Chapter4 inventory2008

Gripping IFRS Inventories

Chapter 4
Inventories
Reference: IAS 2

Contents: Page
1. Introduction 137

2. Definitions 137

3. Different classes of inventories 137

4. Recording inventory movement: periodic versus perpetual 138
4.1 Overview 138
Example 1: perpetual versus periodic system 138
4.2 Stock counts, inventory balances and stock theft 139
4.2.1 The perpetual system and the use of stock counts 139
4.2.2 The periodic system and the use of stock counts 139
Example 2: perpetual versus periodic system and stock theft 140
4.3 Gross profit and the trading account 141
Example 3: perpetual and periodic system: stock theft and profits 142

5. Measurement: cost 144
5.1 Overview 144
5.2 Cost of purchase 144
5.2.1 Transport costs 144
5.2.1.1 Transport/ carriage inwards 145
5.2.1.2 Transport/ carriage outwards 145
Example 4: transport costs 145
5.2.2 Transaction taxes 146
Example 5: transaction taxes 146
5.2.3 Rebates 147
Example 6: rebates 147
5.2.4 Discount received 148
Example 7: discounts 148
5.2.5 Finance costs due to extended settlement terms 149
Example 8: extended settlement terms 149
5.2.6 Imported inventory 151
Example 9: exchange rates – a basic understanding 151
Example 10: foreign exchange 152
5.3 Cost of conversion 153
5.3.1 Variable manufacturing costs 153
Example 11: variable manufacturing costs 153
5.3.2 Fixed manufacturing costs 154
5.3.2.1 Under-production and under-absorption 154
Example 12: fixed manufacturing costs – under-absorption 154
5.3.2.2 Over-production and over-absorption 156
Example 13: fixed manufacturing costs – over-absorption 156
5.3.2.3 Budgeted versus actual overheads summarised 157
Example 14: fixed manufacturing costs – over-absorption 158
Example 15: fixed manufacturing costs – under-absorption 159

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Contents continued … Page

6. Measurement: cost formulas (inventory movements) 160
6.1 Overview 160
6.2 First-in-first-out method (FIFOM) 161
Example 16: FIFOM purchases 161
Example 17: FIFOM sales 161
Example 18: FIFOM sales 162
6.3 Weighted average method (WAM) 162
Example 19: WAM purchases 162
Example 20: WAM sales 163
6.4 Specific identification method (SIM) 163
Example 21: SIM purchases and sales 163

7. Measurement of inventories at year-end 164
7.1 Overview 164
Example 22: lower of cost or net realisable value 164
7.2 Testing for possible write-downs: practical applications 167
Example 25: lower of cost or net realisable value – with disclosure 168

8. Disclosure 171
8.1 Accounting policies 171
8.2 Statement of financial position and supporting notes 171
8.3 Statement of comprehensive income and supporting notes 171
Example 26: disclosure of cost of sales and depreciation 171
8.4 Sample disclosure involving inventories 172
8.4.1 Sample statement of financial position and related notes 172
8.4.2 Sample statement of comprehensive income and related notes 172
8.4.2.1 Costs analysed by nature in the statement of comprehensive
income 172
8.4.2.2 Costs analysed by function in the statement of
comprehensive income 173
8.4.2.3 Costs analysed by function in the notes to the statement of
comprehensive income 173

9. Summary 175

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1. Introduction

The topic of inventories is an important area for most companies and thus an important
section to properly understand.

The issues regarding inventories include:
• when to recognise the acquisition of inventory,
• how to measure the initial recognition,
• how to measure inventory subsequently (year-ends and when sold),
• derecognition of inventory when it is sold or scrapped,
• disclosure of inventories in the financial statements.

2. Definitions

Inventories are assets that are (IAS 2.6):
• held for sale in the ordinary course of business; or
• in the process of production for such sale; or
• in the form of materials or supplies to be consumed in the production process or in the
rendering of services.

Net realisable value is (IAS 2.6):
• the estimated selling price in the ordinary course of business;
• less the estimated costs of completion; and
• less the estimated costs necessary to make the sale.

Fair value is (IAS 2.6):
• the amount for which an asset could be exchanged, or a liability settled,
• between knowledgeable, willing parties in an arm’s length transaction.

The difference between a fair value and a net realisable value is essentially as follows:
• a fair value is what is referred to as an non-entity-specific value, since it is determined by
market forces; whereas
• a net realisable value is what is referred to as an entity-specific value because it is affected
by how the entity plans to sell the asset.

3. Different classes of inventories

The type or types of inventories that an entity may have depends largely on the type of
business: retail, manufacturer and service providers, being the most common types.

If the entity runs a retail business, then the inventory will generally be called: merchandise.
A manufacturing business will generally call his inventory:
• finished goods;
• work-in-progress; and
• raw materials.

Another type of inventory held by many types of businesses (e.g. retail, manufacturer and
service provider) includes fuel, cleaning materials and other incidentals, often referred to as:
• consumable stores.

A business may, of course, have any combination of the above types of inventory.

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4. Recording inventory movements: periodic versus perpetual

4.1 Overview

Inventory movements may be recognised using either the perpetual or periodic system.

The perpetual system refers to the constant updating of both the inventory and cost of sales
accounts for each purchase and sale of inventory. The balancing figure will represent the
value of inventory on hand at the end of the period. This balance is checked by performing a
stock count at the end of the period (normally at year-end).

The periodic system simply accumulates the total cost of the purchases of inventory in one
account, (the purchases account), and updates the inventory account on a periodic basis (often
once a year) through the use of a physical stock count. The balancing figure, in this case, is
the cost of sales.

Example 1: perpetual versus periodic system
C
Opening inventory balance 55 000
Purchases during the year (cash) 100 000

A stock count at year-end reflected 18 000 units on hand (cost per unit: C5).

Required:
Show the t-accounts using
A. the perpetual system assuming that 13 000 units were sold during the year; and
B. the periodic system.

Solution to example 1A: using the perpetual system

Inventory (Asset) Cost of Sales (Expense)
O/ balance 55 000 Cost of sales (2) 65 000 Inventory (2) 65
000
Bank (1) 100 000 C/ balance c/f 90 000
155 000 155 000
C/ balance (3) 90 000
(1) The cost of the purchases is debited directly to the inventory (asset) account.
(2) The cost of the sale is calculated: 13 000 x C5 = C65 000 (since the cost per unit was
constant at C5 throughout the year, the cost of sales would have been the same
irrespective of whether the FIFO, WA or SI method was used).
(3) The final inventory on hand at year-end is calculated as the balancing figure by taking the
opening balance plus the increase in inventory (i.e. purchases) less the decrease in
inventory (i.e. the cost of the sales): 55 000 + 100 000 – 65 000 = 90 000. This is then
compared to the physical stock count that reflected that the balance should be 90 000. No
adjustment was therefore necessary.

Solution to example 1B using the periodic system

Purchases Trading Account
Bank (2) 100 000 T/ account(5) 000 Inventory o/b(3) 55 Inventory c/b(4) 90
000 000
Purchases (5) 000 Total c/f (6) 65
000
155 000 155 000
Total b/f (6) 65 000

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Inventory (Asset)
O/ balance(1) 55 000 T/ account(3) 000
T/ account(4) 90 000

This balance will remain as C55 000 for the entire period until such time as the stock count is
performed.
(1) The purchases are recorded in the purchases account during the period (this account will
be closed off at the end of the period to the trading account).
(2) The closing balance of the inventory account is determined at the end of the period by
physically counting the inventory on hand and valuing it (C90 000). In order for the
closing balance to be recorded, the opening balance of C55 000 needs to first be removed
from the asset account by transferring it to the trading account.
(3) The inventory is counted and valued via a physical stock count (which is typically
performed on the last day of the period, being the end of the reporting period). This
figure is debited to the inventory account with the credit-entry posted to the trading
account: given as C90 000
(4) The total of the purchases during the period is transferred to the trading account.
(5) Notice how the trading account effectively records the cost of sales and that the cost of
sales is the same as if the perpetual system had been used instead: 65 000. Incidentally,
the inventory balance is also the same, irrespective of the method used: 90 000.

4.2 Stock counts, inventory balances and stock theft

In example 1, the cost of sales and inventory balances are not affected by whether the periodic
or perpetual system is used (i.e. cost of sales was C65 000 and inventory was C90 000 in part
A and part B). This may not always be the case however, since a disadvantage of the periodic
system is that any stock thefts will remain undetected. The periodic system is, however, still
useful to small businesses due to its practical simplicity.

4.2.1 The perpetual system and the use of stock counts

When using the perpetual system, the accountant is able to calculate the balance on the
inventory account without the use of a stock count. This balance, however, reflects what the
balance should be – not necessarily what the actual balance is. A sad truth of our society is
that it is plagued by theft. Therefore, even though the accountant is not reliant on the stock
count, a stock count is performed as a control measure. In other words, the balance calculated
by the accountant is checked by performing a stock count at the end of the period (normally at
year-end).

If the physical count reveals a lower stock level than is reflected by the balance on the
inventory account, the difference will be accounted for as a stock theft (expense) (if the
physical count reflects more stock than appears in the inventory account, then this suggests
that an error may have occurred in recording the purchases or sales during the period).

