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KAS 2 – INVENTORIES

EXPLANATORY NOTES

Explanatory Notes to Kosovo Accounting Standards are intended to provide additional understanding of the Standards and technical guidance as to their use and application. In case of any divergence between Explanatory Notes and Standards, the Standards prevail.

1. Accounting for inventories is a major consideration for many entities because of its significance on both the balance sheet, where inventories may constitute a large part of total assets, and the income statement, where sold inventories are included in the cost of sales. Also, inventories are often used as security for short-term borrowing.

2. An entity may also purchase quantities of items, such as stationery and supplies, that are not intended for resale but for use in the business. Quantities of such items on hand at the balance sheet date are classified as prepaid expenses and not as inventories.

3. Accounting for inventories is important for two main types of entities:

• Merchandising entities; and

• Manufacturing entities

A merchandising entity, whether a wholesaler or a retailer, accounts for goods that will be resold in their existing condition. The inventory is usually titled Merchandise Inventory on the balance sheet, while records of the different types of goods included in the total inventory are maintained in subsidiary ledgers.

A manufacturing entity usually has three types of inventory:

• Raw materials;

• Work in process; and

• Finished goods

Raw materials are the goods that will be put into production and transformed into the finished product.

Work in process is the name given to the goods that are in the process of transformation.

Finished goods are the completed products that have not yet been sold.

4. Accounting for inventories in accordance with KAS 2 needs to address the three following concerns:

• Ownership;

• Cost elements; and

• Valuation

Ownership

5. Ownership involves determination of the point in time when goods should be included in inventory. In general, goods should be included in the buyer’s inventory, and excluded from the seller’s, when legal title passes from the seller to the buyer. However, several complicating issues may arise, such as:

• Goods in transit;

• Consignment sales;

• Product financing arrangements; and

• Sales to a buyer with the right of return.

Goods in transit

6. In general, but subject to local laws and customs, goods in transit from the seller to the buyer should be included in the inventory of the entity that is financially responsible for the transportation costs. In overland shipping contracts, the term “FOB” (free on board) is widely used internationally to indicate when title passes. For example, the term “FOB destination” on a seller’s invoice indicates that the buyer acquires ownership of the goods when they arrive. So, any goods in transit at the balance sheet date should be included in the seller’s inventory. The reverse holds if the invoice shows “FOB shipping point”.

Consignment sales

7. In situations where goods are difficult to sell, or buyers lack the resources to purchase items for resale, selling goods “on consignment” is a marketing method that is frequently employed. The owner (the consignor) sends out goods “on consignment” to an agent (the consignee) who will take appropriate care of the merchandise and attempt to sell it. Title does not pass from the consignor to the consignee so the consigned merchandise remains on the consignor’s balance sheet until it is sold. When the consignee sells the merchandise, title passes to the buyer. The consignee notifies the consignor of the sale and forwards the sales proceeds, minus the consignee’s commission.

Product financing arrangements

8. A product financing arrangement is a transaction that allows an entity, known as the sponsor, to pay for inventory previously purchased on credit by selling the merchandise to a financing entity and agreeing to repurchase it later. The repurchase price would include financing and other carrying costs. The financing entity often borrows the funds to pay the sponsor from another financial institution, with the purchased merchandise serving as collateral. The sponsor will repurchase the merchandise when he sells it to, and is paid by, a customer. The financing entity uses the proceeds to pay off the debt to the financial institution.

Cost Elements

9. The cost of inventories includes cost of purchase, cost of conversion, and other costs incurred in bringing the inventories to their present location and condition.

10. The purchase cost of inventories includes:

• The purchase price

• Transport and handling costs in bringing the inventories to their present location and condition

• Import duties and other taxes that are not refundable

• Other costs directly attributable to the acquisition of finished goods, materials and services

Trade discounts, rebates, and other similar items are deducted in determining the purchase costs.

