2. 8 Inventory After studying this chapter, you should be able to:
Understand inventory from a business perspective.
Define inventory from an accounting perspective.
Identify which inventory items should be included in ending inventory.
Identify the effects of inventory errors on the financial statements and adjust for them.
Determine the components of inventory cost.
Distinguish between perpetual and periodic inventory systems and account for them.
Identify and apply GAAP cost formula options and indicate when each cost formula is appropriate.

3. 8 Inventory After studying this chapter, you should be able to:
(continued)
Explain why inventory is measured at the lower of cost and market, and apply the lower of cost and net realizable value standard.
Identify inventories that are or may be valued at amounts other than the lower of cost and net realizable value.
Apply the gross profit method of estimating inventory.
Identify how inventory should be presented and the type of inventory disclosures required by ASPE and IFRS.
Explain how inventory analysis provides useful information and apply ratio analysis to inventory.
Identify differences in accounting between ASPE and IFRS, and what changes are expected in the near future.

4. Inventory Understanding Inventory Recognition Measurement
What types of companies have inventory?
Inventory categories
Inventory planning and control
Information for decision-making
Recognition
Accounting definition
Physical goods included in inventory
Inventory errors
Measurement
Costs included in inventory
Inventory accounting systems
Cost formulas
Lower of cost and net realizable value
Exceptions to the lower of cost and NRV model
Estimating inventory
Presentation, Disclosure, and Analysis
Presentation and disclosure of inventories
Analysis
IFRS / ASPE Comparison
Comparison of IFRS and ASPE
Looking ahead

5. Inventory Classification
Inventory is classified as a current asset
A merchandising company:
has one inventory account on the balance sheet called Merchandise Inventory;
the cost of the inventory sold is transferred to Cost of Goods Sold (COGS) on the income statement
A manufacturing company:
will normally have three inventory accounts on the balance sheet: raw materials, work in process and finished goods;
Cost of Goods Manufactured (COGM) is used by a manufacturer which is similar to the COGS
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6. Manufacturing Operations
Inventory Cost Flows
Manufacturing Operations
Raw Materials
Direct Labour
Mfg. Overhead
Work in Process
Inventory
Finished
Goods
$$$
COGM
$$$
COGS
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$$$
COGS

7. Inventory Definition of Inventory: Inventories are “assets:
held for sale in the ordinary course of business;
in the process of production for such sale; or
in the form of materials or supplies to be consumed in the production process or in the rendering of services.”
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8. Items to Be Included in Inventory
Legal title to goods generally determines items to be included in inventory
The following goods are included in the seller’s inventory:
Goods in transit (if seller has title during shipment, i.e., if shipped f.o.b. destination)
Goods out on consignment
Goods sold under buyback agreements
Goods sold with high rates of return that cannot be estimated
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9. Effect of Inventory Errors
Error in Effect on Income Effect on Balance
End Inv. Statement Items Sheet Items
Under COGS (over) Retained Earnings (under)
stated Net Income (under) -Working Capital (under)
-Current ratio (under)
Over COGS (under) -Retained Earnings (over)
stated Net Income (over) Working Capital (over)
-Current ratio (over)
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10. Example
Given for the year 2014: COGS = $1.4 million Retained Earnings (R/E) = $5.2 million December 31st inventory errors both discovered after 2014 books were closed: 2013: inventory overstated by $110, : inventory overstated by $45,000 Calculate correct 2014 COGS and R/E at Dec. 31, 2014
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11. Example COGS (as originally stated in 2014) $1,400,000
Add: December 31, 2014 over-
statement error ,000
1,445,000
Less: December 31, 2013 over-
statement error ,000
Corrected 2014 COGS $1,335,000
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Retained Earnings (2014 original) $5,200,000
Less: correction for 2014 inventory ,000
Retained Earnings (2014 restated) $5,155,000
Note: 2013 inventory error is self-corrected as it was discovered after the books for 2014 were closed

