1
IFRS: Inventories
by
Publication Date – 10/15/2015
Copyright Information
Copyright 2015 by CPE Depot
2
Program Description
This course presents an overview of IAS 2 Inventories, the accounting standard for classifying and measuring inventories in IFRS financial statements. This module also discusses the IASB’s and FASB’s efforts towards achieving convergence in this area of
financial reporting.
Field of Study
Accounting
Recommended CPE Credits
2 CPE Credits
Instructional Delivery Method
Self-Study
Program Level
Overview
Program Prerequisites
None
Advanced Preparation
None
Program Expiration Date
This course, including the final exam, must be completed within one year of the date of purchase or enrollment.
Instructions
In order to receive credit for this course, all students should review the learning objectives and outcomes, read and understand all program materials, answer all review questions, and complete and
pass the final exam.
3
The passing score for the final exam for this course is 70% or better answered correctly. In the event that you score less than 70% correct you must retake the final exam.
4
Copyright © Michael J. Walker, CPA
5
Table of Contents
INVENTORIES .............................................................................................................................................1
1.0 INTRODUCTION TO IAS 2......................................................................................................................1 1.1 Objective ........................................................................................................................................1 1.2 Scope ..............................................................................................................................................1
2.0 INVENTORY CLASSIFICATIONS .............................................................................................................2 2.1 Raw materials inventory ................................................................................................................2 2.2 Work in process inventory..............................................................................................................3 2.3 Finished goods inventory ...............................................................................................................3
3.0 INVENTORY SYSTEMS...........................................................................................................................4 3.1 Perpetual inventory system ............................................................................................................4 3.2 Periodic inventory system ..............................................................................................................4 Review Questions ...................................................................................................................................6
4.0 MEASUREMENT OF INVENTORIES (PART 1) ..........................................................................................8 4.1 Items included in inventory ............................................................................................................8 4.2 Costs includes in inventory ..........................................................................................................10 Review Questions .................................................................................................................................13
5.0 MEASUREMENT OF INVENTORIES (PART 2) ........................................................................................14 5.1 Introduction to inventory cost formulas .......................................................................................14 5.2 Specific identification formula .....................................................................................................15 5.3 Average cost formula ...................................................................................................................16 5.4 First-in, first-out (FIFO) formula ................................................................................................17 Review Questions .................................................................................................................................20
6.0 MEASUREMENT OF INVENTORIES (PART 3) ........................................................................................24 6.1 Net realizable value .....................................................................................................................24 6.2 Inventory write-downs..................................................................................................................24
7.0 DISCLOSURES .....................................................................................................................................25 8.0 IFRS & U.S. GAAP CONVERGENCE ..................................................................................................26
8.1 Key differences between IFRS and U.S. GAAP – Inventories ......................................................26 8.2 Last-in, first-out (LIFO) cost formula ..........................................................................................27 Review Questions .................................................................................................................................30
9.0 SUMMARY ..........................................................................................................................................31 REVIEW QUESTION ANSWERS....................................................................................................................32 GLOSSARY .................................................................................................................................................38
1
Inventories
Learning Objectives:
After studying this module participants should be able to:
Identify major classifications of inventory. Distinguish between perpetual and periodic inventory systems. Describe the items to include as inventory cost. Describe and compare the formulas used to measure inventories in IFRS financial
statements. Explain when reporting entities measure inventories at net realizable value in IFRS
financial statements.
1.0 Introduction to IAS 2
1.1 Objective
As the name suggests, IAS 2 Inventories prescribes the accounting treatment for
inventories. A primary issue in accounting for inventories is the amount of cost to be
recognized as an asset and carried forward until the related revenues are recognized. IAS
2 provides guidance on the determination of cost and its subsequent recognition as an
expense, including any write-down to net realizable value. It also provides guidance on
the cost formulas that are used to assign costs to inventories.
Accounting for inventories is important because the purchase, manufacture, and sale of
products are critical to the profitability of many companies. The cost (carrying value) of
the inventory usually has a material effect on a company’s IFRS balance sheet. Since the
ending inventory of one period is the beginning inventory of the next period, the cost of
the inventory on a company’s balance sheet will have an effect on its cost of goods sold
and net income of the next period. In addition, various accounting practices (such as
inventory cost formulas and valuation principles) are widely used and may have a
significant effect on asset valuation and income determination.
1.2 Scope
Inventories are assets of a company that are (1) held for sale in the ordinary course of
business, (2) in the process of production for sale, or (3) held for use in the production of
goods or services to be made available for sale. Inventory specifically excludes any assets
that a company does not sell in the normal course of business, such as marketable
securities, or property, plant, and equipment that the company intends to sell.
2
IAS 2 specifically applies to all inventories, except:
a. Work in progress arising under construction contracts, including directly related service
contracts (see IAS 11 Construction Contracts);
b. Financial instruments (see IAS 32 Financial Instruments: Presentation and IAS 39
Financial Instruments: Recognition and Measurement); and
c. Biological assets related to agricultural activity and agricultural produce at the point of harvest (see IAS 41 Agriculture).
2.0 Inventory Classifications
A company may use several different accounts to classify inventory under IAS 2,
depending on its business:
A merchandising company, whether wholesale or retail, purchases goods for resale and does not alter their physical form. Consequently, it needs only one type of inventory
account, generally called merchandise inventory (or simply ‘inventory’).
A manufacturing company does change the physical form of the goods and typically uses three inventory accounts, generally called raw materials inventory, work in process inventory, and finished goods inventory. These classifications are discussed in further detail below.
2.1 Raw materials inventory
Raw materials inventory includes the tangible goods acquired for direct use in the
production process. The inventory includes materials that a company acquired from
natural sources, such as the iron ore used by a steel mill. Raw materials may also include
products purchased from other companies, such as the steel or subassemblies used in the
manufacture of appliances. Raw materials are different from parts inventory, which is a
term often used for the inventory of replacement parts.
Some reporting entities include in raw materials inventory those materials that are not
directly a part of the manufacturing process but are needed for it successful operation.
However, these entities often distinguish these items by classifying them as factory
supplies, manufacturing supplies, or indirect materials. Examples of such materials
include lubricating oil and cleaning supplies.
3
2.2 Work in process inventory
Work in process inventory includes the products that are started in the manufacturing
process but are not yet complete. This partially completed inventory includes three cost
components:
1. Raw materials.
2. Direct labor. This term refers to the cost of the labor used directly in the manufacture of
the product.
3. Manufacturing overhead. This term refers to the costs other than raw materials and direct labor that are part of the manufacturing process. It includes variable overhead (such as supplies and some indirect labor) and fixed overhead (such as insurance, utilities, and depreciation on the assets used in the production activities).
2.3 Finished goods inventory
Finished goods inventory includes the fully manufactured products awaiting sale. The
inventory includes the same three cost components as the work in process inventory, but
all the costs are combined into a single cost per unit for all the completed units.
The exhibit below illustrates how inventory costs flow through the three categories
discussed thus far (raw materials, work in process and finished goods).
Exhibit 2.1 – Inventory Cost Flow
4
As Exhibit 2.1 shows, inventory cost flows begin with the purchase of raw materials and
end with the sale of finished goods and the recognition of an expense item known as ‘cost
of goods sold’. Generally speaking, this term refers to the direct costs attributable to the
production of the inventory sold by a company. This amount includes the cost of the
materials and direct labor used in creating the goods.
3.0 Inventory Systems
Reporting entities generally use one of two types of systems for maintaining inventory
records and calculating cost of goods sold – the perpetual system or the periodic system.
3.1 Perpetual inventory system
A perpetual inventory system is an inventory system that keeps a continuous record of
the physical quantities in its inventory. Purchases and sales of inventory items are
recognized as they occur through direct adjustments to the Inventory account, allowing
management to plan and control the inventory and avoid shortages.
Under the perpetual inventory system, cost of goods sold is recorded at the time of each
sale by debiting the Cost of Goods Sold account (on the Statement of Income) and
crediting the Inventory account (on the Statement of Financial Position). The perpetual
system therefore provides a continuous record of the balances in both these accounts.