4.2.2 The periodic system and the use of stock counts

When using the periodic system, the accountant does not have any idea of what his cost of
sales are until the stock count is performed. Since we are using the stock count to calculate
the cost of sales, the accountant will also not have an idea of what the inventory balance
should be (if we had the cost of sales figure, we could have calculated the closing balance as:
opening balance + purchases – cost of sales). In short: when using the periodic system, the
accountant is unable to calculate the balance on the inventory account without the use of a
stock count. If the accountant does not know what the balance should be, the stock count will
not be able to highlight any stock thefts.

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The fact that any stock thefts will remain undetected if the periodic system is used is shown in
this next example.

Example 2: perpetual versus periodic system and stock theft
C Units
Opening inventory balance 55 000 11 000
Purchases during the year (cash) 100 000 20 000


Required:
Show the t-accounts using
A. the perpetual system assuming that the company sold 13 000 units during the year; and
B. the periodic system.

Solution to example 2A using the perpetual system and stock theft

Inventory (Asset) Cost of sales (Expense)
O/ balance 55 Cost of S 65 000 Inventory (2) 65
000 (2) 000
Bank (1) 100 Subtotal 90 000
000 c/f
155 155
000 000
Subtotal (3) 90 Cost of 10 000
000 T(4)
C/ bal c/f 80 000
90 90 000
000
C/ 80
balance(5) 000

Cost of theft (Expense)
Inventory (4) 10
000

(1) The cost of the purchases is debited directly to the inventory (asset) account.
(2) The cost of the sale is calculated: 13 000 x C5 = C65 000 (since the cost per unit was
constant at C5 throughout the year, the cost of sales would have been the same
irrespective of whether the FIFO, WA or SI method was used). If the business has very
few sales or has a sophisticated system, the inventory and cost of sales accounts are
updated immediately for each sale that takes place. This example processes the
cumulative sales for the year.
(3) The final amount of inventory that should be on hand at year-end is calculated as the
balancing figure by taking the opening balance plus the increase in inventory (i.e.
purchases) less the decrease in inventory (i.e. the cost of the sales): 55 000 + 100 000 – 65
000 = 90 000
(4) A stock count is performed and whereas there should have been 18 000 units on hand at
year-end (11 000 + 20 000 – 13 000 units), there are only 16 000 units. It is therefore
clear that 2 000 units have been stolen. The cost of this theft is therefore 10 000 (2 000 x
C5).
(5) The closing balance of inventory must reflect the reality and therefore the balance has
been reduced from what it should have been (90 000) to what it is (80 000).

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Solution to example 2B using the periodic system and stock theft

Purchases Trading Account
Bank (2) 100 000 T/account(5) 100 000 Inventory o/b(3) 55 Inventory c/b (4)
80
000 000
Purchases (5) 000 Total c/f (6) 75
000
155 000 155 000
Total b/f (6) 75 000

Inventory (Asset)
O/ balance(1) 55 000 Trade a/c(3) 000
Trade a/c(4) 80 000

(1) This balance will remain as C55 000 for the entire period until such time as the stock
count is performed.
(2) The purchases are recorded in the purchases account during the year (this account will be
closed off at the end of the period to the trading account).
(3) The closing balance of the inventory account is determined at the end of the period by
physically counting the inventory on hand and valuing it (C90 000). In order for the
closing balance to be recorded, the opening balance of C55 000 needs to first be removed
from the asset account by transferring it to the trading account.
(4) The inventory is counted and valued via a physical stock count (which is typically
performed at the end of the reporting period). This figure is debited to the inventory
account with the credit-entry posted to the trading account: C80 000 (16 000 x C5).
(5) The total of the purchases during the period is transferred to the trading account.
(6) The trading account effectively records the cost of sales. Whereas the perpetual system in
Part A indicated that cost of sales was 65 000 and that there was a cost of theft of 10 000,
this periodic system indicates that cost of sales is 75 000. In other words, the periodic
system assumed that all missing stock was sold. It is therefore less precise in describing
its expense but it should be noted that the total expense is the same under both systems
(periodic: 75 000 and perpetual: 65 000 + 10 000). Incidentally, the inventory balance is
the same under both methods: 80 000.

4.3 Gross profit and the trading account

If one uses the periodic system, the trading account is first used to calculate cost of sales. The
sales account is then also closed off to the trading account, at which point the total on the
trading account (sales – cost of sales) equals the gross profit (or gross loss). This total is then
transferred to (closed off to) the profit and loss account together with all other income and
expense accounts. The total on the profit and loss account will therefore equal the final profit
or loss for the year.

If the perpetual system is used, the trading account is only used to calculate gross profit: it is
not used to calculate cost of sales. The cost of sales account and sales account are transferred
to (closed off to) the trading account. The total on this trading account (sales – cost of sales)
represents the gross profit. This total will be transferred to (closed off to) the profit and loss
account together with all other income and expense accounts. The total on the profit and loss
account will therefore equal the final profit or loss for the year.

The gross profit calculated according to the perpetual system may differ from that calculated
under the periodic system if, for example, stock theft went undetected. The final profit or loss
calculated in the profit and loss account will, however, be the same.

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The use of the trading account to calculate gross profit and how gross profits can differ is
shown in this next example.

Example 3: perpetual and periodic system: stock theft and profits
C Units
Opening inventory balance 55 000 11 000
Purchases during the year (cash) 100 000 20 000
Revenue from sales totalled C95 000 for the period (cash).

Required:
Show the ledger accounts and extracts of the statement of comprehensive income using:
A. the perpetual system assuming that the company sold 13 000 units during the year; and
B. the periodic system assuming that sales totalled C95 000.

Solution to example 3A: perpetual system: stock theft and profits

Inventory (Asset) Cost of sales (Expense)
O/ balance 55 000 Cost of S 65 000 Inventory 65 000 TA (1) 65 000
Bank 100 Subtotal 90 000
000 c/f
155 155
000 000
Subtotal 90 000 Cost of T 10 000
b/f
C/ bal c/f 80 000
90 000 90 000
C/ balance 80 000

Cost of theft (Expense)
Inventory 10 000 P&L (3) 10 000

Sales (Income)
Trade Acc 95 000 Bank 95 000
(1)

Trading account (Closing account) Profit and loss account (Closing account)
CoS (1) 65 Sales (1) 95 Cost: theft (3) 10 000 Trade A/c 30 000
000 000 (GP) (2)
P&L (2) 30 Total c/f 20 000
000
95 95 30 000 30 000
000 000
Total b/f 20 000
(4)

(1) Sales and cost of sales are transferred to the trading account.
(2) The total on the trading account (gross profit) is transferred to the profit and loss account.
(3) All other income and expenses are closed off at the end of the year to the profit and loss
account.

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(4) If there were no other income and expense items, then this total represents the final profit
for the year. It would then be transferred to the equity account: retained earnings.

Company name
Statement of comprehensive income
For the period ended …. (extracts)
CY PY
C C
Revenue from sales 95 000 x
Cost of sales (65 000) (x)
Gross profit 30 000 x
Cost of theft (10 000) (x)
Profit before considering other income and 20 000 x
expenses

Solution to example 3B: periodic system: stock theft and profits

Inventory (Asset) Sales (Income)
O/ 55 000 TA 55 000 TA (2) 95 000 Bank 95 000
balance
TA 80 000

Purchases
Bank 100 TA 100 000
000

Trading account (Closing account) Profit and loss account (Closing account)
Inv o/bal 55 000 Inv c/bal 80 000 TA (GP) (3) 20
000
Purchases 100 Total c/f 75 000
000
155 155 000
000
Total b/f 75 000 Sales (2) 95 000
(1)

P&L (3) 20 000
95 000 95 000

(1) The total brought forward on the trading account represents the cost of inventory
(assumed to be cost of sales).
(2) Sales are credited to the trading account.
(3) The balance on the trading account represents the gross profit and this is transferred to the
profit and loss account. All other income and expense accounts are then also transferred
to (closed off to) the profit and loss account. The profit and loss account therefore
converts gross profit into the final profit for the period.

Company name
For the period ended …. (extracts)
CY PY

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C C
Revenue from sales 95 000 x
Cost of sales (75 000) (x)
Gross profit (4) 20 000 x

(4) Notice how the gross profit in the statement of comprehensive income is 20 000 under the
periodic system but is 30 000 under the perpetual system. The final profit in both cases
is, however, 20 000.

5. Measurement: cost (IAS 2.10)

5.1 Overview

The costs that one should include in (i.e. capitalise to) inventory include the (IAS 2.10):
• costs to purchase the inventory,
• costs to convert the inventory into a saleable or consumable condition; and
• other costs to bring the inventory to its present location and condition.

5.2 Cost of purchase (IAS 2.11)
The cost of inventory would include all costs directly associated with the acquisition, such as:
• purchase price,
• transport costs (inwards),
• import duties and transaction taxes that are not reclaimable * by the business, and
• other direct costs.
The following costs would be excluded from the cost of inventory:
• import duties and transaction taxes that are reclaimable * by the business,
• financing costs due to extended payment terms.
*: The acquisition of inventory very often involves the payment of transaction taxes and
import duties. Sometimes these taxes or import duties (which are either paid over to the
supplier or directly to the tax authority) and are able to be reclaimed at a later date from the
tax authorities. If they can be reclaimed (recovered), then there is no net cost to the business.
A typical example is the transaction tax levied by many countries: VAT. See chapter 3 for
more information in this regard.
The following would be set-off against the cost of inventory:
• rebates received,
• trade, bulk and cash discounts received,
• settlement discounts received or expected to be received.
Only those costs that are incurred in bringing the inventory to its present location and
condition may be capitalised. The following costs should therefore always be expensed:
• abnormal amounts of wastage;
• storage costs (unless these are directly attributable to the production process, e.g. the cost
of storage in-between processes that is considered to be unavoidable and normal); and
• selling costs.
5.2.1 Transport Costs
There are two types of transport costs (carriage costs): transport inwards and transport
outwards, each of which being accounted for differently.
5.2.1.1 Transport/ carriage inwards
The cost of transport inwards refers to the cost of transporting the purchased inventory from
the supplier to the purchaser’s business premises. It is a cost that was incurred in ‘bringing the
inventory to its present location’ and should therefore be included in the cost of inventory.

