Semester 1 Week 7 PP (Inventories and Impairment)

Question 1

What do Inventories consist of?

Answer 1

Inventories consist of:
1. Finished goods (manufactured by you) or goods for resale (goods purchased completed to be sold on).
2. Work-in-progress (WIP)
3. Raw materials and consumables

Question 2

What should the cost of inventories include?

Answer 2

The direct costs of the item.
Any necessary costs such as sales tax and delivery costs.
Any costs of conversion (in other words the cost of the work that you’ve put into the item.
Broadly speaking similar to non-current assets, any costs to get the item to its ‘current state and current location’.

Question 3

What do cost of inventories not include?

Answer 3

Any general admin – not a cost of production.
Sales and distribution costs – not a cost of production.
Abnormal amounts of wasted materials or labour.
Storage – unless actually part of the process.

Question 4

What is the Cost of Sales (COS) formula?

Answer 4

Cost of sales = Opening Stock + Purchases – Closing Stock

Question 5

What should be excluded from the year end inventories?

Answer 5

Inventories are usually determined by a year end physical stock count.
Care must be taken not to include:
Goods already bought and paid for by customers.
Consignment stock – goods delivered to you but not yet paid for (in other words you don’t own them) common in certain parts of retail.

Question 6

Louise Ltd. is a retailer of wines and spirits. A year end stock count reveals she has 43 bottles of Grey Swan Vodka in stock.
How does she value these?
The cost of the first purchase?
The cost of the last purchase?
The average cost of the goods?

Answer 6

FIFO (First-In-First-Out)
AVCO – average cost

No other method currently accepted.

Question 7

What is FIFO (First in First Out)

Answer 7

First In First Out – assumes that goods bought first are sold or used first.
For example in a shop they are likely to sell the oldest milk first. They are unlikely to sell the newest milk first and leave the oldest ones in the store to go off.

Question 8

What is AVCO (Average Cost of goods)

Answer 8

The Average Cost of goods. Often used where goods are high volume, indistinguishable and individually low value.
E.g. sand, nails, material etc.

Question 9

Harrison manufactures jackets, they have the following purchases in the year ended 31 December 20X2.
1/3/X2: 14,000m at £2.80/m
1/6/X2: 12,000m at £3.60/m
1/11/X2: 12,500m at £3.45/m
At the year end 2,000m remain in stock
Value the goods using:
The FIFO method
The AVCO method

Answer 9

If 2,000m remain in stock they must come from the last batch (the November one).
Therefore 2,000m at £3.45/m = £6,900

Average cost = [(14,000 x £2.80) + (12,000 x £3.60) + (12,500 x £3.45)]/(14,000+12,000+12,500) = £3.26/m
Therefore 2,000m at £3.26 = £6,520

Question 10

How do we value inventories?

Answer 10

In line with the prudence principle inventories are held at the lower of cost and NRV.
In other words the lower of what the item cost and what it will sell for.
This is done on a line-by-line basis, we don’t look at the total cost and the total NRV. We look at each item of stock.

Question 11

What is NRV?

Answer 11

Net Realisable Value
The sales price
Less:
Any selling costs
Any costs to complete

We get NRV by the looking at what the item will actually sell for post year end.
Can take into account post year end events if relevant (the item will sell next year)

Question 12

Answer 12

Question 13

Answer 13

Question 14

What are inventory provisions?

Answer 14

Sometimes it is felt by the directors that there is a risk but not a certainty that inventory will sell for less than cost.
In this case it would be appropriate to create an inventories provision rather than writing down the value of inventory.
This provision is a separate line on the trial balance but is netted off in the final accounts.

Question 15

Wallis Ltd. has 400 winter coats currently being held at £40 each. The retail price is £60.
Due to the warm weather this year the directors of Wallis are concerned the coats will only sell for £30 and have decided to create the appropriate provision.

Answer 15

The goods are currently held at the lower of cost and NRV (£40: lower of £40 and £60).
The directors are concerned, however, that they will only sell for £30. Therefore a provision of £40 - £30 = £10 a coat is required.
For 400 coats this is 400 x £10 = £4,000
Dr P/L Cost of sales 4,000
Cr Inventories provision 4,000
Being inventories provision

Note: The cost side goes to cost of sales there is no “bad inventories” cost.
The journal creates a separate provision, which is netted off on the final statement of financial position. It does not go to inventories.

Question 16

Inventories disclosure: On the statement of financial position just one total figure with the provision netted off.
Therefore a separate note required:

1. Separating inventories into three categories of finished goods and goods for resale, WIP and raw materials and consumables.
2. Showing the effect of the provision.

But what does this look like?

Answer 16

Question 17

The carrying value (CV) is what an asset is currently held at or ‘carried’ at in the accounts.
For example the carrying value of a car will be its Net Book Value (NBV).

But what if the item’s not worth that?

