SECTION IX. ACCOUNTING FOR INVENTORY

SECTION IX. ACCOUNTING FOR INVENTORY A. IAS 2 IAS 2 Inventories pertains to inventories that are: Assets held for sale in the ordinary course of business (finished goods and merchandise); Assets in the production process for sale in the ordinary course of business (work in process); and Materials and supplies to be consumed in production (raw materials) or rendering of a service. Certain inventories are excluded from IAS 2; these are listed in the standard. Measurement The fundamental principle of IAS 2 is: Inventories should be measured at the lower of historical cost or net realizable value in accordance with the prudence concept. Cost of inventories should include: Purchase costs. Processing or conversion costs including direct labor and production overheads. Production overheads include variable overheads and fixed overheads allocated at normal production capacity. Other costs incurred in bringing the inventories to their present location and condition. Specific components of the cost categories above are listed both in IAS 2 and Chapter 2 section 4 of the Mongolian Guidelines on Accounting. Certain costs should not be included in inventory cost: Abnormal expenses of materials, labor or other abnormal production costs; Storage costs, unless they are necessary in the production process; Administrative costs that do not contribute to bringing inventories to their present location and condition; and Selling costs. These costs should be expensed in the period in which they are incurred. Once it is determined what costs should be included in the cost of inventory, the method for assigning that cost to cost of goods sold as sales are made presents another issue. IAS and Mongolian Guidelines specify using one of three cost flow assumptions: Specific identification in cases where specific items are identifiable; First-In First-Out method the first unit purchased is considered to be the first sold; or Weighted average this can be calculated on a periodic basis or updated when each additional shipment is received. The Last-In First-Out (LIFO) cost flow assumption considers the last unit purchased to be the first unit sold. This method for assigning cost is currently listed as an 102

Allowed Alternative Treatment in IAS 2 (not in Mongolian guidelines) but LIFO is likely to be disallowed by the IASB in the near future. The cost flow assumption used is an application of an accounting principle and must be consistently applied to all items within a particular inventory classification from year to year. Different cost flow assumptions can be used for different kinds of inventory but the method used for a particular class cannot be changed unless it is required by law, required by a new standard or can be shown to result in a more appropriate presentation. If a change is made, IAS requires specific disclosures. The value of remaining inventory on hand is a current asset on the Balance Sheet. Under a number of circumstances the cost of inventories as determined above may not be recoverable. This may be the case when the inventories have been damaged, have become obsolete or if their selling prices have declined. Inventory value must be scrutinized periodically to determine if the cost is recoverable; otherwise the asset will be overstated. If the cost is not recoverable then the inventory is written down to net realizable value (NRV). NRV is the estimated selling price less the estimated costs of completion and costs necessary to make the sale. The estimate of NRV should be based on the most reliable evidence at the date the estimate is made. Inventories are usually written down using the following methods: On an item-by-item basis. Similar items are grouped together. Each service is treated as a separate item. Materials and other supplies used in production of finished goods are not written down to NRV unless the finished products in which they will be included are expected to be sold below cost. When inventories are written down to NRV, the loss is recognized as an expense of the period in which the write-down is made. Example: Company K sells TV sets. At December 31 they had 20 Model G TVs on hand with a cost of Tog 125,000 each. Model G TVs utilized a technology that was becoming obsolete. The company had been having a hard time selling them. They conducted research and found that the estimated price at which they would be able to sell the TVs was Tog 100,000. The decision was made to write down the cost of the 20 Model G TVs to NRV of 100,000 each. The accounting entry should be: Dr. Other Expense 500,000 (Loss on write-down of inventory) Cr Inventory 500,000 The following items related to inventory should be recognized as expense in the Income Statement: Cost of inventories sold. Write down to NRV. Inventory losses. Abnormal wastage. Non-allocated production overheads. 103