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5.2.1.2 Transport/ carriage outwards
Frequently, when a business sells its inventory, it offers to deliver the goods to the customer’s
premises. The cost of this delivery is referred to as ‘transport outwards’. It is a cost that is
incurred in order to complete the sale of the inventory rather than to purchase it and may
therefore not be capitalised (since it is not a cost that was incurred in ‘bringing the inventory
to its present location’). Transport outwards should, therefore, be recorded as a selling
expense in the statement of comprehensive income instead of capitalising it to the cost of the
inventory.
Example 4: transport costs
A company purchases inventory for C100 from a supplier. No VAT was charged. The
following additional information is provided:
Cost of transport inwards C25
Cost of transport outwards C15
All amounts were on credit and all amounts owing were later paid in cash.
Required:
Calculate the cost of the inventory and show all related journal entries.
Solution to example 4: transport costs

Calculation
Cost of inventory purchased: 100 + 25 = C125

Journals Debit Credit
Inventory (A) 125
Trade payable (L) 125
Cost of inventory purchased on credit: 100 + 25 (transport
inwards)

Transport outwards (E) 15
Cost of delivering inventory to the customer

Bank 100
Payment of supplier

Bank 25
Payment of the transport company that transported goods from
supplier

Bank 15
Payment of the transport company that transported goods to the
customer

5.2.2 Transaction taxes

The only time that transaction taxes (e.g. VAT) or import duties will form part of the cost of
inventory is if they may not be claimed back from the tax authorities. This happens, for

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example, where the entity fails to meet certain criteria laid down by the tax authority (e.g. if
the entity is not registered as a vendor for VAT purposes).

Example 5: transaction taxes

An entity purchased inventory. The costs thereof were as follows:
C
Total invoice price (including 14% VAT) paid in cash to the supplier 9 120
Import duties paid in cash directly to the country’s Customs 5 000
Department

Required:
Show the ledger accounts assuming:
A. The VAT and the import duties were refunded by the tax authorities one month later.
B. The VAT and the import duties will not be refunded.

Solution to example 5A: refundable taxes and import duties

Inventory (Asset) VAT receivable (Asset)
Bank (1) (5) 8 000 Bank (1) 1 120 Bank (3) 1 120

Bank Import duties receivable (Asset)
VAT 1 120 Inv & VAT 9 Bank (2) 5 000 Bank (4) 5 000
receivable (3) Receivable (1) 120
Import duties 5 000 Import 5
recoverable (4) duties 000
recoverable
(2)

(1) The VAT portion of the invoice price must be separated and recognised as a receivable
since the entity will claim this VAT back: 9 120 / 114 x 14 = 1 120. The balance of the
invoice price is recognised as inventory since this represents the real cost to the entity:
9 120 / 114 x 100 = 8 000
(2) The import duties payable directly to the Customs Department were also refundable and
therefore the entire import duty paid is recognised as a receivable. This can happen
where, for example, another country in which the entity operates offers a dispensation
whereby it refunds certain taxes paid by the entity to other countries.
(3) VAT refund received.
(4) Import duty refund received.
(5) Notice that the inventory account reflects C8 000 and that equals net amount paid per the
bank account is also C8 000: 9 120 + 5 000 – 1 120 – 5 000.

Solution to example 5B: non-refundable taxes and import duties

Inventory (Asset) Bank
Bank (1) 9 120 Inv (1) 9 120
Bank (2) 5 000 IDR (2) 5 000
14 14
120 120

(1) The VAT portion of the invoice price is not separated since none of it is refundable.
(2) The import duties payable directly to the Customs Department were not refundable and
are therefore part of the costs of acquiring the inventory.

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(3) Notice that the inventory account reflects a balance of C14 120 and that this equals the
amount paid per the bank account: 9 120 + 5 000.

5.2.3 Rebates

The entity that is purchasing inventory may receive a rebate that is somehow related to the
inventory. There are many different types of rebates possible. The rule is, however, that if
the rebate is received as a reduction in the purchase price, then the cost of the inventory must
be reduced by the rebate. Some rebates, although connected to the inventory, are not really a
direct reduction in the purchase price but a refund of certain of the entity’s costs. In this case,
the rebate received should be recognised as income instead.

Example 6: rebates

An entity purchased inventory for cash. The details thereof were as C
follows:
• Invoice price (no VAT is charged on these goods) 9 000
• Rebate offered to the entity by the supplier 1 000
Required:
Show the ledger accounts assuming that the terms of the agreement made it clear that the
rebate:
A. Was a reduction to the invoice price of the inventory; and
B. Was a refund of the entity’s expected selling costs.
Solution to example 6A: rebate reducing cost of inventory
Bank (1) 8 000 Inv (1) 8 000

(1) The rebate reduces the cost of inventory: 9 000 – 1 000

Solution to example 6B: rebate not reducing cost of inventory

(1)
Bank 9 000 Inv (1) 8 000

Rebate received (Income)
Bank (1) 1 000

(1) The cost of inventory is shown at 9 000 even though only 8 000 is paid. This is because
the rebate of C1 000 is not connected to the cost of the inventory but the entity’s future
expected selling costs. The rebate is recognised as income instead because by
recognising it as income, it enables the rebate income to be matched with the related
selling expenses.

5.2.4 Discount received

There are a variety of discounts that you could receive on the purchase of goods:

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• trade discount or bulk discount : this is usually received after successfully negotiating the
invoice price down, because you are a regular customer or you are buying in bulk; and
• cash discount : this is sometimes received as a ‘reward’ for paying in cash;
• settlement discount: this is sometimes received as a ‘reward’ for paying promptly.
All these discounts are deducted from the cost of the inventory. Trade discounts, bulk
discounts and cash discounts are generally agreed to on the transaction date. Settlement
discounts, however, will have to be estimated on the transaction date based on when the entity
expects to settle its account with the creditor.

Example 7: discounts

An entity purchased inventory. The costs thereof were as follows: C
• Marked price (no VAT is charged on these goods) 9 000
• Trade discount 1 000

Required:
Show the ledger accounts assuming:
A. The entity pays in cash on transaction date and receives a cash discount of C500; and
B. The supplier offers an early settlement discount of C400 if the account is paid within
20 days: the entity pays within the required period of 20 days.
C. The supplier offers an early settlement discount of C400 if the account is paid within
20 days: the entity pays after a period of 20 days.

Solution to example 7A: discounts including a cash discount

(1)
Bank 7 500 Inventory 7 500
(1)

1) The marked price is reduced by the trade discount and the cash discount: 9 000 – 1 000 –
500

Solution to example 7B: discounts including a settlement discount

Inventory (Asset) Trade payables (Liability)
Bank (1) 7 600 Bank (2) 7 600 Inventory 8 000
(1)

Sett Disc 400
All (3)

Bank Settlement discount allowance (negative
liability)
Tr Payable 7 Inventory 400 Tr Payable 400
(2) (1) (3)
600

(1) The marked price is reduced by the trade discount and the estimated settlement discount:
9 000 – 1 000 – 400 = 7 600. The settlement discount is an estimated discount until the
payment is made within the required period, at which point the discount becomes an
actual discount received. Until then, the creditor’s account is credited with the full
amount payable and an allowance for possible settlement discount of C400 is debited
(this reduces the carrying amount of the creditors presented in the statement of financial
position).
(2) The entity pays within 20 days and the settlement discount becomes a reality (i.e. the
estimated discount becomes an actual discount). The payment is therefore only C7 600.

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(3) Since the creditor is paid within the required settlement period, the entity earned its
settlement discount. The settlement discount allowance is thus reversed to the creditors
account (clears the balance owing to nil).

Solution to example 7C: discounts including a settlement discount

Inventory (Asset) Trade payables (Liability)
Bank (1) 7 600 Bank (2) 8 Inventory 8 000
000 (1)

Bank Settlement discount allowance (negative liability)
Tr Payable 8 Inv (1) 400 Fin exp (3) 400
(2)
000

Finance expense
Sett Disc 400
All (3)

(1) The marked price is reduced by the trade discount and the estimated settlement discount:
9 000 – 1 000 – 400 = 7 600. The settlement discount is an estimated discount until the
payment is made within the required period, at which point the discount becomes an
actual discount received. Until then, the creditor’s account is credited with the full
amount payable and an allowance for possible settlement discount of C400 is debited
(this reduces the carrying amount of the creditors presented in the statement of financial
position).
(2) The entity pays after 20 days and the settlement discount is forfeited. The payment is
therefore C8 000.
(3) Since the creditor is not paid within the required settlement period, the entity lost its
settlement discount. The settlement discount allowance is thus recognised as an expense.

