In this class, we will focus on the recognition of inventories within the balance sheet. If we look at the structure of the assets, inventories enter the current assets. Also in this case, we have the problem of recognition of these inventories, because there are different approaches through which inventories can be recognized. This is instead not the case for cash and trade receivables because their value is immediately visible for the company. Given that we are talking about current assets, we don't have the problem of recognition subsequent to the initial measurement. So specifically, we're going to focus on how we can recognize inventories within the balance sheet. Let's start from the definition of inventories. If you think of the production process, so this is the representation of a production process, we can have three different types of inventories. We can have inventories of raw materials, which means that at the end of the period, so in the moment in which the balance sheet is defined and prepared, we have some raw materials that are in the warehouse not yet considered for the production process. Again, at the end of the period, in the moment in which the balance sheet is prepared, we can also have inventories of finished goods. Meaning that in the warehouse, we have some finished product that have not been sold yet. In between, we can also have inventories of work-in-progress. So in this case, we are talking about something which is no more raw material, not yet finished products. Given that in the balance sheet, we are providing a snapshot of the company at the end of the period, we can have all of them. So we can have raw materials, work in progress, but also we can have finished products. There is a problem of what is the value of these inventories that we can recognize within the balance sheet. So again, we are talking about the problem of the recognition. There are two alternatives following International Accounting Standards that can be adopted for recognizing inventories. The first alternative is to adopt what is defined as cost model for recognizing inventories, while the second alternative is to use what is defined as net realizable value. So what's the difference between the two approaches? In one case, where the cost model, the idea is to recognize inventories by looking at the amount of resources that have been absorbed by these inventories during the financial year. If we adopt a cost approach, it is possible to evaluate the inventories by adopting what is defined as First In, First Out approach, or by adopting what is defined as weighted average. The idea is always the same, is to evaluate the amount of resources that has been absorbed by the inventories over the financial year. But the approach that is adopted specifically for calculating the value of the resources changes, moving from the First In, First Out approach to the weighted average. On the opposite instead, it is possible to use the net realizable value by calculating the value of the inventories as the difference between the estimated selling price of the finished product minus the estimated costs of completion of our inventories. International Accounting Standards suggests to use the lower between the cost and the net realizable value in order to recognize the value of the inventories within the balance sheet. So the lower between them is the one which is adopted for evaluating them within the balance sheet. Now, let see what changes in the moment in which we want to adopt the First In, First Out or the weighted average for recognizing these inventories. Let's see this with a simple example. Assuming that we have a company, and this company is a reseller, meaning that the company purchases finished products for reselling them again. Specifically, the company realizes bags. At the end of the period, we have in the warehouse five different products, in this case, five different bags. As you can see from the picture, we have that each bag has a different value and the overall value of the inventories. So the amount of resource that is absorbed by these inventories, if we solved them, is equal to a €110. That's the value of the inventories in the warehouse. Now, let's see what happens if we adopted what is defined as First In, First Out approach. This approach suggests that the first product that enters the warehouse, is also the first product that goes out. So assuming this is the order, the first product that enters the warehouse is the bag that costs €20. Then the second product that enters the warehouse is the €25 bag. Then we have the third product that enters the warehouse, which is the €15 bag. Then we have the third product, that is the €30 beg. Finally, we have the fifth product, which is the bag that costs €20. Now, assuming that during the period, the company sold the first three bags, and which are the first three bags that are sold by the company? The First In, First Out approach suggests that the first bag that entered the warehouse is also the first that goes out. So the three bags that are sold by the company are the first three. So if we need to evaluate the inventories, the value of the inventories is the value of the last two bags that are inside the warehouse. So the value of the inventories is the value of the last two bags that we have inside, which is €50. This is what happens by adopting the First In, First Out approach. We have different calculations that we need to do in the moment in which our weighted average is adopted. The weighted average, as we can imagine from the name, it's simply a weighted average of the amount of inventories that we have in the warehouse. So in this specific case, the value of the inventories will be the overall value of the inventories. So 110, divided by the total number of products that we have five, multiplied by the number of inventories that we have inside the warehouse. In this case, we have two bags which are inside the warehouse. So in this case, the weighted average will give us a value of €44. So what's the difference between the two approaches? You can see that the final value that we have recognized in the balance sheet is different. In the first case, we have €50 because this is the remaining value of the bags that are inside the warehouse, because the first product that enters are also the first that went out. But in the weighted average, we do not care at the order in which products enter the warehouse. We just look at the weighted average between the overall amount of inventories that we have inside.