Perpetual inventory systems have evolved rapidly over the past several years with the
computerization of accounting systems. For example, most retail stores now use “point of
sale” cash register systems in which each product has a unique code (e.g. a UPC code)
that is entered into the system as each unit is sold. Some companies utilize radio
frequency identification technologies (RFID) to track inventory by attaching RFID tags.
Both UPC codes and RFID tags enable the retailer to immediately update its inventory
and cost of goods sold accounts as each sale is made.
When a reporting entity uses a perpetual system, it also generally takes a physical count
at least once a year to confirm the balance in the inventory account. Any difference
between the physical count and the inventory account balances results from errors in
recording, shrinkage, water, breakage, theft, and other causes. The company would adjust
its Inventory account and increase its Cost of Goods Sold (or recognize a loss) for the cost
of the difference in the two quantities so that the perpetual records are in agreement with
the physical count.
3.2 Periodic inventory system
A reporting entity using a periodic inventory system does not maintain a continuous
record of the physical quantities (or costs) of inventory on hand. It records all
5
acquisitions of inventory during the accounting period by debiting the Purchases account.
The entity then adds the total in the Purchases account at the end of the accounting
period to the cost of the inventory on hand at the beginning of the period. This sum
equals an amount referred to as the cost of goods available for sale (during the period).
To compute the cost of goods sold, the entity then subtracts the ending inventory from the
cost of goods available for sale. Note that under the periodic inventory system, the cost
of goods sold is a residual amount that depends on a physical count of ending inventory.
This process is referred to as “taking a physical inventory.” Reporting entities that use the
periodic system generally take a physical inventory at least once a year.
Exhibit 3.1 provides an example of the cost of goods sold calculation under the periodic
inventory system.
Exhibit 3.1 – Cost of goods sold calculation (periodic system)
Beginning inventory (Jan. 1st) $100,000 Cost of goods acquired or produced during the year 800,000 Cost of goods available for sale 900,000
Ending inventory (Dec. 31st) (200,000) Cost of goods sold
$700,000
6
Review Questions
1. Which of the following items would most likely be considered outside the scope of
IAS 2?
a. Company A’s raw materials inventory.
b. Company B’s manufactured goods held for sale.
c. Company C’s financial instruments portfolio.
d. Company D’s partially completed inventory items.
Beantown Corp. is a plastic toy manufacturing company that has the following items of
inventory as of December 31, 201X: (1) 5,000 toy trucks that are fully assembled and are
awaiting sale, (2) 7,000 partially assembled toy soldiers, and (2) 20,000 gallons of crude
oil reserves (used in the creation of plastic).
2. Under IAS 2, Beantown Corp. would most likely classify its fully assembled toy
trucks as:
a. Work-in-process inventory.
b. Finished goods inventory.
c. Merchandise inventory.
d. Raw materials inventory.
3. Under IAS 2, Beantown Corp. would most likely classify its partially assembled toy
soldiers as:
a. Work-in-process inventory.
b. Finished goods inventory.
c. Merchandise inventory.
d. Raw materials inventory.
4. Under IAS 2, Beantown Corp. would most likely classify its crude oil reserves as:
a. Work-in-process inventory.
b. Finished goods inventory.
7
c. Merchandise inventory.
d. Raw materials inventory.
5. Blue Jay Inc. uses an inventory system to maintain its inventory accounting
records. Blue Jay’s system would most likely be considered a ‘perpetual inventory
system’ if which of the following were true?
a. The system records all inventory acquisitions to the Purchases account.
b. The system maintains a continuous balance in the company’s Inventory
account.
c. The system can only calculate cost of goods sold at the end of a
reporting period.
d. The system calculates cost of goods sold by subtracting the company’s
ending inventory from its cost of goods available for sale.
8
4.0 Measurement of Inventories (Part 1)
IAS 2 paragraph 9 states the following:
Inventories shall be measured at the lower of cost and net realizable value.
Sections 4 and 5 will address the primary accounting issues associated with measuring
inventories at cost under IAS 2;
Section 6 will address the primary accounting issues associated with measuring
inventories at their net realizable value under IAS 2.
Measuring inventory at cost on the Statement of Financial Position under IAS 2 can be a
complex process. It requires answering the following questions:
1. Which physical goods should be included in inventory? (i.e. who owns the goods?)
2. Which costs should be included in inventory? (i.e. product costs vs. period costs)
3. Which cost flow assumption should be adopted? (i.e. specific identification, average cost, FIFO, etc.)
4.1 Items included in inventory
The transfer of legal title is the general guideline used to determine whether a company
should include an item in inventory on its IFRS financial statements. Unfortunately,
transfer of legal title and the underlying economic substance of the transaction may not
match. For example, legal title may have passed to the purchaser, but the seller of the
goods retains the economic control of the goods (i.e. the risk and rewards of ownership).
Conversely, transfer of legal title may not occur, but the economic substance of the
transaction is such that the seller no longer retains the risk and rewards of ownership.
Therefore in more complex situations, the economic substance of the transaction takes
precedence over its legal form to determine whether the buyer or the seller has economic
control.
Goods are often shipped under one of two alternatives: FOB (free-on-board) shipping
point or FOB destination. When goods are in transit at the end of the accounting period,
the terms of shipment determine whether the seller or the buyer includes them in its
inventory:
If the goods are shipped FOB shipping point, control of (and legal title to) the goods is
transferred at the shipping point when the seller delivers them to the buyer (or to a
9
transportation company that is acting as an agent for the buyer). The buyer has economic control and includes those goods in its inventory, and the seller excludes them.
If the goods are shipped FOB destination, control of (and legal title to) the goods is not
transferred until the goods are delivered to the buyer’s destination. The seller has economic control and includes those goods in its inventory, and the buyer excludes them.
Exhibit 4.1 – FOB Shipping Point vs. FOB Destination
Economic control may also transfer before or after physical possession (and legal
ownership) transfer. For example, suppose the buyer requests that the seller holds the
goods to be delivered later and the goods are segregated from the seller’s other inventory
so that the risk of ownership has passed to the buyer. In this case, control has passed, and
the seller should exclude the goods from inventory and the buyer should include them.
This is known as a “bill and hold” sale.
Also, goods may be transferred on consignment. Under this arrangement, a company
such as Boston Corp. (the consignor) ships various merchandise to New York Inc. (the
consignee), who acts as Boston’s agent in selling the consigned goods. New York Inc.
agrees to accept the goods without any liability, except to exercise due care and
reasonable protection from loss or damage, until it sells the goods to a third party. When
New York Inc. sells the goods, it remits the revenue (less a selling commission and
expenses incurred in accomplishing the sale) to Boston Corp. In this example, the
consignor (Boston Corp.) retains economic control and ownership of the consigned goods
while the consignee (New York Inc.) attempts to sell them. The consignor includes the
goods in its inventory until they are sold by the consignee.
In summary, the transfer of legal title usually determines when the seller records the sale
of goods and the buyer records the inventory in their respective accounting systems.
However, both companies should adjust the recorded amounts in situations where the
possession of legal title is not consistent with economic control on the balance sheet date.
10
4.2 Costs includes in inventory
Reporting entities generally account for the acquisition of inventories on a cost basis. The
cost of inventory is the price paid or consideration given to acquire it. Under IAS 2,
inventory cost includes costs directly or indirectly incurred in bringing an item to its
existing condition and location. For each item of inventory (purchased or manufactured),
a reporting entity must make a decision as to whether or not each cost meets this
definition. If it does, the entity includes it in the cost of inventory. If it does not, the entity
immediately recognizes it as an expense.
Such costs include product costs and period costs, as well as purchase discounts (when
applicable).
Product Costs
IAS 2 paragraph 10 states the following:
The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.
The costs described in the above paragraph are commonly referred to as product costs,
which are those costs that “attach” to the inventory. As a result, product costs are
recognized as “Inventories” in IFRS financial statements. These costs are directly
connected with bringing the goods to the buyer’s place of business and converting such
goods to a salable condition.
