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  1. 1. INVENTORY AND COST OF SALES Recognition and measurement of inventory Relationship between cost, GP and SP Establishing cost of inventory Cost formulas Lower of cost and NRV Inventory errors Estimating inventory
  2. 2. OUTCOMES <ul><li>Explain the recognition and measure principles related to inventory </li></ul><ul><li>Compute the relationship between cost, GP and SP </li></ul><ul><li>Determine the cost of inventory and account for goods in transit, goods on consignment and inventory shortages </li></ul><ul><li>Use the inventory cost formulae </li></ul><ul><li>Measure and record inventories </li></ul><ul><li>Calculate inventory errors </li></ul><ul><li>Estimate the value of closing inventory </li></ul>
  3. 3. RECOGNITION AND MEASUREMENT OF INVENTORY <ul><li>Affects I/S and SOFP </li></ul>Inventory on hand at beginning of period Inventory on hand at end of period ( A on SOFP ) Purchases of inventory during the period Inventory sold during the period ( COS on I/S ) Cost of inventory available for sale
  4. 4. Recognition and measurement of inventory. . . <ul><li>Inventories are assets </li></ul><ul><ul><li>held for sale in ordinary course of business </li></ul></ul><ul><ul><li>held as materials or supplies to be consumed </li></ul></ul><ul><li>Important to distinguish between goods held for resale and consumable stores </li></ul><ul><li>Sales </li></ul><ul><li>- COS </li></ul><ul><li>= GP </li></ul><ul><li>- E </li></ul><ul><li>= Profit </li></ul>Cost of goods held for resale included in COS to determine GP Cost of consumable stores included in expenses to determine profit 
  5. 5. RELATIONSHIP BETWEEN COST, GP AND SP <ul><li>Mark-up on cost </li></ul><ul><li>Cost 100 mark-up on cost = GP/C = 25% (25/100) </li></ul><ul><li>GP 25 </li></ul><ul><li>SP 125 expected GP% = GP/SP = 20% (25/125) </li></ul><ul><li>Expected GP % </li></ul><ul><li>Cost 75 mark-up on cost = GP/C = 33,3% (25/75) </li></ul><ul><li>GP 25 </li></ul><ul><li>SP 100 expected GP% = GP/SP = 25% (25/100) </li></ul>
  6. 6. ESTABLISHING THE COST OF INVENTORY <ul><li>Cost of inventory comprises all costs of purchase and other costs incurred in bringing the inventory to its present location and condition. </li></ul>Cost of inventory Costs of purchase Other costs = + <ul><li>purchase price (net of deferred finance expense) </li></ul><ul><li>import duties </li></ul><ul><li>non-recoverable taxes </li></ul><ul><li>transport costs </li></ul><ul><li>handling costs </li></ul><ul><li>less </li></ul><ul><li>Cash & trade discounts </li></ul>
  7. 7. Goods in transit <ul><li>Goods which have not physically arrived </li></ul><ul><li>Two problems </li></ul><ul><ul><li>whether ownership has passed from supplier to buyer </li></ul></ul><ul><ul><li>whether buyer has processed the purchase of the goods </li></ul></ul><ul><li>Ownership </li></ul><ul><ul><li>if ownership has not passed, goods remain property of seller </li></ul></ul><ul><ul><li>if ownership has passed (and goods not delivered), then the goods are in transit </li></ul></ul>
  8. 8. <ul><li>Terms of the agreement </li></ul><ul><ul><li>FOB supplier’s warehouse </li></ul></ul><ul><ul><li>FOB foreign airport / harbour </li></ul></ul><ul><ul><li>FOR destination station </li></ul></ul>Supplier’s warehouse Foreign port Destination port Buyers premises Goods in transit . . .
  9. 9. No entry processed for goods in transit <ul><li>Adjusting entry required to state the asset (goods in transit) and liability (accounts payable) at correct amount </li></ul><ul><li>Entry same for periodic and perpetual systems </li></ul><ul><ul><li>two B/S items affected </li></ul></ul><ul><ul><li>I/S not affected </li></ul></ul><ul><li>Adjusting entry </li></ul><ul><ul><li>Dr Goods in transit </li></ul></ul><ul><ul><li>Cr Accounts payable </li></ul></ul>
  10. 10. Entry processed for goods in transit <ul><li>Periodic system </li></ul><ul><ul><li>Original entry Dr Purchases Cr Accounts payable </li></ul></ul><ul><ul><li>Adjusting entry Dr Goods in transit Cr Purchases / COS </li></ul></ul><ul><li>Perpetual system </li></ul><ul><ul><li>Original entry Dr Inventory Cr Accounts payable </li></ul></ul><ul><ul><li>Adjusting entry Dr Goods in transit Cr Inventory </li></ul></ul><ul><li>COS overstated </li></ul><ul><li>GP & P understated </li></ul><ul><li>COS correct </li></ul><ul><li>GP & P correct </li></ul>
  11. 11. Solution : Goods in transit
  12. 12. Goods on consignment <ul><li>Goods on consignment are </li></ul><ul><ul><li>goods delivered by entity owning the goods (consignor) </li></ul></ul><ul><ul><li>to another entity who sells the goods on behalf of the owner (consignee) </li></ul></ul><ul><li>Risks and rewards of ownership remains with consignor </li></ul><ul><ul><li>included in consignor’s inventory </li></ul></ul><ul><ul><li>not included in consignee’s inventory </li></ul></ul>
