WILEY

IFRS EDITION
Prepared by
Coby Harmon
University of California, Santa Barbara
6-1 Westmont College
 PREVIEW OF CHAPTER 6

Financial Accounting
IFRS 3rd Edition
Weygandt ● Kimmel ● Kieso
6-2
 CHAPTER

6 Inventories
LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Discuss how to classify and determine inventory.

2. Explain the accounting for inventories and apply the inventory cost flow
methods.
3. Explain the financial effects of the inventory cost flow assumptions.
4. Explain the lower-of-cost-or-net realizable value basis of accounting for
inventories.
5. Indicate the effects of inventory errors on the financial statements.
6. Discuss the presentation and analysis of inventory.
6-3
 Classifying and Determining Inventory
Learning Objective 1
Discuss how to classify and
Classifying Inventory determine inventory.

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

 Inventory  Raw Materials

 Work in Process
• HELPFUL HINT
Regardless of the classification,  Finished Goods
companies report all inventories
under Current Assets on the
statement of financial position.

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 ACCOUNTING ACROSS THE ORGANIZATION
A Big Hiccup
JIT can save a company a lot of money, but it isn’t without risk. An
unexpected disruption in the supply chain can cost a company a lot
of money. Japanese automakers experienced just such a disruption
when a 6.8-magnitude earthquake caused major damage to the
company that produces 50% of their piston rings. The rings
themselves cost only $1.50, but you cannot make a car without
them. No other supplier could quickly begin producing sufficient
quantities of the rings to match the desired specifications. As a
result, the automakers were forced to shut down production for a
few days—a loss of tens of thousands of cars.
Source: Amy Chozick, “A Key Strategy of Japan’s Car Makers Backfires,”
Wall Street Journal (July 20, 2007).

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 Determining Inventory Quantities

Physical Inventory taken for two reasons:

Perpetual System
1. Check accuracy of inventory records.

2. Determine amount of inventory lost due to wasted raw

materials, shoplifting, or employee theft.

Periodic System
1. Determine the inventory on hand.

2. Determine the cost of goods sold for the period.

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 Determining Inventory Quantities

TAKING A PHYSICAL INVENTORY

Involves counting, weighing, or measuring each kind of
inventory on hand.

Companies often “take inventory”

 when the business is closed or
business is slow.

 at the end of the accounting period.

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 ETHICS INSIGHT
Falsifying Inventory to Boost Income
Managers at a women’s apparel maker were convicted of falsifying
inventory records to boost net income—and consequently to boost
management bonuses. In another case, executives at an
electronics manufacturer were accused of defrauding lenders by
manipulating inventory records. The indictment said the company
classified “defective goods as new or refurbished” and claimed that
it owned certain shipments “from overseas suppliers” when, in fact,
the company either did not own the shipments or the shipments
did not exist.

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 Determining Inventory Quantities

DETERMINING OWNERSHIP OF GOODS

GOODS IN TRANSIT

 Purchased goods not yet received.

 Sold goods not yet delivered.

Goods in transit should be included in the inventory of the

company that has legal title to the goods. Legal title is
determined by the terms of sale.

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 DETERMINING OWNERSHIP OF GOODS

GOODS IN TRANSIT Illustration 6-2

Terms of sale

Ownership of the goods passes

to the buyer when the public
carrier accepts the goods from
the seller.

Ownership of the goods

remains with the seller until the
goods reach the buyer.

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 Determining Ownership of Goods

Question
Goods in transit should be included in the inventory of the
buyer when the:

a. public carrier accepts the goods from the seller.

b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

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 Determining Ownership of Goods

CONSIGNED GOODS
To hold the goods of other parties and try to sell the goods for
them for a fee, but without taking ownership of the goods.

Many car, boat, and antique dealers sell goods on consignment,

why?