5.2.5 Finance costs due to extended settlement terms

Instead of paying in cash on transaction date or paying within a short period of time, an entity
could choose to pay over a long period of time. Instead of receiving a discount and thus
decreasing the cash outflow, this choice would increase the cash outflow. The time value of
money must be taken into consideration when estimating the fair value of the cost and the
cost of paying over an extended period of time must be reflected as an interest expense. This
applies in all cases where the effect of the time value of money is considered to be material.

Example 8: extended settlement terms

An entity purchased inventory on 1 January 20X1. The costs thereof were as follows:
• Invoice price payable on 31 December 20X2 C6 050
• Market interest rate 10%
Required:
Show the journal entries assuming:
A. The effect of the time value of money is not considered to be material; and
B. The effect of the time value of money is considered to be material.

Solution to example 8A: extended settlement terms: immaterial effect

1 January 20X1 Debit Credit

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Inventory (A) 6 050
Trade payable (L) 6 050
Cost of inventory purchased on credit (time value ignored because
effects immaterial to the company)

31 December 20X2
Bank 6 050
Payment for inventory purchased from X on 1 January 20X1 (2
years ago)

Solution to example 8B: extended settlement terms: material effect

The cost of the inventory must be measured at the present value of the future payment
(thereby removing the finance costs from the cost of the purchase, which must be recognised
as an expense).

The present value can be calculated using a financial calculator by inputting the repayment
period (2 years), the future amount (6 050) and the market related interest rate (10%) and
requesting it to calculate the present value. (FV = 6 050, i = 10, n = 2, COMP PV)

This can also be done without a financial calculator, by following these steps:

Step 1: calculate the present value factors
Present value factor on due date 1.00000
Present value factor one year before payment is 1 / (1+10%) 0.90909
due
Present value factor two years before payment is 0.90909 / (1 + 10%) or 0.82645
due 1 / (1 + 10%) / (1 + 10%)

Step 2: calculate the present values
Present value on transaction 6 050 x 0.82645 (2 years before payment is 5 000
date due)
Present value one year later 6 050 x 0.90909 (1 year before payment is 5 500
due)
Present value on due date Given: future value (or 6 050 x 1) 6 050

The interest and balance owing each year can be calculated using an effective interest rate
table:

Year Opening balance Interest expense Payments Closing balance
20X1 5 000 Opening PV 500 5 000 x 10% (0) 5 500 5 000 + 500
20X2 5 500 550 5 500 x 10% (6 050) 0 5 500 + 550 – 6050
1 050 (6 050)

Notice that the present value is 5 000 and yet the amount paid is 6 050. The difference
between these two amounts is 1 050, which is recognised as interest expense over the two
years.

Inventory (A) 5 000
Trade payable (L) * 5 000

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Cost of inventory purchased on credit (invoice price is 6 050, but
recognised at present value of future amount). 10% used to
discount the future amount to the present value: 6 050 / 1.1 / 1.1 or
6 050 x 0.82645
31 December 20X1
Interest expense 500
Trade payable (L) * 500
Effective interest incurred on present value of creditor: 5 000 x
10%

31 December 20X2 Debit Credit
Interest expense 550
Trade payable (L) * 550
Effective interest incurred on present value of creditor: 5 500 x
10%
Bank 6 050
Payment of creditor: 5 000 + 500 + 550
* Notice that the trade payable balance:
• At 1 January 20X1 (2 years before payment is due) is 5 000. This is calculated using the
‘present value factor for two years’: 6 050 x 0.82645 = 5 000,
• At 31 December 20X1 (1 year before payment is due) is 5 500 (5 000 + 500). This can be
checked by using the ‘present value factor after 1 year’ of 0.90909: 6 050 x 0.90909 =
5 500.
• At 31 December 20X2 (immediately before payment) is 6 050 (5 000 + 500 + 550). This
can be checked using the ‘present value factor for now’ of 1: 6 050 x 1 = 6 050

5.2.6 Imported inventory

When inventory is purchased from a foreign supplier the goods are referred to as being
‘imported’. A complication of an imported item is that the cost of the goods purchased is
generally denominated in a foreign currency on the invoice. This foreign currency amount
must be converted into the local currency using the currency exchange rate ruling on
transaction date.

Example 9: exchange rates – a basic understanding
Mr. X has $1 000 (USD) that he wants to exchange into South African Rands (R).
Required:
Calculate the number of Rands he will receive if the exchange rate ruling on the date he
wants to exchange his dollars for Rands is:
A. R5: $1 (direct method); and
B. $0.20: R1 (indirect method).
Solution to example 9A: exchange rates – dollar is the base
$1 000 x R5 / $1 = R5 000 (divide by the currency you’ve got and multiply by the currency
you want)

Solution to example 9B: exchange rates – Rand is the base
$1 000 x R1 / $0.20 = R5 000 (divide by the currency you’ve got and multiply by the
currency you want)
Since currency exchange rates vary daily, it is very important to identify the correct
transaction date since this will determine both when to recognise the purchase and what
exchange rate to use when measuring the cost of the inventory.

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The transaction date for an imported asset is determined using the same principles used had
the asset been purchased locally: when the risks and rewards of ownership are transferred.

There are two common ways of purchasing goods from a foreign supplier: on a ‘customs,
insurance and freight’ basis (CIF) or a ‘free on board’ basis (FOB). The difference between
the two affects the date on which risks and rewards are transferred and thus determine the
transaction date. Although the terms of the agreement must always be thoroughly
investigated first, the general rule is that:
• if goods are purchased on a FOB basis, the risks and rewards are transferred as soon as
the goods are loaded onto the ship at the foreign port; and
• if goods are purchased on a CIF basis, the risks and rewards are transferred only when the
goods arrive safely in the local harbour and are released from customs.
In summary: goods purchased from a foreign supplier will be recorded by the purchaser, by
converting the foreign currency into what is called the reporting entities functional currency
(generally his local currency), using the spot exchange rate ruling on the transaction date.
Any change in the spot exchange rate thereafter is generally recognised in profit or loss (i.e. is
recognised as an expense or income and not recognised as an adjustment to the inventory
asset account).

Example 10: foreign exchange

A company in South Africa purchases $100 000 of raw materials from a supplier in America.
The following are the spot rates (rates of exchange on a particular date):
Date: R: $1
1 January 20X2 R7,20:$1
15 February 20X2 R7,30: $1
15 March 20X2 R7,50: $1
The goods are loaded onto the ship in New York on 1 January 20X2 and are released from the
Customs Department at the Durban harbour (South Africa) on 15 February 20X2. The
company pays the American supplier on 15 March 20X2. The currency of South Africa is
rands (R) and the currency of America is dollars ($).

Required:
Calculate the cost of inventory and the foreign exchange gain or loss and show the related
journal entries, assuming the following:
A. The goods are purchased FOB.
B. The goods are purchased CIF.

Solution to example 10A: foreign exchange – FOB
Inventory (A) $100 000 x 7,20 = R720 000 720 000
Creditor (foreign) 720 000
Purchase of inventory from New York
15 March 20X2
Foreign exchange loss ($100 000 x 7,50) – 720 000 30 000
Translation of foreign creditor on payment date:

Creditor (foreign) 720 000 + 30 000 or $100 000 x 750 000
7.50
Bank 750 000
Payment of foreign creditor
Solution to example 10B: foreign exchange – CIF

15 February 20X2 Debit Credit

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Inventory (A) $100 000 x 7,30 = R730 000 730 000
Purchase of inventory from New York
15 March 20X2
Foreign exchange loss ($100 000 x 7,50) – 730 000 20 000
Translation of foreign creditor on payment date
Creditor (foreign) 730 000 + 20 000 or $100 000 x 750 000
7.50
Bank 750 000
Payment of foreign creditor
Notice: The amount paid under both situations is R750 000 (using the spot rate on payment
date). The inventory is, however, measured at the spot rate on transaction date: the
transaction dates differed between part A (FOB) and part B (CIF) and therefore the cost of
inventory differs in part A and part B. The movement in the spot rate between transaction
date and payment date is recognised in profit and loss (i.e. not as an adjustment to the
inventory asset account).

5.3 Cost of conversion (IAS 2.12 - .14)

Manufactured inventory on hand at the end of the financial period must be valued at the total
cost of manufacture, being not only the cost of purchase of the raw materials but also the cost
of converting the raw materials into a finished product, including:
• direct and indirect costs of manufacture; and
• any other costs necessarily incurred in order to bring the asset to its present location and
condition (where even administrative overheads could be included if it can be argued that
they contributed to bringing the asset to its present condition and location).

Apart from the need to know the total manufacturing cost to debit to the inventory account, it
is also important to know what the manufacturing cost per unit is when quoting customers.
Manufacturing costs (direct and indirect) may be divided into two main categories:
• variable costs: these are costs that vary directly or almost directly with the level of
production e.g. raw materials (a direct cost that varies directly), labour and variable
overheads (indirect costs that vary directly or almost directly); and
• fixed costs: these are indirect costs that do not vary with the level of production e.g.
factory rental, depreciation and maintenance of factory buildings.

5.3.1 Variable manufacturing costs

Variable costs increase and decrease in direct proportion (or nearly in direct proportion) to the
number of units produced (or level of production). By their very nature it is easy to calculate
the variable cost per unit.