The term “all costs of purchase” used in IAS 2 includes:
1. The purchase price, 2. Import duties and other taxes, 3. Transportation costs, and 4. Handling costs directly related to the acquisition of the goods.
Conversion costs generally include direct materials, direct labor, and manufacturing
overhead costs. Manufacturing overhead costs include indirect materials, indirect labor,
and various costs (such as depreciation, taxes, insurance, and utilities).
“Other costs” include costs incurred to bring the inventory to its present location and
condition ready to sell. An example of these other costs is the costs to design a product
for specific customer needs.
11
Period Costs
Period costs are those costs that are indirectly related to the acquisition or production of
goods. Period costs (such as selling expenses and administrative expenses) are therefore
not included as part of the inventory costs.
IAS 2 paragraph 15 provides examples of “period costs”:
Examples of costs excluded from the cost of inventories and recognized as expenses in the period in which they are incurred are:
a. abnormal amounts of wasted materials, labor or other production costs; b. storage costs, unless those costs are necessary in the production
process before a further production stage; c. administrative overheads that do not contribute to bringing inventories to
their present location and condition; and d. selling costs.
Purchase Discounts
Purchase discounts are reductions in the selling prices granted to customers. These
discounts may be used to provide an incentive for a first-time purchaser or as a reward for
a large order. In some cases, incentives are provided to encourage early payment. There
has been some diversity in practice regarding the U.S. GAAP accounting for these
discounts, with some entities recording the discount as a reduction in inventory while
others treating the discount as revenue. However these discounts must be recorded as a
reduction from the cost of inventories (and not as revenue) under IFRS.
IFRS reporting entities may account for this cost reduction using one of two methods: the
gross price method or the net price method.
Under the gross price method, a reporting entity records the purchase at the gross price
and records the amount of the discount in the accounting system only if the discount is taken. This discount should be deducted from the purchase price of the inventory.
Under the net price method, a reporting entity records the purchase at its net price and records the amount of the discount in the accounting system only if the discount is not
taken. This discount lost is treated as an expense and is reported in the “Other income and expense” section of the income statement.
The gross price and net price methods are illustrated in the exhibit below. Assume that a
company purchases $1,000 of goods under terms of 1/10, n/30 (a 1% discount is allowed
if payment is made within 10 days; otherwise, full payment is due within 30 days).
12
Exhibit 4.2 – Purchase Discounts: Gross Price Method vs. Net Price Method
Some prefer the net price method because (1) it provides a correct reporting of the cost of
the asset and related liability, and (2) it can measure management inefficiency by holding
management responsible for discounts not taken. However many believe that the
somewhat more complicated net method is not justified by the resulting benefits. As a
result, the gross method is the much more widely used method.
13
Review Questions
6. Met Corp. is an online sporting goods retailer. The company’s orders are received
exclusively through its website, and its products are shipped “FOB destination” to
customers. Under IAS 2, Met Corp. would relinquish economic control of its
merchandise after which of the following events occur?
a. The company purchases the raw materials necessary to create the
products.
b. The products are fully manufactured.
c. The company receives the purchase order through its website.
d. The products are delivered to the customer’s destination.
7. Companies A, B, C & D are assessing whether or not to include certain
expenditures in the cost bases of its inventories under IAS 2. Which of the following
inventory accounting practices would most likely comply with the Standard’s
requirements?
a. Company A includes conversion costs in its inventory cost basis.
b. Company B excludes the product’s purchase price from its inventory cost
basis.
c. Company C includes selling and administrative expenses in its inventory
cost basis.
d. Company D excludes direct labor costs from its inventory cost basis.
8. Philly Inc. recently purchased some wholesale goods from East Corp. The terms of
the purchase order stated that Philly would receive a 2% discount if payment was
made to East Corp. within 10 days. However due to an accounting system error,
the payment was not made until 30 days after the purchase date. Assuming that
Philly uses the net price method, which of the following best describes the proper
accounting treatment for this purchase discount under IAS 2?
a. The company must recognize the lost discount as revenue.
b. The company must not recognize the lost discount on its IFRS financial
statements.
c. The company must recognize the lost discount as an expense.
14
d. The company must add the lost discount to the purchase price of the
inventory.
5.0 Measurement of Inventories (Part 2)
5.1 Introduction to inventory cost formulas
Exhibit 5.1 – Inventory Unit and Cost Flow Relationships
A reporting entity typically starts an accounting period with some units in the beginning
inventory and then purchases (or produces) additional units during the period. Together
these are the goods available for sale, which the company then either sells or retains in its
ending inventory.
For IFRS financial statement purposes, a company must assign costs to these units. The
cost of the beginning inventory (i.e. the cost of the ending inventory of the preceding
period) is the beginning balance in the Inventory account. As discussed previously, the
beginning balance in Inventory plus the cost of purchases is the cost of goods available
for sale. Under IAS 2, this total cost is allocated between the cost of goods sold and
ending inventory using a cost formula.
Consider the following example of Patriot Corp., which had the following transactions in
its first month of operations:
Date Purchases Sold or issued Balance
March 2 2,000 @ $4.00 2,000 units March 15 6,000 @ $4.40 8,000 units March 19 4,000 units 4,000 units March 30 2,000 @ $4.75 6,000 units
15
From this information, Patriot Corp. computes the ending inventory of 6,000 units and
the cost of goods available for sale (beginning inventory + purchases) of:
900,43$75.4$@000,240.4$@000,600.4$@000,2
The question is which price (or prices) should the company assign to the 6,000 units of
ending inventory? The answer depends on which cost formula it uses. The cost formulas
permitted by IAS 2 include specific identification, average cost and first-in, first-out
(FIFO).
5.2 Specific identification formula
Specific identification calls for identifying each item sold and each item in inventory. A
company includes in cost of goods sold the costs of specific items sold. It includes in
inventory the costs of the specific items on hand. This formula may be used only in
instances where it is practical to separate physically the different purchases made. As a
result, most companies only use this formula when handling a relatively small number of
costly, easily distinguishable items. In the retail trade, this includes some types of
jewelry, fur costs, automobiles, and some furniture. In manufacturing, it includes special
orders and many products manufactured under a job cost system.
To illustrate, assume that Patriot Corp.’s 6,000 units of inventory consists of 1,000 units
from the March 2 purchase, 3,000 units from the March 15 purchase, and 2,000 from the
March 30 purchase. Patriot Corp. would compute its ending inventory and cost of goods
sold as follows.
Exhibit 5.2 – Measuring Inventories using the Specific Identification Formula
Date No. of Units Unit Cost Total Cost
March 2 1,000 $4.00 $4,000 March 15 3,000 4.40 13,200 March 30 2,000 4.75 9,500 Ending inventory 6,000 $26,700
Cost of goods available for sale (computed in the section 5.1)
$43,900
Less: Ending inventory (26,700) Cost of goods sold $17,200
IAS 2 paragraph 23 states the following:
16
The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs.
Conceptually, the specific identification formula is ideal because it matches actual costs
against actual revenue and results in ending inventory being reported at its actual cost.
Therefore IAS 2 requires the use of this formula in cases where inventories are not
ordinarily interchangeable or for goods and services produced or segregated for specific
projects. Unfortunately for most companies, the specific identification formula is not
practicable. Only in situations where inventory turnover is low, unit price is high, or
inventory quantities are small are the specific identification criteria met.
5.3 Average cost formula
As its name implies, the average cost formula prices items in the inventory on the basis
of the average cost of all similar goods available during the period. There are two
versions of the average cost formula: the weighted-average formula (for periodic
inventory systems) and the moving-average formula (for perpetual inventory systems).
Weighted-average formula
When a reporting entity uses the periodic inventory system, the average cost formula is
known as the weighted-average formula. The entity calculates the cost of the units for the
period based on the cost of the beginning inventory and the average cost of the units
purchased or manufactured, weighted according to the number of units at each cost. In
other words, the average cost per unit for the period is the cost of goods available for
sale divided by the number of units available for sale. Under IAS 2, the reporting entity
would use this average cost for both its ending inventory and cost of goods sold.
