Question

• What are the complicating situations for determining which items should be counted as part of inventory?
• Why do we need to discuss LIFO liquidations in the notes to F/S? What do they tell F/S readers?

Answer 1

Situations for determining the items should be counted as part of inventory

Costs of Purchase
The costs of purchase consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar
items are deducted in determining the costs of purchase.

Costs of Conversion
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 the cost of factory management and administration. Variable
production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials
The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an 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 production overheads 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 production overheads allocated to each unit of production is decreased so that inventories are not measured above cost. Variable production overheads are assigned to each unit of production on the basis of the actual use of the production facilities.
A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or when there is a main product and a by-product. When the costs of conversion of each product are not separately identifiable, they are allocated
between the products on a rational and consistent basis. The allocation may be based, for example, on the relative sales value of each product either atthe stage in the production process when the products become separately identifiable, or at the completion of production. Most by-products as well
as scrap or waste materials, by their nature, are immaterial. When this is the case, they are often measured at net realisable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost.

Other Costs
1.Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include overheads other than production overheads or the costs of designing products for specific
customers in the cost of inventories.
2. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition and are, therefore, usually not included in the cost of inventories.
Exclusions from the Cost of Inventories

In determining the cost of inventories it is appropriate to exclude certain costs and recognise them as expenses in

the period in which they are incurred. Examples of such costs are:
(a) abnormal amounts of wasted materials, labour, or other production
costs;
(b) storage costs, unless those costs are necessary in the production
process prior to a further production stage;
(c) administrative overheads that do not contribute to bringing the
inventories to their present location and condition; and
(d) selling and distribution costs.

LIFO liquidations in the notes to F/S

A LIFO liquidation is when a company sells the most recently acquired inventory first. It occurs when a company that uses the last-in, first-out (LIFO) inventory costing method liquidates its older LIFO inventory. A LIFO liquidation occurs when current sales exceed purchases, resulting in the liquidation of any inventory not sold in a previous period.

Whenever the number of units that are sold exceeds the number of units that are purchased or manufactured during a period, the number of units in ending inventory will be lower than the number of units in beginning inventory, and a company which uses the LIFO method is said to experience a LIFO liquidation wherein some of the older units held in inventory are assumed to have been sold.

If inventory unit costs have been rising and LIFO liquidation occurs, an inventory-related increase in gross profits will be produced. This increase in gross profits will occur because of the lower inventory carrying amounts of the liquidated units. The lower inventory carrying amounts are used for the cost of sales while the sales are reported at current prices. The gross profit on these units is higher than the gross profit that would be recognized using more current costs. These inventory-related profits caused by LIFO liquidation are however one-time events and are unsustainable.

During economic downturns, LIFO liquidation could result in higher gross profit than would otherwise be realized. If the LIFO layers of inventory are temporarily depleted and not replaced by the fiscal year-end, LIFO liquidation will occur resulting in unsustainable higher gross profits.

LIFO liquidation may also generate positive cash flow and result in higher taxable income and higher tax payments.