Chapter 7

Inventory
7.1

Paragraph 9 of AASB 102 requires that inventories shall be measured at

the lower of cost and net realisable value.
Adopting the lower of cost and net realisable value rule basically means that if inventory is
likely to generate revenue in excess of cost then it should be recorded at cost, but if it is
likely to generate revenue (less incremental costs associated with making a sale) which is less
than cost then it should be written down. That is, unrealised gains shall not be recorded, but
unrealised losses shall be recorded. This is consistent with the accounting doctrine of
conservatism (but not consistent with the perspective that financial statements should be free
from bias, whether it be a conservative bias, or otherwise).
Arguments for and against the valuation rule may be assessed in terms of the primary
objectives of general-purpose financial reporting by reporting entities as provided in our
conceptual framework. Our conceptual framework states that an objective of generalpurpose financial reporting is to provide relevant and reliable information.
Possible advantages:
Recording inventory at cost (or NRV if it is lower) will generally provide reliable information.
For example, cost is a number that can be traced to production records. It is fairly easy to
verify.
As management has an upper limit as to the amount at which inventory is recorded (the lower
of cost and NRV) the scope for opportunistically manipulating financial statements is
reduced.
Possible disadvantages:
The major disadvantage would seem to relate to the issue of relevance. If inventory cost
$100 000 but has a current market value of $500 000 then how relevant is cost?
Another issue to consider is whether the doctrine of conservatism is consistent with the views
espoused within the AASB Framework. It would not seem to be consistent. The doctrine of
conservatism introduces a bias towards understating assets. The AASB Framework, on the
other hand, states that financial information should be free from bias.
Another point is that recording inventory at cost means that in real terms, profitability might
be overstated. For example, assume that we purchased at item of inventory for $100 two
months ago, but the current replacement cost of the inventory is $125. If we are to sell the
inventory for $130 then we would record a profit of $30, which we could be entitled to
distribute as dividends (ignoring tax effects). However, if we retain the $100 so as to buy
another item of inventory we will find that we can no longer buy such an item as it has gone
up in price from the historical cost. Hence, we might argue that recording inventory at cost
leads us to effectively overstating what might be considered as the real profit.

7.2

Inventory is to be recorded at the lower of cost and net realisable value. If inventory has a fair
value above cost then a revaluation is not permitted. If the net realisable value is less than

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cost then it must be written down to net realisable value. This write-down would not be
considered to be a revaluation.
Lower of cost and net realisable value can provide a very conservative reflection of the value
of inventory, with the result that the amount reported in the entitys financial statements may
be a great deal less than its market value. This treatment, as espoused in AASB 102, is
generally consistent with the accountants somewhat dated Doctrine of Conservatism. This
doctrine holds that gains should not generally be recognised until they are realised, while
losses should be recognised in the period in which they first become foreseeable - that is,
losses do not have to be realised to be recognised for accounting purposes. This asymmetric
approach to the recognition of expenses and revenues is not consistent with the AASB
Framework for the Preparation and Presentation of Financial Statements (the AASB
Framework). The AASB Framework requires that the recognition of revenues/income and
expenses should be made on the same basis, with due recognition given to issues such as the
probability that the inflow or outflow of economic benefits has occurred, and whether the
inflow or outflow can be reliably measured. However, accounting standards such as AASB
102 have precedence over the AASB Framework.
7.3

Cost of inventories is defined at paragraph 10 of AASB 102 as the aggregate of:

(a)
(b)
(c)

the cost of purchase;

the cost of conversion; and
other costs incurred in bringing the inventories to their present location and condition.

In allocating costs to inventories, manufacturing fixed costs shall be allocated to inventory by

way of absorption costing. The systematic allocation of production overheads must be based
on the normal operating capacity of the production facilities.
7.4

An inventory cost-flow assumption is an assumption about the order in which inventory is

being sold. It is necessary to have such an assumption in order to determine the cost of goods
sold. The assumption is particularly necessary when an entity is selling assets of a similar or
identical nature and the costs of the items are not the same. In such an instance it would not
be possible to determine precisely the cost of each item being sold. Hence, an assumption is
necessary, such as when the item sold was the earliest one produced (FIFO).
The cost-flow assumption chosen should best reflect the actual physical flow, and should be
applied consistently from period to period.