To illustrate, Patriot Inc. computes the ending inventory and cost of goods sold as
follows.
Exhibit 5.3 – Measuring Inventories using the Weighted-average Formula
Date No. of Units Unit Cost Total Cost
March 2 2,000 $4.00 $8,000 March 15 6,000 4.40 26,400 March 30 2,000 4.75 9,500 Total goods available 10,000 $43,900
Weighted-average cost per unit = $43,900 / 10,000 units = $4.39
Inventory in units 6,000 units Ending inventory 6,000 * $4.39 = $26,340
Cost of goods available for sale (computed in the section 5.1)
$43,900
17
Less: Ending inventory (26,340) Cost of goods sold $17,560
In computing the average cost per unit, Patriot Corp. includes its beginning inventory (if
any), both in the total units available and in the total cost of goods available.
Moving-average formula
When a reporting entity uses the perpetual inventory system, the average cost formula is
known as the moving-average formula. This formula applies the same principles as the
weighted average formula; however, it is known as the “moving” average formula
because a new weighted average cost must be computed after each purchase.
To illustrate, Patriot Inc. computes the ending inventory and cost of goods sold as
follows.
Exhibit 5.4 – Measuring Inventories using the Moving-average Formula
Date Purchased Sold/Issued Balance
March 2 2,000 @ $4.00 $8,000 2,000 @ $4.00 $8,000 March 15 6,000 @ $4.40 26,400 8,000 @ $4.30 34,400 March 19 4,000 @ $4.30
$17,200 4,000 @ $4.30 17,200
March 30 2,000 @ $4.75 9,500 6,000 @ $4.45 26,700
In this formula, Patriot Corp. computes a new average unit cost each time it makes a
purchase. For example, on March 15th, after purchasing 6,000 units for $26,400, Patriot
Corp. has 8,000 units costing $34,400 (i.e. $8,000 plus $26,400) on hand. The average
unit cost is $34,400 divided by 8,000 units, or $4.30. Patriot Corp. uses this unit cost in
measuring withdrawals until it makes another purchase. At that point, Patriot Corp.
computes a new average unit cost. Accordingly, the company shows the cost of the 4,000
units withdrawn on March 19 at $4.30, for a total cost of goods sold of $17,200. On
March 30, following the purchase of 2,000 units for $9,500, Patriot Corp. determines a
new unit cost of $4.45, for an ending inventory of $26,700.
5.4 First-in, first-out (FIFO) formula
The FIFO (first-in, first-out) formula assumes that a company uses goods in the order
in which it purchases them. In other words, the FIFO formula assumes that the first goods
purchased are the first used or sold (and therefore the first costs incurred are the first
transferred to cost of goods sold). The inventory remaining must therefore represent the
most recent costs.
Exhibit 5.5 – FIFO cost flow assumptions
18
To illustrate, assume that Patriot Corp. uses a periodic inventory system. The company
determines the cost of its ending inventory by taking the cost of the most recent purchase
and working back until it accounts for all units in the inventory. Patriot Corp. then
determines its ending inventory and cost of goods sold as follows.
Exhibit 5.6 – Measuring Inventories using the FIFO Formula (Periodic)
Date No. of Units Unit Cost Total Cost
March 30 2,000 $4.75 $9,500 March 15 4,000 4.40 17,600 Ending inventory 6,000 $27,100
Cost of goods available for sale (computed in the section 5.1)
$43,900
Less: Ending inventory (27,100) Cost of goods sold $16,800
If Patriot Corp instead uses a perpetual inventory system in quantities and dollars, it
assigns a cost amount to each withdrawal. Then the cost of the 4,000 units removed on
March 19 consists of the cost of the items purchased on March 2 and March 15. Patriot
Corp. determines its ending inventory and cost of goods sold as follows.
Exhibit 5.7 – Measuring Inventories using the FIFO Formula (Perpetual)
Date Purchased Sold/Issued Balance
March 2 2,000 @ $4.00 $8,000 2,000 @ $4.00 $8,000 March 15
6,000 @ $4.40
26,400
2,000 @ $4.00 6,000 @ $4.40
34,400
March 19
2,000 @ $4.00 2,000 @ $4.40
$16,800
4,000 @ $4.40
17,600
March 30
2,000 @ $4.75
9,500
4,000 @ $4.40 2,000 @ $4.75
$27,100
Here, the ending inventory is $27,100, and the cost of goods sold is $16,800 [i.e. (2,000
@ 4.00) + (2,000 @ $4.40)].
19
Notice that the cost of goods sold ($16,800) and ending inventory ($27,100) are the same
in the two FIFO examples provided. In all cases where FIFO is used, the inventory and
cost of goods sold would be the same at the end of the month whether a perpetual or
periodic system is used. This is because the same costs will always be first in and,
therefore, first out. This is true whether a company computes cost of goods sold as it sells
goods throughout the accounting period (the perpetual system) or as a residual at the end
of the accounting period (the periodic system).
One objective of FIFO is to approximate the physical flow of goods. When the physical
flow of goods is actually first in, first out, the FIFO method closely approximates specific
identification. At the same time, it prevents manipulation of income. With FIFO, a
company cannot pick a certain cost item to charge to expense.
Another advantage of the FIFO method is that the ending inventory is close to current
cost. The first goods in are the first goods out, and therefore the ending inventory consists
of the most recent purchases. This is particularly true with rapid inventory turnover. This
approach generally approximates replacement cost on the IFRS statement of financial
position (a.k.a. the balance sheet) when price changes have not occurred since the most
recent purchases.
However, the FIFO method fails to match current costs against current revenues on the
income statement. A company charges the oldest costs against the more current revenue,
possibly distorting gross profit and net income.
20
Review Questions
Brave Corp. uses the specific identification formula for calculating its ending inventory
and cost of goods sold under IAS 2. The company had the following transactions during
the month ended July 31, 201X (the company’s first month of operations):
Date Purchases Sold or Issued Balance
July 1 3,000 @ $5.00 3,000 units
July 19 1,000 units 2,000 units
July 26 2,000 @ $5.50 4,000 units
9. Based on the information provided above, Brave Corp.’s cost of goods available
for sale for the month ended July 31, 201X equals:
a. $21,000.
b. $25,000.
c. $26,000.
d. $27,500.
10. Based on the information provided above, Brave Corp. would report $________
ending inventory on its IFRS balance sheet for July 31, 201X.
a. $20,000.
b. $21,000.
c. $22,000.
d. $23,000.
11. Based on the information provided above, Brave Corp.’s cost of goods sold for
the month ended July 31, 201X equals:
a. $5,000.
b. $5,500.
c. $11,000.
d. $15.000.
21
Marlin Inc. uses a periodic inventory system and the average cost formula for
calculating its ending inventory and cost of goods sold under IAS 2. The company had
the following transactions during the month ended December 31, 201X (the
company’s first month of operations):
Date Purchases Sold or Issued Balance
December 3 10,000 @ $4.25 10,000 units
December 8 13,000 @ $4.50 23,000 units
December 16 17,000 units 6,000 units
December 30 15,000 @ $5.00 21,000 units
12. Based on the information provided above, Marlin Inc.’s cost of goods available
for sale for the month ended December 31, 201X equals:
a. $161,500.
b. $171,000.
c. $176,000.
d. $190,000.
13. Based on the information provided above, Marlin Inc. would report
approximately $________ ending inventory on its IFRS balance sheet for December
31, 201X.
a. $60,211.
b. $69,474.
c. $78,737.
d. $97,263.
14. Based on the information provided above, Marlin Inc.’s cost of goods sold for the
month ended December 31, 201X equals:
a. $78,737.
b. $97,263.
c. $106,526.
d. $115,789.
22
National Corp. uses a periodic inventory system and the first-in, first-out (FIFO) formula
for calculating its ending inventory and cost of goods sold under IAS 2. The company
had the following transactions during the month ended May 31, 201X (the company’s
first month of operations):
Date Purchases Sold or Issued Balance
May 5 8,000 @ $6.50 8,000 units
May 12 3,000 @ $7.00 11,000 units
May 20 6,000 units 5,000 units
May 30 4,000 @ $7.25 9,000 units
15. Based on the information provided above, National Corp.’s cost of goods
available for sale for the month ended May 31, 201X equals:
a. $97,500.
b. $102,000.
c. $105,000.
d. $108,750.
