning Inventory + Purchases - Ending Inventory = COGS

(UNDER THE (UNDER THE Cost of Goods Cost of Goods Available for SaleAvailable for Sale PERIODIC PERIODIC

INVENTORY INVENTORY SYSTEM)SYSTEM)

UNDER THE PERPETUAL INVENTORY SYSTEM:UNDER THE PERPETUAL INVENTORY SYSTEM:

It would accumulate the cost of merchandise sold in the COGS account, and deduct the cost from the Inventory account each time a sales is made.

10

In the previous chapter, we implicitly assumed that each unit in the inventory is acquired for the same cost. However, in practice that is not the case. Even if a company sells one type of good, it buys them at varying prices

Therefore, when identical units of inventory have different unit costs, the question is: Which cost should be used to compute the amount of cost of goods sold?

Determination of the unit cost to be assigned to units sold is called the COST FLOW, i.e. how cost of units move from the Inventory account to the COGS account

11

Inventory Cost FlowsAccording to the IAS (Int. Acc. Stds.) and TAS (Turkish Acc. Stds.), the following cost flow methods can be used, regardless of the inventory system that they are using (periodic or perpetual):

1.Specific Identification Method

2.First-in First-out (FIFO)

4.Weighted Average

3.Last-in First-out (LIFO) – not allowed by IFRS or CMB

12

Specific Identification Method

Used when the actual cost of the item is tracked

When a company sells limited variety of high-priced goods, it keeps track of each item individually (generally applicable for low-volume companies, because if the volume is high, it is very difficult to keep track)

Ex: A car dealer specifically knows the cost of each car, and therefore when a car is sold, COGS is debited by the cost of that specific car

13

Cost Flow vs. Physical Flow

First-in First-out (FIFO), and weighted average methods assume that flow of costs may be unrelated to physical flow of goods

The accounting regulations do not require that the physical flow of goods and the related cost flow to be the same

14

Date Explanation Units Unit Cost

Total Cost1.1.2000 Beg.Inv. 100 TL 10 TL 1.00015.5.2000 Purchase 200 11 2.20020.5.2000 Sale 25025.7.2000 Purchase 300 12 3.60010.10.2000 Sale 3001.12.2000 Purchase 400 13 5.200Total 1.000 TL 12.000

Cacun Elektronik B55 Alpha Relay

Illustrative Example of the Remaining 3 Cost Flow Methods: FIFO, LIFO & Weighted Avg.

* The company had 1000 units available for sale for a total of TL 12 mill. during the period.

* Of these available units, 550 units were sold and 450 units still remain in the inventory at the end of 2000.

15

First-in First-out MethodFIFO

FIFO method assumes that the goods purchased earlier will be sold first

The cost of the first units on hand is assigned to the units sold first

16

FIFO-COGS:Periodic Inventory System

Units Sold Unit Cost Total Cost550 100 x 10 TL 1.000

200x 11 2.200250 x 12 3.000

550 TL 6.200

FIFO -Ending Inventory: Periodic Inventory System

Units on hand Unit Cost Total Cost450 400 x 13 TL5.200

50 x 12 600450 TL 5.800

17

FIFO – COGS and Ending Inventory : Perpetual Inventory SystemCOGS Inv. Balance

(units x (units xunit cost) unit cost)

1.1.2000 100 x 10 =1.000

100 x 10 = 1.000

200 x 11 = 2.200

20.5.2000 250 100 x 10 TL 1.000

150 x 11 1.650 50 x 11 = 550

50 x 11= 550

300 x 12 =3.600

10.10.2000 300 50 x 11 550

250 x 12 3.000 50 x 12 = 600

50 x 12 =600

400 x 13 =5.200

550 TL 6.200 5.800

1.12.2000 400@13

25.7.2000 300@12

15.5.2000 200@11

Date Purchased Units Sold

Unit Cost

Beginning Inventory

Ending Inventory

Cost of Goods Sold

Since under the Perpetual Inventory System, composition of inventory changes after every merchandising transaction, date is very important

18

Weighted Average

Goods available are homogeneous and the cost to be assigned to each unit sold is the same (under the Periodic Inventory System)

Unit Cost = Total Cost of Goods Available for Sale Total Number of Units Available for Sale

19

Weighted Average Method: Periodic Inventory System

Unit Cost = 12.000.000/1.000 = TL 12.000 per unit

COGS = TL 12.000 (avg. unit cost) x 550 (# of units sold) = TL 6.600.000

Ending Inv. = TL 12.000 (avg. unit cost) x 450 (# of units remaining on hand) = TL 5.400.000

or by using the formula COGS = Beg. Inv+Purch.–End. Inv., COST OF GOODS AVAIL. FOR SALE

End. Inv. = TL 12.000.000 - TL 6.600.000 = TL 5.400.000

20

Weighted Average– COGS and Ending Inventory : Perpetual Inventory System

Unit Cost COGS Inv. Balance

Assigned (units x unit cost)

(total cost ÷

number of units = unit cost)

1.1.2000 100 x 10 =1.000

15.5.2000 200@ 11 3.200 ÷ 300= 10.66

20.5.2000 250 250*10,66 2.667 50 x 10.66=533

25.7.2000 300@ 12 (533+ 3600) ÷ 350= 11.81

10.10.2000 300 300*11,81 3.543 50 x 11.81 = 590.50

1.12.2000 400 @ 13 (590.50 + 5.200) ÷ 450= 12.87

550 TL 6.210 TL 5.790

Date Purchased Units Sold

* Because the date of the purchase & sale is the deciding factor here; every time a purchase is made, a new weighted average unit cost is computed and that cost is assigned to subsequent sales until the next purchase when a new cost is computed.