7.5

AASB 102 requires that the cost of inventories of items that are not ordinarily
interchangeable, or are produced and segregated for specific projects, must be assigned a cost
by using specific identification.
In explaining the above requirements, paragraph 24 of AASB 102 states:
Specific identification of cost means that specific costs are
attributed to identified items of inventory. This is the appropriate
treatment for items that are segregated for a specific project,
regardless of whether they have been bought or produced.
However, specific identification of costs is inappropriate when
there are large numbers of items of inventory that are ordinarily
interchangeable. In such circumstances, the method of selecting

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those items that remain in inventories could be used to obtain

predetermined effects on profit or loss.
Where items of inventory are interchangeable, the cost of inventories must be assigned using
either FIFO or weighted average cost formulas. As paragraph 25 of AASB 102 states:
The cost of inventories, other than those dealt with in paragraph
23, shall be assigned by using the first-in, first-out (FIFO) or
weighted average cost formula. An entity shall use the same cost
formula for all inventories having a similar nature and use to the
entity. For inventories with a different nature or use, different cost
formulas may be justified.
7.6

Under the perpetual (or continuous) inventory system the accounting system provides a
continuous record of inventory on hand, and cost of goods sold (that is, it is perpetually upto-datehence the name). Each time an item of inventory is sold, apart from recognising the
revenue and the associated inflow of economic benefits (in the form of an increase in cash or
accounts receivable), there is also an accounting entry that recognises the cost of the goods
sold and the reduction in the value of inventory.
Under the physical (or periodic) inventory system, inventory is determined periodically by
way of a stock-take. Cost of goods sold is also determined following the stock-take and is
calculated by adding the cost of the opening inventory to the cost of the purchases for the
period, and then subtracting the cost of the closing inventory.

7.7

Under absorption costing, fixed costs are included in the cost of inventories. They are
considered to be as much a part of the cost of conversion as direct labour and other variable
costs. Under direct costing, fixed production costs are treated as period costs and thus
excluded from the cost of inventories.

7.8

Standard costs are predetermined product costs established from bases such as planned
production and/or operations; planned cost and efficiency levels; and expected capacity
utilisation. Standard costs may be used to arrive at the cost of inventory only where the
standards are set so as to be realistically attainable, reviewed regularly and, where necessary,
revised in the light of current conditions. Paragraph 21 of AASB 102 states:
Techniques for the measurement of the cost of inventories, such as
the standard cost method or the retail method, may be used for
convenience if the results approximate cost. Standard costs take
into account normal levels of materials and supplies, labour,
efficiency and capacity utilisation. They are regularly reviewed and,
if necessary, revised in the light of current conditions.

7.9

If items are similar and the buyer has no preference over which items they acquire, an entity
can, by adopting the specific identification method, manipulate income by selecting which
item they are selling. If they want to increase profits they may select the items that are
recorded at a lower cost. Conversely, if they want to record lower profits (perhaps they are
subject to some form of political cost which is linked to high reported profits) they may
nominate those items that have a higher recorded cost as being the items that were sold. With
this in mind, AASB 102 requires that the specific identification method only be used where
items are not ordinarily interchangeable, or where goods or services have been produced and
segregated for specific projects.

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In terms of LIFO, a firm may manipulate income by acquiring numerous items at year end
(which may then be treated as being sold), with the view that those items may provide a
desired effect to cost of goods sold. LIFO is not permitted in Australia.
7.10

AASB 102 does not provide a specific argument against the use of LIFO, although the
method is not permitted within Australia. The basis of this prohibition could be that there is a
view that such a cost-flow assumption would rarely match the actual physical flow of goods.
Typically, one would expect an entity to sell its older stock first, rather than the latest stock it
acquired. Under LIFO, closing inventory would be assumed to be older goods, which were
possibly bought some years earlier, with the obvious implication that inventory may be valued
at prices that were only available a number of years previously.
Further, as the textbook indicates, using LIFO provides the opportunity for management to
manipulate profits by electing to acquire stock just prior to year end.

7.11
Product line
Wetsuits
Blocks of wax
Flippers
Boardshorts

Cost
$5 000
$3 000
$10 000
$20 000

NRV
$7 000
$2 000
$9 500
$20 500

Lower of
cost and NRV
$5 000
$2 000
$9 500
$20 000
$36 500

The closing value of inventory, therefore, would be $36 500.

