Inventories

1
Chapter 9
Inventories
2
Objectives

• Discuss the nature of inventories and how to
  measure them
• Explain what is included in the cost of inventory
  
• Explain cost flow assumptions and apply both FIFO
  and weighted average cost formulas
• Explain the net realizable value basis of
  measurement
• Implement the disclosure requirements of IAS

3
The Nature of Inventories

• IAS 2 defines inventories as assets that are
• Held for sale
• In the process of production
• Materials or supplies to be used in production
• Inventories are classified as current assets
• Cost of goods sold (COGS) is the expense account
  used to record the costs of inventory once sold

4
Initial Recognition of Inventory

• Inventories shall be measured at the lower of
  cost and net realizable value. (IAS 2 para 9)
• Cost Components
• Costs of purchase
• Costs of conversion
• Costs in bringing inventory to present location
  condition

5
Determination of Cost

• The cost of purchase comprises
• The purchase price
• Import duties and other transaction taxes
• Transport, handling and other directly
  attributable costs
• Any discounts are to be deducted

6
Costs of Conversion

• Costs of conversion are those costs directly
  related to production including
• Direct labor
• Systematic allocation of fixed and variable
  production overheads
• Variable overheads vary with volume of
  production. Allocated based on actual use of
  production facilities
• Fixed overheads remain constant regardless of
  the volume of production. Allocated based on
  normal production capacity.

7
Assigning Costs to Inventory on Sale

• IAS 2 requires the specific identification method
  be used where possible to assign costs to
  inventory
• Under this method costs are individually
  identified for each inventory item
• Where there are large numbers of homogenous
  inventory items one of the following two methods
  should be used
• First-in first-out (FIFO)
• Weighted average cost method
• NOT Last-in First-out (LIFO)

8
Comparison to US GAAP

• IFRS
• The same cost flow assumptions must be used for
  inventory with a similar nature and use even if
  inventory is held in different geographic
  locations and/or by different entities.
• LIFO method is not allowed.

• US GAAP
• Different cost flow assumptions may be used for
  inventory with a similar nature and use.
• LIFO method is allowed.

9
Cost Flow Assumptions

• Analysis of companies as of 2010

• Exxon had a reserve of 21.3 billion in 2010 and
  17.1 billion in 2009. In 2010, this was 53 of
  Exxons operating income, 70 of its net income
  and 7 of its assets.
• Carpenter Technology Corp. had a reserve balance
  that was 28 times its operating income and 158
  times its net income in 2010.

Variable Mean Median
Reserve balance (in millions) 294 38
Net income (in millions) 686 99
LIFO reserve/operating income 65 17
LIFO reserve/net income 129 24
LIFO reserve/assets 4 2
LIFO reserve/inventory 8 14
Inventory is the LIFO inventory with the reserve
added back. Analysis of companies as of 2010
using Compustat 6,423 companies in the sample of
which 4,459 companies had inventory of which 302
companies had a LIFO reserve.
10
Lower of Cost or Market

• US GAAP
• Reports at the LCM
• Market is defined as replacement cost with a
  floor (NRV less normal profit margin) and a
  ceiling (NRV).
• NRV is defined as the estimated selling price
  less the estimated costs of completion and sale.
• Reversals of prior write-downs are not allowed.

• IFRS
• Reports at the lower of cost or net realizable
  value (LCNRV)
• NRV is defined as the estimated selling price
  less the estimated costs of completion and sale.
• Since replacement cost would typically be less
  than NRV, IFRS will generally result in lower
  write-downs than US GAAP.
• Reversals of prior write-downs can be made and
  recognized in income.

11
Net Realizable Value (NRV)

• NRV may fall below cost due to
• Fall in selling price
• Physical deterioration of inventory
• Obsolescence
• The costs and NRV of inventories should normally
  be compared "item by item" (IAS2).
• However, similar or related items may be grouped
  if this is appropriate.

12
Inventory Write-down Example

• Example 1 inventory write-down
• Part 1On December 31, 2012, Jets International
  had an inventory of five different types of
  airplane parts. Given the current fuel costs,
  airplane parts are not as valuable as they once
  were. The chart on the next slide provides the
  cost basis, net realizable value, replacement
  cost and net realizable value less normal profit
  margin as of December 31, 2012. Jets
  International prepares its inventory valuation
  comparisons on an item-by-item basis.