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 ANATOMY OF A FRAUD

Ted Nickerson, CEO of clock manufacturer Dally Industries, was feared by all of
his employees. Ted also had expensive tastes. To support this habit, Ted took
out large loans, which he collateralized with his ordinary shares of Dally
Industries. If the price of Dally’s shares fell, he was required to provide the bank
with more ordinary shares. To achieve target net income figures and thus
maintain the share price, Ted coerced employees in the company to alter
inventory figures. Inventory quantities were manipulated by changing the
amounts on inventory control tags after the year-end physical inventory count.
For example, if a tag said there were 20 units of a particular item, the tag was
changed to 220. Similarly, the unit costs that were used to determine the value
of ending inventory were increased from, for example, $125 per unit to $1,250.
Both of these fraudulent changes had the effect of increasing the amount of
reported ending inventory. This reduced cost of goods sold and increased net
income.
Total take: $245,000
The Missing Control
Independent internal verification. The inventory records should have been spot-
checked periodically, verifying that the number of units agreed with the amount
on hand and that the unit costs agreed with vendor price sheets.
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 > DO IT!
Deng Yaping Company completed its inventory count. It arrived at a total inventory
value of ¥200,000. You have been given the information listed below. Discuss how
this information affects the reported cost of inventory.
1. Deng Yaping included in the inventory goods held on consignment for Falls Co.,
costing ¥15,000.
2. The company did not include in the count purchased goods of ¥10,000, which
were in transit (terms: FOB shipping point).
3. The company did not include in the count inventory that had been sold with a
cost of ¥12,000, which was in transit (terms: FOB shipping point).

Solution
1. Goods of ¥15,000 held on consignment should be deducted from the inventory
count.
2. The goods of ¥10,000 purchased FOB shipping point should be added to the
inventory count.
3. Item 3 was treated correctly. Inventory should be ¥195,000
(¥200,000 - ¥15,000 + ¥10,000).
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 Classifying and Determining Inventory
Learning Objective 2
Explain the accounting for
Inventory is accounted for at cost. inventories and apply the
inventory cost flow methods.
 Cost includes all expenditures necessary
to acquire goods and place them in a condition ready for
sale.
 Unit costs are applied to quantities to compute the total cost
of the inventory and the cost of goods sold using the
following costing methods:
► Specific identification
► First-in, first-out (FIFO) Cost Flow
► Average-cost Assumptions

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 Inventory Costing

Illustration: Crivitz TV Company purchases three identical 50-

inch TVs on different dates at costs of £700, £750, and £800.
During the year Crivitz sold two sets at £1,200 each. These
facts are summarized below.

Illustration 6-3
Data for inventory costing example

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 Specific Identification

If Crivitz sold the TVs it purchased on February 3 and May 22,

then its cost of goods sold is £1,500 (£700 + £800), and its
ending inventory is £750.

Illustration 6-4
Specific identification method

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 Specific Identification

Actual physical flow costing method in which items still in

inventory are specifically costed to arrive at the total cost of
the ending inventory.

 Practice is relatively rare.

 Most companies make

assumptions (cost flow
assumptions) about which units
were sold.

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 Cost Flow Assumptions

There are two assumed cost flow methods:

1. First-in, first-out (FIFO)

2. Average-cost

Cost flow does not need be consistent with the physical

movement of the goods.

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 Cost Flow Assumptions

Data for Lin Electronics’ Astro condensers.

Illustration 6-5

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

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 Cost Flow Assumptions

FIRST-IN, FIRST-OUT (FIFO)

 Costs of the earliest goods purchased are the first to be
recognized in determining cost of goods sold.

 Often parallels actual physical flow of merchandise.

 Companies obtain the cost of the ending inventory by

taking the unit cost of the most recent purchase and
working backward until all units of inventory have been
costed.

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 FIRST-IN, FIRST-OUT (FIFO)

Illustration 6-6
Allocation of costs—FIFO method
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 FIRST-IN, FIRST-OUT (FIFO)

• HELPFUL HINT
Another way of thinking about
the calculation of FIFO ending
inventory is the LISH
assumption—last in still here.
Illustration 6-6
Allocation of costs—FIFO method

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 Cost Flow Assumptions

AVERAGE-COST
 Allocates cost of goods available for sale on the basis
of weighted-average unit cost incurred.

