Lesson 7: Inventories

Question 1

What is Cost of Inventories?

Answer 1

The cost of the Purchased Goods is recorded in the inventory account. It includes:

a) Cost price of goods
b) Any expenses (incidental costs) incurred to obtain, or to get the goods ready for sale/use or to prepare the goods before they are ready to be sold.

Examples: Freight, import duties, insurance, packing materials, salaries of workers to process the goods, etc.

Question 2

What are Costs of Conversions

Answer 2

The costs of conversion of inventories include costs DIRECTLY RELATED to the units of production such as DIRECT LABOUR (for manufacturing businesses)

Question 3

What is FIFO (First-In-First-Out)?

Answer 3

Under the FIFO method, the EARLIEST INVENTORIES are the first costs assigned to cost of goods sold.

In simpler terms, the GOODS WHICH COME IN FIRST are the FIRST TO LEAVE upon a sale.

This method of assigning costs to both inventory and COGS assumes that inventory are sold in the order acquired.

The cost of ending inventory in the Balance Sheet is therefore, always based on the latest cost incurred

Question 4

What is WAC (Weighted Average Cost)?

Answer 4

The WAC method of assigning cost requires the use of the WAC per unit of inventory at the time of sale.

After each new purchase of goods, the NEW UNIT COST of the goods held is RE-CALCULATED. The subsequent cost of sales would be at this cost:

WAC =
Total cost of goods available for sale/Total Quantity of goods

Question 5

What is the Historical Cost Concept?

Answer 5

Money values used in accounting should be derived only from actual events. Assets and services acquired by an enterprise are recorded at the original cost of acquisition

Question 6

What is the Perpetual Inventory System?

Answer 6

It means that its inventory account is continually updated to reflect purchases and sales

Question 7

Note:
WAC method evens out price fluctuations but there is a time lag between market price and inventory valuation. The COGS and the ending inventory represent neither the current cost nor the earlier historical cost

Question 8

What are the effect of Different Cost Flow Methods on Financial Statement?

Answer 8

When purchase prices do not change, the same cost amounts are assigned with each method. When purchase prices are different, the cost flow method a company uses can significantly affect the gross profit reported in the income statement.

Question 9

What happens when costs regularly rise? (FIFO)

Answer 9

FIFO assigns the lower amount to COGS, yielding the higher gross profit and net profit

Question 10

What happens when costs regularly rise? (WAC)

Answer 10

WAC yields the higher COGS and lower profit as it averages the recent higher costs with earlier lower costs

Question 11

What happens when costs regularly declines? (FIFO and WAC)

Answer 11

The opposite occurs

Question 12

What happens when there are no price changes? (FIFO and WAC)

Answer 12

Each inventory costing method assigns the SAME costs amounts to inventory and to COGS

Question 13

above points 9-12 can be found on pg 6

Question 14

What are the advantages of FIFO?

Answer 14

FIFO assigns an amount to inventory on the statement of financial position that APPROXIMATES ITS CURRENT COST. (meaning - the most up-to-date inventory cost on the Balance Sheet, closest to latest market price).

It also mimics the actual flow of goods for most businesses

Question 15

What are the advantages of WAC?

Answer 15

WAC tends to smooth out erratic changes in costs. However, the COGS and ending inventory MAY NOT REFLECT the market price

Question 16

What is the Consistency Concept?

Answer 16

The Consistency Concept states that similar accounting procedures should be used for items of similar nature from period to period.

This will facilitate COMPARISON OF FINANCIAL RESULTS and DECISION MAKING. It will also GUARD AGAINST MANIPULATION of accounting reports by simply switching to another accounting method that yields more desired results

Question 17

What is Net Realisable Value (NRV)?

Answer 17

NRV refers to the price the ending inventory could be sold for less all selling costs incurred. It is sometimes referred to as the market price of goods.

Question 18

Note:
The cost of inventories may not be recoverable if those inventories are DAMAGED, if they have become WHOLLY or PARTIALLLY OBSOLETE, or if their selling price has DECLINED

Question 18

What does Cost refer to?

Answer 18

Cost refers to the Historical Cost.

i.e. price paid for the ending inventory using FIFO or WAC

Question 19

How should the value of ending inventory be reported?

Answer 19

The value of ending inventory in the financial statements should be reported at the Lower Of The Historical Cost And The NRV (LCM Rule). If the NRV of the ending inventory is less than the historical cost, the ending inventory is reported at the NRV instead; and the difference in value is considered an impairment loss on inventory.

Question 20

What is Prudence Concept?

Answer 20

It states that Provision should be made for all foreseeable losses but profits should not be recognised until their realisation is reasonably certain

Question 21

Note:
a) If the NRV of the ending inventory is more than the historical cost, the ending inventory REMAINS AT THE COST PRICE and NO ADJUSTMENT IS NEEDED in the books

Answer 21

b) The practice of writing inventories below costs to NRV is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use. This is in line with the Prudence Concept which states that provision should be
made for all foreseeable losses but profits should not be recognised until their realisation is reasonably certain.

If NRV of the ending inventory is lower than its cost price, it means that a loss will likely occur in subsequent period(s) when the ending inventory is sold. Hence this foreseeable loss should be recognised now to be prudent although no gain has actually occurred since the goods have yet to be sold.

If the NRV of the ending inventory is higher than its costs, it means that the goods can likely be sold for a profit in subsequent period(s). However, this foreseeable gain cannot be recognized now because the profit is yet to be realised (since the goods are not sold). In doing so will overstate profits and violate the prudence concept.

Question 22

What is the LCM rule?

Answer 22

The value of ending inventory in the financial statements should be reported at the Lower Of The Historical Cost And The NRV

Question 23

What is the Article or Item-by-Item method?

Answer 23

The cost price and market price are compared for each article and the lower figure is taken. These lower figures identified are then added together to give the total valuation

Question 24

What is the Category Method?

Answer 24

Similar or interchangeable articles are put together into categories. Then the cost price and market price for each category are compared and the lower of these 2 figures for each category is then taken.

For one category, cost price may be lower and for another, market price could be lower.

The lower figures chosen for each category are then added together to give the total valuation

Question 25

What are the Criticisms against the LCM rule?

Answer 25

-The rule is inconsistent because it recognises unrealised losses but ignores unrealised gains
-The rule requires the reporting of estimated losses as definite deductions from income even though the losses may not be eventually incurred

Question 26

What are unrealised losses?

Answer 26

losses that have not occurred

Question 27

What are unrealised gains?

Answer 27

profits that have not yet been earned

Question 28

What is Impairment loss on Inventory?

Answer 28

If the NRV of the ending inventory is LESS than the historical cost, the ending inventory is reported at the NRV instead; and the difference in value is considered an impairment loss on inventory

Question 29

Note:
If adjustment for impairment loss was NOT made, inventory will be overstated by the impairment loss amount, hence total current assets and total assets will also be overstated by this amount in the current period