12. Costs Included in Inventory
Inventory cost includes “all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition”
These costs include:
Product costs including invoice, freight, and other direct acquisition costs
Conversion costs which include direct labour and fixed and variable overhead
Period costs (selling, general, and administrative) are not inventoriable costs
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13. Costs Included in Inventory
Other issues to consider:
Purchases discounts: gross method vs. net method
Vendor rebates: cash rebates related to inventory generally recorded as a reduction to the cost of inventory
“Basket” purchases and joint product costs: total cost allocated to units based on relative sales value
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14. Costs Included in Inventory
Interest or borrowing costs
Under IFRS, interest costs are included as product costs if manufacturing of inventory takes a long time (otherwise, company has a choice whether to capitalize interest costs or not)
Under ASPE, interest costs may be either capitalized or expensed, but policy must be disclosed.
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15. Purchase Commitments
Where a company commits to purchase inventory, but title has not passed to the buyer
Non-cancellable purchase contracts are not recorded, but if material, they are disclosed in the notes to the financial statements
Loss provision is recognized on onerous contracts (even though no specific requirement under ASPE)
Onerous contracts are contracts where unavoidable costs to complete the contract are higher than expected benefits
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16. Inventory Accounting Systems
An accurate inventory accounting system is important for:
ensuring availability of inventory items
preventing excessive accumulation of
inventory items
Just-in-time (JIT) inventory order systems have helped reduce inventory levels
The perpetual system maintains a continuous record of inventory changes
The periodic system updates inventory records in the ledger only periodically
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17. Perpetual System
Purchases of inventory and cost of inventory sold are recorded directly in the Inventory account
Cost of freight, purchase returns and allowances, and purchase discounts are all recorded in the Inventory account
Cost of Goods Sold (COGS) is debited and Inventory is credited when inventory is sold
A subsidiary ledger is maintained for individual inventory items on hand
Periodic inventory counts are still required to ensure reliability
Any differences between the inventory balance and the physical count are captured in a separate account called Inventory Over and Short (or may be recorded as an adjustment to Cost of Goods Sold)
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18. Periodic System
Inventory purchases are recorded as a debit to a Purchases account
Cost of Goods Sold and Inventory accounts are not kept up to date
The quantity and cost of inventory on hand is determined by taking a physical inventory count
Cost of Goods Sold is determined at the end of the period
Under both periodic and perpetual inventory systems, physical counts of inventory are conducted at least once a year as there is the risk of loss and errors (e.g. waste, breakage, theft)
Freight, purchase returns and allowances, and purchase discounts are recorded in separate accounts
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19. Perpetual and Periodic Systems: Example
Fesmire Limited reports the following data: Beginning Inventory : 100 units at $6 Purchases: (all credit) 900 units at $6 Defective units (returned) 50 units at $6 Sales: (all credit) 600 units at $12 Ending Inventory: 350 units at $6 Provide all journal entries under each system.
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20. Record Inventory Changes
Perpetual System
7,200
Sales
(600 units x $12)
3,600
Inventory
(600 units x $6)
300
Accounts Payable
(900 units x $6)
5,400
Accounts Receivable