Illustration

Calculation of the purchase cost of inventories:

Euros

Invoiced price of merchandise--100,000 units @ 4 each 400,000

Cash discount available if paid within 10 days -- 2% -8,000

Freight charges 2,000

Import duties and taxes 40,000

Merchandise returned to seller -15,000

Cost of purchased merchandise 419,000

11. Conversion costs of manufacturing inventories include:

• Costs directly related to the units of production, such as direct labor

• A systematic allocation of fixed production overheads and variable production overheads that are incurred in converting materials into finished goods

• Other costs that may be added to inventory

12. Fixed production overheads are indirect production expenses that are relatively stable in amount, regardless of the volume of production. The allocation of fixed production overheads to the conversion costs is based on the normal capacity of the production facilities. That is, 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.

Illustration of fixed overhead allocation:

An enterprise is operating at normal capacity of 20,000 production units and incurs the following fixed costs:

Euros

Production factory rental 100,000

Production machinery rental 80,000

Communication charges 10,000

Supervisory salaries 50,000

Total 240,000

The amount of fixed cost allocated to each unit of production is calculated as 240,000 € / 20,000 units, or 12€.

13. Variable production overheads are indirect production expenses that vary in relation to output. They are allocated to each unit of production on the basis of the actual use of the production facilities. Examples of variable production overheads include:

• Electrical power

• Fuel costs for production machinery

• Machine rental paid per operation

Illustration

An enterprise incurs the following variable production overheads related to the production of 20,000 units:

Total Euros

Electric power 160,000

Production equipment fuel 80,000

Equipment maintenance 30,000

Machine lubricants 20,000 290,000

The amount of variable cost allocated to each unit of production is 14.5 calculated as 290,000€/20,000 units, or 14.5€

In the above example the total amount of fixed and variable production overheads allocated to each unit of production is 12€ plus 14.5€ equals 26.5 €.

14. Unallocated production overheads result when production is less than the level needed to fully allocate all overhead expenses. When this situation occurs, the amount of unallocated production overheads is recognized as an expense in the period in which incurred.

To illustrate, assume operations at 90% capacity:

Euros

Overhead expenses actually incurred 50,000

Allocated to cost of production [50,000 x 90%] 45,000

Expense as unallocated production overheads 5,000

15. Occasionally the opposite situation occurs when, in periods of unusually high production, the amount of fixed overhead that is normally allocated to each unit of production would result in a total allocation that is higher than the overhead cost incurred. In this case, the overhead allocation is decreased so that inventories are not measured above cost.

Illustration

An enterprise incurs the following fixed production overheads:

Euros

Production factory rental 10,000

Production machinery rental 8,000

Communication charges 2,000

Supervisory salaries 5,000

Total 25,000

The amount of normal production capacity is 10,000, so the fixed production overheads allocated to each unit of production is 2.5 €, calculated as 25,000 € /10,000 units. If, however, actual production is 12,500 units, which is 125% capacity, the maximum amount of fixed production overheads that should be allocated to each unit is 2 €, calculated as 25,000€/12,500.

Costs not included in inventory

16. Costs other than material and conversion costs may be included in inventory only to the extent that they are necessary to bring the goods to their present location and condition. As an example, licensing fees paid by a computer manufacturer for preloaded software such as Windows 98®. Generally excluded from inventory would be administrative and selling expenses, which must be accounting for as period costs on the income statement; the cost of wasted materials, labor, or other production costs; and most storage costs.

Inventory Valuation

17. Inventories are measured at the lower of cost or net realizable value, and reported at no more than the amount expected to be realized from sale or use.

18. The cost of inventories should be assigned by using the weighted average cost formula. Under this formula, the total cost of the beginning inventory and net purchases is divided by the units available for sale to obtain a weighted average cost. The ending inventory and the cost of goods sold are then priced at this average cost.