• What is the amount of write-down (if any)
  required using US GAAP? Please provide the
  necessary journal entry.
• What is the amount of write-down (if any)
  required using IFRS? Please provide the
  necessary journal entry.

13
Inventory Write-down Example
Part 1 (continued)
Cost NRV RC NRV-NPM
Part 1 10,000 20,000 15,000 12,000
Part 2 20,000 19,000 18,000 17,000
Part 3 5,000 3,000 4,000 2,000
Part 4 8,000 15,000 12,000 11,000
Part 5 15,000 12,000 9,000 11,000
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Inventory Write-down Example
Example 1 Part 1 solution
Original cost NRV RC NRV-NPM US GAAP market US GAAP LCM IFRS LCNRV
Part 1 10,000 20,000 15,000 12,000 15,000 10,000 10,000
Part 2 20,000 19,000 18,000 17,000 18,000 18,000 19,000
Part 3 5,000 3,000 4,000 2,000 3,000 3,000 3,000
Part 4 8,000 15,000 12,000 11,000 12,000 8,000 8,000
Part 5 15,000 12,000 9,000 11,000 11,000 11,000 12,000
Total 58,000 50,000 52,000
15
Inventory Write-down Example

• Part 1 solution (continued)
• US GAAP IFRS
• Original cost 58,000 Original cost
  58,000
• LCM 50,000 LCNRV 52,000
• Write-down 8,000 Write-down
  6,000
• US GAAP journal entry IFRS journal entry
• COGS 8,000 Inventory write-down expense
  6,000
• Inventory 8,000 Inventory
  valuation allowance 6,000
• The amount of inventory write down in this
  example is 8,000 using US GAAP because the LCM
  is less than the original cost. The amount is to
  be recorded in the income statement to COGS and
  directly to inventory because a future reversal
  of write-downs is not permitted. Using IFRS, the
  write-down is 6,000 because the LCNRV is less
  than the original cost. The write-down is not
  required to be recorded in a specific income
  statement account. A valuation allowance is used
  because future reversals of write-downs are
  permitted.

16
Inventory Write-down Reversal Example

• Example 1 write-down reversal
• Part 2The airline industrys business was so
  terrible during 2013 that Jets International
  still had the same five parts in its inventory as
  of December 31, 2013. However, fuel prices have
  decreased, so the outlook is more optimistic. As
  of the end of the year, Jets Internationals
  original cost basis, net realizable value,
  replacement cost and net realizable value less
  the normal profit are as shown on the next slide.

• What is the amount of write-down reversal (if
  any) required using US GAAP? Please provide the
  necessary journal entry.
• What is the amount of write-down reversal (if
  any) required using IFRS? Please provide the
  necessary journal entry.

17
Inventory Write-down Reversal Example
Part 2 (continued)
Original Cost NRV RC NRV-NPM
Part 1 10,000 21,000 16,000 13,000
Part 2 20,000 20,000 19,000 18,000
Part 3 5,000 4,000 9,000 3,000
Part 4 8,000 16,000 11,000 12,000
Part 5 15,000 14,000 10,000 12,000
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Inventory Write-down Reversal Example
Example 1 Part 2 solution
Original Cost IFRS LCNRV December 31, 2012 NRV IFRS LCNRV December 31, 2013
Part 1 10,000 10,000 21,000 10,000
Part 2 20,000 19,000 20,000 20,000
Part 3 5,000 3,000 4,000 4,000
Part 4 8,000 8,000 16,000 8,000
Part 5 15,000 12,000 14,000 14,000
Total 58,000 52,000 56,000
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Inventory Write-down Reversal Example

• Part 2 solution (continued)
• No reversal of a write-down is permitted using US
  GAAP.
• IFRS
• December 31, 2013 LCNRV 56,000
• December 31, 2012 LCNRV 52,000
• Write-down 4,000
• Journal entry
• Inventory valuation allowance 4,000
• Inventory write-down expense 4,000
• Since the LCNRV at December 31, 2013 exceeds the
  LCNRV at December 31, 2012 by 4,000, this amount
  is recorded as a reversal to the previous
  write-down. The reversal cannot be more than the
  original write-down.

20
Disclosure

• IAS 2 para 36 - 37 outline requirements
• Need to classify into categories
• Common classifications
• Merchandise
• Production supplies
• Materials
• Work in progress
• Finished goods

21
HOMEWORK

• Exercise 9.11
• DUE THURSDAY, SEPTEMBER 11