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1
InventoriesAn Important Source
of Income
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JOIN KHALID AZIZ
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:0322-3385752R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,
KARACHI, PAKISTAN.
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Why inventories are so important?
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Because the valuation of inventories directly affects the bottom line figure in the I/S by affecting COGS and thereby Gross Profit (Sales-COGS)
At the same time, it has an effect on the B/S since Inventory is usually the most significant item among the Current Assets in merchandising & manufacturing companies
The amount of inventories on hand, and the time it takes to sell them is very crucial to the performance of any firm (called Inventory Turnover – Stok Devir Hızı)
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1. Physical count of
Inventory
2. Determination of
ownership of the goods, i.e. account for:
Goods in Transit
Consignment Goods
Determination of Inventory Units
Two Step Process:
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Seller
Buyer
F.O.B. SHIPPING POINT
WHO OWNS THE GOODS ON THE
WAY?
GOODS IN TRANSITGOODS IN TRANSIT
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Seller
Buyer
F.O.B. DESTINATION
WHO OWNS THE GOODS ON THE
WAY?
GOODS IN TRANSITGOODS IN TRANSIT
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Consignment Goods Marketing agreement btw. the consigner (owner of
the goods) and the consignee (holder of the goods). Here, the consignee sells the goods on behalf of the consigner
Ex: Automobile Dealer selling consignment goods. Consignee, even though he is selling it, doesn’t own the goods, so he should not include it in his inventory. On the other hand, consigner should include the goods in his inventory since he is the owner
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Inventory Costs
Beginning Inventory + Purchases - Ending Inventory = COGS
(UNDER THE (UNDER THE Cost of Goods Cost of Goods Available for SaleAvailable for Sale PERIODIC PERIODIC
INVENTORY INVENTORY SYSTEM)SYSTEM)
UNDER THE PERPETUAL INVENTORY SYSTEM:UNDER THE PERPETUAL INVENTORY SYSTEM:
It would accumulate the cost of merchandise sold in the COGS account, and deduct the cost from the Inventory account each time a sales is made.
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In the previous chapter, we implicitly assumed that each unit in the inventory is acquired for the same cost. However, in practice that is not the case. Even if a company sells one type of good, it buys them at varying prices
Therefore, when identical units of inventory have different unit costs, the question is: Which cost should be used to compute the amount of cost of goods sold?
Determination of the unit cost to be assigned to units sold is called the COST FLOW, i.e. how cost of units move from the Inventory account to the COGS account
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Inventory Cost FlowsAccording to the IAS (Int. Acc. Stds.) and TAS (Turkish Acc. Stds.), the following cost flow methods can be used, regardless of the inventory system that they are using (periodic or perpetual):
1.Specific Identification Method
2.First-in First-out (FIFO)
4.Weighted Average
3.Last-in First-out (LIFO) – not allowed by IFRS or CMB
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Specific Identification Method
Used when the actual cost of the item is tracked
When a company sells limited variety of high-priced goods, it keeps track of each item individually (generally applicable for low-volume companies, because if the volume is high, it is very difficult to keep track)
Ex: A car dealer specifically knows the cost of each car, and therefore when a car is sold, COGS is debited by the cost of that specific car
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Cost Flow vs. Physical Flow
First-in First-out (FIFO), and weighted average methods assume that flow of costs may be unrelated to physical flow of goods
The accounting regulations do not require that the physical flow of goods and the related cost flow to be the same
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Date Explanation Units Unit Cost
Total Cost1.1.2000 Beg.Inv. 100 TL 10 TL 1.00015.5.2000 Purchase 200 11 2.20020.5.2000 Sale 25025.7.2000 Purchase 300 12 3.60010.10.2000 Sale 3001.12.2000 Purchase 400 13 5.200Total 1.000 TL 12.000
Cacun Elektronik B55 Alpha Relay
Illustrative Example of the Remaining 3 Cost Flow Methods: FIFO, LIFO & Weighted Avg.
* The company had 1000 units available for sale for a total of TL 12 mill. during the period.
* Of these available units, 550 units were sold and 450 units still remain in the inventory at the end of 2000.