Disclosure IAS 2 requires disclosure of accounting policy for inventories, carrying amount of inventories carried at cost, carrying amount of inventories carried at NRV, carrying amount of inventories pledged as security, cost of inventories recognized as expense and other information. See IAS 2 for specifics. Perpetual and Periodic Systems Depending on how inventory cost flows are recorded, the following two types of inventory accounting systems are distinguished: 1. Perpetual system 2. Periodic system Periodic system 1. Dr. Purchases Cr. Account payable 2. Dr. Account payable 500 Cr. Purchase returns 3. Dr. Account payable 1,500 Cr. Purchase discount Cr. Cash 500 30 1,470 Perpetual system 1. Dr. Inventory Cr. Account payable 2. Dr. Account payable 500 Cr. Inventory 3. Dr. Account payable 1,500 Cr. Inventory Cr. Cash 500 30 1,470 500 = 1,500 x 0.98 = 1,470 4. Dr. Account receivable Cr. Sales revenue 4. Dr. Account receivable Cr. Sales revenue No entry Dr. COGS Cr. Inventory Inventory Inventory Bal. 10,000 Bal. 10,000 500 30 Bal. 8,470 5(a) Dr. Inventory Dr. Purchase discount Dr. Purchase returns Dr. COGS Cr. Purchases Cr. Inventory 5 (b) Dr. Income summary Cr. COGS Dr. Sales revenue Cr. Income summary 8,470 30 500 10,000 5(a) No entry 5 (b) Dr. Income summary Cr. COGS Dr. Sales revenue Cr. Income summary 104

B. METHODOLOGY ON THE CONVERSION OF INVENTORY ACCOUNTING Main Issues In order to convert the inventory accounting system of an entity, accountants should have knowledge of the following subjects: The items defined as inventory; Inventory costing and items to be included in the cost of inventory acquired or produced; Inventory costing methods: Specific Identification, FIFO, weighted average; Differences between periodic or perpetual systems of inventory; Main journal entries to record acquisition and issuance of inventory; Accounting for goods on consignment; Main cost flow assumption for the inventory cost flows. The accountant should learn about these issues by studying IAS and the guidelines approved by Minister of Finance and Economy. This knowledge will be a prerequisite for conversion of inventory accounting at an enterprise that intends to implement IAS (specifically IAS 2). Inventory accounting is discussed in Part 4 of Chapter 2 of the Accounting Guidelines approved by Resolution No. 116 by Minister of Finance. Main Problems and Weaknesses in Inventory Accounting. The following problems and weaknesses are likely to be noticed in the inventory accounting system of an entity. Raw materials, supplies and finished goods Problems and Weaknesses No subsidiary ledgers are kept for inventory accounts. The cost of raw materials is not estimated correctly. This will include inappropriate identification of freight-in, VAT and other taxes. The actual quantity or amount for ending inventory differs from reported amounts. Cost of raw materials issued is not allocated to appropriate accounts. Purchases are sometimes recorded at a price that includes profit (selling price) rather than at purchase cost. Impact on Financial Statements Reduced likelihood of accurate reporting of inventory balances in financial statements. Relevant payables may also be misstated. The cost of goods sold and the cost of work-in-process are recorded or reported incorrectly. This affects the accuracy of both the Balance Sheet and the Income Statement. The inventory balances are over or understated on the Balance Sheet. Cost of goods sold or cost of goods produced is under or overstated. If purchases are recorded at a selling price, assets will be overstated on the Balance Sheet and the cost principle of accounting will be violated. Thus, total assets and future profits will be misstated. 105

