Topic 5

Inventory
(MFRS 102)
1. Describe the nature of inventory
2. Determine the initial recognition of inventory cost
3. Identify major classifications of inventory and
inventory flow issues
4. Distinguish the accounting for inventory using
perpetual and periodic inventory systems.
5. Understand the cost flow assumption
 The nature of inventories
1. MFRS 102 is equivalent to IAS 2 Inventories as issued and amended by the IASB,
including the effective and issuance dates. Entities that comply with MFRS 102 will
simultaneously be in compliance with IAS 2.

2. MFRS 102 Para 6 defines inventories as assets that are:

a) Held for sale in the ordinary course of business
b) In the process of production; or
c) Materials or supplies to be used in production

3. Inventories are classified as current assets. They satisfy the criteria for current asset
classification under MFRS 101.

4. Cost of goods sold (COGS) is the expense account used to record the costs of
inventory once it is disposed.
 Initial recognition of inventory
cost
O Inventories shall be measured at the lower of cost and
net realisable value (NRV) (MFRS 102 para 9).
O MFRS 102 para 6 states:
‘Net realisable value is the estimated selling price in the
ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the
sale.’
Note:
Fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date. (See MFRS 13 Fair Value Measurement.)
 NRV & Fair Value
O MFRS 102 para 7:
Net realisable value (NRV) refers to the net amount that an
entity expects to realise from the sale of inventory in the
ordinary course of business.
Fair value reflects the price at which an orderly transaction
to sell the same inventory in the principal (or most
advantageous) market for that inventory would take place
between market participants at the measurement date. The
former is an entity-specific value; the latter is not. Net
realisable value for inventories may not equal fair value less
costs to sell.
 Cost of inventory
O MFRS 102 para 10:
The cost of inventories shall comprise of all:
(1) costs of purchase,
(2) costs of conversion and
(3) other costs incurred in bringing the inventories to their present location and condition.

(1) Cost of purchase:

a) The purchase price

b) Import duties and other transaction taxes

c) *Transport, handling and other directly attributable costs

d) Any discounts, rebates and other similar items are to be deducted

Terms of sale
*FOB shipping point- freight costs incurred from the point of shipment are paid by the
buyer. Thus, include in cost of purchase.
If FOB destination – the seller pays all freight costs.
 Cost of inventory
Transaction taxes
If taxes are recoverable from the taxing authorities then care must be taken to
exclude these amounts from the cost of purchase.

Trade and cash discount

O Trade discounts are reduction in selling prices granted to customers. Thus,
they must be deducted from the price of purchase.
O Cash discount are offered as an incentive for early payment of amount owing
on credit sales. Ex: ‘2/7, n/30’. Settlement discount should be deducted from
the cost of inventories rather than expense as discount revenue.

Deferred payment terms

O The difference between the amount paid and a purchase on normal credit term
– must be recognised as interest expense over the period of deferral.
 Cost of inventory
(2) Cost of conversion:
Costs of conversion are those costs directly related to the unit of
production, including:
O Direct labour
O Systematic allocation of fixed and variable production overheads that are incurred
in converting materials into finished goods.

O Variable overheads: vary with volume of production. Allocated based

on actual use of production facilities. Example: cost of material per unit,
cost of labour (per hour).

O Fixed overheads: remain constant regardless of the volume of

production. Allocated based on normal production capacity. Example:
depreciation expense
 Cost of inventory
(3) Other costs

-Other costs can be included if they are ‘incurred in bringing the inventories to their present location
and condition’. Example: specific design expense incurred in producing goods for individual
customer.
- MFRS 123 Borrowing Cost – borrowing cost (interest cost) can be included if inventories are
qualifying asset.

Exclude costs
Para 16 MFRS 102, costs that cannot be included, and must be recognised as an
expense when incurred:
- Abnormal amount of wasted materials, labour or production costs
- Storage costs, unless necessary in the production process before a further
production stage.
- Administrative overhead that do not contribute to bringing inventories to their
present location and condition.
- Period cost: (Selling costs, general and administrative expense)
Classification of inventory
Inventories are asset:
 items held for sale in the ordinary course of
business, or
 goods to be used in the production of goods to be
sold.