7.12 Date
2 July 2008
5 July 2008
1 August 2008

In
200 @ $75

100 @ $75
300 @ $80

10 August 2008
24 December 2008

100 @ $75
130 @ $80
150 @ $88

30 December 2008
15 March 2009

100 @ $80
200 @ $90

16 March 2009
15 June 2009

Out

70 @ $80
150 @ $88
80 @ $90
200 @ $88

25 June 2009
____________
1 050: $87,800

100 @ $90
__________
830: $68,400

200 @ $75
100 @ $75
100 @ $75
300 @ $80
170 @ $80

Balance
$15 000
$7 500
$7 500
$24 000
$13 600

170 @ $80
150 @ $88
70 @ $80
150 @ $88
70 @ $80
150 @ $88
200 @ $90
120 @ $90

$13 600
$13 200
$5 600
$13 200
$5 600
$13 200
$18 000
$10 800

120 @ $90
200 @ $88
20 @ 90
200 @ $88

$10 800
$17 600
$1 800
$17 600
220: $19 400

The cost of sales for the year is $68 400 and the value of closing inventory is $19 400.

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7.13

(a)
(b)
(c)

7.14

Specific-identification is to be used when the inventory items are not ordinarily

interchangeable or the particular goods or services are produced and segregated for
specific projects.
Weighted-average cost may be used where the respective goods are interchangeable
and not produced and segregated for specific projects.
First-in first-out may be used where the respective goods are interchangeable and not
produced and segregated for specific projects.

Inventory cost
Material
Labour
Factory overheads
Total cost

$10 000
$8 000
$4 000
$22 000

Net-realisable value
Sale price
Less smiley face modifications
Freight charges
Net-realisable value

$20 000
$2 000
$1 000

$3 000
$17 000

On the basis of the above calculations, the inventory should be recorded at $17 000, which is
the lower of cost and net realisable value.

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7.15

(a)

FIFO
The cost of sales is comprised of the beginning inventory of 1000 units and the next
7000 units purchased. The ending inventory comprises the last 2000 units purchased.
Cost of sales = (1000 @ $10) + (3000 @ $12) + (4000 @ $14) = $102 000
Ending inventory = (2000 @ $15) = $30 000

(b)

Weighted-average cost
The cost of sales and ending inventory are costed at the weighted-average price of
beginning inventory and purchases.
Weighted-average cost = $132 000 10 000 units = $13.20 per unit
Cost of sales = (8000 x $13.20) = $105 600
Ending inventory = (2000 @ $13.20) = $26 400

(c)

LIFO
The cost of sales is comprised of the last 8000 units purchased. The ending inventory
is comprised of the beginning inventory of 1000 units and 1000 of the units purchased
on 1 September 2005.
Cost of sales = (2000 @ $15) + (4000 @ $14) + (2000 @ $12) = $110 000
Ending inventory = (1000 @ $10) + (1000 @ $12) = $22 000

7.16

Pursuant to AASB 102, absorption costing is required when valuing inventory for the
purposes of general-purpose financial reporting. Under absorption costing any fixed
production costs, such as the foremans salary and factory rent, are assigned to inventory on
the basis of normal operating capacity; that is, they are treated as product costs. Other fixed
costs, such as those relating to administration, are written off in the period incurred. That is,
they are treated as period costs, not product costs.
In explaining the allocation of overheads, paragraphs 12 and 13 of AASB
102 state:
12.

The costs of conversion of inventories include costs directly

related to the units of production, such as direct labour. They
also include a systematic allocation of fixed and variable
production overheads that are incurred in converting
materials into finished goods. Fixed production overheads
are those indirect costs of production that remain relatively
constant regardless of the volume of production, such as
depreciation and maintenance of factory buildings and
equipment, and the cost of factory management and
administration. Variable production overheads are those
indirect costs of production that vary directly, or nearly

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directly, with the volume of production, such as indirect

materials and indirect labour.
13.

The allocation of fixed production overheads to the costs of

conversion is based on the normal capacity of the production
facilities. Normal capacity is the production expected to be
achieved on average over a number of periods or seasons
under normal circumstances, taking into account the loss of
capacity resulting from planned maintenance. The actual
level of production may be used if it approximates normal
capacity. The amount of fixed overhead allocated to each unit
of production is not increased as a consequence of low
production or idle plant. Unallocated overheads are
recognised as an expense in the period in which they are
incurred. In periods of abnormally high production, the
amount of fixed overhead allocated to each unit of
production is decreased so that inventories are not measured
above cost. Variable production overheads are allocated to
each unit of production on the basis of the actual use of the
production facilities.