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First-in First-out MethodFIFO
FIFO method assumes that the goods purchased earlier will be sold first
The cost of the first units on hand is assigned to the units sold first
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FIFO-COGS:Periodic Inventory System
Units Sold Unit Cost Total Cost550 100 x 10 TL 1.000
200x 11 2.200250 x 12 3.000
550 TL 6.200
FIFO -Ending Inventory: Periodic Inventory System
Units on hand Unit Cost Total Cost450 400 x 13 TL5.200
50 x 12 600450 TL 5.800
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FIFO – COGS and Ending Inventory : Perpetual Inventory SystemCOGS Inv. Balance
(units x (units xunit cost) unit cost)
1.1.2000 100 x 10 =1.000
100 x 10 = 1.000
200 x 11 = 2.200
20.5.2000 250 100 x 10 TL 1.000
150 x 11 1.650 50 x 11 = 550
50 x 11= 550
300 x 12 =3.600
10.10.2000 300 50 x 11 550
250 x 12 3.000 50 x 12 = 600
50 x 12 =600
400 x 13 =5.200
550 TL 6.200 5.800
1.12.2000 400@13
25.7.2000 300@12
15.5.2000 200@11
Date Purchased Units Sold
Unit Cost
Beginning Inventory
Ending Inventory
Cost of Goods Sold
Since under the Perpetual Inventory System, composition of inventory changes after every merchandising transaction, date is very important
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Weighted Average
Goods available are homogeneous and the cost to be assigned to each unit sold is the same (under the Periodic Inventory System)
Unit Cost = Total Cost of Goods Available for Sale Total Number of Units Available for Sale
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Weighted Average Method: Periodic Inventory System
Unit Cost = 12.000.000/1.000 = TL 12.000 per unit
COGS = TL 12.000 (avg. unit cost) x 550 (# of units sold) = TL 6.600.000
Ending Inv. = TL 12.000 (avg. unit cost) x 450 (# of units remaining on hand) = TL 5.400.000
or by using the formula COGS = Beg. Inv+Purch.–End. Inv., COST OF GOODS AVAIL. FOR SALE
End. Inv. = TL 12.000.000 - TL 6.600.000 = TL 5.400.000
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Weighted Average– COGS and Ending Inventory : Perpetual Inventory System
Unit Cost COGS Inv. Balance
Assigned (units x unit cost)
(total cost ÷
number of units = unit cost)
1.1.2000 100 x 10 =1.000
15.5.2000 200@ 11 3.200 ÷ 300= 10.66
20.5.2000 250 250*10,66 2.667 50 x 10.66=533
25.7.2000 300@ 12 (533+ 3600) ÷ 350= 11.81
10.10.2000 300 300*11,81 3.543 50 x 11.81 = 590.50
1.12.2000 400 @ 13 (590.50 + 5.200) ÷ 450= 12.87
550 TL 6.210 TL 5.790
Date Purchased Units Sold
* Because the date of the purchase & sale is the deciding factor here; every time a purchase is made, a new weighted average unit cost is computed and that cost is assigned to subsequent sales until the next purchase when a new cost is computed.
Ending Inventory : 450 x 12.87 = 5.790
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Summary Perpetual Inventory System
FIFO Weighted Ave.COGS 6.200 6.210Ending Inventory 5.800 5.790
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Lower of Cost or Market
• Inventories, similar to other assets are originally recordedat the historical cost
• However, as time passes the value of the inventories mightdecline in the market because of the obsolescence factor
• IFRS specify that the companies should use the lower-ofcost-or market (LCM) valuation basis
• the market value is the current replacement cost of theinventory
• LCM rule can be applied with any of the cost flow methods, or the specific identification method
• LCM may be applied to individual items or major categories of inventory the decline in value is not expected to increase in the very near future
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ItemInventory Value
at Cost (TL)Inventory Value at Market (TL)
Inventory Value at LCM (TL)
W 9.750 9.375 9.375
X 7.248 7.872 7.248
Y 8.787 8.181 8.181
Z 7.040 7.360 7.040
Total 32.825 32.788 31.844
Example-LCM-1Item Quantity Unit Cost
(TL)Unit
Market (TL)
W 75 130 125
X 48 151 164
Y 101 87 81
Z 64 110 115
Item by item
Date Account Title and Description Debit Credit
Loss from Decline in Value of Inventory Allowance for Decline in Value of Inventory 981To record the decline in value.
