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Financial Accounting
Module code: MAN2907L


Accounting for Inventory and
Contract Work-in-Progress
(Week 13)
Accounting for Inventory
Learning Objective
Inventory defined and the controversy
The requirements of IAS 2 Inventories
Inventory valuation
Inventory control
Creative accounting
Audit of year-end physical count
Contract work-in-progress and profit (IAS 11
Construction Contracts)
Published financial statements
Inventory Defined
IAS 2 Inventories defines inventories as assets:
held for sale in the ordinary course of
business (finished goods);
in the process of production for such sale
(work in process);
in the form of materials or supplies to be
consumed in the production process or in
the rendering of services (raw materials).
Inventory Defined -
Measurement
The measurement of inventory involves:
the establishment of physical existence and
ownership;
the determination of unit costs;
the calculation of provisions to reduce cost
to net realisable value (e.g. obsolete, slow
moving or unsaleable stocks), if necessary
(impairment).
Inventory Impact on Profit
Example Nissan Motor Co. Ltd Figure 20.1
2010 Inventory
reduced by 5%
%
change
Pre-tax profits (mil. yen) 141,680 101,566 28%
Inventories (mil. yen) 802,278 762,164 5% 5%
40,114
Inventory (inv.) Valuation
Important to get closing stock accurate
Possibility for profit smoothing
Year 1 Year 1 (with inv. inflated)
Sales 100,000 100,000
Opening inv. - -
Purchases 65,000 65,000
Less: Closing inv. 5,000 15,000
Cost of sales 60,000 50,000
Profit 40,000 50,000
Year 2 Year 2 (with inv. inflated)
Sales 150,000 150,000
Opening inv. 5,000 15,000
Purchases 100,000 100,000
Less: Closing inv. 15,000 15,000
Cost of sales 90,000 100,000
Profit 60,000 50,000
Elliott & Elliott (2012)
Figure 20.2
Inventory Valuation Methods - FIFO
Figure 20.3 First-in-first-out method (FIFO)
Receipts Issues Balance
Date Quantity Rate Quantity Rate Quantity Rate
Jan
10 15 150 10 150
Feb
8 15 120 2 30
Mar
10 17 170 12 200
Apr
20 20 400 32 600
May
2 15 30
10 17 170
12 20 240
Cost of goods sold 560
Inventory 8 20 160
Inventory Valuation Methods - AVCO
Figure 20.4 Average cost method (AVCO)
Receipts Issues Balance
Date Quantity Rate Quantity Rate Quantity Rate
Jan
10 15 150 10 150
Feb
8 15 120 2 30
Mar
10 17 170 12 200
Apr
20 20 400 32 600
May
24 18.75 450
Cost of goods sold 570
Stock 8 18.75 150
Extract from J Sainsbury plc 2008
Annual Report:
Inventories
Inventories are valued at the lower of cost and
net realizable value. Inventories at warehouses
are valued on a first-in, first-out basis. Those
at retail outlets are valued at calculated
average cost prices. Cost includes all direct
expenditure and other appropriate attributable
costs incurred in bringing inventories to their
present location and condition.
Elliott & Elliott (2012), page 533
Methods Rejected by IAS 2
Last-in-first-out (LIFO) and (by implication)
replacement cost are rejected by IAS 2

Last-in-first-out (LIFO)
The cost of the inventory most recently
received is charged out first at the most
recent cost, i.e. the inventory value is based
upon an old cost, which may bear little
relationship to the current cost.
Extract from Wal-Mart Stores Inc
2008 Annual Report:
Inventories
The company value inventories at the lower of cost or market
as determined primarily by the retail method of accounting,
using the last-in, first-out (LIFO) method for substantially all
of the Wal-Mart Stores segments merchandise inventories.
Sams Club merchandise and merchandise in our distribution
warehouses are valued based on the weight average cost
using the LIFO method. Inventories of foreign operations
are primarily valued by the retail method of accounting, using
the first-in, first-out (FIFO) method. At January 31, 2008
and 2007, our inventories valued at LIFO approximate
those inventories as if they were valued at FIFO.
Inventory Valuation Methods - LIFO
Figure 20.5 Last-in-first-out method (LIFO)
Receipts Issues Balance
Date Quantity Rate Quantity Rate Quantity Rate
Jan
10 15 150 10 150
Feb
8 15 120 2 30
Mar
10 17 170 12 200
Apr
20 20 400 32 600
May
20 20 400
4 17 68
Cost of goods sold 588
Inventory 8 132
May closing balance = (2 x 15) + (6 x 17) = 132
Procedure to Ascertain Cost
Direct material
Direct labour
Appropriate overhead

