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TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 8 CHAPTER 8 Inventory.

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Presentation on theme: "TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 8 CHAPTER 8 Inventory."— Presentation transcript:

1 TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 8 CHAPTER 8 Inventory Kieso Weygandt Warfield Young Wiecek McConomy

2 CHAPTER Copyright © John Wiley & Sons Canada, Ltd. 8 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. Inventory 2

3 CHAPTER Copyright © John Wiley & Sons Canada, Ltd. 8 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. Inventory 3

4 4 Copyright © John Wiley & Sons Canada, Ltd. Inventory Understanding Inventory What types of companies have inventory? Inventory categories Inventory planning and control Information for decision-making 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 Recognition Accounting definition Physical goods included in inventory Inventory errors Presentation, Disclosure, and Analysis Presentation and disclosure of inventories Analysis IFRS / ASPE Comparison Comparison of IFRS and ASPE Looking ahead

5 5 Copyright © John Wiley & Sons Canada, Ltd. 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

6 6 Copyright © John Wiley & Sons Canada, Ltd. Inventory Cost Flows Manufacturing Operations $$$ COGM $$$ Raw Materials Direct Labour Mfg. Overhead COGS $$$ Work in Process Inventory Finished Goods COGS

7 7 Copyright © John Wiley & Sons Canada, Ltd. Inventory Definition of Inventory: Inventories are assets: (a)held for sale in the ordinary course of business; (b)in the process of production for such sale; or (c)in the form of materials or supplies to be consumed in the production process or in the rendering of services.

8 8 Copyright © John Wiley & Sons Canada, Ltd. 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 sellers inventory: 1.Goods in transit (if seller has title during shipment, i.e., if shipped f.o.b. destination) 2.Goods out on consignment 3.Goods sold under buyback agreements 4.Goods sold with high rates of return that cannot be estimated

9 9 Copyright © John Wiley & Sons Canada, Ltd. Effect of Inventory Errors Error inEffect 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)

10 10 Copyright © John Wiley & Sons Canada, Ltd. Example Given for the year 2014: COGS = $1.4 million Retained Earnings (R/E) = $5.2 million December 31 st 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

11 11 Copyright © John Wiley & Sons Canada, Ltd. Example COGS (as originally stated in 2014)$1,400,000 Add: December 31, 2014 over- statement error 45,000 1,445,000 Less: December 31, 2013 over- statement error 110,000 Corrected 2014 COGS$1,335,000 Retained Earnings (2014 original) $5,200,000 Less: correction for 2014 inventory 45,000 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 12 Copyright © John Wiley & Sons Canada, Ltd. 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

13 13 Copyright © John Wiley & Sons Canada, Ltd. 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

14 14 Copyright © John Wiley & Sons Canada, Ltd. 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.

15 15 Copyright © John Wiley & Sons Canada, Ltd. 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

16 16 Copyright © John Wiley & Sons Canada, Ltd. 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

17 17 Copyright © John Wiley & Sons Canada, Ltd. 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)

18 18 Copyright © John Wiley & Sons Canada, Ltd. 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

19 19 Copyright © John Wiley & Sons Canada, Ltd. 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.

20 20 Copyright © John Wiley & Sons Canada, Ltd. Perpetual System 7,200 Sales (600 units x $12) 7,200 3,600Inventory (600 units x $6) 300 3,600 Accounts Payable (900 units x $6) 5,400 Accounts Receivable Accounts Payable Inventory (50 units x $6) Cost of goods sold Purchase Return Sale Inventory Purchase Record Sales RevenueRecord Inventory ChangesTransaction

21 21 Copyright © John Wiley & Sons Canada, Ltd. Periodic System 5, Purchases Inventory (beg.) 3,600 2, Cost of goods sold Inventory (end - count) Purchases Returns Year-End Adjusting Entry 7,200 Sales (600 units x $12) 7,200 Accounts Payable (900 units x $6) Accounts Payable Purch. Returns and Allowances 5, ,400 Accounts Receiv.No entrySale PurchasesPurchase Return Record Sales RevenueRecord Inventory ChangesDate

22 22 Copyright © John Wiley & Sons Canada, Ltd. Cost Formulas IFRS and ASPE recognize three acceptable cost formulas: 1. Specific identification 2. First-in, First-out (FIFO) 3. Weighted average cost

23 23 Copyright © John Wiley & Sons Canada, Ltd. 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

24 24 Copyright © John Wiley & Sons Canada, Ltd. 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

25 25 Copyright © John Wiley & Sons Canada, Ltd. 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)

26 26 Copyright © John Wiley & Sons Canada, Ltd. 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

27 27 Copyright © John Wiley & Sons Canada, Ltd. 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

28 28 Copyright © John Wiley & Sons Canada, Ltd. Cost Formulas LIFO is not acceptable because: 1. LIFO does not represent actual inventory flows reliably 2. Costs assigned to ending inventory (oldest costs) do not represent recent cost of inventory on hand 3. Can distort reported income on the income statement LIFO has never been allowed by CRA