Costs of inventory
Variable costs
Factory salaries
Raw material purchased
Freight in
Less closing inventory (assumed)

$200 000
$200 000
$10 000
$
0

Divide by units produced

Per unit variable costs

$210 000
$410 000
10 000
$41.00

Fixed costs
Factory rent
Insurancefactory
Electricityfactory
Ratesfactory
Repairs and maintenance
Factory foremans salary
Factory depreciation
Divide by normal operating capacity
Per unit fixed costs
Unit cost per hat

$300 000
$30 000
$50 000
$20 000
$40 000
$60 000
$50 000
$550 000
10 000

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$96.00

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7.17

Coolum Pty Ltd

Cost of good manufactured
Opening raw materials
Purchases of raw materials

$000
20
290
310
10
300
90
5
25

Closing raw materials

Raw materials used
Factory wages (V)
Cleaning (V)
Maintenance
Variable costs

420

Fixed factory overhead

Factory supervisors salary
Depreciation
Insurance

35
65
50
150

Allocated to production on the basis of normal capacity

$150 x 60 000/100 000
Cost of goods manufactured
* $8.50 per unit, below net realisable value of $11.84
Income statement
Sales 50 000 x $12
Opening Inventory
40 000
Cost of goods manufactured
510 000
Closing Inventory
127 500
Cost of goods sold
Gross profit
Selling and administrative expenses
Administration salaries
Selling expenses
Rental of office equipment
Freight outwards
Factory overhead in excess of allocation
Loss before tax

90
*510

$
600 000

422 500
177 500
80 000
30 000
15 000
8 000
60 000
(15 500)

7.18
Opening Inventory
Purchases
Available for sale
Units sold
Closing inventory

Units
10
45
55
44
11

(a)
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Periodic inventory system with the weighted average cost flow method
$
220
400
270
210
$1100 which equals an average cost of $20

10 units @ $22.00
20 units @ $20.00
15 units @ $18.00
10 units @ $21.00
55 units

per unit
Cost of goods sold 44 x $20 = 880
Closing inventory 11 x $20 = 220
Periodic inventory system with the FIFO cost flow method
Cost of goods sold
10 units @ $22.00
20 units @ $20.00
14 units @ $18.00
Closing inventory
1 unit @ $18.00
10 units @ $21.00

$220
400
252

$872

18
210

$228

Periodic inventory system with the LIFO cost flow method

Cost of goods sold
10 units @ $21
15 units @ $18
19 units @ $20
Closing inventory
1 unit @ $20.00
10 units @ $22

$210
270
380

$860

20
220

$240

Perpetual inventory system with the weighted average cost flow method
Purchases
Opening Bal
31/7

Sales

20 @ $20

Inventory
10 @ $22 = $220
10 @ $22 = $220
20 @ $20 = $400

2/8
4/8
31/8

5 units @ $20.67 = $103

16 units @ $20.67 = $331
15 @ $18

30 @ $20.67 = $620
25 @ $20.67 = $517
9 @ $20.67 = $186
9 @ $20.67 = $186
15 @ $18 = 270

3/9
10/9

12 units @ $19 = $228

10 @ $21

24 @ $19 = $456
12 @ $19 = $228
12 @ $19 = $228

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10 @ $21 = $210
29/9
30/9

11 units @ $19.91 = $219

$881

22 @ $19.91 = $438
11 @ $19.91 = $219
$219

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Perpetual inventory system with FIFO cost flow method

Purchases
Opening Bal
31/7

Sales

Inventory
10 @ $22 = $220
10 @ $22 = $220

20 @ $20

2/8

5 units @ $22 = $110

20 @ $20 = $400
5 @ $22 = $110

4/8

5 units @ $22 = $110

20 @ $20 = $400
9 @ $20 = $180

11 units @ $20 = $220

31/8

15 @ $18

3/9

9 @ $20 = $180
9 units @ $20 = $180

15 @ $18 = 270
12 @ $18 = $216

3 units @ $18 = $54

10/9

10 @ $21

29/9

12 @ $18 = $216
11 units @ $18 = $198

10 @ $21 = $210
1 @ $18 = $18

$872

10 @ $21 = $210
$228

30/9
Perpetual inventory system with LIFO cost flow method
Purchases
Opening Bal
31/7

Sales

20 @ $20

Inventory
10 @ $22 = $220
10 @ $22 = $220

2/8

5 units @ $20 = $100

20 @ $20 = $400
10 @ $22 = $220

4/8

15 units @ $20 = $300

15 @ $20 = $300
9 @ $22 = $198

1 units @ $22 = $22

31/8

15 @ $18

3/9
10/9

9 @ $22 = $198
12 units @ $18 = $216

15 @ $18 = $270
9 @ $22 = $198
3 @ $18 = $54
9 @ $22 = $198

10 @ $21

3 @ $18 = $54
29/9

10 units @ $21 = $210

10 @ $21 = $210
9 @ $22 = $198

30/9

1 unit @ $18 = $18

$866

2 @ $18 = $36
$234

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(b)

Perpetual inventory systems provide more timely information about quantities on

hand and costing. While it does require more data entry, this is largely automated
through the use of computers and electronic information systems.

