 Hello and welcome to the session. This is Professor Farhad and the session we're going to be looking at IAS 2 which deals with inventories. This topic is covered in the international accounting course as well as the CPA exam. You are expected to know the difference between how US GAAP treats inventory versus IFRS. As always I would like to remind you to connect with me on LinkedIn. If you don't have a LinkedIn account I strongly encourage you to create one. YouTube is where I house all my lectures. Please subscribe, like my lectures, like them, put them in playlists, share them with others, let the world know about them. If you're benefiting from my YouTube it means other people might benefit as well. This is my Instagram account. I'm trying to grow and this is my Facebook account. I do have some premium accounts or some premium product on Gumroad and this is my website. So let's start to talk about inventory. What is inventory? Basically inventory is an asset. To be more specific it's a current asset. What's inventory? Inventory when you buy something for $10 that's your cost then you turn around and you sell it for something other than $10. Hopefully for more than $10. So you bought something for $10 and we're going to call this $10 is the cost and you're going to go ahead and sell it whatever you sold that product that you sold that's assumed for $15. So you bought a computer or a calculator or a telephone whatever you bought you bought it for then you sold it for $15. The cost of that item is your inventory cost and that's what inventory is. Now we have to understand that IFRS provides more extensive guidance than US GAAP. So the IFRS they go a little bit more into details on how they cover inventories. What would the cost of inventories include for IFRS? Well it includes the cost of the purchase obviously how much it costs you plus any import duties. What are import duties? If you buy something from overseas from another country you might have to pay taxes. You might have to pay other taxes other than import duties. You might have to pay transportation to get that asset to get that inventory to your warehouse. You might have to pay handling costs. All of these are considered cost of your inventory. Now if you are converting the inventory in other words if you are buying raw material or you are buying inventory then you are doing minor conversion. What can you what can you include? Well you can include your direct labor the labor that you incurred and you can include systematic allocation of variable and fixed production overhead using be careful normal level. What is normal level? It means this is how you operate on in a normal circumstances and you would allocate the overhead whether it's variable or fixed based on a normal level. Now if you don't know what a normal level is if you don't know what overhead variable and fixed go to my managerial or cost accounting course on YouTube but this is what this is what you are expected to allocate. The third item it might include other costs such as design so if you're designing a product you have to pay money for that that's part of your inventory. Also interest if it takes time to bring to bring to a saleable condition sometimes you might have to include interest cost. I'm not going to get involved I'm not going to get you know we're not going to bug ourselves with interest but if you really think about it all of these items one two and three basically you can summarize it is any cost that's going to prepare your inventory for a saleable condition so any cost necessary to bring your inventory to a saleable location and condition it's considered inventory cost it's part of your inventory cost. Now there are certain items that IFRS explicitly execute and those are abnormal waste of material than other production so if you are producing something and you incur not normal abnormal it means more than normal. Now what's considered normal and abnormal the company itself they will decide based on their production level what's considered normal waste and what's considered abnormal if it's abnormal then guess what it's not inventory it becomes an expense it's basically a loss okay also you would execute storage unless it's necessary for the production process so storage you know just for the sake of the storage it's not it's not included if it's for the production necessary notice here it's necessary for the production process then storage cost would be included administrative overhead definitely would not be included and selling cost is basically selling expense the expense to sell the product basically it's an expense it's an effort you are undertaken to sell the product it is not it is not a it's not an asset so you have to make sure you understand what's considered inventory and what's considered not inventory now on the exam you might be as a simple question as administrative overhead to administrative for inventory purposes that's not inventory okay so just make sure you know what's included and what's not and the best way to illustrate this is to let's take a look at an at an example just to see how this all fits together as a result of a downturn in the economy opti plaques corporation has excess productive capacity on january first year three up tax signed special order contract to manufacture custom design generator for a new customer the customer requested that generator be ready to pick up by june 15 year three and guarantee it will take possession of the generator by july 15 so just keep it for us for a month opti plaques has incurred the following direct costs related to design so they cost to complete the design three thousand dollar purchase price of material in parts eighty thousand transportation cost to get the material in any parts of the manufacturer in facility two thousand dollar direct labor ten thousand direct labor at a twelve dollar per rate at a rate of twelve dollars one hundred and twenty thousand cost to store finished product from june 15 to june 30th two