Businesses with inventory

 Inventory flow issue
O For merchandising company: one inventory account
 Inventory flow issue
O For manufacturing company: three inventory accounts
Inventory flow issue
Inventory flow issue
Inventory cost flow
 Accounting for inventory
O There are two types of systems for maintaining
accurate inventory records:
(1) Perpetual System
(2) Periodic System
Accounting for inventory
O Perpetual system
 Accounting for inventory
O Perpetual system

- This system is more complicated and expensive, but the advent of

new technology, like computerized accounting package and point of
sale machine that linked directly to accounting record, most
business can afford to and do use the perpetual method.

- This method requires a subsidiary ledger to be maintained, with a

separate record for each inventory item detailing all movements in
both quantity and cost.

- This subsidiary record is linked to the general ledger account for

inventory , and regular reconciliation are carried out to ensure the
accuracy and completeness of accounting records.
Accounting for inventory
O Periodic system

Cost of Goods Sold = Beginning inventory

(+) Purchases
(+) Freight inwards
(-) Purchase return
(-) Cash discount received
(-) Ending inventory
 Accounting for inventory

1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:

Beginning inventory RM100,000

Purchases (net) (+) 800,000
Goods available for sale 900,000
Ending inventory (-) 125,000
Costs of Goods Sold RM775,000

Periodic system is more costs effective and easy to apply, however

the exact quantity cannot be determined on a day-to-day basis.
 Accounting for inventory

Example: Farisha Company had the following transactions. Record the

transactions using the Perpetual and Periodic system.

Details Unit Cost/Price per Total (RM)

unit
Beginning 100 RM6 RM600
inventory

Purchases 900 RM6 RM5,400

Sales 600 RM12 RM7,200
Ending 400 RM6 RM2,400
inventory
 Accounting for inventory
RM6

RM600 RM600

RM6

RM12

Cost of Goods Sold

(600 at RM6

RM6

RM2,400 (RM600+RM5,400RM3,600)
 Accounting for inventory
Illustration: Assume that at the end of the reporting
period, the perpetual inventory account reported an
inventory balance of $4,000. However, a physical
count indicates inventory of $3,800 is actually on hand.
The entry to record the necessary write-down is as
follows.
Dr. Inventory Over and Short 200
Cr. Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In

practice, companies sometimes report Inventory Over and Short in
the “Other income and expense” section of the income statement.
Accounting for inventory
Treatment for purchase discount

Purchase cost RM10,000

Invoices of RM4,000

Invoices of RM6,000
Basic Issues in Inventory Valuation
Valuing inventories requiring determining:

1. The physical goods to include in inventory (who

owns the goods?—goods in transit, consigned goods,
special sales agreements).

2. The costs to include in inventory (product vs.

period costs).

3. The cost flow assumption to adopt (specific

identification, average-cost, FIFO, retail, etc.).
Goods included in inventory:

You should know that:

O A company recognizes inventory and accounts

payable at the time it controls the asset.
O Passage of title is often used to determine
control because the rights and obligations are
established legally.
Goods included in inventory:
Goods in transit

O Example: LG (KOR) determines ownership by applying

the “passage of title” rule.
 If a supplier ships goods to LG f.o.b. shipping point, title
passes to LG when the supplier delivers the goods to the
common carrier, who acts as an agent for LG.
 If the supplier ships the goods f.o.b. destination, title
passes to LG only when it receives the goods from the
common carrier.
O“Shipping point” and “destination” are often designated by a
particular location, for example, f.o.b. Seoul.
 Consignment goods