Cost of goods produced Problems and Weaknesses Cost of goods produced is not accounted for correctly and therefore production costs are reported under the sales and administrative expenses category on the Income Statement. If production cost is not accounted for separately, no balance for finished goods inventory is reported on the Balance Sheet. Cost elements for production are not properly identified and accounted for. Due to lack of knowledge of how to record cost of goods sold, finished goods are recorded at a selling price rather than at their cost. Impact on Financial Statements No cost of goods sold is reported on the Income Statement. Sales and administrative expenses are overstated. Profit is not reported correctly. Total assets (inventory) are understated on the Balance Sheet. Expenses and revenue will also be misstated. Cost of goods produced is misstated, and consequently, the profit is presented incorrectly. Finished goods and receivables are misstated on the Balance Sheet. Sales revenue is also misstated on the Income Statement. Since the above weaknesses impair fairness of financial statements, the correction of these weaknesses will a major accomplishment from conversion of the inventory system. Suggested Steps for Converting an Inventory Accounting System The scope of the inventory accounting system conversion differs from one entity to another depending on the size of operations (especially the volume of production and sales) and the status of inventory record keeping. It is suggested that the following general steps be followed in order to convert the inventory accounting system in order to comply with the approved guidelines. We recommend that the following steps be used specifically by those enterprises that have converted their previous financial statements to IAS and are producing new reports. Raw materials and supply items: 1. Review the procedures followed by the enterprise for inventory acquisition, including the procedure for recording; 2. Review the procedures followed by the enterprise for issuing inventory items; 3. Review inventory documentation including initial documents, journals and subsidiary ledgers; 4. Review costs of acquisition, and determine weaknesses if there are any; 5. Ensure the appropriateness of the new main and sub accounts to be used based on the newly developed Chart of Accounts; 6. Ensure or verify the accuracy or fairness of the beginning inventory balances; 7. Record inventory receipts and issuance in appropriate journals. Inventory receipts should be recorded in the Inventory Receipts Journal (IRJ). If Inventory was purchased on credit, the transaction can be recorded in the Purchases Journal (PJ). Attention should be paid to cash purchases of inventory because they are often recorded in the Cash Disbursements Journal. If this is the case, accountants should avoid recording the same transaction in the Inventory Receipts Journal (if it is used). If the same transaction has been recorded in more than one journal, one should avoid 106

double counting when the journal entries are posted to the General Ledger. Inventory issuance is recorded in the Inventory Issuance Journal (InIJ). 8. Prepare journal entries for inventory transactions and post them to the General Ledger. Work-in-Process 1. Review the production costing. (Note: details of production costing are beyond the scope of this manual.) If an entity has a production costing system, evaluate its appropriateness. If an entity has no production cost accounting system, it needs to start accounting for production costs and accountants need to define the necessary changes. 2. Since increases and decreases in the work-in-process account result from entries in other journals and ledgers, the accumulated production costs or expenses need to be controlled using the work-in-process sub accounts. 3. A cost accumulation sheet for a product or workshops is prepared. There is no officially approved statement or form for production costing, but an entity may develop such sheet to reflect its specific business characteristics. This will help improve the accuracy of product costing. As a result of improving production costing gradually, an entity will have developed a Product Cost Statement. Finished goods Cost of goods and services sold is discussed in Part 4.8 of Chapter 2 of the Accounting Guidelines approved by Resolution No. 116 by Minister of Finance. The Resolution states Enterprises are to estimate their cost of goods sold incurred during a reporting period based on production characteristics. As an example, Attachment 1 to this section shows a simplified workshop cost report titled Production Cost Accumulation Sheet of Company B. This sheet helps to control the costs of work-in-process and finished goods. Company B operates two workshops for producing cakes and pastries one for producing cakes and one for producing pastries. The company does not have a work-in-process balance left at the end of a reporting period. Since no cost transfer is made to the next workshop, all production costs of each workshop are recorded in the assigned work-inprocess account in order to determine the cost of finished goods produced at the end of a reporting period. This is a simple system for cost accumulations. In order to obtain more information for management purposes, the company plans to improve their production cost accounting system in the future. Review the documentation for finished goods (for a production company) or merchandise (for a trading company) including initial source documents, journals and ledgers; Ensure the appropriateness of main and sub accounts for finished goods or merchandise; 107