31-Dec-04 981
What should company report on the balance sheet if it were using the total approach?
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Example-LCM-2
Date Account Title and Description Debit Credit15-Aug-05 Cash 1.890
Sales 1.890To recognize the sale of 15 units of item W
15-Aug-05 COGS (*) 1.875 Inventories 1.875To record COGS of the sale of 15 units of item W
(*) Use the declined value of the unit TL 125*15
on 15 August 2005, the company sold 15 units of Item W at TL 126 per unit
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Example-LCM-3Item Inventory
Value at Cost (TL)
Inventory Value at
Market (TL)
Inventory Value at LCM
(TL)W 7.800 7.500 7.500
X 7.248 7.872 7.248
Y 8.787 8.181 8.181
Z 7.040 7.360 7.040
Total 30.875 30.913 29.969
Decline in value of inventories as 31 December 2005 TL 906 CR balance
TL 981 CR balance
TL 981 CR balanceDifference TL 75
Balance of Allowance for Decline in Inventory before adjustment
Date Account Title and Description Debit Credit
31-Dec-05 Allowance for Decline in Value of Inventory 75 Recovery from Decline in Value of Inventory
(a revenue in the income statement) 75To record the recovery of the decline in the value of inventories
Using item-by-item basis 31 December 2005
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Inventory Errors
Understated by Overstated by
TL 1.000 TL 1.000
Year 1Beginning Inventory No effect/ correct No Effect/correct
Cost of goods sold Overstated + 1,000 Understated – 1,000
Gross margin Understated – 1,000 Overstated + 1,000
Net Income Understated – 1,000 Overstated + 1,000Retained Earnings at year end Understated – 1.000 Overstated + 1,000
Year 2Beginning Inventory Understated – 1,000 Overstated + 1,000
Cost of goods sold Understated - 1,000 Overstated + 1,000
Gross margin Overstated + 1,000 Understated – 1,000
Net Income Overstated + 1,000 Understated – 1,000
Retained Earnings at yearend
Overstated + 1,000 Understated – 1,000
Sum of two years income orending shareholders’ equity
No effect /correct No effect/correct
ending shareholders' equity
Ending Inventory Year 1
COGS = Beg. Inv + Purch - End. Inv
GM = Sales - COGS
* If there are no other errors, the effect of the error in the ending inventory in Year 1 will be offset or counter-balanced in two consecutive years (at the end of the following year)
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Estimating the Cost of Goods Sold and Ending Inventory
Two Methods:
1.Gross Margin (Gross Profit Method)
2.Retail Method In cases where the company is unable to take physical count of the inventory (cases of fire or other similar disasters which destroy the inventory); it has to make an estimation of the amount of inventory to file an insurance claim & get money from the insurance company.
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Gross Profit Method (The widely used method based on the COGS formula)
Gross profit percentage = 40% (from previous years) , therefore :
COGS percentage = 60% (100% Net Sales – 40% GM)
Beginning inventory TL200 millionsPurchases 1,000Cost of Goods Available for Sale TL1,200 millionsCOGS : Net Sales 1,000 Gross Profit (40% of 1000) 400 600 Ending Inventory TL 600 millions
Main assumption:
Gross Profit Percentage (Gross Profit/Net Sales) is the same or similar to the previous years. Then, the COGS ratio is calculated by deducting Gross Profit% from the Net Sales percentage of 100)
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Inventory Management and Ethical Issues
• inventories are closely related with net income and thus with the shareholders’ equity, and the assets
• taking decisions that would affect the ending inventory and cost of goods sold amount, the management can manipulate income
• for example, management might decide to make a large purchase at the end of the period, in order to maximize profits in that period, and then return the goods at the beginning of the following period stating that they are not according to specifications
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Analysis of Inventories
To check whether adequate profits are generated by the operations
To check whether inventory is adequate to meet future demands
Important for two aspects:
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JOIN KHALID AZIZ
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:0322-3385752R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,
KARACHI, PAKISTAN.