CLASSIFYING AND DETERMINING INVENTORY � it�s a current asset.

Merchandising Company (we focus only on these 2 companies in this course)

One Classification:

> Merchandise Inventory

Manufacturing Company

Three Classifications:

> Raw Materials

> Work in Process (roads to be completed can take more than 1 year, in any
case it is a current asset, even if it takes more than 1 year for the work in
process)

> Finished Goods

Helpful Hint

Regardless of the classification, companies report all inventories under Current

Assets on the statement of financial position.

DETERMINING INVENTORY QUANTITIES

Physical Inventory taken for two reasons:

Perpetual System

1) Check accuracy of inventory records. (bc already done more times)

2) Determine amount of inventory lost due to wasted raw materials, shoplifting,

or employee theft.

Periodic System

1) Determine the inventory on hand. (bc it may be the only time a year)

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

TAKING A PHYSICAL INVENTORY

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

Taken,

> when the business is closed or business is slow, bc it�s easier, may be
based on seasonality
> at the end of the accounting period

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.

FREIGHT COSTS

FOB SHIPPING POINT: Ownership of the goods passes to the buyer when the public
carrier accepts the goods from the seller.

FOB DESTINATION: Ownership of the goods remains with the seller until the goods
reach the buyer.

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 (used) car, boat, and antique dealers sell goods on consignment. Why? Or at
newsstands, newspapers are owned by the publisher until they are sold, unsold
newspapers at the end of the day go back to the publisher, they are never owned by
the vendor.

APPLY INVENTORY COST FLOW METHODS AND DISCUSS THEIR FINANCIAL EFFECTS

INVENTORY METHODS AND FINANCIAL EFFECTS

Measurement at inception, first measurement, at time zero, when the assets arrive.
We measure inventory at inception at their historical costs.

Subsequent measurement, second measurement, done at least once a year at year end.
We use the lower between historical costs and net realizable value

Third moment of measurement, when we sell the asset.

The measurement of inventory at inception is accounted for at historical cost +

ancillary costs.

> Cost includes all expenditures necessary to acquire goods and place them in
a condition ready for sale
> Unit costs are applied to quantities to determine the total cost of
inventory and cost of goods sold using the following costing methods:

o Specific identification, we attribute a specific cost to any unit purchased. It

can be used for any kind of assets (so, for any case of inventory). It is usually
used for inventory with specific characteristics: equal or also with technical
differences, few number, different dates, when we can precisely identify which
items we sold.

o Cost flow assumptions (First-in first-out and Average-cost), to calculate

historical costs

If inventory is customized, so easily identifiable, we use specific identification

method.

SPECIFIC IDENTIFICATION

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

COST FLOW ASSUMPTIONS

There are two assumed cost flow methods:

1) First-in, first-out (FIFO), the first goods that arrive at the warehouse are
the first to be sold, as in the food supermarket, employees put the oldest products
in the front

2) Average-cost

3) Last-in, first-out (LIFO), it is very used, but it is prohibited under IAS 2,

but allowed under EU directives and in the US. The last goods that arrive at the
warehouse are the first to be sold, as in a mining company with piles of minerals
and trucks that transport first the top of the piles, made of more recent minerals.

Cost flow does not need be consistent with the physical movement of the goods.

Cost assumptions are made to calculate the historical cost.

First-In, First-Out (FIFO)

> Costs of earliest goods purchased are first to be recognized in determining

cost of goods sold, so, last-in (more recent) are still in the warehouse

> Often parallels actual physical flow of merchandise

> Companies determine cost of ending inventory by taking unit cost of most
recent purchase and working backward until all units of inventory have been costed
LAST-IN, FIRST-OUT (LIFO)

> Costs of latest goods purchased are first to be recognized in determining

cost of goods sold

> Seldom coincides with actual physical flow of merchandise

> Exceptions include goods stored in piles, such as coal or hay

INFLATION EFFECT:

Considering a situation of inflation (gradually increase in unit cost), using FIFO,

it will lead to the highest value of inventory, bc last-in (more expensive) are
still in. So, we are measuring the inventory assets at the highest value. With
inflation, using LIFO, first-in (less expensive) are still in, we are attributing
the lowest cost to the assets. With inflation, using average-cost, we attributing a
cost to the assets which is in the middle. (In case of deflation, the process will
be exactly the opposite and average-cost will be in-between as before.)

LIFO shows in the balance sheet of the company the oldest price, the most different
from current value, fair value at year end, this is the reason why IAS 2 prohibited
LIFO. There are some countries where taxation is very relevant (inflation), LIFO
measures the asset called inventory at the lowest value and it will measure the
cost of the good sold at the highest price, it means lower tax. LIFO is the most
conservative method for calculation of taxable income. This is accounting policy,
which is a legitimate choice. If there is inflation (even if a little and under
control) LIFO is better than average-cost which is better than FIFO.

IAS / IFRS are directed at the preparation of a full set of financial statements by
listed companies and LIFO assumes that last goods that come in are the first to go
out, so, in a situation of inflation/deflation, the current asset called inventory
will be measured at the oldest prices (historical costs), at values which are the
farthest ones from current values. With inflation, these oldest historical costs
will be the lowest, so, there will be an underestimation of the value of inventory.
So we are calculating the cost of goods sold with the highest (and most recent)
prices if compared to average-cost and FIFO. So, if the cost of goods sold is
higher, the gross (taxable) income will be lower and the taxation will be lower (bc
expensive will be higher). So, LIFO leads to a saving in taxation in a context of
inflation.

Since this method measures the balance sheet current asset at the oldest prices,
this is not allowed by IAS 2, bc IAS/IFRS aims at showing as much as possible the
current values of assets and liabilities to the investors. Since IAS/IFRS has been
created for listed companies, investors are more interested in current amounts of
assets and liability, not in historical costs.

EXPLAIN THE STATEMENT PRESENTATION AND ANALYSIS OF INVENTORY

STATEMENT PRESENTATION AND ANALYSIS

Presentation

Statement of Financial Position - Inventory classified as current asset.

Income Statement - Cost of goods sold subtracted from sales.

There also should be disclosure of

1. major inventory classifications

2. basis of accounting (cost or LCNRV)

3. costing method (FIFO, or average-cost), different classes (raw material,

finished products) of inventory can be measured suing different costing method

LOWER-OF-COST-OR-NET REALIZABLE VALUE

When the value of inventory is lower than its cost

> Companies must �write down� inventory to its net realizable value

> Net realizable value: Amount that company expects to realize (receive from
the sale of inventory)

> Example of conservatism, no asset can be written at the end of accounting

period at a value which is higher than revocable amount (in the case of inventory
it is the net realizable value), bc of prudence.