Five Types of Overhead
1. Direct Subcontract, royalties
Non-routine subcontract might be expensed
2. Indirect Factory rent, rates
Power
Depreciation of plant and machinery
Warehouse cost of finished goods
3. Administration
Office costs easily identifiable to production
Apportion wages department on head count
Production specific admin canteen
4. Selling and
distribution
advertising, delivery, sales salaries
not normally included in inventory valuation
sale or return basis incurs delivery costs
included in inventory valuation
5. Finance
cost of borrowing, fees for letters of credit
may be a case for including in inventory
How Much Total Overhead to Include
Important to use normal activity basis
Overhead for the year 200,00
Planned activity 10,000 units Closing inventory 3,000 units
Actual activity 6,000 units Direct costs 2 per unit
Stock value based on actual activity
Direct costs (6,000 3,000) x 2 6,000
Overhead (3,000/6,000) x 200,000 100,000
Closing stock value 106,000
Stock value based on planned or normal activity
Direct costs (6,000 3,000) x 2 6,000
Overhead (3,000/10,000) x 200,000 60,000
Closing stock value 66,000
Net Realizable Value (NRV)
Prudence requires LOWER of COST & NRV
Permanent fall in market price
Excessively priced stock
High stock levels and liquidity problems
Deteriorating
Obsolescence
Marketing strategy to penetrate a market
NRV takes into account any additional costs to
sell.
Net Realizable Value (NRV)
An Example
Inventory Control
Problem when inventory is taken at different
date to year-end
Figure 20.6 Adjusted inventory figure
Creative Accounting
Year-end manipulation
Ineffective cut-off procedures
Suppression of invoices
Window dressing
Subjective use of NRV rule
Load overheads onto inventory in low profit
periods
Optimistic view of obsolescence
Inaccuracies in the physical inventory count
Inventory Count
Audit attendance
Identification of inventory items
Ownership of Inventory items
Physical condition of inventory items
Adjustment if inventory taken after the year-end date
After the year-end sales made - 100,000 (@ cost plus 25%):
inventory should be increased by 100,000/(1 +25%) = 80,000
After the year-end purchases received - 45,000: would
reduce inventory by 45,000.
Adjustment if errors are discovered
Treatment of Inventory Items
IAS 11 - Construction Contracts
Fixed price contracts
Cost escalation clause
Cost-plus contracts
Allowable costs
Percentage
Account for individually, combined or segmented
Group of contracts
Separate proposals for each asset
The IASB and FASB have been reviewing IAS 11 with a
view to construction contracts being covered by the one
Revenue Recognition standard. KPMG provides a
summary on the proposed standard on Revenue from
Contracts with Customers.
Recognise Net Income When?
Completed contracts method
Percentage of completion method
Favoured by IAS 11

Identifying Contract Revenue
Initial amount of revenue agreed in contract
Variations may occur
Cost escalation clauses
Customer caused delays
Errors in specification or design
Incentive payment targets reached
Variations recognised as revenue
Probably resulting in revenue
Reliable measurement
Identifying Contract Costs
1. Costs directly relating to specific contract, e.g.




2. Costs that are attributable to contract activity in
general & can be allocated to specific contracts
Systematic allocated based on normal level of activity.
Items such as: insurance; construction overheads; cost of design
and technical assistance not capable of being specifically
allocated.

3. Costs specifically chargeable to customer under the
contract
Contract specifies reimbursement: development costs; general
administration.