Example 11: variable manufacturing costs
Assume that one unit of inventory manufactured uses:
• 3 labour hours (at C3 per hour) and
• 1 kilogram of raw material X (at C2 per kg excluding VAT).
Required:
A. Calculate the variable manufacturing cost per unit of inventory.
B. Show the journal entries for the manufacture of 10 such units assuming that the labour is
paid for in cash and assuming that the raw materials were already in stock. Assume
further that the 10 units were finished.
Solution to example 11: variable manufacturing costs

Calculation: variable manufacturing cost per unit C

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Direct labour: 3 hours x C3 9
Direct materials: 1 kg x C2 2
Variable manufacturing cost per unit 11

Journals Debit Credit
Inventory: work-in-progress 90
Bank 90
Cost of manufacture of 10 units: labour cost paid in cash (10 x C9)
Inventory: raw materials 20
Cost of manufacture of 10 units: raw materials used (10 x C2)
Journals continued … Debit Credit
Inventory: finished goods 110
Completed units transferred to finished goods (10 units x C11): 90
+ 20

5.3.2 Fixed manufacturing costs
It is not as easy to calculate the fixed manufacturing cost per unit. The cost of inventory needs
to be known during the year for quoting purposes as well as for any reports needing to be
provided during the year. Since the standard requires that the cost of inventory includes fixed
manufacturing overheads, we need to calculate a fixed cost per unit, which we call the fixed
manufacturing overhead application rate (FOAR).
We won’t be able to calculate an accurate fixed cost per unit until the end of the year since we
will only know the extent of the actual production at the end of the year. As mentioned above,
however, a rate is needed at the beginning of the year for the purposes of quoting, budgeting
and interim reporting. This means that a budgeted fixed overhead application rate (BFOAR)
using budgeted normal production as the denominator, is calculated as an interim measure:
Fixed manufacturing overheads
Normal production

The actual fixed overhead application rate (AFOAR), however, would depend on the actual
level of inventory produced in any one period and can only be calculated at year-end.
Greater of: actual and normal production

5.3.2.1 Under-production and under-absorption

If the company produces at a level below budgeted production, a portion of the fixed
overheads in the suspense account will not be allocated to the asset account. This unallocated
overhead amount is termed an ‘under-absorption’ of fixed overheads and since it results from
under-productivity, it refers to the cost of the inefficiency, which is quite obviously not an
asset! This amount is expensed instead.

Example 12: fixed manufacturing costs – under-absorption
Fixed manufacturing overheads C100 000
Normal expected production (units) 100 000
Actual production (units) 50 000

Required:
A. Calculate the budgeted fixed manufacturing overhead application rate;
B. Calculate the actual fixed manufacturing overhead application rate; and

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C. Journalise the fixed manufacturing costs.

Solution to example 12A: budgeted fixed manufacturing overhead application rate
= Fixed manufacturing
overheads
Budgeted production
= C100 000
100 000 units
= C1 per unit
We use this C1 per unit when quoting to our customers and when drafting interim financial
statements.

Solution to example 12B: actual fixed manufacturing overhead application rate

= Fixed manufacturing overheads
Greater of: budgeted and actual
production

= C100 000
100 000 units

= C1 per unit

Explanation why the actual production could not be used in this example:
The actual application rate is calculated using the normal budgeted production since, in this
case, the budgeted production exceeded the actual production. If the actual production had
been used it would result in inventory being overvalued:

= Fixed manufacturing
overheads
Actual production

= C100 000
50 000
units
= C2 per unit
Each unit would erroneously include fixed manufacturing costs of C2 instead of the normal
C1 as a result of the company’s inefficiency! Bearing in mind that the Framework states that
the value of an asset should represent the probable future economic benefits expected to flow
from the asset, it does not make sense to show the cost of inventory at twice its normal value
(C2 instead of C1) simply because the company was inefficient. Measuring the inventory
using C2 would suggest that the future economic benefits are expected to double.
Another way of looking at it is: if we used C2 per unit, the value of 50 000 units inventory
would represent the full amount of fixed overheads incurred (C100 000) when only half of the
required inventory was produced (therefore, only half of the fixed overheads should be
included in the inventory account). Half the fixed overheads were wasted and therefore 50%
x 100 000 should be expensed.
The answer to this problem is to capitalise only the normal cost per unit (C1) to the inventory
asset and expense the balance of the fixed manufacturing overheads (actual: C2 – normal: C1
= wastage: C1) as abnormal wastage of company resources.
Solution to example 12C: fixed manufacturing overheads – journals
During the year Debit Credit

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Fixed manufacturing costs (Suspense account) 100 000
Bank/ Creditor 100 000
Fixed manufacturing overheads incurred: given
Inventory (A) 50 000
Allocation of fixed manufacturing overheads to inventory over the
year: 50 000 x C1 (BFOAR)
At year-end
Fixed manufacturing overhead expense (E) (under-absorption) 50 000
Expensing of the balance of the fixed manufacturing overhead
suspense account at year-end: 100 000 (total paid) – 50 000
(capitalised)

5.3.2.2 Over-production and over-absorption
If the company’s actual level of production exceeds budgeted production, the budgeted fixed
overhead application rate per unit will be higher than the actual fixed overhead application
rate per unit.
If the budgeted application rate is used to absorb fixed overheads into the cost of the
inventory during the course of the year, fixed manufacturing overheads will be ‘over-
absorbed’ into the cost of inventory by the end of the year if the entity produced more units
that were budgeted (over-production). This means that the asset will be overstated as the costs
capitalised are not the actual costs incurred (i.e. will be shown at a value that exceeds cost)
and will therefore need to be reduced.
Example 13: fixed manufacturing costs – over-absorption
Fixed manufacturing overheads C100 000
Normal expected production (units) 100 000
Actual production (units) 200 000
Required:
A. Calculate the budgeted fixed manufacturing overhead application rate;
B. Calculate the actual fixed manufacturing overhead application rate; and
C. Journalise the fixed manufacturing costs.
Solution to example 13A: budgeted fixed manufacturing overhead application rate
Budgeted production
= C100 000
100 000 units
= C1,00 per unit
Solution to example 13B: actual fixed manufacturing overhead application rate
Greater of: budgeted and actual
production
= C100 000
200 000 units

= C0.50 per unit
Although we would have used the BFOAR of C1 per unit throughout the year for quoting our
customers and for allocating fixed manufacturing costs to inventory during the period, the

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final inventory balance would be valued using the actual cost (AFOAR) of C0.50 per unit
instead.

If the company valued their final inventory balance using the budgeted fixed overhead
application rate of C1 instead, C200 000 of fixed overheads would have been included in
inventory (C1 x 200 000 units). This is not allowed since the actual fixed overheads incurred
were only C100 000 (IAS 2, which governs inventories, prohibits the measurement of
inventory at above cost).

Solution to example 13C: fixed manufacturing overheads - journal

During the year Debit Credit
Fixed manufacturing costs (suspense account) 100 000
Bank/ Creditor 100 000
Fixed manufacturing overheads incurred during the year: given
Inventory (A) 200 000 x C1 (BFOAR) 200 000
Fixed manufacturing costs (suspense account) 200 000
Allocation of fixed manufacturing overheads to inventory over the
year
At year-end
Fixed manufacturing costs (suspense account) (over-absorption) 100 000
Inventory (A) 100 000
Reversing the excess fixed manufacturing costs transferred to the
inventory account (the suspense account will now have a zero
balance)

5.3.2.3 Budgeted versus actual overhead rates summarised
Budgeted production will seldom equal actual production and therefore the budgeted costs
(BFOAR) per unit will generally not equal the actual costs (AFOAR) per unit. If, therefore,
the budgeted fixed overhead absorption rate (BFOAR) is multiplied by the actual units
produced, too much or too little of the overhead costs actually incurred are included in the
inventory cost.

The budgeted fixed overhead application rate is therefore calculated at:
• the beginning of the year to measure the cost of inventory during the year; and then
• at the end of the year to measuring the inventory balance.

The budgeted fixed overhead application rate is calculated at the beginning of the year:
BFOAR =
Budgeted production

The actual fixed overhead application rate (AFOAR) is calculated at the end of the year:
AFOAR =
Greater of: budgeted production and actual production

In the event that actual production is greater than budgeted production, the actual fixed
overhead application rate (AFOAR) is calculated using actual production since this avoids
inventory being overvalued as a result of over-efficiency.

In the event that actual production is less than budgeted production, the actual fixed overhead
application rate is calculated using budgeted production, since this avoids inventory being
overvalued as a result of company inefficiencies.
Example 14: fixed manufacturing costs – over-absorption
Budgeted production 1 000 units

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Actual production 1 500 units
Budgeted fixed non-manufacturing overheads C10 000
Budgeted fixed manufacturing overheads C40 000
Prime costs per unit C12 per unit
Required:
A. Calculate the budgeted fixed overhead application rate at the beginning of the year.
B. Calculate the actual fixed overhead application rate at the end of the year.
C. Show the entries in the related t-accounts.