29 29 Copyright © John Wiley & Sons Canada, Ltd. Cost Formulas : Example Call-Mart reports the following transactions for March: Date Purchases SalesBalance (units) 1 Beginning ,500 units 2, ,000 units 8, Sold 4,000 units 4, ,000 units 6,000 Determine the cost of goods sold and the cost of ending inventory, under each cost formula

30 30 Copyright © John Wiley & Sons Canada, Ltd. Weighted-Average Formula Date PurchasesUnit CostPurchase Cost March units$3.80$ 1,900 March 21,500 units$4.00$ 6,000 March 156,000 units$4.40$26,400 March 302,000 units$4.75$ 9,500 10,000 units $43,800 Unit Cost = $43,800 10,000 = $4.38 Cost of goods availableCost of goods soldEnding inventory $43,8004,000 X $4.38 = 17,5206,000 X $4.38 = $26,280

31 31 Copyright © John Wiley & Sons Canada, Ltd. Moving-Average Formula Date PurchasesUnit Cost Purchase Cost On Hand March units$3.80$ 1,900 $ 1,900 March 21,500 units$4.00$ 6,000 $ 7,900 March 156,000 units$4.40$26,400 $ 34,300 Mar. 19 New Unit Cost calculated – to use for Cost of Goods Sold $34,300/8,000 units = $ and $ = $17,150 March 194,000 units remaining 17,150 March 302,000 units$4.75$ 9,500 26,650 New Unit Cost calculatedto use as COGS for next sale and for inventory $26,650/6,000 units = $ NOTE: With each new purchase, a new average unit cost is determined

32 32 Copyright © John Wiley & Sons Canada, Ltd. First-In, First-Out Formula Date PurchasesUnit CostPurchase Cost March units$3.80$ 1,900 March 21,500 units$4.00$ 6,000 March 156,000 units$4.40$26,400 March 302,000 units$4.75$ 9,500 $43,800 - $27,100 = $16,700 6,000 units $4.75=$ 9,500 $4.40= 17,600 $27,100 $43,800 Ending inventory Cost of goods sold Cost of goods available

33 33 Copyright © John Wiley & Sons Canada, Ltd. 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: 1.Which physical goods should be included as part of inventory? 2.What costs should be included as part of inventory cost? 3.What cost formula should be adopted? 4.Has there been an impairment in value of inventory items held?

34 34 Copyright © John Wiley & Sons Canada, Ltd. 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

35 35 Copyright © John Wiley & Sons Canada, Ltd. Determining Lower of Cost and NRV Item Cost NRV LC&NRV Spinach $80,000 $ 120,000 $ 80,000 Carrots 100, , ,000 Cut beans 50,00040,000 40,000 Peas 90,00072,000 72,000 Mixed vegetables95,00092,000 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

36 36 Copyright © John Wiley & Sons Canada, Ltd. 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

37 37 Copyright © John Wiley & Sons Canada, Ltd. Recording Decline in NRV– Direct Method (Perpetual Inventory System) Inventory At CostAt 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 Sold12,000 Cr. Inventory 12,000

38 38 Copyright © John Wiley & Sons Canada, Ltd. 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

39 39 Copyright © John Wiley & Sons Canada, Ltd. Recording Decline in NRV: Indirect Method (Perpetual Inventory System) InventoryAt CostAt 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

40 40 Copyright © John Wiley & Sons Canada, Ltd. 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

41 41 Copyright © John Wiley & Sons Canada, Ltd. 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: 1. Beginning inventory + purchases = cost of goods available for sale 2. Goods not sold are in ending inventory 3. Cost of goods available for sale – cost of goods sold = ending inventory

42 42 Copyright © John Wiley & Sons Canada, Ltd. 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: 30% Estimate the ending inventory using the gross profit method

43 43 Copyright © John Wiley & Sons Canada, Ltd. Gross Profit Method: Example Beg. Inventory + Purchases – COGS = Estimated Ending Inventory Cost of goods sold = Sales x ( ) = Sales x 70% $60,000 + $200,000 - ($280,000x0.7) = Ending Inventory $60,000 + $200,000 - ($196,000)= $64,000

44 44 Copyright © John Wiley & Sons Canada, Ltd. Understanding Markups 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) If Sales is $1, Gross profit % = $1 x (.25/1.25) = 20% Gross Profit % = Markup % / (1 + markup %)0 Assume you are given markup on cost What is gross profit on selling price?

45 45 Copyright © John Wiley & Sons Canada, Ltd. Disclosure and Presentation Examples of required disclosures: 1.Measurement policy 2.Total inventory, as well as inventory by classification 3.Amount of inventory recognized as expense on the income statement (usually reported as cost of goods sold) 4.Any amount of inventory pledged as security for liabilities IFRS has more disclosure requirements than ASPE

46 46 Copyright © John Wiley & Sons Canada, Ltd. Common ratios 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

47 47 Copyright © John Wiley & Sons Canada, Ltd. 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

48 48 Copyright © John Wiley & Sons Canada, Ltd. Looking Ahead No major changes are expected in the standards

49 49 Copyright © John Wiley & Sons Canada, Ltd. 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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