 Applies weighted-average unit cost to the units on

hand to determine cost of the ending inventory.

Illustration 6-8
Formula for weighted-average unit cost

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 AVERAGE-COST

Illustration 6-9
Allocation of costs—average-cost method

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 AVERAGE-COST

Illustration 6-11

Illustration 6-9
Allocation of costs—average-cost method

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 > DO IT!
The accounting records of Shumway Ag Implement show the following.
Beginning inventory 4,000 units at £ 3
Purchases 6,000 units at £ 4
Sales 7,000 units at £12
Determine the cost of goods sold during the period under a periodic
inventory system using (a) the FIFO method and (b) the average-cost
method.
Solution
Cost of goods available for sale = (4,000 × £3) + (6,000 × £4) = £36,000
Ending inventory = 10,000 − 7,000 = 3,000 units
(a) FIFO: £36,000 − (3,000 × £4) = £24,000
(b) Average cost per unit: [(4,000 × £3) + (6,000 × £4)] ÷ 10,000 = £3.60
Average-cost: £36,000 − (3,000 × £3.60) = £25,200
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 Financial Statement and Tax Effects of
Cost Flow Methods
Learning Objective 3
Explain the financial effects of
Either of the two cost flow assumptions the inventory cost flow
assumptions.
is acceptable for use. For example,
 adidas (DEU) and Lenovo (CHN) use the average-cost
method, whereas
 Syngenta Group (CHE) and Nokia (FIN) use FIFO.

A recent survey of IFRS companies, approximately

► 60% use the average-cost method,

► 40% use FIFO, and
► 23% use both for different parts of their inventory.
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 INCOME STATEMENT EFFECTS

Illustration 6-10
6-29 Comparative effects of cost flow methods LO 3
 STATEMENT OF FINANCIAL POSITION
EFFECTS

 A major advantage of the FIFO method is that in a period

of inflation, the costs allocated to ending inventory will
approximate their current cost.

 A major shortcoming of the average-cost method is that in

a period of inflation, the costs allocated to ending inventory
may be understated in terms of current cost.

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 TAX EFFECTS

 Both inventory and net income are higher when companies

use FIFO in a period of inflation.

 Average-cost results in the lower income taxes (because of

lower net income) during times of rising prices.

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 Using Cost Flow Methods Consistently

 Method should be used consistently, enhances

comparability.
 Although consistency is preferred, a company may change
its inventory costing method.

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 Cost Flow Assumptions

Question
In periods of rising prices, average-cost will produce:
a. higher net income than FIFO.
b. the same net income as FIFO.
c. lower net income than FIFO.
d. net income equal to the specific identification method.

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 Cost Flow Assumptions

Question
Factors that affect the selection of an inventory costing
method do not include:
a. tax effects.
b. statement of financial position effects.
c. income statement effects.
d. perpetual vs. periodic inventory system.

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 GLOBAL INSIGHT
Is LIFO Fair?
ExxonMobil Corporation (USA), like many U.S. companies, uses a cost flow
assumption called last-in, first-out (LIFO) to value its inventory for financial
reporting and tax purposes. In one recent year, this resulted in a cost of goods
sold figure that was $5.6 billion higher than under FIFO. By increasing cost of
goods sold, ExxonMobil reduces net income, which reduces taxes. Critics say
that LIFO provides an unfair “tax dodge.” As the U.S. Congress looks for more
sources of tax revenue, some lawmakers favor the elimination of LIFO.
Supporters of LIFO argue that the method is conceptually sound because it
matches current costs with current revenues. In addition, they point out that
this matching provides protection against inflation. International accounting
standards do not allow the use of LIFO. As a result, the net income of foreign
oil companies, such as BP (GBR) and Royal Dutch Shell (GBR and NLD), are
not directly comparable to U.S. companies, which makes analysis difficult.
Source: David Reilly, “Big Oil’s Accounting Methods Fuel Criticism,” Wall Street Journal
(August 8, 2006), p. C1.