Solution to example 14A: budgeted fixed manufacturing overheads rate (AP > BP)
Budgeted production
= C40 000
1 000 units
= C40 per unit

Solution to example 14B: actual fixed manufacturing overheads rate (AP > BP)
Greater of: budgeted production and actual
production
= C40 000
1 500 units
= C26,67 per unit

Solution to example 14C: t-accounts (AP > BP)
Bank Fixed manufacturing overheads (Suspense)
FOE (1) 10 Bank (2) 40 000 Inv (4) 60 000
000
FMOS (2) 40 Inv (5) 20 000
000
Inv (3) 18 (7)
60 000 (7)
60 000
000

Inventory (Asset) Fixed overheads (Expense)
Bank (3) 18 000 FMOS (5) 20 000 (1) 10
000
FMOS (4) 60 000 Balance 58 000
c/d
78 000 78 000
Balance (6) 58 000

(1) payment of non-manufacturing fixed overheads: C10 000 – these are always expensed

(2) payment of manufacturing fixed overheads: C40 000 – these are first accumulated in a
suspense account and then either capitalised to inventory or expensed

(3) payment of prime costs (direct materials and direct labour): C12 x 1 500 = C18 000,
debited directly to inventory

(4) manufacturing fixed overheads are allocated to the inventory asset as follows (i.e.
absorbed into inventory) using the budgeted fixed overhead application rate:

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BFOAR x actual production: C40 x 1 500 = C60 000
(5) since the manufacturing costs incurred only amounted to C40 000, C20 000 too much has
been debited to inventory: this over-absorption is simply reversed. This is calculated as
the excess of actual over-budgeted production x BFOAR: 500 x C40 = C20 000 (or
C60 000 – C40 000)
(6) notice that the balance is C58 000, which equates with the prime cost per unit plus the
final fixed manufacturing overheads per unit: (C12 + C26,67) x 1 500 = C58 000
(7) notice that the suspense account has been cleared out (has a zero balance)!

Example 15: fixed manufacturing costs – under-absorption

Budgeted production 1 000 units
Actual production 500 units
Budgeted fixed non-manufacturing overheads C10 000
Budgeted fixed manufacturing overheads C40 000
Prime costs per unit C12 per unit
Required:
A. Calculate the budgeted fixed overhead application rate at the beginning of the year.
B. Calculate the final fixed overhead application rate at the end of the year.
C. Show the entries in the related t-accounts.

Solution to example 15A: budgeted fixed manufacturing overheads rate (BP > AP)
Budgeted production
= C40 000
1 000 units
= C40 per unit

Solution to example 15B: actual fixed manufacturing overheads rate (BP > AP)

Greater of: budgeted production or actual
production
= C40 000
1 000 units
= C40 per unit

Solution to example 15C: t-accounts (BP > AP)

Bank Fixed manufacturing overheads (Suspense)
FOE (1) 10 Bank (2) 40 Inv (4) 20
000 000 000
FMOS (2) 40 FOE (5) 20
000 000
Inv (3) 6 000 (7)
40 (7)
40
000 000

Inventory (Asset) Fixed overheads (Expense)
Bank (3) 6 000 Bank (1) 10

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000
FMOS (4) 20 000 Balance 26 FMOS (5) 20
c/d 000 000
26 000 26 000 30
000
Balance 26 000
(6)

(1) payment of non-manufacturing fixed overheads: C10 000 – these are always expensed

(2) payment of manufacturing fixed overheads: C40 000 – these are first accumulated in a
suspense account and then either capitalised to inventory or expensed

(3) payment of prime costs (direct materials and direct labour): C12 x 500 = C6 000 – debited
directly to inventory

(4) manufacturing fixed overheads are allocated to the inventory asset as follows (i.e.
absorbed into inventory) using the budgeted fixed overhead application rate: BFOAR x
actual production:
C40 x 500 = C20 000

(5) the manufacturing costs incurred amounted to C40 000, but since only 500 units have
been produced, only C20 000 has been debited to inventory, with C20 000 remaining
unallocated in the fixed overhead suspense account. This must be treated as an expense
since this relates to the cost of the inefficiency (abnormal wastage). This may be
calculated as follows: excess of budgeted production over actual production x budgeted
fixed overhead application rate:
C40 x 500 = C20 000

(6) notice that the balance is C26 000, which equates with the prime cost plus the final fixed
manufacturing overheads per unit: (C12 + C40) x 500 = C26 000

(7) notice that the fixed overhead suspense account has been cleared out (i.e. has a balance of
zero).

6. Measurement: cost formulas (inventory movements) (IAS 2.23 - .27)

6.1 Overview

The movement of inventories refers to the purchase and the subsequent sale thereof or, where
applicable, the conversion into another type of inventory or asset (i.e. in the case of a
manufacturing company, the conversion from a raw material into work-in-progress and then
into finished goods).

There are three different cost formulae allowed when measuring these movements, being the:
• first-in-first-out method (FIFOM);
• weighted average method (WAM); and
• specific identification method (SIM).

The recording of the cost of the initial purchase of the inventory will not differ with the
method chosen but, if the cost of each item of inventory during the year is not constant, the
cost of the goods sold or converted will.

The same cost formula must be used for all inventories having a similar nature and use.

6.2 First-in-first-out method (FIFOM)

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This method may be used where the goods forming part of inventories are similar in value.
The general assumption under this method is that the oldest inventory is used or sold first
(whether or not this is the actual fact). The method is best explained by way of example.

Example 16: FIFOM purchases

January purchases one kilogram of X C100
January purchases two kilograms of X C220

Required:

Post the related journal entries in the t-accounts using the FIFO method.

Solution to example 16: FIFOM purchases (t-accounts)

Inventories (A) Bank
Jan 100 Jan 100
Jan 220 Jan 220

It should be noted that there will now be two balances in the inventory account. This is
necessary in order that when the goods are sold, the cost of the older inventory can be
determined.

Please note that the inventory that would be disclosed in the statement of financial position
would be the total of the two balances (i.e. C320).

Example 17: FIFOM sales

Assume the same information given in the previous example together with the following sale:
January Sales A half a kilogram of X Cost C?

Required:
Post the cost of sales journal entry in the t-accounts using the FIFO method.

Solution to example 17: FIFOM sales (t-accounts)

Inventories (A) Cost of Sales (E)
Balance 1 100 3rd Jan 50 3rd Jan 50
Balance 2 220 Balance c/f 270
320 320
Balance 1 50
Balance 2 220

The inventory purchased earlier is assumed to be sold first. In other words, the cost of the
inventory sold is valued based on the cost of the oldest stock first: half of the first batch is
sold and therefore the cost of the sale is estimated at 100 x 50% = C50.

The inventory account still has two balances, where the oldest balance (balance 1) has been
reduced. None of the second batch has been used yet and therefore balance 2 remains
unchanged.

If the selling price was C150, the gross profit would be C150 – C50 = C100.

Example 18: FIFOM sales

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Assume the same purchases as given in example 16 together with the following sale:
January Sales 1 ½ kilograms of X Cost C?

Required:
Post the cost of sales journal entry in the t-accounts using the FIFO method.

Solution to example 18: FIFOM sales (t-accounts)

Balance 1 100 3rd Jan 155 3rd Jan 155
Balance 2 220 Balance c/f 165
320 320
Balance 1 0
Balance 2 165

The inventory purchased earlier is assumed to be sold first. In other words, the cost of the
inventory sold is valued based on the cost of the oldest stock first: all of the first batch (1
kilogram) is sold plus ½ kilogram of the second batch (which consisted of 2 kilograms). The
cost of the sale is therefore estimated at 100 x 1 / 1 kilogram + 220 x 0.5 / 2 kilograms) =
C155.

The inventory account now only has one balance, since the first batch (balance 1) has been
entirely used up. A quarter of the second batch has been used and therefore balance 2 is now
¾ of its original value ( ¾ x 220 = 165 or 220 x (2 – 0.5) / 2 kilograms).

If the selling price was C250, the gross profit would be C250 – C155 = C95.

6.3 Weighted average method (WAM)

As with the first-in-first-out method, the weighted average method is suitable only when the
goods are similar in value. Whenever goods are sold or converted, the cost of the sale is
calculated by working out the average cost of the goods sold, rather than simply assuming
that the oldest goods were sold first. The average costs incurred over a time period will
therefore be used to calculate the cost of inventory sold, rather than the actual cost incurred on
the item. This is best explained by way of example.

Example 19: WAM purchases
January Purchases one kilogram of X C100
January Purchases two kilograms of X C220
Required:
Post the related journal entries in the t-accounts using the weighted average method.

Solution to example 19: WAM purchases
1st Jan 100 1st Jan 100
2nd Jan 220 Jan 220
Balance 320

Example 20: WAM sales

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Assume the same information given in the previous example together with the following sale:
January Sales one kilogram of X cost entity?

Required:

Post the related cost of sale journal in the ledger accounts using the weighted average method.
Solution to example 20: WAM sales
The weighted average cost per kilogram is calculated as follows:

total cost of inventories
quantity of inventories on hand
= C320
3kg

= C106.67 per kg

Balance 320,00 Jan 106,67 Jan 106,67
Balance c/d 213,33
320,00 320,00
Balance 213,33
b/d
If the selling price was C150, then the gross profit would be C150 – C106,67 = C43,33.
There is only one balance on the inventory account.

6.4 Specific identification method (SIM)

This method is suitable for items of inventory that are dissimilar in value, for example a
retailer of exotic cars. Each item of inventory is assigned its actual cost and this cost is
expensed when this item is sold (using any of the above methods would be materially
inaccurate and misleading).

Example 21: SIM purchases and sales
C
January Purchase 1 Beetle cost: 25 000
March Purchase 1 Porsche cost: 150 000
April sold 1 Porsche selling price: 175 000
Required:
Post the related journal entries in the t-accounts using the SI method.
Solution to example 21: SIM purchases and sales

It would be unreasonable to use the first-in-first-out method, in which case the cost of the
Beetle would be matched with the sale proceeds of the Porsche.
Similarly, the weighted average method would not be suitable since the values of each of the
vehicles are so dissimilar that it would cause the cost to be distorted to unacceptable
proportions.
The only method that is suitable in this instance is the specific identification method, which
means just that: specifically identify the actual unit sold and then use the actual cost of that
unit to match against the proceeds of the sale thereof.