Illustration of calculating averages

Assume the following data:

Purchased Unit Cost Total Cost

Date Quantity € €

3 January 10 2.00 20.00

15 January 40 2.50 100.00

Totals: 50 4.50 120.00

SIMPLE AVERAGE: 4.50 €/2 = 2.25 €

WEIGHTED AVERAGE: 120.00 €/50 = 2.40 €

Specific identification method

19. The specific identification method may be used for those inventories that are not ordinarily interchangeable and goods or services produced and segregated for specific projects. Industries that sell high cost, non-interchangeable items such as furs, jewelry, or cars may appropriately use the specific identification method. This method matches the actual cost of the item that is sold with the revenue from that item.

Illustration of the Specific Identification Application for an Auto Dealer

Auto Purchase date Cost

Euros Unsold

1 February 15, 12,000 12,000

2 April 23, 10,000

3 May 5, 18,000

4 May 12, 14,000 14,000

26,000

Auto Date of sale to customer Sales price Cost Gross Profit

2 April 30, 12,000 10,000 2,000

3 May 15, 23,000 18,000 5,000

35,000 28,000 7,000

The auto dealer will report revenue of 35,000 and cost of goods sold of 28,000. The gross profit that will be reported on the income statement is 7,000. The cost of remaining inventory of unsold autos that will be reported on the balance sheet is 26,000 €.

Net Realizable Value

20. Net realizable 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. When an inventory item’s cost exceeds its net realizable value, the excess must be recorded as a loss in the income statement.

Illustration of calculating net realizable value

Assume the following data:

Weighted average cost of an unfinished inventory item 7.00 €

Sales value of finished item at destination 10.00 €

Deduct:

Costs to complete at factory 2.00

Shipping charge to destination 0.25

Sales commission at destination 2.00

Total: 4.25 4.25

Net realizable value: 5.75 5.75

Loss on decline in inventory value 1.25 €

21. Cost reductions may be required when:

• Inventory items are damaged.

• Inventory components have become wholly or partially obsolete.

• Inventory selling prices have declined.

• Estimated costs of inventory item completion have increased.

• Costs incurred to sell inventory items have increased.

22. Inventories are usually reduced to net realizable value on a unit by unit basis. However, it may be appropriate and practical to group similar types of inventory. The amount of the cost reduction of inventories to net realizable value, as well as all inventory losses are recognized as an expense and are included in the cost of goods sold on the income statement in the period the reduction or loss occurs. If there is a later recovery in value, it is recorded as a reduction of cost of goods sold in the period that the recovery occurs.

23. KAS 2 allows the reduction of inventory costs to lower net realizable values on an item by item basis, or in groups of similar items, where appropriate.

Illustration of Net Realizable Value Calculation and Adjustment

A seller of televisions has the following items in inventory on 31 December 2000. Amounts are in euros.

Inventory

Type Cost Net realizable value Difference Valuation Note

A 2,000 800 (1,200) 800 (1)

B 3,500 4,800 1,300 3,500

C 4,200 5,000 800 4,200

Total 9,700 10,600 8,500 (2)

The televisions are of three different types. Type A has become difficult to sell because new technology has made this type of television outdated.

Note (1)

If the television seller calculates net realizable value on an item by item basis, a 1,200€ inventory write-down is recorded. This is because the net realizable value of Item A is 1,200€ less than cost. The write-down will decrease the inventory to 8,500€ on the Balance Sheet and increase by 1,200€ the expense reported as cost of goods sold.

Accounting entry:

DT. Cost of goods sold 1,200

CT. Inventory 1,200

Note (2)

If the television seller calculates net realizable value based on the combined groups of televisions, no inventory write-down would be necessary This is because the total cost of 9,700 € is lower than the net realizable value of 10,600€. The television seller is not allowed to change its policy for grouping and must be consistent between each reporting period.

Recoveries of previously recognized losses

24. New assessments of net realizable value should be made in each subsequent period. When net realizable value has improved, the loss previously recognized should be reversed and the cost of goods sold should be decreased.

Illustration

A seller of televisions has the following items in inventory on 31 December 2001. Amounts are in euros.