O Example: Williams Art Gallery (the consignor) ships various art

merchandise to Sotheby’s Holdings (USA) (the consignee), who acts as
Williams’ agent in selling the consigned goods.
 Sotheby’s agrees to accept the goods without any liability, except to
exercise due care and reasonable protection from loss or damage, until
it sells the goods to a third party.
 When Sotheby’s sells the goods, it remits the revenue, less a selling
commission and expenses incurred, to Williams.
OGoods out on consignment remain the property of the consignor
(Williams).
 Sales with repurchase agreements

O Example: Hill Enterprises transfers (“sells”) inventory to Chase,

Inc. and simultaneously agrees to repurchase this merchandise at
a specified price over a specified period of time. Chase then uses
the inventory as collateral and borrows against it.
 Essence of transaction is that Hill Enterprises is financing its
inventory—and retains control of the inventory—even though it
transferred to Chase technical legal title to the merchandise.
 Often described in practice as a “parking transaction.”
 Hill should report the inventory and related liability on its books.
 Sales with Rights of Return

O Example: Quality Publishing Company sells textbooks to Campus

Bookstores with an agreement that Campus may return for full credit
any books not sold. Quality Publishing should recognize
a) Revenue from the textbooks sold that it expects will not be returned.
b) An estimated inventory return for the estimated books to be returned.
c) An asset for the books estimated to be returned which reduces the cost
of goods sold.
OIf Quality Publishing is unable to estimate the level of returns, it should not
report any revenue until the returns become predictive.
INVENTORY COST FLOW ASSUMPTIONS
O 1. Specific Identification
 IAS 2 & MFRS 102 requires the specific identification method be
used where possible to assign costs to inventory.
 Under this method costs are individually identified for each
inventory item).
O 2. First-in, First-out (FIFO)
 Assumes that items of inventory purchased/produced first are
sold first.
 Items remaining in inventory are those most recently
purchased/produced.
O 3. Weighted Average cost method
 The cost of each item is determined from the cost of similar items
purchased during the period.
 May be a weighted average or a moving average.
 Cost Flow Methods
To illustrate the cost flow methods, assume that Call-Mart Inc. had the
following transactions in its first month of operations.
Date Purchases Issued/Sold Balance

March 2 2,000@RM4 2,000 units

March 15 6,000@RM4.40 8,000 units
March 19 4,000 units 4,000 units
March 30 2,000@RM4.75 6,000 units
Costs of Goods Available calculation:
Beginning inventory (2,000@RM4) RM8,000
Purchases:
6,000@RM4.40 26,400
2,000@RM4.75 9,500
Goods Available for Sale RM43,900
 Cost Flow Methods
Specific Identification

 Method may be used only in instances where it is

practical to separate physically the different purchases
made. Cost of goods sold includes costs of the specific
items sold.
 Used when handling a relatively small number of costly,
easily distinguishable items.
 Matches actual costs against actual revenue.
 Cost flow matches the physical flow of the goods.
 May allow a company to manipulate net income.
 Cost Flow Methods

Illustration: Call-Mart Inc.’s 6,000 units of inventory consists of

1,000 units from the March 2 purchase, 3,000 from the March 15
purchase, and 2,000 from the March 30 purchase. Compute the
amount of ending inventory and cost of goods sold.
Date No. of units Unit cost Total costs
March 2 1,000 RM4.00 RM4,000
March 15 3,000 RM4.40 RM13,200
March 30 2,000 RM4.75 RM9,500
Ending inventory 6,000 RM26,700

Cost of Goods available for sale: RM43,900

(-) Ending inventory: RM26,700
Cost of goods sold: RM17,200
 Cost Flow Methods
Average cost method

 Prices items in the inventory on the basis of the

average cost of all similar goods available during the
period.
 Not as subject to income manipulation.
 Measuring a specific physical flow of inventory is
often impossible.
 Two methods:
(1) Weighted-Average (Periodic system)
(2) Moving-Average (Perpetual system)
 Cost Flow Methods
Weighted-Average

Date No. of units Unit cost Total cost

March 2 2,000 RM4.00 RM8,000
March 15 6,000 RM4.40 RM26,400
March 30 2,000 RM4.75 RM9,500
Total goods available 10,000 RM43,900

