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MIT565702

WEEK 9
INVENTORY (2)

Lecture Objectives

At the end of this lecture you should be able to:


Understand the need for cost-flow assumptions;
Determine how ending inventory and cost of goods
sold is determined under each cost-flow assumption;
Apply each cost-flow assumption using the periodic
and perpetual inventory methods; and
Apply the lower of cost or market rule

What are Cost-flow Assumptions?


Example
XYZ Company had 1500 shirts on hand at 1 July 2011. These shirts had a
cost of $8 each to purchase. Throughout the year it made the following
purchases:
22 August
19 October
28 January
12 March
8 June

10 000 shirts
19 000 shirts
8 000 shirts
15 000 shirts
6 000 shirts

at
at
at
at
at

$13 each
$10 each
$12 each
$15 each
$13 each

A physical count revealed 3500 shirts on hand as at 30 June 2012


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What are Cost-flow Assumptions?


1500 @ $8
19 000 @ $10

10 000 @ $13
8000 @ $12

Cost of goods sold


56 000 @ $??

15000 @ $15

6000 @ $13

Ending inventory
3500 @ $??

Cost-flow Assumptions

Split costs of opening inventory plus purchases into


COGS and ending inventory

Total dollar amount of goods available for sale:


COGS

Ending inventory

How the costs are divided between COGS and ending


inventory impacts net profit and the inventory figure in
the balance sheet
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What are Cost-flow Assumptions?

How do we determine the value of ending inventory and COGS?


Track each individual items through the inventory flow (specific
identification)
Accurate
Based on physical flow of goods
Time-consuming and expensive
Technology is making specific identification easier (e.g. bar
code technology)
In cases where the costs of specific identification outweigh the
benefits, cost-flow assumptions are a useful alternative
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What Cost-flow Assumptions are


Permitted in Australia?

AASB 102 (IAS 2) Inventories permits the use of three


cost formulas:
Specific identification;
First-in, first-out (FIFO); and
Weighted average

A fourth approach, last-in, first-out (LIFO) is not permitted

Specific Identification

Each unit sold and on hand can be identified by serial


numbers or a specific purchase invoice

Used when inventory items are not interchangeable


Small volume, high dollar value items
Houses; motor vehicles; expensive jewellery

Not possible or cost-effective for many entities

FIFO

Assumes the first units acquired are the first units sold
Beginning inventory sold first and earliest purchases
thereafter

Ending inventory, therefore, is assumed to consist of the


most recently acquired units

Tends to understate COGS and overstate ending


inventory when cost price increases during the period

Weighted Average
Periodic Method
Weighted average calculated as:
Total cost of goods available for sale for a period
Total number units available for sale for a period

Perpetual Method
Moving weighted average, where average price is
recalculated after every purchase
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LIFO

Assumes last units acquired are the cost of first units


sold

Not permitted in Australia (AASB 102 Inventories


para 25)

It has been popular in the United States where it is


allowed for tax purposes if used for accounting
purposes but currently proposed for repeal

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Perpetual vs. Periodic

Recall:
Perpetual method maintains a continuous record of
inventory and COGS
Periodic method calculates inventory and COGS once a
stocktake has occurred

Choosing the perpetual or periodic methods will influence


COGS and closing inventory under some cost-flow
assumptions
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Example
Details
Beginning
Inventory
Purchased
Sold
Purchased
Sold

Date

Units

1/1/

200

Unit
cost
$2

15/1/
17/1/
28/1/
30/1/
Total

300

$3

Total
cost
$400
$900

Units
sold

250
500
1 000

$4

$2 000
$3 300

400
650*

* For specific identification purposes assume 100 units @ $2;


150 @ $3; 400 @ $4

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Specific identification
(Perpetual Method)
PURCHASES
Date
1/1
15/1

Units

300

Unit
cost
3

COGS

Total
cost

30/1

500

Total
cost

900

17/1
28/1

Units Unit
cost

ENDING INVENTORY

100
150

2
3

200
450

400

1600

2 000

TOTAL 2 250

Units
200
200
300
100
150
100
150
500
100
150
100

Unit
cost
2
2
3
2
3
2
3
4
2
3
4

Total
cost
400
400
900
200
450
200
450
2 000
200
450
400
1 050
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Specific identification
(Periodic Method)

Specific identification traces the movement of each


unit of inventory

Implies the use of the perpetual inventory method, as


continuous records are maintained

Specific identification not used in conjunction with the


periodic method

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FIFO
(Perpetual Method)
PURCHASES
Date
1/1
15/1

Units

300

Unit
cost
3

COGS

Total
cost

30/1

200
50
500

Total
cost

900

17/1
28/1

Units Unit
cost

ENDING INVENTORY

2
3

400
150

2 000
250
3
750
150
4
600
TOTAL 1 900

Units
200
200
300

Unit
cost
2
2
3

Total
cost
400
400
900

250
250
500

3
3
4

750
750
2 000

350

1 400
1 400

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FIFO
(Periodic Method)
Ending Inventory
Stocktake of 350 units
(Assume 350 units @ $4)

= $1 400

Cost of Goods Available for Sale


Cost of goods available for sale

= $3 300

Cost of Goods Sold


650 units sold @ $3 300 - $1 400
= $1 900
(Assume 200 units @ $2 + 300 units @ $3 + 150 @ $4 = $1900)
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Weighted Average
(Perpetual Method)
Moving Weighted Average
PURCHASES
Date

Units

Unit
cost

COGS

Total
cost

Units

Unit
cost

ENDING INV.
Total
cost

1/1
15/1

300

*$1 300 500

900

250
500

*$2 650 750


30/1
TOTAL

Unit
cost

Total
cost

200

400

*500

2.60

1300

250

2.60

650

*750

3.53

2 650

350

3.53

1 238

= 2.60

17/1
28/1

Units

2.60

650

2 000

=$3.53
400

3.53 1 412
2 062

1 238
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Weighted Average
(Periodic Method)
Total cost of goods available for sale for a period
Total number units available for sale for a period
= $3.30/unit

Ending inventory

$3 300
1 000
350 x $3.30

COGS

650 x $3.30

= $2 145

= $1 155

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LIFO
(Perpetual Method)
PURCHASES
Date

Units

COGS

Unit

Total

cost

cost

Units

ENDING STOCK/INV.