16. Based on the information provided above, National Corp. would report
approximately $________ ending inventory on its IFRS balance sheet for May 31,
201X.
a. $58,500.
b. $61,200.
c. $63,000.
d. $65,250.
17. Based on the information provided above, National Corp.’s cost of goods sold for
the month ended May 31, 201X equals:
a. $39,000.
b. $40,800.
c. $42,000.
d. $43,500.
23
24
6.0 Measurement of Inventories (Part 3)
IAS 2 paragraph 9 states the following:
Inventories shall be measured at the lower of cost and net realizable value. (Emphasis added)
Inventories are recorded at their historical cost. However, if inventory declines in value
below its original cost, a major departure from the historical cost principle occurs.
Whatever the reason for this decline – obsolescence, price-level changes, or damaged
goods – a company should write down the inventory to net realizable value to report this
loss. Under IAS 2, a reporting entity abandons the historical cost principle when the
future utility (i.e. revenue-producing ability) of the asset drops below its original cost.
6.1 Net realizable value
Under IAS 2, cost is the acquisition price of inventory computed using one of the
historical cost-based methods – specific identification, average cost or FIFO. The term
net realizable value (NRV) refers to the net amount that a company expects to realize
from the sale of inventory. Specifically, IAS 2 states the following:
Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
To illustrate, assume that Yawkey Corp. has unfinished inventory with a cost of $950, a
sales value of $1,000, estimated cost of completion of $50, and estimated selling costs of
$200. Yawkey’s net realizable value is computed as follows: Exhibit 6.1 – Computation of Net Realizable Value
Inventory value – unfinished $1,000 Less: Estimated cost of completion ($50) Less: Estimated cost to sell ($200) ($250) Net realizable value $750
6.2 Inventory write-downs
IAS 2 paragraph 34 states the following:
When inventories are sold, the carrying amount of those inventories shall be recognized as an expense in the period in which the related revenue is recognized. The amount of any write-down of inventories to net realizable value and all losses of inventories shall be recognized as an expense in the period the write-down or loss occurs. The amount of any
25
reversal of any write-down of inventories, arising from an increase in net realizable value, shall be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.
As illustrated in Exhibit 6.1, Yawkey reports its inventory on its IFRS statement of
financial position at $750. In its IFRS income statement, Yawkey would report a Loss on
Inventory Write-Down of $200 (i.e. $950 - $750). A departure from cost is justified
because inventories should not be reported at amounts higher than their expected
realization from sale or use. In addition, IAS 2 requires reporting entities to charge the
loss of utility against revenues in the period in which the loss occurs, not in the period of
sale.
After inventories have been written down under IAS 2, a new assessment is made of the
net realizable value in each subsequent period. When the circumstances that previously
caused inventories to be written down below cost no longer exist or when there is clear
evidence of an increase in net realizable value because of changed economic
circumstances, the amount of the write-down is reversed (i.e. the reversal is limited to the
amount of the original write-down) so that the new carrying amount is the lower of the
cost and the revised net realizable value. This occurs, for example, when an item of
inventory that is carried at net realizable value, because its selling price has declined, is
still on hand in a subsequent period and its selling price has increased.
7.0 Disclosures
IFRS financial statements should include the following inventory-related disclosures (per
IAS 2 p. 36):
a. The accounting policies adopted in measuring inventories, including the cost formula
used;
b. The total carrying amount of inventories and the carrying amount in classifications appropriate to the entity;
c. The carrying amount of inventories carried at net realizable value;
d. The amount of inventories recognized as an expense during the period (through cost of goods sold);
e. The amount of any write-down of inventories recognized as an expense in the period;
f. The amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period;
g. The circumstances or events that led to the reversal of a write-down of inventories; and
h. The carrying amount of inventories pledged as security for liabilities.
26
This information can be disclosed in the statement of financial position or in a separate
schedule in the notes. The relative mix of raw materials, work in process, and finished
goods helps in assessing liquidity and in computing the stage of inventory completion.
Significant or unusual financing arrangements relating to inventories may require note
disclosure. Examples include transaction with related parties, product financing
arrangements, firm purchase commitments, and pledging of inventories as collateral.
8.0 IFRS & U.S. GAAP Convergence
Since 2002, the Financial Accounting Standards Board (FASB) and the International
Accounting Standards Board (IASB) have had formal convergence projects in the works.
The term convergence refers to the efforts by the IASB and FASB to reduce the
numerous differences that exist between IFRS and U.S. GAAP. These convergence
projects are designed to bring U.S. GAAP and IFRS closer together; the ultimate goal of
‘convergence’ is to create a single set of high quality financial reporting standards.
8.1 Key differences between IFRS and U.S. GAAP – Inventories
ASC 330 Inventory is the primary source of guidance on accounting for inventories
under U.S. GAAP.
Both U.S. GAAP and IFRS define inventories as assets that are (1) held for sale in the
ordinary course of business, (2) used in the process of production for sale, or (3)
materials or supplies to be consumed in the production of inventory or in the rendering of
services. The cost of inventory under both U.S. GAAP and IFRS generally includes direct
expenditures of getting inventories ready for sale, including overhead and other costs
attributable to the purchase or production of inventory.
The following table summarizes the key differences between IAS 2 and ASC 330.
Exhibit 8.1 – Key differences between IFRS 8 and ASC 280
Subject IAS 2 ASC 330
Measurement of carrying value
Lower of cost or net realizable value.
Lower of cost or market.
Cost formulas: similar inventories
The same formula used to determine the cost of inventory must be applied to all inventories that have a similar nature and use to the entity.
The same formula used to determine the cost of inventory does not need to be applied to all inventories that have a similar nature and use to the entity.
Cost formulas permitted FIFO and weighted-average cost are acceptable
First-in, first-out (FIFO); last-in, first-out (LIFO); weighted-
27
accounting methods for determining cost of inventory; LIFO is not permitted. The
specific identification method is required for inventory items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects.
average cost; and specific identification are acceptable accounting methods for determining cost of inventory.
Reversal of write-downs Write-downs taken to reduce inventories to the lower of cost or net realizable value are reversed for subsequent increases in value.
Write-downs taken to reduce inventories to the lower of cost or market may not be reversed for subsequent increases in value.
Although a lower-of-cost-or-market approach is used under ASC 330 to determine the
carrying value of inventory, under IAS 2 a lower-of-cost-or-net-realizable-value
approach is used. Under ASC 330, the term "market" generally means current
replacement cost, except that this replacement cost should not (1) exceed net realizable
value or (2) be lower than net realizable value less a normal profit margin. Similarly to
ASC 330, IAS 2 defines net realizable value as estimated selling price less estimated
costs of completion and sale.
8.2 Last-in, first-out (LIFO) cost formula
As noted in Exhibit 8.1, a major difference between IFRS and U.S. GAAP relates to the
LIFO cost formula. U.S. GAAP permits the use of LIFO cost formula for inventory
valuation, while IFRS prohibits its use.
Under the LIFO (last-in, first out) cost formula, a reporting entity includes the most
recent inventory costs incurred in the cost of goods sold and includes the earliest costs
(part or all of which are costs incurred in previous periods) in the ending inventory.
Exhibit 8.2 – LIFO cost flow assumptions
28
Recall from Section 5.1 that Patriot Corp. had the following transactions in its first month
of operations:
Date Purchases Sold or issued Balance
March 2 2,000 @ $4.00 2,000 units March 15 6,000 @ $4.40 8,000 units March 19 4,000 units 4,000 units March 30 2,000 @ $4.75 6,000 units
If Patriot Corp. uses a periodic inventory system, it assumes that the cost of the total
quantity sold or issued during the month comes from the most recent purchases. Patriot
Corp. prices the ending inventory by using the total units as a basis of computation and
disregards the exact dates of sales or issuances. For example, Patriot Corp. would assume
that the cost of the 4,000 units withdrawn absorbed the 2,000 units purchased on March
30 and 2,000 of the 6,000 units purchased on March 15. Exhibit 8.3 shows how Patriot
Corp. computes the inventory and related cost of goods sold.
