1. Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

2. C H A P T E R 8 Inventory: Recognition and Measurement Inventory: Recognition and Measurement

3. 1.Identify major classifications of inventory. 2.Distinguish between perpetual and periodic inventory systems. 3.Identify the effects of inventory errors on the financial statements. 4.Identify the items that should be included as inventory cost. Learning Objectives

4. 5.Explain the difference between variable costing and absorption costing in assigning manufacturing costs to inventory. 6.Distinguish between the physical flow of inventory and the cost flow assigned to inventory. 7.Identify possible objectives for inventory valuation decisions. Learning Objectives

5. 8.Describe and compare the cost flow assumptions used in accounting for inventories. 9.Evaluate LIFO as a basis for understanding the differences among the cost flow methods. 10.Explain the importance of judgement in selecting an inventory cost flow method. Learning Objectives

6. Inventory: Recognition and Measurement Inventory Classification and Control Classification Management and control Basic valuation issues Costs Included in Inventory “Basket” purchases Purchase discounts Product costs Period costs Manufacturing costs Variable versus absorption costing Standard costs Physical Goods Included in Inventory Goods in transit Consigned goods Special sales agreements Effect of inventory errors Cost Flow Assumptions Framework for analysis Specific identification Average cost FIFOLIFO Evaluation and Choice Advantages of LIFO Disadvantages of LIFO Summary analysis Which method to select? Consistency

7. Inventory Classification Inventory consists of:Inventory consists of: –Assets held for sale in the ordinary course of business, or –Goods to be consumed in the production of finished goods A merchandising concern has one inventory account:A merchandising concern has one inventory account: –Merchandise Inventory A manufacturing concern will normally have three inventory accounts:A manufacturing concern will normally have three inventory accounts: –Raw materials –Work in process –Finished goods

8. Inventory Cost Flows Merchandising Operations Cost of goods sold $$$ MerchandiseInventory PurchasesCOGS

9. Inventory Cost Flows Work in Process Inventory $$$COGM Manufacturing Operations FinishedGoods $$$ Raw Materials Labour Mfg. Overhead COGS COGS $$$

10. Inventory Control Inventory control is important for:Inventory control is important for: - Ensuring availability of inventory items - Preventing excessive accumulation of inventory items The perpetual system maintains a continuous record of inventory changesThe perpetual system maintains a continuous record of inventory changes The periodic system updates inventory records only periodicallyThe periodic system updates inventory records only periodically

11. Perpetual System Purchases and sales of inventory recorded directly to Inventory accountPurchases and sales of inventory recorded directly to Inventory account Inventory purchases, freight, purchase returns and discounts are debited/credited to the Inventory accountInventory purchases, freight, purchase returns and discounts are debited/credited to the Inventory account Cost of Goods Sold (COGS) is debited and Inventory is credited for each saleCost of Goods Sold (COGS) is debited and Inventory is credited for each sale Subsidiary ledger maintained for individual inventory itemsSubsidiary ledger maintained for individual inventory items Periodic inventory counts still required to ensure reliabilityPeriodic inventory counts still required to ensure reliability Any differences in counted and recorded quantities are posted to a separate account – Inventory Over and ShortAny differences in counted and recorded quantities are posted to a separate account – Inventory Over and Short

12. Periodic System Inventory purchases recorded as a debit to Purchases accountInventory purchases recorded as a debit to Purchases account COGS is a calculation on the Income StatementCOGS is a calculation on the Income Statement Physical inventory is counted periodicallyPhysical inventory is counted periodically Under both periodic and perpetual inventory systems, physical counts of inventory are conducted at least once a yearUnder both periodic and perpetual inventory systems, physical counts of inventory are conducted at least once a year

13. Perpetual and Periodic Systems: Example Fesmire Limited reports the following data: Beginning Inventory :100 units at $6 Beginning Inventory :100 units at $6 Purchases: (all credit)900 units at $6 Purchases: (all credit)900 units at $6 Sales:(all credit)600 units at $12 Sales:(all credit)600 units at $12 Ending Inventory:400 units at $6 Ending Inventory:400 units at $6 Provide all journal entries under each system.