  13. 13. Inventory shortages <ul><li>Detection and prevention of inventory shortages is a key area of management responsibility </li></ul><ul><li>Physical inventory needs to be counted at regular intervals </li></ul><ul><ul><li>GP% computed for periodic system </li></ul></ul><ul><ul><li>cost of inventory counted is compared to balance in inventory a/c for perpetual system </li></ul></ul>
  14. 14. Periodic system <ul><li>Need to compare actual GP% with expected GP% </li></ul><ul><li>Reconciliation: </li></ul><ul><ul><li>Expected GP% 50,00% </li></ul></ul><ul><ul><li>Actual GP% 48,75% </li></ul></ul><ul><ul><li>Difference 1,25% </li></ul></ul><ul><ul><li>Known shortage 0,50% </li></ul></ul><ul><ul><li>Unknown shortage 0,25% 1,25% </li></ul></ul><ul><li>Cost of shortage is included in COS as cost of inventory lost is included in opening inventory or purchases and not included in closing inventory </li></ul>
  15. 15. Perpetual system <ul><li>Cost of physical count of inventory compared to GL balance in inventory a/c </li></ul><ul><li>Inventory a/c adjusted to reflect physical count by recording difference as inventory shortage </li></ul><ul><li>Adjusting entry Dr COS Cr Inventory </li></ul><ul><li>Reconciliation between expected GP% and actual GP% </li></ul>
  16. 16. Solution : Inventory shortages - Periodic
  17. 17. COST FORMULAE <ul><li>Several different methods for determining COS and cost of inventories </li></ul><ul><ul><li>Specific identification </li></ul></ul><ul><ul><li>FIFO </li></ul></ul><ul><ul><li>Weighted average </li></ul></ul><ul><li>All cost flow assumptions , and do not necessarily conform to the actual physical movement of the goods </li></ul>
  18. 18. Specific identification <ul><li>Used where items of inventory are dissimilar and not interchangeable </li></ul><ul><li>Feasible when inventory items are uniquely identifiable and of sufficient value to keep detailed records </li></ul>
  19. 19. FIFO <ul><li>FIFO method based on the cost flow assumption that the first units acquired are the first units sold </li></ul><ul><li>When using FIFO </li></ul><ul><ul><li>COS is represented by the cost of the earliest purchases </li></ul></ul><ul><ul><li>CI is represented by the cost of the latest purchases </li></ul></ul>
  20. 20. Weighted average <ul><li>Weighted average method is based on the cost flow assumption of the weighted average cost </li></ul><ul><li>Weighted average Cost of inventory at beginning + cost per item = cost of inventory purchased Total units available for sale </li></ul><ul><li>Thus, in times of rising prices, </li></ul><ul><ul><li>COS is reported above the FIFO amount </li></ul></ul><ul><ul><li>CI is reported below the FIFO amount </li></ul></ul>
  21. 21. Solution : Cost formulas (Periodic)
  22. 22. Solution : Cost formulas (Perpetual)
  23. 23. LOWER OF COST OR NET REALISABLE VALUE <ul><li>IAS 2 requires inventory is measured at the lower of </li></ul><ul><ul><li>cost </li></ul></ul><ul><ul><li>NRV </li></ul></ul><ul><li>Cost comprises all costs of purchase and other costs and is computed based on one of the cost formulas </li></ul><ul><li>NRV is determined is determined according to estimates of the net proceeds which will result from the sale of the inventory </li></ul> 
  24. 24. Accounting for the write-down of inventory (periodic system) <ul><li>Closing inventory entered into accounting system at reduced value </li></ul><ul><li>Lower closing inventory leads to </li></ul><ul><ul><li>Higher COS </li></ul></ul><ul><ul><li>Lower GP and profit </li></ul></ul><ul><li>Reconciliation needed between expected GP% and actual GP% </li></ul>
  25. 25. Accounting for the write-down of inventory (perpetual system) <ul><li>Balance on inventory a/c represents cost of inventory at end of period - no specific entry required to introduce closing inventory into accounting system </li></ul><ul><li>Adjusting entry Dr COS Cr Inventory </li></ul><ul><ul><li>Higher COS leads to lower GP and profit </li></ul></ul><ul><ul><li>Reconciliation needed between expected GP% and actual GP% </li></ul></ul>
  26. 26. INVENTORY ERRORS <ul><li>Periodic system </li></ul><ul><li>CI CI overstated understated </li></ul><ul><li>OI 5 5 5 </li></ul><ul><li>+ P 10 10 10 </li></ul><ul><li>- CI (8) (9) (7) </li></ul><ul><li>= COS 7 6 (8) </li></ul><ul><li>Sales 20 20 20 </li></ul><ul><li>GP 13 14 12 </li></ul>GP overstated GP understated
  27. 27. Inventory errors ... <ul><li>Perpetual system </li></ul><ul><li>COS COS understated overstated </li></ul><ul><li>OI 5 5 5 </li></ul><ul><li>+ P 10 10 10 </li></ul><ul><li>- COS (7) (6) (8) </li></ul><ul><li>= CI 8 9 (7) </li></ul>CI understated CI overstated
  28. 28. ESTIMATING INVENTORY <ul><li>Value of closing inventory may need to be estimated in relation to two points in time </li></ul><ul><ul><li>closing inventory at some point in current period (eg, fire or theft) </li></ul></ul><ul><ul><li>closing inventory at end of a previous period (eg, inventory not counted at end of previous period </li></ul></ul>
  29. 29. Estimating inventory...