Ending Inventory : 450 x 12.87 = 5.790

21

Summary Perpetual Inventory System

FIFO Weighted Ave.COGS 6.200 6.210Ending Inventory 5.800 5.790

22

Lower of Cost or Market

• Inventories, similar to other assets are originally recordedat the historical cost

• However, as time passes the value of the inventories mightdecline in the market because of the obsolescence factor

• IFRS specify that the companies should use the lower-ofcost-or market (LCM) valuation basis

• the market value is the current replacement cost of theinventory

• LCM rule can be applied with any of the cost flow methods, or the specific identification method

• LCM may be applied to individual items or major categories of inventory the decline in value is not expected to increase in the very near future

23

ItemInventory Value

at Cost (TL)Inventory Value at Market (TL)

Inventory Value at LCM (TL)

W 9.750 9.375 9.375

X 7.248 7.872 7.248

Y 8.787 8.181 8.181

Z 7.040 7.360 7.040

Total 32.825 32.788 31.844

Example-LCM-1Item Quantity Unit Cost

(TL)Unit

Market (TL)

W 75 130 125

X 48 151 164

Y 101 87 81

Z 64 110 115

Item by item

Date Account Title and Description Debit Credit

Loss from Decline in Value of Inventory Allowance for Decline in Value of Inventory 981To record the decline in value.

31-Dec-04 981

What should company report on the balance sheet if it were using the total approach?

24

Example-LCM-2

Date Account Title and Description Debit Credit15-Aug-05 Cash 1.890

Sales 1.890To recognize the sale of 15 units of item W

15-Aug-05 COGS (*) 1.875 Inventories 1.875To record COGS of the sale of 15 units of item W

(*) Use the declined value of the unit TL 125*15

on 15 August 2005, the company sold 15 units of Item W at TL 126 per unit

25

Example-LCM-3Item Inventory

Value at Cost (TL)

Inventory Value at

Market (TL)

Inventory Value at LCM

(TL)W 7.800 7.500 7.500

X 7.248 7.872 7.248

Y 8.787 8.181 8.181

Z 7.040 7.360 7.040

Total 30.875 30.913 29.969

Decline in value of inventories as 31 December 2005 TL 906 CR balance

TL 981 CR balance

TL 981 CR balanceDifference TL 75

Balance of Allowance for Decline in Inventory before adjustment

Date Account Title and Description Debit Credit

31-Dec-05 Allowance for Decline in Value of Inventory 75 Recovery from Decline in Value of Inventory

(a revenue in the income statement) 75To record the recovery of the decline in the value of inventories

Using item-by-item basis 31 December 2005

26

Inventory Errors

Understated by Overstated by

TL 1.000 TL 1.000

Year 1Beginning Inventory No effect/ correct No Effect/correct

Cost of goods sold Overstated + 1,000 Understated – 1,000

Gross margin Understated – 1,000 Overstated + 1,000

Net Income Understated – 1,000 Overstated + 1,000Retained Earnings at year end Understated – 1.000 Overstated + 1,000

Year 2Beginning Inventory Understated – 1,000 Overstated + 1,000

Cost of goods sold Understated - 1,000 Overstated + 1,000

Gross margin Overstated + 1,000 Understated – 1,000

Net Income Overstated + 1,000 Understated – 1,000

Retained Earnings at yearend

Overstated + 1,000 Understated – 1,000

Sum of two years income orending shareholders’ equity

No effect /correct No effect/correct

ending shareholders' equity

Ending Inventory Year 1

COGS = Beg. Inv + Purch - End. Inv

GM = Sales - COGS

* If there are no other errors, the effect of the error in the ending inventory in Year 1 will be offset or counter-balanced in two consecutive years (at the end of the following year)

27

Estimating the Cost of Goods Sold and Ending Inventory

Two Methods:

1.Gross Margin (Gross Profit Method)

2.Retail Method In cases where the company is unable to take physical count of the inventory (cases of fire or other similar disasters which destroy the inventory); it has to make an estimation of the amount of inventory to file an insurance claim & get money from the insurance company.

28

Gross Profit Method (The widely used method based on the COGS formula)

Gross profit percentage = 40% (from previous years) , therefore :

COGS percentage = 60% (100% Net Sales – 40% GM)

Beginning inventory TL200 millionsPurchases 1,000Cost of Goods Available for Sale TL1,200 millionsCOGS : Net Sales 1,000 Gross Profit (40% of 1000) 400 600 Ending Inventory TL 600 millions

Main assumption:

Gross Profit Percentage (Gross Profit/Net Sales) is the same or similar to the previous years. Then, the COGS ratio is calculated by deducting Gross Profit% from the Net Sales percentage of 100)

29

Inventory Management and Ethical Issues

• inventories are closely related with net income and thus with the shareholders’ equity, and the assets

• taking decisions that would affect the ending inventory and cost of goods sold amount, the management can manipulate income

• for example, management might decide to make a large purchase at the end of the period, in order to maximize profits in that period, and then return the goods at the beginning of the following period stating that they are not according to specifications

30

Analysis of Inventories

To check whether adequate profits are generated by the operations

To check whether inventory is adequate to meet future demands

Important for two aspects:

31

JOIN KHALID AZIZ

ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

CONTACT:0322-3385752R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,

KARACHI, PAKISTAN.