thousand dollar also because of the company and experience in manufacturing generators of this design the cost of material in part included in an abnormal way and included an abnormal amount waste totaling of five thousand so the cost of material here the cost of material there's five thousand dollar of that is because we're we don't have experience with the production of this design of this design of this generator this is abnormal and remember what do we do with abnormal guess what it's not included in inventory it's expense but let's see what the question is in addition to direct costs opti plaques apply variable and fixed overhead to inventory using predetermined overhead rate once again if this statement doesn't make any sense to you go to my managerial accounting or cost accounting the variable overhead rate is two dollars per direct labor hour and the fixed overhead based on a normal level of activity is six dollars per direct labor hour given the decreased level of the production expected in year three opti plaques estimate a fixed overhead application rate of nine dollars per direct labor in year three so normally the the overhead is applied a six dollar per uh per direct labor hour that's the normal rate because they have a decrease in the production in the level of production because there was a downturn in the economy guess what overhead applied went up to nine now between six and nine which one are we going to be using we're going to be using the normal rate not the abnormal rate okay so the question is determine the amount at which the inventory of custom design generator should be reported on the opti plaques corporation June 30th year three balance sheet so simply put tell me when you prepare your balance sheet on June 30th what do you include as part of your inventory well let's start with the three thousand is that the cost to design the product is that included of course it is so the design is included design cost purchase price for the material now purchase price is 80 000 but included in that is 5 000 of abnormal therefore i'm only going to include 75 000 so 80 000 minus 5 i'm only i'm only going to include 75 000 as parts i'm not going to say 80 000 because if i really if i was careful if my employees were well trained then i wouldn't have to do incur that 5 000 transportation cost to get the material and parts ready for the manufacturing facility do you think that's included of course you cannot produce unless you get those manufacturing unless you get the parts to the facility direct labor 10 000 hours at 12 per hour sure it is i incur direct labor related to the production that's included that's 100 and 20 000 sorry it keeps skipping 120 000 cost to store finished product okay so hold on a second two thousand other now what did we say about storage cost storage cost it says here storage unless necessary for the production process that's not necessary for the production process we already produced the product so that 2000 is not included okay now we are left with overhead okay so we incurred 10 the overhead is applied on a direct labor hour so we incur 10 000 direct labor hour so the fixed overhead is times six y times six because that's the normal level of production rate six so so 60 000 is the fixed overhead that's 60 000 so this is the this is all the because so 30 000 plus 75 plus 2 plus 120 plus 60 okay see that i miss anything oh the direct labor 120 i included that oh variable we included the fix we didn't include the variable variable rate is two dollar per direct labor hour i i skipped the variable rate so let me so this is the sorry this is the fixed overhead rate this is the fixed and the variable is 10 000 hour times two is 20 000 that's the variable production cost now if i added all of this it should add up to 200 and 80 000 and this will be my reported inventory as as as of June 30th now 15 days later i'm gonna sell it it becomes cost of goods sold okay but this is basically what the question is asking let's take a look at a few other topics that deals with inventory and the other thing we have to worry about is cost flow assumption what is a cost flow assumption if you remember 5-0 liFO the weighted average specific identification for one thing IFRS does not allow liFO so as far as IFRS is concerned liFO is a gimmick they don't allow last and first out so which method are are accepted well 5-0 is accepted first and first out and weighted average now if you're saying hold on a second what is this 5-0 liFO or 5-0 liFO and weighted average i have no clue what you're talking about well guess what go to my intermediate accounting and i believe chapter 8 and 9 deals in depth about inventories if you don't know how liFO 5-0 work well i hope you do by this time but if you don't go back to my intermediate accounting so the so liFO is not 5-0 and weighted average are you might be saying hold on a second isn't there a fourth method called specific identification well specific identification is not a cost flow assumption that's what actually happens okay so standard cost method and retail method are acceptable only if the approximate cost as per IAS 2 so you could use standard costing you could use the retail method as long as the app approximated the cost okay those two other methods again if you don't know what they are retail method you learn this in intermediate accounting and standard costing in in managerial accounting now cost of inventory not ordinarily interchangeable like unique inventory this is where you would use the specific identification method cost of goods of and services produced and segregated for specific projects so if you are making a specific product for someone guess what you would use the specific identification method as well this is when you would use the specific identification okay an entity must use the cost formula for similar inventory items what does that mean it means if you're using liFO or weighted average you have to use the same cost formula for similar inventory