Answer 17

This is called impairment – it essentially means that the real value of the asset the Recoverable amount (RA) is below the carrying amount of the asset.

Question 18

When could we have impairment?

Answer 18

The standard (IAS 36) requires us to carry out an impairment review in two specific circumstances:
Annually for goodwill.
Annually for intangible assets which are not yet ready for use or have an indefinite useful life.
We are also required to carry out a review when there are ‘indications of impairment’.

Question 19

What would be an indication of impairment be?

Answer 19

You’re visiting a factory, a lot of the equipment seems dusty and looks like it hasn’t been used for a while. Some machinery has storage boxes piled on it and others look broken.

Does it appear as if the equipment is still worth its original value?
Of course not!

Question 20

The alternative to selling an asset is to keep it an use it in the business – in this case the value to the business will come from the cashflows of the asset discounted using an appropriate discount rate.
What is the term for this?

Answer 20

This is called the value in use (VU).

Question 21

How do we determine whether an asset is impaired or not?

Answer 21

In determining whether an asset is impaired or not we will therefore compare the NRV and the VU.
We assume that the business will make the best use of its assets therefore the higher of these would be the recoverable amount (RA).
If the carrying amount (CA) is higher than the recoverable amount (RA) then the asset is impaired.
As RA is the higher of VU and NRV, if one of these is higher than the carrying amount then the asset is not impaired.

Question 22

Pearse Limited has a piece of machinery with a NBV of £100,000 (cost £130,000 accumulated depreciation £30,000).
An impairment review has found that the asset would sell for £95,000 but have selling costs of £5,000.
A discounted cashflow has determined the VU on the asset to be £80,000.

Answer 22

The carrying value is £100,000
The RA is the higher of:
The NRV £90,000 (£95,000 - £5,000)
And the VU £80,000
The RA is therefore £90,000.
The asset is thus only worth £90,000 and is impaired by £10,000. (£100,000 - £90,000).

Question 23

Rossco Ltd. has an asset with a CA of £18,000 the NRV of the asset is £15,000 and a discounted cashflow has given a VU of £19,500.
Although the NRV is lower than the CA, the RA is the higher or VU and NRV (£19,500 v £15,000).

Answer 23

As £19,500 is higher than £18,000 the asset is not impaired.

Question 24

How do we account for an impairment?

Answer 24

When an asset is impaired the debit (cost) side of the journal goes to the P/L.
The credit side goes to the accumulated depreciation of the asset. In essence it’s like the asset is being “used up” quicker than originally expected.
Journal:
Dr P/L Impairment
Cr Asset accumulated depreciation

Question 25

CBC Limited have a building with a NBV of £220,000 (cost £285,000 accumulated depreciation £65,000).
The building will sell for £200,000 with selling costs of £2,000.
A discounted cashflow of the income from the building gives a VU of £208,000.

Answer 25

VU = £208,000
NRV = £200,000 - £2,000 = £198,000
The RA is the higher of the two £208,000
Impairment = £220,000 - £208,000 = £12,000

Dr P/L impairment £12,000
Cr Buildings accumulated depreciation £12,000
Being impairment of asset

Question 26

What are Cash Generating Units (CGUs) and why do businesses consider them?

Answer 26

This is the smallest group of assets which does generate income in its own right.
Examples: individual shop in a chain, production line in a factory, oil rig in an oil field.
In a small business there may just be one.
In theory we should be looking at every single asset in a business. Getting individual cashflows and analysis for each of them.
Is this practical?
Many assets don’t generate cash on their own, for example a freezer in a supermarket, a till in a shop or an individual machine in a factory.
Businesses should therefore consider Cash Generating Units (CGUs).

Question 27

How does impairment work in a CGU?

Answer 27

The rules for impairment in a CGU are broadly the same as with an individual asset:
Take the higher of VU and NRV to get the RA.
If the RA is lower than the CV then you have impairment.
The impairment will be written off against the assets in the following order:
Goodwill
All other assets on a pro-rata basis (i.e. dependent on size)

Question 28

Answer 28

CV = 1,400,000
RA = 1,100,000 (higher of £1,100,000 and £950,000)
So impairment of 1,400,000 – 1,100,000 = 300,000
We take as much as we can to goodwill (100,000)
The remainder (200,000) must be split between the buildings and machinery.
The buildings and machinery account for £1,300,000 combined (£900,000 + £400,000).
Therefore buildings should take 900k/1,300k =69% of impairment
Machinery should take 400k/1,300k = 31% of impairment
69% x 200k = 138,000
31% x 200k = 62,000
Dr P/L impairment 300,000
Cr Goodwill 100,000
Cr buildings accumulated depreciation 138,000
Cr machinery accumulated depreciation 62,000
Being impairment of CGU

Question 29

What order does the P/L come in?

Answer 29

First the title
Then revenue
Then cost of sales
Then all other expenses/income
Good idea to tick off items from the TB as you add them
Then cast (add) the P/L