Exhibit 8.3 – Measuring Inventories using the LIFO Formula (Periodic)
Date No. of Units Unit Cost Total Cost
March 2 2,000 $4.00 $8,000 March 15 4,000 4.40 17,600 Ending inventory 6,000 $25,600
Cost of goods available for sale (computed in the section 5.1)
$43,900
Less: Ending inventory (25,600) Cost of goods sold $18,300
If Patriot Corp instead uses a perpetual inventory system in quantities and dollars, use of
the LIFO formula results in different ending inventory and cost of goods sold amounts
than the amounts calculated under the periodic method. See Exhibit 8.4.
Exhibit 8.4 – Measuring Inventories using the LIFO Formula (Perpetual)
Date Purchased Sold/Issued Balance
March 2 2,000 @ $4.00 $8,000 2,000 @ $4.00 $8,000 March 15
6,000 @ $4.40
26,400
2,000 @ $4.00 6,000 @ $4.40
34,400
March 19
4,000 @ $4.40
$17,600
2,000 @ $4.00 2,000 @ $4.40
16,800
March 30
2,000 @ $4.75
9,500
2,000 @ $4.00 2,000 @ $4.40 2,000 @ $4.75
$26,300
29
The month-end periodic inventory computation presented in Exhibit 8.3 (inventory
$25,600 and cost of goods sold $18,300) shows a different amount from the perpetual
inventory computation (inventory $26,300 and cost of goods sold $17,600). The periodic
system matches the total withdrawals for the month with the total purchases for the
month in applying the last-in, first-out method. In contrast, the perpetual system matches
each withdrawal with the immediately preceding purchases. In effect, the periodic
computation assumed that Patriot Corp. included the cost of goods sold that it purchased
on March 30 in the sale or issue on March 19.
In prohibiting LIFO, the IASB noted that use of LIFO results in inventories being
recognized in the statement of financial position at amounts that may bear little
relationship to recent cost levels of inventories. While some argued for use of LIFO
because it may better match the costs of recently purchased inventory with current prices,
the Board concluded that it is not appropriate to allow an approach that results in a
measurement of profit or loss for the period that is inconsistent with the measurement of
inventories in the statement of financial position. Nonetheless, LIFO is permitted for
financial reporting purposes in the United States and is permitted for tax purposes in
some countries1.
1 IAS 2 paragraphs BC13 – BC14.
30
Review Questions
Tiger Corp. has unfinished inventory with a cost basis of $1,000,000 and an estimated
sales price of $1,200,000. Tiger estimates that it will cost them $300,000 to complete
these items and an additional $100,000 to sell them in the market.
18. The “net realizable value” of Tiger Corp.’s unfinished inventory (as defined by IAS
2) equals:
a. $600,000.
b. $800,000.
c. $900,000.
d. $1,100,000.
19. Based on the information above, Tiger Corp is required to measure its unfinished
inventory at $________ under IAS 2.
a. $800,000.
b. $1,000,000.
c. $1,100,000.
d. $1,200,000.
20. Which of the following inventory accounting practices is permitted under U.S.
GAAP but not under IFRS?
a. Company A values its ending inventory using the weighted-average cost
formula.
b. Company B uses the net price method when accounting for its purchase
discounts.
c. Company B uses the gross price method when accounting for its
purchase discounts.
d. Company D values its ending inventory using the LIFO cost formula.
31
9.0 Summary
IAS 2 Inventories prescribes the accounting treatment for inventories under IFRS. Inventories are assets of a company that are (1) held for sale in the ordinary course of business (finished goods inventory), (2) in the process of production for sale (work in process inventory), or (3) held for use in the production of goods or services to be made available for sale (raw materials).
Cost of goods sold includes the material and direct labor costs used in creating inventories. Reporting entities generally use one of two types of systems for maintaining inventory records and calculating cost of goods sold – the perpetual system or the periodic system.
Under IAS 2, inventories must be measured at the lower of cost and net realizable value.
The cost of inventory is the price paid or consideration given to acquire it. Under
IAS 2, inventory costs include product costs and period costs, as well as purchase
discounts (when applicable).
Cost formulas are used to allocate total inventory costs (i.e. the cost of goods available for sale) between the income statement (i.e. cost of goods sold) and the balance sheet (i.e.
inventories). The cost formulas permitted by IAS 2 include:
o Specific identification. This formula allocates inventory costs by identifying each item
sold and each item in inventory.
o Average cost. This formula prices items in the inventory on the basis of the average cost
of all similar goods available during the period.
o First-in, first-out (FIFO). This formula assumes that the first goods purchased are the
first used or sold (and therefore the first costs incurred are the first transferred to cost of
goods sold). The inventory remaining must therefore represent the most recent costs.
Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Under IAS 2, inventories must be written down to net realizable value if this value is less than their historical cost. These write-downs are recognized as an expense in the period the write-down or loss occurs. Write-downs taken to reduce inventories to the lower of cost or net realizable value are reversed for subsequent increases in value.
ASC 330 Inventory is the primary source of guidance on accounting for inventories under U.S. GAAP.
The primary difference between ASC 330 and IAS 2 is that ASC 330 permits the use of
the last-in, first-out (LIFO) cost formula. Under the LIFO formula, a reporting entity includes the most recent inventory costs incurred in the cost of goods sold and includes the earliest costs (part or all of which are costs incurred in previous periods) in the ending inventory. IAS 2 prohibits the use of the LIFO cost formula.
32
Review Question Answers
1. C. IAS 2 specifically excludes financial instruments from its scope.
Answer A is incorrect. Raw materials inventory is included in the scope of IAS
2.
Answer B is incorrect. Manufactured goods held for sale are included in the
scope of IAS 2.
Answer D is incorrect. Partially completed inventory items (i.e. “work in
process” inventories) are included in the scope of IAS 2.
2. B. Under IAS 2, finished goods inventory includes fully manufactured
products awaiting sale.
Answer A is incorrect. The toy trucks would be considered finished goods (not
work-in-process) inventory under IAS 2 because they are fully assembled
products that are awaiting sale.
Answer C is incorrect. Beantown Corp. is a manufacturing company, and
therefore none of their inventories would be classified as merchandise
inventory under IAS 2. This designation is generally appropriate for only
merchandising companies.
Answer D is incorrect. The toy trucks would be considered finished goods (not
raw materials) inventory under IAS 2 because they are fully assembled
products that are awaiting sale.
3. A. Under IAS 2, work-in-process inventory includes products that have
started the manufacturing process but have not yet been completed.
Answer B is incorrect. The partially assembled toy soldiers have not yet
completed the manufacturing process; therefore they would not be classified
as finished goods inventory under IAS 2.
Answer C is incorrect. Beantown Corp. is a manufacturing company, and
therefore none of their inventories would be classified as merchandise
inventory under IAS 2. This designation is generally appropriate for only
merchandising companies.
Answer D is incorrect. Work-in-process inventory (not raw materials inventory)
includes products that have started the manufacturing process but have not
yet been completed.
4. D. Under IAS 2, raw materials inventory includes the tangible goods acquired
for direct use in the production process. Beantown Corp.’s crude oil reserves
are an example of such materials as they are a basic component used in the
production of the company’s plastic toys.
Answer A is incorrect. Work-in-process inventory includes products that have
started the manufacturing process but have not yet been completed.
Beantown Corp.’s crude oil reserves do not meet this definition.
33
Answer B is incorrect. Finished goods inventory includes fully manufactured
products awaiting sale; Beantown Corp.’s crude oil reserves do not meet this
definition.
Answer C is incorrect. Beantown Corp. is a manufacturing company, and
therefore none of their inventories would be classified as merchandise
inventory under IAS 2. This designation is generally appropriate for only
merchandising companies.
5. B. A perpetual inventory system is one that keeps a continuous record of the
physical quantities in a company’s Inventory account.