Site labour
Costs of materials
Depreciation of plant used on
contract
Cost of moving plant & materials
Cost of hiring P&E
Cost of design and technical
assistance
Estimated costs of
rectification
Recognition of Contract Revenue
and Expenses
Recognise in income statement as soon as
outcome can be reliably estimated
Total revenue reliably measurable
Total costs reliably measurable
Stage of completion accurately identified
External expert e.g. Architect
Contract cost as % of total cost
Physical proportion of work completed
Income Statement Entry
Credited with this % of the net
income
UNLESS too early

Debited (charged) immediately
if a loss

Statement of Financial
Position Entry
Asset/liability
Gross amounts due from/to customers
Comprises
Total cost incurred to date
Plus attributable profits (or less
foreseeable losses)
Less any progress billings.
Advances - liability
Proposed New Accounting Rules
Recognise revenue when control passes
IF the revenue recognition rules change as
proposed, then it is likely that construction contracts
will be altered in the future to more clearly specify
when control of components of the construction
contracts pass to the clients
It may mean that proportionate revenue
recognition as a percentage of work completed
is no longer permitted unless that percentage is
linked to the completion of major milestones.
Approach when a contract can be
separated into components
Keep track of the construction contracts: costs are
accumulated by job;
Distinct components of the job: separate records may
be required for each component as a basis for invoicing.
Records needed to account for
a) Total costs incurred on the contract to date
b) The amount of revenue recognised in the accounts to date
c) The costs incurred in relation to the revenue which has been
recognised
d) The amount of the profit or loss recorded on the contract so far
e) The amount invoiced to the customer so far and
f) The amount unpaid by the customer.


An Example Using A Step Approach
Year to 30 Jun 20X0 (Stage 1 of the contract) Contract 000
Total contract price 25,000
Costs incurred to date 5,500
Anticipated future costs 14,500
Progress billings -
Architects estimate of % completed 30.6.X0 28%
Agreed price for the component completed 7,000
Further Information:
ABC recognised revenue 7m and costs 5.5m on the contract.

Factors indicating that control has passed:
Unconditional obligation to pay
Customer has legal title
Physical possession by the customer
Design is customer-specific: has no alternative use
Step 1 Overall Anticipated Result
Total expected cost to complete the contract: 000
Costs incurred to date 5,500
Anticipated future costs 14,500
Expected total costs 20,000
Contract price 25,000
Forecast profit on the contract 5,000
The contract is expected to be profitable
Profit on the component completed to date of
7m 5.5m = 1.5m can be fully realised.
If forecast total cost is greater than revenue: anticipated cost
overrun need to be recorded as an expense/loss in the
current period.
All anticipated loss on contract needs to be recorded in the current
period, not just those related to the current stage of completion.
Step 2 Income Statement
Step 3 Statement of Financial
Position Entries
Statement of financial position is a cumulative statement
Gross work done for the customer
= Cost incurred to date + profit recognised to date
losses recognised to date
Gross amount due from customers
= Gross work done for the customer amount billed to the customer

000
Costs incurred to date 5,500
Add profits to date 1,500
Less recognised loss to date -
Gross work done for the customer 7,000
Less: amount billed to the customer -
Gross amount due from customer 7,000
Year 2 of Contract 30 June 20X1
Year to 30 Jun 20X0 Contract 000
Total contract price 25,000
Costs incurred to date 14,000
Anticipated future costs to complete the contract 6,000
Architects estimate of % completed 30.6.X1 60%
Agreed contract price for stages 1 & 2 15,000
Progress billings 12,000
Advance payments 4,000
Step 1 Overall Anticipated Result for the Contract
Total expected cost to complete the contract: 000
Costs incurred to date 14,000
Anticipated future costs 6,000
Expected total costs 20,000
Contract price 25,000
Forecast profit on the contract 5,000
Stage 2 Comprehensive Income Statement
Total expected cost to complete the contract: 000 000
Total revenue for stages 1 & 2 15,000
Less revenue already recognised 7,000
Revenue for the period 8,000
Less expenses:
Additional expenses incurred in the period (14,000 5,500) 8,500
Additional anticipated loss accrual -
Total expenses 8,500
Loss for the year (500)
Step 3 Statement of Financial Position Entries
000
Costs incurred to date 14,000
Add profits recognised to date 1,500
Less recognised loss to date (500)
Work performed for the customer 15,000
Less: progress billings 12,000
Gross amount due from customer 3,000