Unit

Total

cost

cost

1/1
15/1

300

900

17/1
250
28/1

500

750

2 000

30/1
400
TOTAL

1 600
2 350

Units

Unit

Total

cost

cost

200

400

200

400

300

900

200

400

50

150

200

400

50

150

500

2000

200

400

50

150

100

400
950

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LIFO
(Periodic Method)
Ending Inventory
Stocktake of 350 units
(Assume 200 units @ $2 + 150 units @ $3)

Cost of Goods Available for Sale


Cost of goods available for sale

= $3 300

$850

Cost of Goods Sold


650 units sold @ $3 300 - $850
= $2 450
(Assume 500 units @ $4 + 150 units @ $3 = $2 450)
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Comparison

Assume selling price is $10 per item;

Sold 650 units x $10 = $6500;

Operating expenses $50; and

Assume there are no stock losses

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PERIODIC
FIFO

PERPETUAL

LIFO

Weighted
average

Spec Id

FIFO

LIFO

Moving
average

SALES

6 500

6 500

6 500

6 500

6 500

6 500

6 500

Less COGS

1 900

2 450

2 145

2 250

1 900

2 350

2 062

Gross profit

4 600

4 050

4 355

4 250

4 600

4 150

4 438

Less expenses

50

50

50

50

50

50

50

Net profit

4 550

4 000

4 305

4 200

4 550

4 100

4 388

Ending inventory

1 400

850

1 155

1 050

1 400

950

1 238

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Comparison
In periods of rising prices:

FIFO results in the highest ending inventory, highest


gross profit, highest net profit and the lowest COGS

LIFO results in lowest ending inventory, lowest gross


profit, lowest net profit and the highest COGS

Weighted average and specific identification results


fall between FIFO and LIFO
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Student Task

Have a go at practice problem 1a b and c on Pg 145-6


of the study guide for discussion in 30 minutes.
Note. In part B prepare stock cards for the FIFO,
LIFO and Moving Weighted Average assumptions

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Workings Periodic Method


Date

Particulars

DR

CR

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Workings Periodic Method


Date

Particulars

DR

CR

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Income Statement (Periodic)


Income statement for the year ended 30 June

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Stock Card - FIFO


DATE

IN

OUT

BALANCE

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Stock Card - LIFO


DATE

IN

OUT

BALANCE

30

Stock Card MOVING WEIGHTED AVERAGE


DATE

IN

OUT

BALANCE

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Workings Perpetual Method


Date

Particulars

DR

CR

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Workings Perpetual Method


Date

Particulars

DR

CR

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Workings Perpetual Method


Date

Particulars

DR

CR

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Workings Perpetual Method


Date

Particulars

DR

CR

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Income Statement (Perpetual)


Income statement for the year ended 30 June

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What is the Lower of Cost or Market


Rule?

Instances arise when the market price of inventory is less


than the cost price
Obsolescence (perishables past their use by date; audio
cassette players)
Damage (damaged goods basket at supermarket)
Demand (summer clearance sale)

In accordance with the principle of conservatism, this


decrease in asset value is to be recognised when it occurs

This is known as the lower of cost or market rule

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Lower of Cost or Market Rule

AASB 102 (IAS 2) Inventories states inventory is to be


valued at the lower of cost or net realisable value on an item
by item basis
If not practicable, may group similar or related items

Net realisable value is the net amount expected to be


realised from the sale of inventory
Selling price less costs incurred to make the sale

This is the value of inventory as it appears in the balance


sheet
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Example
Item no.

675
732
957
977
Total

Units

5
10
15
8

Unit
cost

x
x
x
x

$50
$40
$55
$10

Total
Cost

=
=
=
=

$250
$400
$825
$ 80
1 555

Units

5
10
15
8

Market
Price

x
x
x
x

$45
$48
$30
$15

Total
Market
Price

Lower of
Cost or
Market

= $225
= $480
= $450
= $120
$1 275

$225
$400
$450
$ 80
1 155

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Student Task

What would be the general journal entry from the


previous example to record the lower of cost or
market rule?

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Workings
GENERAL JOURNAL
Date Particulars

DR

CR

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Lecture Outcomes

You should now be able to:


Understand the need for cost-flow assumptions;
Determine how ending inventory and cost of goods
sold is determined under each cost-flow assumption;
Apply each cost-flow assumption using the periodic
and perpetual inventory methods; and
Apply the lower of cost or market rule

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Homework This Week

Questions from Required Exercises?

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Homework Next Week


Case Discussion 1
E. Knight (2001), Inventiveness in inventories, The
Sydney Morning Herald, 9 August, p. 21 (Business).
Issues to consider:
How was the value of inventory determined?
How was this used to manipulate profits?

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Homework Next Week


Case Discussion 2
L. Gettler (2005), One-offs uncork the red for Evans
& Tate, The Age, 14 September, p. 2 (Business)
Issues to consider:
Why was the inventory write-down necessary?
Why were the corporate overheads expensed rather
than capitalised?

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Homework Next Week

Required Exercises P8.2, P8.7, P8.12


Chapter 13 of textbook

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