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 Lower-of-Cost-or-Net Realizable Value
Learning Objective 4
Explain the lower-of-cost-or-net
When the value of inventory is lower realizable value
basis of accounting for
than its cost inventories.

 companies must “write down” the inventory to its net

realizable value.

Net realizable value: Amount that a company expects to

realize (receive from the sale of inventory).

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 Lower-of-Cost-or-Net Realizable Value

Illustration: Assume that Gao TV has the following lines of

merchandise with costs and market values as indicated.

Illustration 6-11
Computation of lower-of-cost-or-net realizable value

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 Inventory Errors
Learning Objective 5
Indicate the effects of inventory
Common Causes: errors on the financial
statements.

 Failure to count or price inventory correctly.

 Not properly recognizing the transfer of legal title to

goods in transit.

 Errors affect both the income statement and statement of

financial position.

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 Income Statement Effects

Inventory errors affect the computation of cost of goods sold

and net income in two periods. Illustration 6-12
Formula for cost of goods sold

Illustration 6-13
Effects of inventory errors on current year’s income statement
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 Income Statement Effects

Inventory errors affect the computation of cost of goods sold

and net income in two periods.

 An error in ending inventory of the current period will have

a reverse effect on net income of the next accounting
period.

 Over the two years, the total net income is correct

because the errors offset each other.

 Ending inventory depends entirely on the accuracy of

taking and costing the inventory.

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 Income Statement Effects Illustration 6-14
Effects of inventory errors on
two years’ income statements

2016 2017
Incorrect Correct Incorrect Correct
Sales € 80,000 € 80,000 € 90,000 € 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income € 22,000 € 25,000 € 13,000 € 10,000

Combined income for (€3,000) €3,000

2-year period is correct. Net income Net income
understated overstated

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 Income Statement Effects

Question
Atlantis Company’s ending inventory is understated
NT$122,000. The effects of this error on the current year’s
cost of goods sold and net income, respectively, are:

a. understated, overstated.

b. overstated, understated.

c. overstated, overstated.

d. understated, understated.

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 Statement of Financial Position Effects

Effect of inventory errors on the statement of financial position

is determined by using the basic accounting equation: Assets
= Liabilities + Equity.

Errors in the ending inventory have the following effects.

Illustration 6-15
Effects of ending inventory errors on statement of financial position

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 > DO IT!

LCNRV Basis; Inventory Errors

(a) Tracy Company sells three different types of home heating
stoves (wood, gas, and pellet). The cost and net realizable
value of its inventory of stoves are as follows.

Determine the value of the company’s inventory under the lower-

of-cost-or-net realizable value approach.
Total inventory value is the sum of these amounts, NT$430,000.
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 > DO IT!

LCNRV Basis; Inventory Errors

(b) Visual Company overstated its 2016 ending inventory by
NT$22,000. Determine the impact this error has on ending
inventory, cost of goods sold, and equity in 2016 and 2017.

2016 2017
Ending inventory NT$22,000 overstated No effect
Cost of goods sold NT$22,000 understated NT$22,000 overstated
Equity NT$22,000 overstated No effect

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 Statement Presentation and Analysis
Learning Objective 6
Discuss the presentation and
Presentation analysis of inventory.

Statement of Financial Position - Inventory classified as

current asset.

Income Statement - Cost of goods sold is subtracted from

sales.

There also should be disclosure of the

1) major inventory classifications,

2) basis of accounting (cost or LCNRV), and

3) costing method (specific identification, FIFO, or average-

cost).
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 Statement Presentation and Analysis

Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying costs
(e.g., investment, storage, insurance, obsolescence, and
damage).

2. Low Inventory Levels – may lead to stock-outs and lost

sales.

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 Analysis

Inventory turnover measures the number of times on

average the inventory is sold during the period.