Net realizable Inventory

Type Cost value Difference Valuation

A 2,000 1,500 ( 500) 1,500

B 3,500 4,000 500 3,500

C 4,200 4,500 300 4,200

Total 9,700 10,000 9,200

Using the item by item method of calculating net realizable value, the inventory valuation of the type A televisions has improved from 800€ to 1,500€ so 700€ of the previous write down is reversed, leaving an accumulated net write down of 500€. The inventory balance would increase by 700€ from 8,500€ to 9,200€.

Accounting entry:

DT. Inventory 700

CT. Cost of goods sold 700

Adjusting to actual inventory

25. It is important that the amount of inventory reported on the balance sheet reflects the actual physical inventory owned by the enterprise. In order to ensure accuracy, a count of inventory items is taken on a regular basis and compared with the accounting records.

26. When comparing actual physical inventory counts against the amounts reported on the accounting records, timing and ownership must be considered. Also, It is not unusual for the actual inventory to differ from the accounting for various reasons, such as minor theft or other unreported shortages. In this event, the inventory balance in the accounting records must be adjusted to reflect the actual value of goods on hand. Any necessary adjustment will be included as a component of the expense item, cost of goods sold, for the reporting period.

Illustration of Physical Inventory Reconciliation

The following information for Company A illustrates the calculation of the inventory balance and the amount of the necessary adjustment.

On 31 December, Company A, a book seller, completed a physical count of its inventory of books. The count determined that the inventory items in the warehouse cost a total of 250,000€. The accounting records show the cost of the books inventory as 279,000€. The following information is also available:

• As of 31 December 31, inventory with a cost of 30,000€ is in the stores of several retail outlets in the city. None of this has yet been sold

• A customer purchased and paid for some books on 30 December and indicated that he would return later that day to collect them. The company recorded the sale transaction. However, the customer was delayed by a snowstorm and his books, with a cost of 5,000€, were still in the warehouse on 31 December.

The cost of inventory that should be reflected on Company A’s balance sheet as of 31 December is 275,000€. That is: 250,000 + 30,000 – 5,000 = 275,000 €.

Company A must adjust the cost of the books inventory in its accounting records from 279,000€ to 275,000€. The 4,000€ adjustment will decrease the inventory balance and increase the cost of goods sold.

Accounting entry:

DT. Cost of goods sold 4,000

CT. Books inventory 4,000

Inventory Reconciliation

27. In order to reconcile a physical count of inventory on hand with the inventory accounting records, it is necessary to take into consideration items that must be included in the inventory count even though they are not physically located with the goods that are counted.

28. An inventory reconciliation worksheet, such as the following, lists situations to consider while reconciling inventory, aids the reconciliation process, and assists in the calculation of an accurate inventory balance.

Items to Be Included in Inventory

|Description |Amount |

|All inventory on hand when the physical inventory is taken | |

|+ Merchandise purchased that is in transit with the title passing to the owner from the shipping point | |

|- Merchandise sold that was counted with physical inventory | |

|+ Merchandise sold that is in transit with the title passing when received by the buyer | |

|+ Merchandise on consignment in other locations that is still owned by the company taking the inventory | |

|count | |

|- Merchandise included in the inventory on hand that belongs to another company but is being held on | |

|consignment | |

|Inventory total | |

|Inventory balance on the accounting records | |

|Inventory adjustment to the accounting records | |

Illustration of Completed Inventory Reconciliation Worksheet

Items to Be Included in Inventory

|Description |Amount |

|All inventory on hand when the physical inventory is taken |250,000 |

|+ Merchandise purchased that is in transit with the title passing to the owner from the shipping point | |

|- Merchandise sold that was counted with physical inventory |5,000 |

|+ Merchandise sold that is in transit with the title passing when received by the buyer | |

|+ Merchandise on consignment in other locations that is still owned by the company taking the inventory |30,000 |

|count | |

|- Merchandise included in the inventory on hand that belongs to another company but is being held on | |

|consignment | |

|Inventory total |275,000 |

|Inventory balance on the accounting records |279,000 |

|Inventory adjustment to the accounting records |(4,000) |

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