in the US you don't have to do so for some items you could use one method for the other items you cannot use so they have more flexibility IFRS you have this you have to use the same method also the IFRS or IAS 2 require inventory to be reported at lower of cost or NRV net realizable value what does that mean it means you have to look at your cost and compare your cost compare your cost versus NRV net realizable value and select the item that's lower of the two so lower of the two is what gets reported so after you after you do FIFO and LIFO I'm sorry LIFO after you do FIFO or weighted average you come up with all your inventory then how do you assign a dollar amount well you either have to use the cost the original cost of the inventory or NRV whichever is lower typically you would apply the this method lower of cost or NRV on an item on an item by item basis usually that's how you would report the NRV okay right down are reversed when selling prices increases so if you write something down and we're going to work an example IFRS would allow you to go back and reverse it obviously reverse it up to your original cost but the fact that you can reverse it US GAAP uses the same approach in computing NRV because they used they used to use a different approach now IFRS and GAAP they use the same approach in determining lower of cost or NRV this is part of the convergence process however IFRS does not allow you to reverse any write downs simply put once you write down an inventory US GAAP you cannot write it up and back in the old days not long ago we used to we used to teach the concept of floor and ceiling when it comes to inventory inventory when we are trying to compute NRV NRV that's no longer the case we no longer have to use this floor and ceiling that's gone this concept is gone GAAP abandoned it so how do we compute then lower of cost or market well let's work an example to see okay that's the best way to illustrate this concept so let's assume we bought an item and we bought it for a thousand dollar that's the cost for us a thousand dollar cost is a thousand estimated selling price 880 notice the the estimated selling price is lower than the cost therefore we have to do something estimated cost the the sell is 50 dollars well guess what when we take the estimated selling price minus the cost the sell which will give us something called NRV so now this is the NRV the cost the historical cost is the cost of a thousand dollar now we bought something for a thousand dollar let's assume that's a computer which is which is very common that you bought a computer for a thousand dollar it did not sell six months later it's only selling for 880 that's pretty normal in the industry so which number would you report would you report the 830 or would you report the thousand dollar well since we are being conservative you have to report 830 dollars of your as inventory on your balance sheet well what does that mean it means you have to write down your inventory you have to write it down to the net realizable value the net realizable value is 830 that's all you can get even if you sell it today well you have to take a loss well what you do is you debit which you would increase a loss you will debit a loss and you credit which is you would reduce inventory for 170 what you did is you wrote down you wrote down your inventory by 170 dollars you took the loss now sometime this 50 dollars now it's given estimated cost the sell is is 50 dollars sometime what they would say something like this they would say cost the sell is 5 percent of sale so what you do is you take your selling price which is a thousand dollar whatever your selling price is time whatever your selling price times that rate to find out what's the estimated cost to sell now let's assume at the end of the first quarter and year to replacement cost has increased to 900 so if you want to buy it it's 900 the estimated selling price has increased to 980 and the estimated cost to the sell remained at 950 now you have to compute the new nrv 980 the estimated selling price minus cost to replace 50 your new nrv is 930 so your new nrv is 930 remember now have to compare your nrv which is this is 930 you have to compare your nrv 930 to your historical cost of a thousand your historical cost sell a thousand well what do you have to report the the lower of these two the lower of these two is 930 but hold on a second you already wrote it down to 830 earlier earlier you wrote down your inventory to 830 can you write it up to 930 and the answer is yes under IFRS this 100 dollar is greater than the carrying amount and 70 dollar less than its historical cost so you are allowed under IFRS to write up to write your inventory to reverse your losses so you will debit inventory you would increase inventory and you will credit an income account recovery of inventory loss so basically you recovered you remember last year you wrote it down last year you wrote it down 170 now you wrote it up 100 okay you could write it up up until the the historical cost okay but but under us gap you can do so under us gap once it's down to 830 once you write it down to 830 this becomes your new historical cost the 830 once you write it down so in the prior set in the prior um we wrote it down to 830 once you write it down to 830 let's assume the inventory recovered you can't you cannot write it up so once it's written down the 830 becomes your new historical cost and guess what if your inventory is really worth more well you're going to sell it and when you sell it you can book it as a profit so this is still a difference between us gap and IFRS you cannot reverse um you cannot reverse once lcm is applied once lcm is applied it becomes your new cost under us gap under IFRS you can recover some of that you can recover previously written down inventory cost if you have any questions any comments about this topic please email me if you happen to visit my website for additional lectures please consider donating good luck