Cost of Goods Sold

Inventory
=
Turnover
Average Inventory

Days in inventory measures the average number of days

inventory is held.
Days in Year (365)
Days in Inventory
=
Inventory Turnover

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 Analysis
Illustration: Esprit Holdings (HKG) reported in a recent annual report a
beginning inventory of HK$3,209 million, an ending inventory of
HK$3,254 million, and cost of goods sold for the year ended of
HK$12,071 million. The inventory turnover formula and computation for
Esprit Holdings are shown below.

Illustration 6-17
Inventory turnover formula Days in Inventory: Inventory turnover of 3.7 times
and computation for Esprit
Holdings (in millions) divided into 365 is approximately 99 days. This is
the approximate time that it takes a company to
sell the inventory.
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 ACCOUNTING ACROSS THE ORGANIZATION
Improving Inventory Control with RFID
Many large retailers have improved their inventory control with the
introduction of radio frequency identification (RFID). Much like bar
codes, which tell a retailer the number of boxes of a specific
product it has, RFID goes an additional step, helping to distinguish
one box of a specific product from another. RFID uses technology
similar to that used by keyless remotes that unlock car doors.
Companies currently use RFID to track shipments from supplier to
distribution center to store. Other potential uses include monitoring
product expiration dates and acting quickly on product recalls.
Many companies also anticipate faster returns and warranty
processing using RFID. This technology will further assist
managers in their efforts to ensure that their store has just the right
type of inventory, in just the right amount, in just the right place.

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 > DO IT!
Early in 2017, Seoul Company switched to a just-in-time inventory
system. Its sales, cost of goods sold, and inventory amounts for 2016
and 2017 are shown below.
2016 2017
Sales revenue ₩2,000,000 ₩1,800,000
Cost of goods sold 1,000,000 910,000
Beginning inventory 290,000 210,000
Ending inventory 210,000 50,000
Determine the inventory turnover and days in inventory for 2016 and
2017. 2016 2017

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APPENDIX 6A
Illustration 6A-1
Inventoriable units and costs
Perpetual Inventory System
Learning Objective 7
Apply the inventory cost
flow methods to perpetual
inventory records.

Assuming the Perpetual Inventory System, compute Cost of Goods

Sold and Ending Inventory under FIFO and average-cost.
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 First-In-First-Out (FIFO)

Illustration 6A-2
Perpetual system—FIFO Cost of Goods Sold
Ending Inventory

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 Average-Cost

Illustration 6A-3
Perpetual system— Cost of Goods Sold Ending Inventory
average-cost method

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APPENDIX 6B Estimating Inventories
Learning Objective 8
Describe the two methods of
Gross Profit Method estimating inventories.

Estimates the cost of ending inventory by applying a gross

profit rate to net sales.

Illustration 6B-1
Gross profit method formulas

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 Gross Profit Method
Illustration: Kishwaukee Company’s records for January show net sales
of $200,000, beginning inventory $40,000, and cost of goods purchased
$120,000. The company expects to earn a 30% gross profit rate.
Compute the estimated cost of the ending inventory at January 31 under
the gross profit method. Illustration 6B-2
Example of gross profit method

6-56
 Retail Inventory Method

Company applies the cost-to-retail percentage to ending

inventory at retail prices to determine inventory at cost.

Illustration 6B-3
Retail inventory method formulas
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 Retail Inventory Method

Illustration: Illustration 6B-4

Application of retail inventory method

Note that it is not necessary to take a physical inventory to estimate

the cost of goods on hand at any given time.

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APPENDIX 6C LIFO Inventory Method
Learning Objective 9
Apply the LIFO inventory
Last-In-First-Out (LIFO) costing method.

 Under IFRS, LIFO is not permitted for financial

reporting purposes.

 Assumes latest goods purchased are first to be sold.

 Seldom coincides with actual physical flow of

merchandise, except for goods stored in piles, such as
coal or hay.