Answer A is incorrect. Under a perpetual system, purchases and sales are not
recorded to a Purchases account; rather, they are recorded directly to the
Inventory account as they occur.
Answer C is incorrect. Cost of goods sold can only be calculated at the end of a
reporting period under a periodic (not perpetual) system. Under a perpetual
system, cost of goods sold can be determined instantaneously as sales are
made.
Answer D is incorrect. This describes how cost of goods sold is calculated
under a periodic inventory system (not a perpetual system).
6. D. When goods are shipped FOB destination, control of (and legal title to) the
goods is not transferred until the goods are delivered to the buyer’s
destination. Therefore Met Corp. would maintain economic control of the
merchandise until the products are delivered to the customer’s destination.
Answer A is incorrect. Economic control of the goods would not transfer to the
customer (under FOB destination) simply because the raw materials used to
create the products have been purchased. Rather, economic control would
transfer after the finished goods have been delivered to the customer’s
destination.
Answer B is incorrect. Economic control of the goods would not transfer to the
customer (under FOB destination) simply because the goods have been fully
manufactured. Rather, economic control would transfer after the finished
goods have been delivered to the customer’s destination.
Answer C is incorrect. Economic control of the goods would not transfer to the
customer (under FOB destination) simply because the company has received a
purchase order. Rather, economic control would transfer after the finished
goods have been delivered to the customer’s destination.
7. A. Under IAS 2, reporting entities must include conversion costs (i.e. direct
materials, direct labor and manufacturing overhead costs) in the cost basis of
inventory.
Answer B is incorrect. A product’s purchase price should be included in (not
excluded from) the cost basis of inventory under IAS 2.
34
Answer C is incorrect. Selling and administrative expenses should be excluded
from (not included in) the cost basis of inventory under IAS 2.
Answer D is incorrect. Direct labor and other conversion costs should be
included in (not excluded from) the cost basis of inventory under IAS 2.
8. C. Under the net price method, lost purchase discounts are recognized as an
expense in a reporting entity’s IFRS income statement.
Answer A is incorrect. The company would recognize the lost discount as an
expense (not revenue) under the net price method.
Answer B is incorrect. The company would recognize the lost discount as an
expense under the net price method.
Answer D is incorrect. The company would recognize the lost discount as an
expense under the net price method; the discount would not be added back to
the purchase price of the inventory.
9. C. Brave Corp’s cost of goods available for sale equals $26,000, i.e. (3,000
units X $5.00) + (2,000 units X $5.50).
Answer A is incorrect. This amount is the value of Brave Corp.’s ending
inventory as of 7/31/201X (not its cost of goods available for sale).
Answer B is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s total purchases (5,000 units) by the price paid for
the units purchased on July 1 (i.e. $5.00).
Answer D is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s total purchases (5,000 units) by the price paid for
the units purchased on July 26 (i.e. $5.50).
10. B. Brave Corp’s ending inventory using the specific identification formula
equals (2,000 X $5.00) + (2,000 X $5.50) = $21,000. Note that the cost of
the company’s entire inventory as of 7/19 was $5.00 per unit; therefore the
company was able to specifically identify these costs when calculating the
cost of the 1,000 items that were sold on this date.
Answer A is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s ending inventory in units by the price paid for the
units purchased on July 1 (i.e. $5.00).
Answer C is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s ending inventory in units by the price paid for the
units purchased on July 26 (i.e. $5.50).
Answer D is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s ending inventory in units by the price paid for the
units purchased on July 26 (i.e. $5.50) and then adds the number of units sold
on 7/19.
35
11. A. Brave Corp’s cost of goods sold using the specific identification formula
equals 1,000 units sold X $5.00 = $5,000. Note that the cost of the
company’s entire inventory as of 7/19 was $5.00 per unit; therefore the
company was able to specifically identify these costs when calculating the
cost of the 1,000 items that were sold on this date.
Answer B is incorrect. This amount is the result of an incorrect calculation that
multiplies the number of units sold on 7/19 by the price paid for the units
purchased on July 26 (i.e. $5.50).
Answer C is incorrect. This amount is the cost of the units purchased on 7/26
(not the cost of the units sold on 7/19).
Answer D is incorrect. This amount is the cost of the units purchased on 7/1
(not the cost of the units sold on 7/19).
12. C. Marlin Inc.’s cost of goods available for sale equals (10,000 units X $4.25)
+ (13,000 units X $4.50) + (15,000 units X $5.00) = $176,000.
Answer A is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s total purchases (38,000 units) by the price paid for
the units purchased on December 3 (i.e. $4.25).
Answer B is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s total purchases (38,000 units) by the price paid for
the units purchased on December 8 (i.e. $4.50).
Answer D is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s total purchases (38,000 units) by the price paid for
the units purchased on December 30 (i.e. $5.00).
13. D. Marlin Inc.’s ending inventory using the average cost formula equals
($176,000 cost of goods available for sale / 38,000 units purchased) * 21,000
units ending inventory = $97,263.
Answer A is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s inventory purchases on 12/8 (13,000 units) by the
weighted average cost per unit ($4.6316). The ending inventory units should
instead be used in the calculation.
Answer B is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s inventory purchases on 12/30 (15,000 units) by the
weighted average cost per unit ($4.6316). The ending inventory units should
instead be used in the calculation.
Answer C is incorrect. This amount is the company’s cost of goods sold (not
ending inventory) for the month ended 12/31/20X1.
14. A. Marlin Inc.’s cost of goods sold using the average cost formula equals
($176,000 cost of goods available for sale / 38,000 units purchased) * 17,000
units sold = $78,737.
Answer B is incorrect. This amount is the company’s ending inventory (not
cost of goods sold) for the month ended 12/31/20X1.
36
Answer C is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s inventory purchases on 12/3 and 12/8 (23,000 total
units) by the weighted average cost per unit ($4.6316). The 17,000 units sold
on 12/16 should instead be used in the calculation.
Answer D is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s inventory purchases on 12/3 and 12/30 (25,000 total
units) by the weighted average cost per unit ($4.6316). The 17,000 units sold
on 12/16 should instead be used in the calculation.
15. C. National Corp.’s cost of goods available for sale equals (8,000 units X
$6.50) + (3,000 units X $7.00) + (4,000 units X $7.25) = $102,000.
Answer A is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s total purchases (15,000 units) by the price paid for
the units purchased on May 5 (i.e. $6.50).
Answer B is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s total purchases (15,000 units) by the price paid for
the units purchased on May 12 (i.e. $7.00).
Answer D is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s total purchases (15,000 units) by the price paid for
the units purchased on May 30 (i.e. $7.25).
16. C. National Corp. had 9,000 units in its ending inventory. Under IAS 2, these
units would be valued at $63,000 using the FIFO cost formula. This amount
equals (4,000 units X $7.25) + (3,000 units X $7.00) + (2,000 units X
$6.50).
Answer A is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s ending units (9,000) by the price paid for the 8,000
units purchased on May 5 ($6.50).
Answer B is incorrect. This amount is the value of National Corp.’s ending
inventory using the average cost formula (not the FIFO cost formula).
Answer D is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s ending units (9,000) by the price paid for the 8,000
units purchased on May 30 ($7.25).
17. A. The FIFO cost formula assumes that the first goods purchased by a
company are the first ones sold. Therefore National Corp.’s cost of goods sold,
which is valued using the earliest inventory price available during the
reporting period, equals 6,000 units sold X $6.50 = $39,000.
Answer B is incorrect. This amount is the value of National Corp.’s cost of
goods sold using the average cost formula (not the FIFO cost formula).
Answer C is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s sold units (6,000) by the price paid for the 3,000
units purchased on May 12 ($7.00).
37
Answer D is incorrect. This amount is the result of an incorrect calculation that
multiplies the company’s sold units (6,000) by the price paid for the 4,000
units purchased on May 30 ($7.25).
18. B. The net realizable value of Tiger Corp.’s unfinished inventory equals the
$1,200,000 estimated selling price – $300,000 estimated cost of completion –
$100,000 estimated selling costs = $800,000.