(50 units x $6)
Cost of goods sold
Purchase Return
Sale
Purchase
Record Sales Revenue
Record Inventory Changes
Transaction
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21. Record Inventory Changes
Periodic System
5,400
600
Purchases
Inventory (beg.)
3,600
2,100
300
Cost of goods sold
Inventory (end - count)
Purchases Returns
Year-End Adjusting Entry
7,200
Sales
(600 units x $12)
Accounts Payable
(900 units x $6)
Purch. Returns
and Allowances
Accounts Receiv.
No entry
Sale
Purchase
Return
Record Sales Revenue
Record Inventory Changes
Date
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22. Cost Formulas
IFRS and ASPE recognize three acceptable cost formulas: 1. Specific identification 2. First-in, First-out (FIFO) 3. Weighted average cost
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23. Cost Formulas
The ending inventory in units is the same in all three methods; the cost is different
The cost of goods sold and the cost of ending inventory are different
The cost of purchases is the same in all three methods
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24. Specific Identification
Each item sold and purchased is individually identified
Required for goods that are not ordinarily interchangeable; and that are produced and segregated for specific projects
Advantages:
Matches actual costs with revenue
Ending inventory reported at specific cost
Disadvantages:
May be costly to implement and maintain
May lead to income manipulation
May be difficult to allocate certain costs (e.g., storage, shipping) to specific inventory items
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25. Weighted Average Cost
Justification for using weighted average cost formula:
Reasonable to cost inventory based on an average cost
Costs assigned closely follows the actual physical flow
Simple to apply, objective, less subject to income manipulation
Ending inventory cost on balance sheet is made up of average costs
Moving-average cost formula refers to a weighted-average method used with perpetual records (both units and dollars)
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26. First-In, First-Out (FIFO)
Advantages:
Attempts to approximate physical flow of goods
Ending inventory made up of most recent costs, therefore close to its replacement cost
Does not permit manipulation of income
Disadvantages:
Current costs not matched to current revenues, as oldest cost of goods are used with current revenue
When prices are changing rapidly, gross profit and net income are distorted
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27. Choice of Cost Formula
Inventory standards limit the choice of cost formula
Specific identification is required in some cases
Should choose the best method that:
1. best reflects the physical flow
2. reflects the most recent costs in the inventory account, and
3. use this method for all inventory assets with same characteristics
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28. Cost Formulas LIFO is not acceptable because:
LIFO does not represent actual inventory flows reliably
Costs assigned to ending inventory (oldest costs) do not represent recent cost of inventory on hand
Can distort reported income on the income statement
LIFO has never been allowed by CRA
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29. Cost Formulas : Example
Call-Mart reports the following transactions for March:
Date Purchases Sales Balance (units)
Beginning
,500 units ,000
,000 units ,000
Sold 4,000 units 4,000
,000 units ,000
Determine the cost of goods sold and the cost of ending inventory, under each cost formula
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30. Weighted-Average Formula
Date Purchases Unit Cost Purchase Cost
March units $3.80 $ 1,900
March 2 1,500 units $4.00 $ 6,000
March 15 6,000 units $4.40 $26,400
March 30 2,000 units $4.75 $ 9,500
10,000 units $43,800
Unit Cost = $43,800  10,000 = $4.38
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Cost of goods available
Cost of goods sold
Ending inventory
$43,800
4,000 X $4.38 = 17,520
6,000 X $4.38 = $26,280