Weighted- Average cost per unit= RM43,900/10,000 = RM4.39

Ending inventory in unit = 6,000 unit

Therefore costs of ending inventory = RM4.39@RM6,000 = RM26,340

COGS = RM43,900 – RM26,340 = RM17,560

 Cost Flow Methods
Moving-Average

Date Purchased Issued/sold Balance

March 2 (2,000@RM4) 8,000 (2,000@RM4) 8,000
March 15 (6,000@RM4.40) 26,400 (8,000@RM4.30)
34,400
March 19 (4,000@RM 4,000@RM4.30
4.30) 17,200
17,200
March 30 (2,000@RM4.75) 9,500 6,000@RM4.45
26,700
 Cost Flow Methods
First-In, First-out (FIFO)

 Assumes goods are used in the order in which

they are purchased.

 Approximates the physical flow of goods.

 Ending inventory is close to current cost.

 Fails to match current costs against current

revenues on the income statement.
 Cost Flow Methods
First-In, First Out (FIFO) (Periodic System)

Date No of units Unit cost Total cost

March 30 2,000 RM4.75 RM9,500
March 15 4,000 RM4.40 RM17,600
Ending inventory 6,000 RM27,100

Cost of goods available RM43,900

(-) ending inventory 27,100
Cost of goods sold RM16,800

Determine cost of ending inventory is done by taking the cost of the most
recent purchase and working backwards until it accounts for all units in
the inventory.
 Cost Flow Methods

O First-In, First Out (FIFO) (Perpetual System)

Date Purchased Issued/sold Balance
March 2 (2,000@RM4) (2,000@RM4) 8,000
8,000
March 15 (6,000@RM4.40) (2,000@RM4) 8,000
26,400
(6,000@RM4.40)
26,400
March 19 (2,000@RM4) 4,000@RM4.40
8,000 17,600
(2,000@RM4.40)
17,200
March 30 (2,000@RM4.75) 4,000@RM4.40 17,600
9,500
2,000@RM4.75
9,500
 Disclosure
MFRS 102 para 36 - 37 outline the requirements, and para 38-39 for more explanations:

Among them:
Para 36: The financial statements shall disclose:
(a) the accounting policies adopted in measuring inventories, including the cost formula used;
(b) the total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity;
(c) the carrying amount of inventories carried at fair value less costs to sell;
(d) the amount of inventories recognised as an expense during the period;
(e) the amount of any write-down of inventories recognised as an expense in the period in
accordance with paragraph 34;
the amount of any reversal of any write-down that is recognised as
a reduction in the amount of inventories recognised as expense in
the period in accordance with paragraph 34;
(g) the circumstances or events that led to the reversal of a write-down
of inventories in accordance with paragraph 34; and
(h) the carrying amount of inventories pledged as security for liabilities.
 Inventory Valuation Methods—Summary

Comparison assumes periodic inventory procedures and the

following selected data.
Inventory Valuation Methods—Summary
 Inventory Valuation Methods—Summary

When prices are rising, average-cost results in the higher cash

balance at year-end (because taxes are lower).
 Perpetual Periodic
Purchase Dr. Inventory Dr. Purchase
Cr. Accounts payable Cr. Accounts payable
Purchase return Dr. Accounts payable Dr. Accounts payable
Cr.Inventory Cr Purchase returns
Purchase discounts Dr. Accounts payable Dr. Accounts payable
Cr.Inventory Cr Purchase
discounts
Sales Dr. Accounts receivable Dr. Accounts receivable
Cr. Sales Cr. Sales

Dr. COGS
Cr. Inventory
Sales return Dr. Inventory Dr. Sales return
Cr. COGS Cr. Accounts
receivable
Dr. Sales return
Cr. Accounts receivable
Closing entry no entry Dr. COGS
Cr. Inventory (opening)

Dr. Inventory (Closing)

Cr. COGS