14. Perpetual System Transaction Record Inventory Changes Record Sales Revenue PurchaseInventory5,400 Accounts Payable Accounts Payable (900 units x $6) 5,400 Sale Cost of goods sold 3,600 Accounts Receivable 7,200 Inventory (600 units x $6) 3,600 Sales Sales (600 units x $12) 7,200

15. Periodic System Date Record Inventory Changes Record Sales Revenue PurchasePurchases5,400 Accounts Payable Accounts Payable (900 units x $6) 5,400 Sale No entry Accounts Receiv. 7,200 Sales Sales (600 units x $12) 7,200 Year-End Adjusting Entry Cost of goods sold Inventory (ending) 3,6002,400 Purchases Inventory (beg.) 5,400600

16. Financial Statement Presentation Net Sales$,$$$ Cost of Goods Sold $$$ Gross Profit$,$$$ Net Sales $,$$$ Cost of Goods Sold: Opening Inventory $$$ Add: Net Purchases $$$ Cost of Goods Available for Sale $,$$$ Less: Ending Inventory $$$ Ending Inventory $$$ Cost of Goods Sold $$$ Gross Profit $,$$$ PerpetualPeriodic

17. Basic Valuation Issues Ending inventory valuation requires answers to each of the following: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 flow assumption should be adopted?

18. Items to Be Included in Inventory Legal title to goods determines inclusionLegal title to goods determines inclusion The following goods are included in the seller’s inventory:The following goods are included in the seller’s inventory: 1.Goods in transit (if seller has title during shipment) 2.Goods out on consignment 3.Goods sold under buyback agreements 4.Goods sold with high rates of return that cannot be estimated 5.Instalment sales (if collectibility cannot be estimated)

19. Effect of Inventory Errors EndingEffect on Income Effect on Balance InventoryStatement Items Sheet Items Under-COGS (over) Retained Earnings (under) statedNet Income (under) Working Capital (under) Over-COGS (under) Retained Earnings (over) statedNet Income (over) Working Capital (over) As an example, consider Brief Exercise 8-10

20. Brief Exercise 8-10 Given for the year 2005: COGS = $1.4 million Retained Earnings (R/E) = $5.2 million December 31 st inventory errors: 2004: overstated by $110,000 2005: overstated by $45,000 Calculate correct COGS and R/E for December 31, 2005

21. COGS (as originally stated)$1,400,000 Add: December 31, 2005 over- statement error 45,000 statement error 45,000 1,445,000 1,445,000 Less: December 31, 2004 over- statement error 110,000 statement error 110,000 Corrected COGS $1,335,000 Retained Earnings (original) $5,200,000 Less: correction for 2005 inventory 45,000 Retained Earnings (restated)$5,155,000 Note: 2004 inventory error self-corrected Brief Exercise 8-10

22. Costs Included in Inventory Costs included in inventory are known as “inventoriable costs”Costs included in inventory are known as “inventoriable costs” These costs include:These costs include: –Product costs (direct materials, direct labour and manufacturing overhead) –Purchase (net) costs, and freight-in Period costs (selling and administrative) are not inventoriable costsPeriod costs (selling and administrative) are not inventoriable costs “Basket” purchases total cost allocated to units based on relative sales value“Basket” purchases total cost allocated to units based on relative sales value

23. Inventory Valuation: Variable costing Under variable costing, inventory costs include only the following manufacturing costs:Under variable costing, inventory costs include only the following manufacturing costs: –Direct materials used –Direct labour –Variable manufacturing overhead Fixed manufacturing overhead is treated as a period costFixed manufacturing overhead is treated as a period cost All period costs are ignoredAll period costs are ignored Variable costing is appropriate for internal decision-makingVariable costing is appropriate for internal decision-making

24. Inventory Valuation: Absorption Costing Under absorption costing, inventory costs include all manufacturing costs as follows:Under absorption costing, inventory costs include all manufacturing costs as follows: –Direct materials used –Direct labour –Variable manufacturing overhead –Fixed manufacturing overhead All other costs are period costs and are ignoredAll other costs are period costs and are ignored Both methods are acceptable, but absorption costing is generally used in CanadaBoth methods are acceptable, but absorption costing is generally used in Canada