31. Moving-Average Formula
Date Purchases Unit Cost Purchase Cost On Hand
March units $3.80 $ 1, $ 1,900
March 2 1,500 units $4.00 $ 6, $ 7,900
March 15 6,000 units $4.40 $26, $ 34,300
Mar. 19 New Unit Cost calculated – to use for Cost of Goods Sold
$34,300/8,000 units = $4.2875
and $ = $17,150
March 19 4,000 units remaining ,150
March 30 2,000 units $4.75 $ 9, ,650
New Unit Cost calculated—to use as COGS for next sale and for inventory
$26,650/6,000 units = $4.4417
NOTE: With each new purchase, a new average unit cost is determined
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32. First-In, First-Out Formula
Date Purchases Unit Cost Purchase Cost
March units $3.80 $ 1,900
March 2 1,500 units $4.00 $ 6,000
March 15 6,000 units $4.40 $26,400
March 30 2,000 units $4.75 $ 9,500
6,000 units
$4.75 = $ 9,500
$4.40 = 17,600
$27,100
Ending inventory
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$43,800
Cost of goods available
$43,800 - $27,100 = $16,700
Cost of goods sold

33. Basic Valuation Issues
Most inventory is valued using a cost-based system at “lower of cost and net realizable value”
Specialized inventory (e.g. biological assets, including plants and animals) may use a “net realizable value” model (or “fair value less cost to sell”)
Under the typical cost-based system, ending inventory valuation requires answers to each of the following:
Which physical goods should be included as part of inventory?
What costs should be included as part of inventory cost?
What cost formula should be adopted?
Has there been an impairment in value of inventory items held?
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34. Lower of Cost and NRV Inventory is initially recorded at cost
Inventory is valued at the lower of cost and net realizable value (LC&NRV)
Net realizable value (NRV) is the estimated selling price less the estimated costs to complete and sell
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35. Determining Lower of Cost and NRV
Item Cost NRV LC&NRV Spinach $80,000 $ 120,000 $ 80,000 Carrots 100, , ,000 Cut beans 50,000 40,000 40,000 Peas 90,000 72,000 72,000 Mixed vegetables 95,000 92,000 92,000 Final inventory value $ 384,000 Comparison of cost and NRV should be done on an item- by-item basis Grouping inventory for purposes of valuation is permitted only under certain circumstances
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36. Recording the LC&NRV Under the Direct Method:
The Inventory account is recorded at its net realizable value at year end if the NRV is less than cost
Loss becomes part of cost of goods sold on the income statement
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37. Recording Decline in NRV– Direct Method (Perpetual Inventory System)
Inventory At Cost At NRV Adjustment
Beginning $65,000 $65,000 $-0-
End of year $82,000 $70,000 $12,000
Under the Direct method:
Dr. Cost of Goods Sold 12,000
Cr Inventory ,000
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38. Recording Cost vs. NRV Under the Indirect (Allowance) Method:
Inventory reported at cost with declines and recoveries recorded through an Allowance (valuation) account on the balance sheet; a Loss account is reported on the income statement
Recovery of market value decline is recorded up to but not exceeding original cost
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39. Recording Decline in NRV: Indirect Method (Perpetual Inventory System)
Inventory At Cost At NR Adjustment Beginning $65,000 $65,000 $-0- End of year $82,000 $70,000 $12,000 Under the Allowance method: Dr. Loss Due to Decline in NRV 12,000 Cr. Allowance to Reduce Inventory 12,000
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40. Exceptions to the LC&NRV Model
Inventories measured at Net Realizable Value if:
Sale is assured, or there is active market and minimal risk of not completing the sale, and
Costs of disposal can be estimated
Inventories measured at Fair Value Less Cost to Sell include
Inventories of commodity broker-traders
Biological assets and agricultural produce at point of harvest
There is no specific ASPE guidance on measurement of these assets
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41. Gross Profit Method of Estimating Inventory
Gross profit method is used to estimate ending inventory
Estimates may be required in such situations: interim reporting, fire loss, testing reasonableness of cost from an actual inventory count
Method is based on the three assumptions:
Beginning inventory + purchases = cost of goods available for sale
Goods not sold are in ending inventory
Cost of goods available for sale – cost of goods sold = ending inventory
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42. Gross Profit Method: Example
Given:
Beginning inventory (at cost): $ 60,000
Purchases (at cost) : $ 200,000
Sales (at selling price) : $ 280,000
Gross profit percentage on sales: %
Estimate the ending inventory using the gross profit method
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43. Gross Profit Method: Example
Beg. Inventory + Purchases – COGS = Estimated Ending
Inventory
Cost of goods sold = Sales x ( ) = Sales x 70%
$60,000 + $200, ($280,000x0.7) = Ending Inventory
$60,000 + $200, ($196,000) = $64,000
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44. Understanding Markups
Assume you are given markup on cost
What is gross profit on selling price?
Assume markup on cost is 25%
Cost + Gross Profit = Sales ==> C + 25%C = Sales
Cost of goods sold (1 + 25%) = Sales
Cost of goods sold = Sales x (1/1.25)
Gross Profit = Sales x (.25/1.25)
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If Sales is $1, Gross profit % = $1 x (.25/1.25) = 20%
Gross Profit % = Markup % / (1 + markup %)0

45. Disclosure and Presentation
Examples of required disclosures:
Measurement policy
Total inventory, as well as inventory by classification
Amount of inventory recognized as expense on the income statement (usually reported as cost of goods sold)
Any amount of inventory pledged as security for liabilities
IFRS has more disclosure requirements than ASPE
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46. Common ratios Average Days to Sell Inventory: Cost of Goods Sold
Inventory Turnover:
Cost of Goods Sold
Average Inventory
Measures number of times on average inventory was sold during the period
Average Days to Sell Inventory:
365
Inventory Turnover
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47. Comparison of IFRS and ASPE
Major different between IFRS and ASPE relates to a specific IFRS standard covering biological assets and agricultural produce at the point of harvest
ASPE has no specific guidance in this area
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48. Looking Ahead
No major changes are expected in the standards
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49. COPYRIGHT
Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.