163 Chapter 4


Beetle 25 Porsche 150 Beetle 25
000 000 000
Porsche 150 Balance 25 000 Porsche 150
000 000
175 000 175 000
Balance 25 000 Cost of Sales (E)
Porsche 150
000

The profit on sale can now be accurately determined as C175 000 – C150 000 = C25 000.

7. Measurement of inventories at year-end (IAS 2.9 and .28 - .33)

7.1 Overview
Although the Framework states that an asset should be measured at an amount representing
future economic benefits expected to be derived from the asset, the standard governing
inventories disallows the measurement of inventory above cost. Therefore, unlike other
assets, even if an inventory asset is expected to render future economic benefits in excess of
its cost, it may never be valued above cost.
Inventories must be measured at the lower of cost or net realisable value. At the end of each
financial year, inventories should therefore be tested for impairments by calculating the net
realisable value (see definitions) and comparing this with the cost of inventories.
If the net realisable value is lower than cost, the inventories must be written down to this
lower amount. This is the concept of prudence in action: recognising losses as soon as they
are expected rather than waiting for them to happen.

Example 22: lower of cost or net realisable value
A company has inventory on hand at year-end (31 December 20X2) that it expects to be able
to sell in the ordinary course of business for C100. The cost of these inventories is C70.
In order to sell this inventory, the company expects to incur selling costs of C20 and expects
to incur further costs of C30 to put this inventory into a saleable condition .
Required:
A. Calculate the net realisable value;
B. Calculate any possible write-down; and
C. Journalise any write-down necessary.
D. Show where the write-down would be included and disclosed in the financial statements.

Solution to example 22A: net realisable value calculation

Net realisable value C
Estimated selling price 100
Less estimated selling costs 20
Less estimated costs to complete 30
Net realisable value 50

Solution to example 22B: check for possible write-down

Write-down C
Cost 70

164 Chapter 4


Inventory write-down 20

Solution to example 22C: journalise the write-down

Journal Debit Credit
Write-down of inventories (E) 20
Inventories (A) 20
Write-down of inventories to net realisable value (70-50)

Solution to example 22D: disclosure of the write-down

Company name
For the year ended 31 December 20X2 (extracts)
Note 20X2 20X1
C C
Revenue x x
Cost of sales (x + 20) (x) (x)
Other costs disclosed using function or nature (x) (x)
method
Profit before tax 3 (x) (x)

Company name
Notes to the financial statements
For the year ended 31 December 20X2
20X2 20X1
3. Profit before tax C C
Profit before taxation is stated after taking into account the following separately disclosable
(income)/ expense items::
- Write-down of inventories 20 x

If the net realisable value is greater than cost, then no adjustment would be made: the practice
of valuing inventories to a net realisable value that is higher than cost is not allowed since this
would effectively result in the recognition of gross profit before the sale has taken place (and
therefore before it has been earned), which would not be prudent.

The following information relates to the balance of inventory at year-end: C
Cost of inventory 100
Future expected gross profit 50
Required:
Calculate whether or not the inventory balance needs to be adjusted and journalise any
adjustment.

165 Chapter 4


Solution to example 23: lower of cost or net realisable value

Calculation: test for impairment of inventory C
Cost 100
Net realisable value (given) 150
Inventory write-down (only relevant if cost is greater than net realisable value) N/A

If the inventory that was written down in a prior year is still on hand at the end of the current
year and the circumstances that lead to the write-down have now reversed such that the net
realisable value has increased, then the previous write-down may be reversed.

This accounting treatment (based on the concept of prudence) dovetails perfectly with the
rules for ‘revenue recognition’ (IAS 18). In a nutshell, the revenue from the sale of inventory
is recognised only when inventories are sold and not before! If you were to value inventory
above cost, a gain would be recognised in the current year, which would represent the future
profit on the future sale of the inventory! This is not allowed because this would effectively
be allowing the recognition of income before it is earned which is obviously not prudent.


A company has inventory on hand at year-end that was written down in year 1 to a net
realisable value of C50 (its original cost was C70).

Required:
Show the journal entries in year 1 and year 2 and show how the write-back (if any) would be
disclosed in year 2; assuming that the net realisable value of this stock at the end of the year 2
is:
A. C55;
B. C75.

Solution to example 24A: lower of cost or net realisable value: write-back

W1: calculation of write-down or reversal of write-down Yr 2 Yr 1
Carrying amount 50 70
Net realisable value (C55) limited to cost (C70): cost is not a limiting 55 50
factor
Write-down/ (reversal of previous write-down) 5 20

End of year 1: journal Debit Credit
Inventories (A) 20
Write-down of inventories: W1
End of year 2: journal
Inventories (A) 5
Reversal of write-down of inventories (I) 5
Reversal of previous write-down of inventories: W1

Company name
Note 20X2 20X1
C C
Revenue x x
Cost of sales (x - 5) (x) (x)
method

166 Chapter 4


Company name
20X2 20X1

(income)/ expense items:
- Write-down/ (Reversal of write-down) of inventories (5) 20

Solution to example 24B: net realisable value calculation and journal

W1: calculation of write-down or reversal of write-down Yr 2 Yr 1
Carrying amount 50 70
Net realisable value (Yr2: (C75) limited to cost (C70): cost is a 70 50
limiting factor)
Write-down/ (reversal of previous write-down) (20) 20

End of year 1: journal Debit Credit
Inventories (A) 20
Write-down of inventories: W1

End of year 2: journal
Inventories (A) 20
Reversal of write-down of inventories (I) 20
Reversal of previous write-down of inventories: W1

Company name 20X2 20X1
Note C C
Revenue x x
Cost of sales (x - 20) (x) (x)
method

Company name
20X2 20X1
(income)/ expense items:
- Write-down/ (Reversal of write-down) of inventories (20) 20

7.2 Testing for possible write-downs: practical applications

When testing for possible write-downs, each item of inventory should be tested separately.
What this means is simply that an estimated percentage write-off would not be acceptable.
The write-down must be carefully estimated based on the actual circumstances of the entity.

In certain circumstances, for example, a product line (e.g. a cutlery set) must be looked at as a
whole rather than on an individual item-by-item basis when these individual items cannot be
sold separately: e.g if the knives, forks and spoons manufactured as part of the cutlery set are

167 Chapter 4


not sold separately, then the cutlery set should be tested for impairment as a separate product
line rather than trying to measure the individual knives, forks and spoons making up the set.

Inventory should generally not be tested for impairment based on general classifications, such
as raw materials, work-in-progress, finished goods and consumable stores. If, for example,
the category of raw materials has a net realisable value that is less than its cost, but the raw
materials are to be used in the manufacture of a profitable finished product and will therefore
not be sold in its raw state, then a write down of the raw materials would make no sense.

On the other hand, the testing for impairment of a general classification such as raw materials
would be appropriate if, for example, the finished product in which the raw materials are used
is not profitable and there is a chance that the raw materials and work-in-progress could be
sold off separately or even dumped.

If the raw material is to be converted into a finished product and the net realisable value of
these raw materials, (for example, the cost of steel on hand used in the manufacture of
bicycles), is less than their cost, no write-down would be required if the net realisable value of
the finished product (i.e. the bicycle) is greater than its cost. If, however, the net realisable
value of the finished product (i.e. the bicycle) is less than the cost thereof, then the materials
on hand (e.g. steel) would need to be individually tested for impairment.

Example 25: lower of cost or net realisable value – with disclosure

A bookkeeper has provided you with the following information regarding inventory on hand
at 31 December 20X2, used in the manufacture of two product lines: motorbikes and bicycles:
Cost NRV: NRV: Write-
if sold if sold as a down
‘as is’ completed required
product
C C C C
Raw materials 100 000 45 000 65 000
Supply of steel (used for motorbikes) 40 000 25 000 15 000
Supply of aluminium (used for 60 000 20 000 50 000
bicycles)
Work-in-progress 80 000 80 000 65 000
Incomplete motorbikes 30 000 20 000 25 000
Incomplete bicycles 50 000 60 000 40 000
Finished Goods 160 000 170 000
Motorbikes 80 000 N/a 60 000
Bicycles 80 000 N/a 110 000

340 000

The lifecycle of both product lines is coming to an end and the company has decided that
where it is more profitable to sell a class of inventory such as raw materials ‘as is’ than to
convert it into the finished product, then the class of inventory will be sold ‘as is’.
Cost of sales before any adjustments to the cost of inventory was C450 000.

Required:
A Fill in the missing figures, and then calculate the total write-down required.
B Disclose all related information in the financial statements. Comparatives are not
required.