Verify the accuracy of the beginning balance of finished goods; Review the journal entries made for the finished goods cost flows to ascertain whether or not they were proper; Correctly record the finished goods transactions for the current accounting period in the appropriate journals; The method of accounting for cost flow for inventory sold should be determined and the appropriate journal entries should be prepared. This step will also determine the value of cost of goods sold. Verify that the cost flow records satisfy the following formula. If this formula is not satisfied, it means that the records are incorrect. Cost of Goods Sold = beginning balance of Finished Goods + Cost of Goods Produced - ending balance of Finished Goods. Results of Inventory Accounting Conversion Enterprises should achieve the following results from converting their inventory accounting systems to comply with the approved guidelines: Appropriate sub and main accounts are set up. Inventory acquisitions and issuances are recorded correctly and completely in the appropriate inventory ledgers and journals. All inventory transactions are fully supported by valid documents. The cost for acquisition and issuance are correctly valued and accounted for. The production cost is accumulated and the system for product costing set established. Increases and decreases in finished goods are fully controlled by the use of accounting records including journals and ledgers. The method for accounting for cost flow of finished goods or merchandise sold is established and appropriate records kept. (Note: the method used for cost flow and determining the ending balance of finished goods and cost of goods sold should be applied consistently.) Guidance for Improving Production Cost Accounting A common practice is that production costs are either not accumulated and accounted for separately, or they are accumulated incorrectly. Therefore, an important part of an inventory accounting system conversion in accordance with IAS is to start to accurately accumulate costs and properly account for cost of goods. The following brief guidance will help the enterprise accountant to set up a product costing system. 1. Define the cost elements of product costing Production costs are accrued for the following main cost elements: Direct material Direct labor Production overhead 2. Main methods of product costing 108

A method of production costing depends on the organization of production operations, and the type and nature of production. The Process costing method is used for the production where goods are produced in large quantities through several production stages that involve one or more production workshops. The Job order costing method is used where specific products are produced on the basis of an order received from a customer and the cost of that product is identifiable. An alternative method is to determine the cost of products in batches. This method is called batch job order costing. 3. Process costing system When the process costing system is used, cost or expenses are accumulated by each cost element and accounted for at each production stage or workshop. The accumulated cost of the first production stage is transferred to the next production stage. The additional production costs incurred for that next production stage are added. Total accumulated production cost is then transferred to the finished goods account if the production process is completed, or to the next production stage if production is not complete. Using this system the full cost of goods produced is determined. When process costing is applied, the production cost flow is controlled in the following way: Sub accounts are set up for each production stage or workshop; A supporting schedule or sheet is developed. The sheet clearly reflects the cost transferred from the prior production stage and expenses incurred during that stage. A product costing sheet should be kept for each production stage; The product costing sheet for the last production stage should also meet the above requirement. In addition, the sheet should show the cost of goods produced, the quantity of products produced, and the calculation of unit cost. Production costs can be recorded by their elements direct materials, direct labor, and production overhead. 4. Production cost accumulation sheet It is important that the system established be easy to use and understand. Therefore, an enterprise may use a simple production cost accumulation sheet that reflects the specific characteristics of the entity. Such sheet is useful for estimating production efficiency and controlling expenses. This is a simplified production cost report. When production cost accounting cannot be organized at the perfect level initially, a separate production cost sheet can serve as a useful tool to control costs and verify whether the entries related to the cost flow of work-in-process and finished goods are accurate. Presented below in Exhibit 1, as an example is a Production Cost Accumulation Sheet of Company B. 109

Exhibit 1 Company B Production Cost Accumulation Sheet Account: Work-in-Process No Date Journal Description WORKSHOP: Cakes Direct labor Direct materials Factory overhead WORKSHOP: Pastries Direct labor Direct materials Factory overhead Oct. CD Direct materials 16,100 II Oct. P Direct labor 120,000 40,000 P Health and Social Insurance 22,800 7,600 FA Depreciation 66,086 Subtotal - October 16,100 120,000 88,886 40,000 7,600 CD Direct materials 7,250 II 3,569,349 571,394 P Direct labor 120,000 40,000 P Health and Social Insurance 22,800 7,600 CD Indirect material 5,750 CD Electricity 150,660 FA Depreciation 66,086 CD Technological analysis 45,520 Subtotal - November 3,576,599 120,000 290,816 571,394 40,000 7,600 II Direct materials 5,556,311 Direct labor 120,000 40,000 Health and Social Insurance 22,800 7,600 FA Depreciation 66,086 Electricity 71,000 Subtotal - December 5,556,311 120,000 88,886 40,000 78,600 Total - Quarter 9,149,010 360,000 468,590 571,394 120,000 93,800 1 Workshop beginning balance - 2 Costs added to workshop 9,977,601 785,194 Direct materials 9,149,010 571,394 Direct labor 360,000 120,000 Factory overhead 468,590 93,800 3 Workshop ending balance - 4 Cost of finished goods (4=1+2-3) 9,977,601 785,194 110