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 Last-In-First-Out (LIFO)
Illustration 6C-1
Allocation of costs—LIFO method

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 Last-In-First-Out (LIFO)

Illustration 6C-1
Allocation of costs—LIFO method

Illustration 6C-2
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 A Look at U.S. GAAP Learning Objective 10
Compare the accounting for
inventories under IFRS and
U.S. GAAP.
Key Points
 The requirements for accounting for and reporting inventories are more
principles-based under IFRS. That is, GAAP provides more detailed
guidelines in inventory accounting.
 IFRS requires companies to use the same cost flow assumption for all goods
of a similar nature. GAAP has no specific requirement in this area.

Similarities
 The definitions for inventory are essentially similar under GAAP and IFRS.
Both define inventory as assets held-for-sale in the ordinary course of
business, in the process of production for sale (work in process), or to be
consumed in the production of goods or services (e.g., raw materials).
 Who owns the goods—goods in transit or consigned goods—as well as the
costs to include in inventory, are accounted for the same under GAAP and
IFRS.

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 A Look at U.S. GAAP
Key Points
Differences
 Both GAAP and IFRS permit specific identification where appropriate. IFRS
actually requires that the specific identification method be used where the
inventory items are not interchangeable (i.e., can be specifically identified).
If the inventory items are not specifically identifiable, a cost flow
assumption is used. GAAP does not specify situations in which specific
identification must be used.
 A major difference between IFRS and GAAP relates to the LIFO cost flow
assumption. GAAP permits the use of LIFO for inventory valuation. IFRS
prohibits its use. FIFO and average-cost are the only two acceptable cost
flow assumptions permitted under IFRS.

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 A Look at U.S. GAAP
Key Points
Differences
 When testing to see if the value of inventory has fallen below its cost, IFRS
defines market as net realizable value. Net realizable value is the estimated
selling price in the ordinary course of business, less the estimated costs to
complete and sell. In other words, net realizable value is the best estimate
of the net amounts that inventories are expected to realize. GAAP, on the
other hand, defines market as essentially replacement cost. The GAAP
method of inventory valuation is often referred to as the lower-of-cost-or-
market (LCM).

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 A Look at U.S. GAAP
Key Points
Differences
 Under GAAP, if inventory is written down under the lower-of-cost-or-market
valuation, the new basis is now considered its cost. As a result, the
inventory may not be written back up to its original cost in a subsequent
period. Under IFRS, the write-down may be reversed in a subsequent
period up to the amount of the previous write-down. Both the write-down
and any subsequent reversal should be reported on the income statement.
 IFRS generally requires pre-harvest inventories of agricultural products
(e.g., growing crops and farm animals) to be reported at fair value less cost
of disposal. GAAP generally requires these items to be recorded at cost.

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 A Look at U.S. GAAP
Looking to the Future
One convergence issue that will be difficult to resolve relates to the use of the
LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use.
Conversely, the LIFO cost flow assumption is widely used in the United States
because of its favorable tax advantages. In addition, many argue that LIFO
from a financial reporting point of view provides a better matching of current
costs against revenue and, therefore, enables companies to compute a more
realistic income.

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 A Look atAU.S.
LookGAAP
at IFRS
GAAP Self-Test Questions
Which of the following should not be included in the inventory of a
company using GAAP?

a) Goods held on consignment from another company.

b) Goods shipped on consignment to another company.

c) Goods in transit from another company shipped FOB

shipping point.

d) None of the above.

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 A Look atAU.S.
LookGAAP
at IFRS
GAAP Self-Test Questions
Which method of inventory costing is prohibited under IFRS?

a) Specific identification.

b) FIFO.

c) LIFO.

d) Average-cost.

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 A Look atAU.S.
LookGAAP
at IFRS
GAAP Self-Test Questions
Specific identification:

a) must be used under IFRS if the inventory items are not

interchangeable.

b) cannot be used under IFRS.

c) cannot be used under GAAP.

d) must be used under IFRS if it would result in the most

conservative net income.

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 Copyright

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