168 Chapter 4


Solution to example 25A: calculation of write-down

Cost NRV: NRV: Write-
if sold if sold as a down
‘as is’ completed required
product
C C C C
Raw materials
Supply of steel on hand (used for 40 000 25 000 15 000 25 000
motorbikes)
Supply of aluminium (used for bicycles) 60 000 20 000 50 000 50 000
Work-in-progress
Incomplete motorbikes 30 000 20 000 25 000 25 000
Incomplete bicycles 50 000 60 000 40 000 60 000
Finished Goods
Motorbikes 80 000 N/a 60 000 60 000
Bicycles 80 000 N/a 110 000 110 000
340 000

The lower of cost or net realisable value for each item of inventory is as follows (using the
highlighted amounts in the above table):

Lower of cost or net realisable value: C
Raw materials 75 000
Supply of steel on hand (used for motorbikes) 25 000
Supply of aluminium (used for bicycles) 50 000

Lower of cost or net realisable value continued C
Work-in-progress 75 000
Incomplete motorbikes 25 000
Incomplete bicycles 50 000
Finished Goods 140 000
Motorbikes 60 000
Bicycles 80 000

Write-down Calculations C
Raw materials 100 000 – 75 000 25 000
Work-in-progress 80 000 – 75 000 5 000
Finished Goods 160 000 – 140 000 20 000
50 000

The calculation of the net realisable value and related write-down is explained as follows:

The total cost of inventory is C340 000, but the net realisable value thereof depends on what
the company does with the individual components of the two product lines (motorbikes and
bicycles). The write down would be based on sound business principles of profit making.
Therefore, where there are two possible net realisable values, the higher of the two net
realisable values would be used.

Raw materials: The steel supply would be sold ‘as is’ rather than be converted into a
motorbike, since this renders the greatest economic benefits (C25 000 versus C15 000) thus
requiring a write-down of C15 000 (C40 000 – C25 000). On the other hand, the aluminium
supply would be used in making the completed bicycles since this would render the greatest
economic benefits (C50 000 versus C20 000) thus requiring a write-down of only C10 000
(C60 000 – C50 000). The value of raw materials would therefore be C75 000 with a related
write-down of C25 000 (C100 000 – C75 000).

169 Chapter 4


Work-in-progress: The incomplete motorbikes would first be completed and then sold since
this renders the greater economic benefits (C25 000 versus C20 000), thus requiring a write-
down of C5 000 (C30 000 – C25 000). The incomplete bicycles would be sold ‘as is’ instead
of being completed and then sold (C60 000 versus C40 000), thus no write-down is required
for the incomplete bicycles. The value of work-in-progress is therefore C75 000 (C25 000 +
C50 000) and the cost thereof is C80 000, with a required write-down of C5 000.

Finished goods: Since the net realisable value of the bicycles exceeds the cost thereof, no
write-down will be required. The net realisable value of the motorbikes, however, is less than
the cost thereof (C60 000 versus C80 000) and therefore a write-down of C20 000 is required.
The value of finished goods is therefore C140 000 (C60 000 + C80 000) with a resultant
write-down of C20 000.

Solution to example 25B: disclosure

Company name
Note 20X2 20X1
C C
Revenue x x
Cost of sales (x + 50 000) (x) (x)
Other costs disclosed using function/ nature (x) (x)
method

Company name
Statement of financial position
At 31 December 20X2 (extracts)
Note 20X2 20X1
ASSETS C C
Current assets
Inventories 3 290 000 x

Company name
Note 20X2 20X1
C C
3. Inventory
Raw materials (25 000 + 50 000) 75 000 x
Work-in-progress (25 000 + 50 000) 75 000 x
Finished goods (60 000 + 80 000) 140 000 x
290 000 x

5. Profit before tax
Profit before taxation is stated after taking into account the following separately
disclosable (income)/ expense items::
- Write-down of inventories (cost: 340 000 – nrv: 290 000) 50 000 x

170 Chapter 4


8. Disclosure (IAS 2.36 - .39)

8.1 Accounting policies
An accounting policy note is required indicating the accounting policy in respect of the
measurement of inventories and cost formula used (i.e. lower of cost or net realisable value).

8.2 Statement of financial position and supporting notes
Inventories must be shown as a separate line item on the face of the statement of
comprehensive income. (IAS 1).
The note supporting the inventories amount in the statement of comprehensive income should
indicate the (IAS 2):
• carrying amount of inventories broken down into classifications appropriate to the entity;
• amount of inventories pledged as security.
8.3 Statement of comprehensive income and supporting notes
The cost of inventories recognised as an expense (whether the function or nature method is
used to disclose the costs). If the nature method is used, the cost of inventory expense will
have to be disclosed in the notes. If the function method is used, the cost of inventory
expense may be disclosed either on the face of the statement of comprehensive income or in
the notes thereto. Please remember that the cost of inventories expense, which must be
disclosed separately, includes costs such as depreciation on factory-related property, plant and
equipment (which were originally capitalised to inventory), which must also be disclosed
separately. Similarly, cost of inventories expense includes costs such as write-downs of
inventory (and reversals thereof), which must also be disclosed separately.
If there was a write-down of inventories, this should be disclosed in the notes and if a
previous write-down of inventories is reversed, both the amount of the reversal and the
circumstances that led to the reversal should be disclosed.

Example 26: disclosure of cost of sales and inventory related depreciation
A company incurred cost of sales of C100 000. Included in this amount was depreciation of
C20 000 on an item of plant used to manufacture inventory.
Required:
Disclose the above in the statement of comprehensive income and related notes thereto.
Solution to example 26: disclosure of cost of sales and inventory related depreciation
Company name
For the year ended … (extracts)
Note 20X2
C
Revenue x
Cost of sales 3 (100 000)
Gross profit x
Company name
For the year ended … (extracts)
20X2
3. Cost of sales C
Cost of sales includes:
Depreciation on plant 20 000

171 Chapter 4


8.4 Sample disclosure involving inventories

8.4.1 Sample statement of financial position and related notes

Company name
Statement of financial position
At 31 December 20X2 (extracts)
Note 20X2 20X1
ASSETS C C
Current assets
Inventories 5 xxx xxx
Accounts receivable xxx xxx
Cash xxx xxx

Company name
Note 20X2 20X1
C C

2. Accounting policies
2.1 Inventories
Inventories are valued at the lower of cost or net realisable value, where the cost is calculated
using the actual cost/ standard cost/ retail method (selling price less gross profit percentage).
Movements of inventory are recorded on the weighted average method (or FIFO or SIM).

5. Inventories
Finished goods xxx xxx
Work-in-progress xxx xxx
Raw materials xxx xxx
Consumable stores xxx xxx
xxx xxx
The company pledged C30 000 of inventories as security for a non-current loan (see
note…)

8.4.2 Sample statement of comprehensive income and related notes

8.4.2.1 Sample: costs analysed by NATURE in the statement of comprehensive income

Company name
Not 20X2 20X1
e C C
Revenue x x
Add changes in finished goods and work-in-progress inventory (x) (x)
Raw materials used and consumed (x) (x)
Staff costs (etc) (x) (x)
Other expenses (x) (x)
Finance costs (x) (x)

172 Chapter 4


Company name
Note 20X2 20X1
C C
3. Profit before tax
Included in profit before tax are the following:
Cost of inventory expense (cost of sales + write-downs – write- x x
downs reversed)
Depreciation (etc) x x
Reversal of previous write-down of raw materials due to the recent (x) (x)
legalisation of the use thereof
Write-down of inventories x x

8.4.2.2 Sample: costs analysed by FUNCTION in the statement of comprehensive income

Company name
Note 20X2 20X1
C C
Revenue x x
Cost of inventory expense (x) (x)
(cost of sales + write-downs – write-downs reversed + under-applied
fixed overheads)
Distribution Costs (x) (x)
Administrative Costs (x) (x)
Other Operating Expenses (x) (x)
Profit before tax (not required) (x) (x)

8.4.2.3 Sample: costs analysed by FUNCTION in the notes to the statement of
comprehensive income

Company name
Note 20X2 20X1
C C
Revenue x x
Profit before finance costs 3 x x
Profit before tax (x) (x)

173 Chapter 4


Company name
Note 20X2 20X1
3. Analysis of costs by function C C
Included in profit before finance costs are the following costs, analysed by function:
Cost of inventory expense (cost of sales + write-downs – write- x x
downs reversed)
Distribution Costs x x
Administrative Costs x x
Other Operating Expenses x x

174 Chapter 4


9. Summary

Inventory Valuation:
lower of cost or net
realisable value

Cost Net realisable value:
Calculation techniques: Calculation:
- Actual; Estimated selling price;
- Standard; or Less: estimated costs to
- Retail method. complete;
Less: estimated selling costs.

Include Exclude

- the general rule: costs that - abnormal wastage;
are incurred in order to bring - storage costs (unless
the asset to its present necessary to the production
location and condition; process);
- examples include: - administrative expenses
raw materials; that do not contribute to
labour; the ‘general rule’
variable manufacturing - selling costs;
overheads; - transport costs outwards
fixed manufacturing (involved in the sale);
overheads; - transaction taxes that are
transport costs inwards; recoverable (e.g. VAT).
non-refundable taxes.

The inclusion of fixed manufacturing overheads in the cost of inventories
deserves extra mention:

Fixed manufacturing
overheads (FMO) are
included in the cost of
the inventory asset using
a FMO allocation rate
based on:

Budgeted production if: Actual production if:
Actual production = or < budgeted actual production > budgeted
production production
- if AP < NP, then some of the If AP > NP, then all of the FMO will
FMO will not be capitalised and be capitalised (if normal production
will be included as part of the was used as the base instead of
cost of inventory expense actual production, then more costs
(considered to be abnormal would be capitalised than is
wastage) incurred!)
- if AP = NP, then all FMO’s are
capitalised

175 Chapter 4


Measurement of inventory
movements (cost formula)

If goods are similar: use either If goods are not similar: use

- Weighted average (WA) - Specific identification (SI)
method method
- First-in-first-out (FIFO)
method

176 Chapter 4

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