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8 Inventory After studying this chapter, you should be able to:

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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 L01

6 Manufacturing Operations
Inventory Cost Flows Manufacturing Operations Raw Materials Direct Labour Mfg. Overhead Work in Process Inventory Finished Goods $$$ COGM $$$ COGS L01 $$$ 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.” L02

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 L03

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) L04

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 L04

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 L04 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 L05

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 L05

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. L05

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 L05

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 L06

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) L06

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 L06

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. L06

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 L06

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 L06

22 Cost Formulas IFRS and ASPE recognize three acceptable cost formulas: 1. Specific identification 2. First-in, First-out (FIFO) 3. Weighted average cost L07

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 L07

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 L07

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) L07

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 L07

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 L07

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 L07

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 L07

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 L07 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 L07

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 L07 $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? L08

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 L08

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 L08

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 L08

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 L08

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 L08

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 L08

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 L09

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 L10

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 L10

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 L10

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) L10 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 L11

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 L12

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 L13

48 Looking Ahead No major changes are expected in the standards L13

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.

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