(c)

If the companies use their LIFO layers of inventory, they will have a very low
reported cost of goods sold. In the US companies are required to use the same
inventory cost-flow method for taxation and accounting. Thus depleting the LIFO
layers would result in lower cost of goods sold and lower tax deductions.

7.19 (a) Periodic inventory system with the FIFO cost flow method
Cost of goods sold
50 units @ $450
$22,500
5 units @ $400
$2,000
$24,500
Closing inventory
40 units @ $500
30 units @ $403

$20,000
$12,090

55 units @ $400

$22,000

30 July
Dr
Purchases
Cr
Accounts payable
4 August
Dr
Accounts payable
Cr
Discount revenue
Cr
Cash

24,000
24,000
24,000
480
23,520

28 August
Dr
Cash
Cr
Sales

28,000

23 September
Dr
Purchases
Cr
Accounts payable

12,090

1 November
Dr
Late payment expense
Dr
Accounts payable
Cr
Cash

121
12,090

24 December
Dr
Cash
Cr
Sales

13,500

1 March
Dr
Purchases
Cr
Accounts payable

20,000

5 March
Dr
Accounts payable

$54,090

28,000

12,090

12,211

13,500

20,000
20,000

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Cr
Cr

Discount revenue
Cash

400
19,600

30 June
Dr
Opening inventory (cost of
goods sold)
Cr
Inventory (balance sheet)
Dr
Cr

Inventory
Closing inventory (cost of
goods sold)

Dr
Cr

22,500
22,500
54,090
54,090

Inventory write-down expense 10,340

Inventory

10,340

Cost of good sold under the periodic system would therefore equal:
Opening Inventory
plus Purchases

22,500
56,090
78,590
54,090
24,500

less Closing inventory

Cost of goods sold

Balance of closing inventory $54,090 less inventory write-down expense $10,340 = $43,750.

(b) Perpetual inventory system with FIFO cost flow method

Purchases
Opening Bal
30/7

Sales

Inventory
50 @ $450 = $22,500
50 @ $450 = $22,500

60 @ $400

28/8

40 units @ $450 = $18,000

23/9

60 @ $400 = $24,000
10 @ $450 = $4,500
60 @ $400 = $24,000
10 @ $450 = $4,500

30 @ $403

60 @ $400 = $24,000
24/12

10 units @ $450 = $4,500

5 units @ $400 = $2,000

1/3

40 @ $500

30 @ $403 = $12,090
55 @ $400 = $22,000
30 @ $403 = 12,090
55 @ $400 = $22,000
30 @ $403 = $12,090

TOTALS

130 for total

40 @ $500 = $20,000
55 units for a total of 125 for a total of $54,090

of $56,090
30 July
Dr
Inventory

$24,500
24,000

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Cr

Accounts payable

4 August
Dr
Accounts payable
Cr
Discount revenue
Cr
Cash
28 August
Dr
Cash
Cr
Sales
Dr
Cr

Cost of good sold

Inventory

24,000
24,000
480
23,520
28,000
28,000
18,000
18,000

23 September
Dr
Inventory
Cr
Accounts payable

12,090

1 November
Dr
Late payment expense
Dr
Accounts payable
Cr
Cash

121
12,090

24 December
Dr
Cash
Cr
Sales

13,500

Dr
Cr

Cost of goods sold

Inventory

1 March
Dr
Inventory
Cr
Accounts payable
5 March
Dr
Accounts payable
Cr
Discount revenue
Cr
Cash

12,090

12,211

13,500
6,500
6,500
20,000
20,000
20,000

30 June
Dr
Inventory write-down expense 10,340
Cr
Inventory

400
19,600

10,340

Balance of cost of goods sold for the year ending 30 June: $24,500
Inventory write-down expense:
$10,340
Value of closing inventory:
$43,750*
*proof of closing inventory = opening inventory + purchases cost of goods sold inventory write
down = $22,500 + $56,090 - $24,500 - $10,340 = $43,750 = 125 x $350.

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