Answer A is incorrect. This amount is the result of an incorrect calculation that
subtracts the estimated cost of completion and estimated selling costs from
the inventory’s cost basis (rather than the estimated selling price).
Answer C is incorrect. This amount is the result of an incorrect calculation that
subtracts only the estimated cost of completion (and not the estimated selling
costs) from the estimated selling price to arrive at the net realizable value.
Answer D is incorrect. This amount is the result of an incorrect calculation that
subtracts only the estimated selling costs (and not the cost of completion)
from the estimated selling price to arrive at the net realizable value.
19. A. Tiger Corp. is required to measure its unfinished inventory at net realizable
value ($800,000) under IAS 2 because this amount is less than the
inventory’s cost basis ($1,000,000).
Answer B is incorrect. The company would not measure its unfinished
inventory at cost ($1,000,000) because this amount is greater than the
inventory’s net realizable value ($800,000). IAS 2 requires entities to measure
such items at the lower of cost or net realizable value.
Answer C is incorrect. The company would measure its unfinished inventory at
net realizable value ($800,000), not at this incorrect amount.
Answer D is incorrect. The company would measure its unfinished inventory at
net realizable value ($800,000), not at the estimated selling price.
20. D. The LIFO cost formula is permitted under U.S. GAAP, but not under IFRS.
Answer A is incorrect. The weighted-average cost formula is permitted under
both U.S. GAAP and IFRS.
Answer B is incorrect. The net price method for purchase discounts is
permitted under both U.S. GAAP and IFRS.
Answer C is incorrect. The gross price method for purchase discounts is
permitted under both U.S. GAAP and IFRS.
38
Glossary
Asset – A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. Average cost formula – A cost formula under IAS 2 that prices items in the inventory on the basis of the average cost of all similar goods available during the period. There are two versions of the average cost formula: the weighted-average formula (for periodic inventory systems) and the moving-average formula (for perpetual inventory systems). Cost of goods available for sale – The sum of all inventory purchases made during a reporting period plus the beginning inventory. Cost of goods sold – The direct costs attributable to the production of the inventory sold by a company. Consignment – An arrangement under which a company (the consignor) ships various merchandise to another company (the consignee), who acts as the consignor’s agent in selling the consigned goods. Convergence – Ongoing project initiated by the FASB and IASB to reduce the differences between U.S. GAAP and IFRS and ultimately create one single set of global accounting standards. Conversion costs – Costs that are directly connected with bringing goods to the buyer’s place of business and converting such goods to a salable condition. These costs generally include direct materials, direct labor, and manufacturing overhead costs. Cost formula – Under IAS 2, a method for allocating inventory costs between the income statement (i.e. cost of goods sold) and the balance sheet (i.e. ending inventory). The cost formulas permitted by IAS 2 include specific identification, average cost and first-in, first-out (FIFO). Direct labor – The cost of the labor used directly in the manufacture of a product.
39
Equity – The residual interest in the assets of the entity after deducting all of its liabilities. Expenses – Decreases in economic benefits during the accounting period in the form of outflows or depletion of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. FIFO (first-in, first-out) formula – A cost formula under IAS 2 that assumes that the first goods purchased are the first used or sold (and therefore the first costs incurred are the first transferred to cost of goods sold). The inventory remaining must therefore represent the most recent costs. Financial Accounting Standards Board (FASB) - a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public's interest. The FASB's mission is "to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information”. Financial statements – Presentation of financial data including balance sheets, income statements and statements of cash flows, or any supporting statement that is intended to communicate an entity’s financial position at a point in time and its results of operations for a period then ended. Finished goods inventory – Fully manufactured products awaiting sale. FOB (free-on-board) shipping point – A convention that determines when legal title of goods has passed from the seller to the buyer. If goods are shipped FOB shipping point, control of (and legal title to) the goods is transferred at the shipping point when the seller delivers them to the buyer (or to a transportation company that is acting as an agent for the buyer). The buyer has economic control and includes those goods in its inventory, and the seller excludes them. FOB (free-on-board) shipping point – A convention that determines when legal title of goods has passed from the seller to the buyer. If goods are shipped FOB destination, control of (and legal title to) the goods is not transferred until the goods are delivered to the buyer’s destination. The seller has economic control and includes those goods in its inventory, and the buyer excludes them.
40
Generally Accepted Accounting Principles (GAAP) – Conventions, rules and procedures necessary to define accepted accounting practice at a particular time. The highest level of such principles is set by the FASB. Gross price method – A method for accounting for purchase discounts on inventory items. Under the gross price method, a reporting entity records the purchase at the gross price and records the amount of the discount in the accounting system only if the discount is taken. This discount should be deducted from the purchase price of the inventory. Income – Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. The definition of income encompasses both revenue and gains. International Accounting Standards Board (IASB) – A privately funded, London-based organization whose goal is to establish a single set of enforceable global financial reporting standards. International Financial Reporting Standards (IFRS) – International standards, interpretations and the “Framework for the Preparation and Presentation of Financial Statements” adopted by the IASB. Inventories – Assets of a company that are (1) held for sale in the ordinary course of business, (2) in the process of production for sale, or (3) held for use in the production of goods or services to be made available for sale. Liability – The present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. LIFO (last-in, first-out) formula – A cost formula permitted under U.S. GAAP that includes the most recent inventory costs incurred in the cost of goods sold and includes the earliest costs (part or all of which are costs incurred in previous periods) in the ending inventory. Unlike U.S. GAAP, IAS 2 prohibits the use of the LIFO method. Manufacturing overhead – The costs other than raw materials and direct labor that are part of the manufacturing process. It includes variable overhead (such as supplies and some indirect labor) and fixed overhead (such as insurance, utilities, and depreciation on the assets used in the production activities).
41
Materiality – A convention relating to the importance/significance of an amount, transaction, or discrepancy. Omissions or misstatements of items are material if they could (individually or collectively) influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. Measurement – The process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement. Merchandise inventory – Inventory held for resale by a merchandising company. Net price method – A method for accounting for purchase discounts on inventory items. Under the net price method, a reporting entity records the purchase at its net price and records the amount of the discount in the accounting system only if the discount is not taken. This discount lost is treated as an expense and is reported in the “Other income and expense” section of the income statement. Net realizable value – A measurement basis for inventories under IAS 2; it is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Period costs – Costs that are indirectly related to the acquisition or production of inventories. Period costs (such as selling expenses and administrative expenses) are therefore not included as part of the inventory costs. Periodic inventory system – An inventory system that does not maintain a continuous record of the physical quantities (or costs) of inventory on hand. It records all acquisitions of inventory during the accounting period by debiting the Purchases account. Perpetual inventory system – An inventory system that keeps a continuous record of the physical quantities in its inventory. Purchase discounts – Reductions in the selling prices granted to customers. Product costs – All costs of purchase, costs of conversion and other costs incurred in bringing inventories to their present location and condition.
42
Raw materials inventory – Tangible goods acquired for direct use in the production process. Recognition – The process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition set out in the IFRS Framework. The Framework states that an item that meets the definition of an element should be recognized if (1) it is probable that any future economic benefit associated with the item will flow to or from the entity and, (2) the item has a cost or value that can be measured with reliability. Specific identification formula – A cost formula under IAS 2 that calls for identifying each item sold and each item in inventory. A company includes in cost of goods sold the costs of specific items sold. It includes in inventory the costs of the specific items on hand. Statement of cash flows – A financial statement that provides information that enables users to evaluate the changes in net assets of an entity, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. Statement of changes in equity – A financial statement that is used to bridge the gap between the amount of equity the owners have in the business at the beginning of the accounting period and the amount of their equity at the end of the period. Statement of comprehensive income – A financial statement that presents all items of income and expense recognized in a period. Statement of financial position – A financial statement that presents an entity’s assets, liabilities and owner’s equity as of a specific date. It is also referred to as a balance sheet. Work in process inventory – Products that are started in the manufacturing process but are not yet complete. This partially completed inventory includes three cost components: raw materials, direct labor and manufacturing overhead.
43