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Characteristics of Inventories

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Characteristics of Inventories Characteristics of Inventories • belong to current assets • kept in stock either to be sold to customers or to be consumed by activities of the accounting entity • Retailer, wholesaler – merchandise inventory • Manufacturer – finished goods – work in progress: goods not yet ready for sale – raw materials and purchased parts • Most relevant standard: IAS 2 • Aside: optimal level of inventory – trade-off between holding costs, ordering cost, service level, customer satisfaction, smooth production 1 The Inventory Balance Equation • Value of inventory at time t = Initial inventory + inflows – outflows up to t – initial inventory: from past period; zero at start of business • depends on valuation method used for inflows and outflows – inflows: valued at cost • same as for fixed assets: „all costs incurred in order to bring the inventories to their present location and condition“ – outflows: different approaches • direct identification • assumed order of depletion • averaging – determine market value of ending inventory and apply balance equation 2 Importance of Inventory Valuation • inventory valuation affects the income statement and the balance sheet • impact on ratios used in financial statement analysis • The Gross Profit Equation: Gross profit = Sales Revenue ⎧ ⎪ -( beginning inventory ⎪ COGS ⎨ ⎪ +purchases ⎩⎪ – ending inventory) • Effect of inventory valuation on gross profit: – closing inventory understated (overstated) Î gross profit for the period understated (overstated) – opening inventory understated (overstated) Î gross profit for the period overstated (understated). 3 Initial valuation of inventory • Inventories shall be measured at the lower of cost and net realizable value – Costs include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition – Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated cost necessary to make the sale • At initial recognition of – Materials – Purchased parts – Merchandise inventory …..purchasing costs are usually applicable 4 Initial valuation of work in progress and finished goods inventory • Inventory cost includes the cost of conversion – This refers to direct and indirect manufacturing costs • Direct labor • Direct material cost • Production overhead cost – Fixed and variable overhead – Fixed overhead costs should be allocated fully to inventory only to the extent that normal capacity utilization is present – Do not capitalize cost of idle capacity! 5 Inventory valuation – an example • Candy Inc. spent the fourth quarter of its fiscal year producing candy for easter. 2.000 batches were produced at labor cost of € 20 per batch and € 150 for material per batch. direct cost • Other cost in that quarter: – € 20.000 – salary for production supervisors – € 28.000 – depreciation of production facilities – € 2.000 – setup cost manufacturing – € 11.250 – salary of factory manager overhead – € 68.750 – various manufacturing overhead – € 250.000 – cost of headquarters administrative – € 40.000 – salary of sales representatives overhead selling overhead 6 Multi-product case • Overhead needs to be allocated to different products – matter of cost accounting • Usual method – choose an allocation base e.g. direct cost or direct labor hrs. – calculate the overhead rate per unit of the allocation base – multiply units of allocation base in product times overhead rate 7 The inventory is to be valued as follows: • Provided normal capacity is 2000 batches – Direct cost: € 170 – Manufacturing overhead: € 65 ( 130.000 / 2.000 ) – Administrative overhead: --- – Selling overhead: --- – Total: € 235 per batch Î Value of inventory: € 470.000 • Assume normal capacity is 2500 batches – Direct cost: € 170 – Manufacturing overhead: € 52 ( 130.000 / 2.500 ) – Administrative overhead: --- – Selling overhead: --- – Total: € 222 per batch Î Value of inventory: € 444.000 8 Cost flow assumptions for inventory valuation • If distinguishable items are purchased and sold – Firms are required to monitor actual goods flow and record corresponding costs (specific identification) • identical items of merchandise purchased and sold (at different prices) – usually impractical to monitor actual goods flow and record corresponding costs assumption about cost flow – Average Cost Cost flow assumptions – First-In, First-Out – Last-In, First-Out • IAS 2 allows for FIFO and average cost only – A cost formula applied needs to be applied for all inventories similar in nature 9 Inventory valuation – applying different methods • We use the following data to calculate inventory, cost of sales, and gross profit for the different methods: Purchase of 8 units @ € 2,50 (March) 4 units @ € 3,00 (April) 4 units @ € 4,00 (June) Sale of 2 units @ € 5,00 (May) 10 Specific Identification • items purchased and sold must be distinguishable • for the example: – cost of goods sold either 5.00 or 6.00 depending on whether items out of March‘s or April‘s purchase were used. 11 Inventory valued at average cost: Average Cost Inventory Inventory Cost of in numbers value Sales March 8 units @ 2,5 = 20 April 4 units @ 3 = 12 June 4 units @ 4 = 16 June end total 16 units @ 3 48 Sale of 2 items (May) - 2 units @ 3 -6 6 Ending inventory 14 units @ 3 42 Cost of sales 6 • units in inventory are valued at the average cost of the goods available for sale, i.e. total cost of inventory over number of items • method easy to handle • objective in nature, less room for manipulation 12 Inventory valued using FIFO First-In, First-Out Inventory Inventory Cost of (FIFO) in numbers value Sales March 8 units @ 2,5 = 20 April 4 units @ 3 = 12 June 4 units @ 4 = 16 June end total 16 48 Sale of 2 items (May) - 2 units @ 2,5 (March) = -5 5 Ending inventory 14 = 43 Cost of sales 5 • cost of the first items purchased is assigned to the first items sold • ending inventory valued at most recent cost • disadvantage: „old“ costs are matched with current revenues • no manipulation of income figures 13 Inventory valued using LIFO Last-In, First-Out Inventory Inventory Cost of (LIFO) in numbers value Sales March 8 units @ 2,5 = 20 April 4 units @ 3 = 12 June 4 units @ 4 = 16 June end total 16 48 Sale of 2 units (May) - 2 @ 4 (June) = -8 8 Ending inventory 14 = 40 Cost of sales 8 • cost of items purchased last is assigned to items sold first • items from the earliest purchases rest in ending inventory • advantage: most recent costs are matched with current revenues • disadvantage: possible distortion of inventory figure 14 • (again) no manipulation of income figures? Comparison of the effects on gross profit Average Cost FIFO Sales 10 Sales 10 Purchases 48 Purchases 48 Closing Inventory 42 Closing Inventory 43 Cost of sales 6 Cost of sales 5 Gross profit 4 Gross profit 5 LIFO Gross profit highest under FIFO and Sales 10 lowest under LIFO, (only in a period of rising prices. The reverse would be true Purchases 48 Closing Inventory 40 if prices decline.) Cost of sales 8 This year‘s closing inventory is next Gross profit 2 year‘s opening inventory! 15 Summary of Income Effects - When Inventory Costs (Prices) are Increasing Ending inventory, Average- gross profit, LIFO cos t FIFO and net income Summary of Income Effects - When Inventory Costs (Prices) are Decreasing Ending inventory, Average- gross profit, LIFO cos t FIFO and net income 16 Impact of accounting principles on inventory valuation • Consistency principle Æ stick to one method for inventory valuation • Relevance, reliability Æ if valuation method is changed, disclose that • Comparability Æ if two companies use different methods, effects of valuation methods need to be determined for purposes of comparison 17 Subsequent inventory valuation • Inventory to be measured at the lower of cost and net realizable value – Impairment test at the end of a financial year – If net realizable value is below book value impairment is required • Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated cost necessary to make the sale – This refers to the selling price of a finished good rather than an input factor – Inventory valuation ensures that assets or income figures are not overstated • Possible reasons why market value may be lower: – physical deterioration, obsolescence, market downturn 18 Example: lower of cost and net realizable value 19.
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