25. Cost Flow Assumptions The objective is to most clearly reflect periodic incomeThe objective is to most clearly reflect periodic income Cost flow assumptions need not be consistent with physical flow of goodsCost flow assumptions need not be consistent with physical flow of goods Objectives of choosing an inventory valuation method are to:Objectives of choosing an inventory valuation method are to: 1.Realistically match expenses against revenue 2.Report inventory at a realistic amount 3.Minimize income taxes

26. Cost Flow Assumptions The cost flow assumptions are: 1. Specific identification 2. Average cost 3. First-in, First-out (FIFO) 4. Last-in, First-out (LIFO)

27. Cost Flow Assumptions: Notes The ending inventory in units is the same in all four methods: the cost is differentThe ending inventory in units is the same in all four methods: the cost is different The cost of goods sold and the cost of ending inventory are differentThe cost of goods sold and the cost of ending inventory are different The cost of purchases is the same in all four methodsThe cost of purchases is the same in all four methods LIFO results in the smallest reported net income (with rising prices)LIFO results in the smallest reported net income (with rising prices)

28. Cost Flow Assumptions: Example Call-Mart reports the following transactions for March Date Purchases (Sold) Balance 1beginning inventory (@$3.80)500 21,500 units(@$4.00) 2,000 156,000 units (@$4.40) 8,000 19(4,000 units sold) 4,000 19(4,000 units sold) 4,000 302,000 units (@$4.75) 6,000 302,000 units (@$4.75) 6,000 Determine the cost of goods sold and the cost of ending inventory, under each cost flow assumption.

29. Specific Identification Items sold and purchased are individually identified as to costItems sold and purchased are individually identified as to cost Works best with items that are unique, high cost, with small numbers held as inventoryWorks best with items that are unique, high cost, with small numbers held as inventory Advantage:Advantage: –Matches actual costs with revenue Disadvantages:Disadvantages: –May be costly to implement and maintain –May lead to income manipulation

30. Weighted-Average Method Date PurchasesUnit CostPurchase Cost March 1500 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 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 Method Cost of goods available Cost of goods sold Ending inventory $43,800 4,000 X $4.2875 = 17,150 6,000 X $4.4417 = $26,650 Date PurchasesUnit CostPurchase CostOn Hand March 1500 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 New Unit Cost calculated – to use as Cost of Goods Sold $34,300/8,000 units = $4.2875 March 19(4,000) units sold 17,150 March 302,000 units$4.75$ 9,500 26,650 New Unit Cost calculated—to use as COGS for next sale and for inventory $26,650/6,000 units = $4.4417

32. Average Cost Method Average unit cost calculated (and used for COGS) with each new purchase with moving averageAverage unit cost calculated (and used for COGS) with each new purchase with moving average Seen as a compromise between LIFO and FIFOSeen as a compromise between LIFO and FIFO Advantages:Advantages: –Easy to apply, objective, not as subject to income manipulation –Provides income tax minimization during rising prices Disadvantage:Disadvantage: –Recent costs reflected in COGS, older costs reflected in Inventory

33. First-In, First-Out Method Date PurchasesUnit CostPurchase Cost March 1500 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 2,000 @ $4.75=$ 9,500 4,000 @ $4.40= 17,600 $27,100 $43,800 Ending inventory Cost of goods sold Cost of goods available

34. First-In, First-Out Method Advantages: Attempts to approximate physical flow of goodsAttempts to approximate physical flow of goods Ending inventory close to current costEnding inventory close to current costDisadvantages: Current costs not matched to current revenuesCurrent costs not matched to current revenues –Oldest cost of goods are used with current sale price In times of rapidly increasing prices, leads to gross profit and net income distortionsIn times of rapidly increasing prices, leads to gross profit and net income distortions

35. Last-In, First-Out Method Date PurchasesUnit CostPurchase Cost March 1500 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 – $25,500 = $18,300 6,000 units 500 @ $3.80=$ 1,900 500 @ $3.80=$ 1,900 1,500 @ $4.00= 6,000 4,000 @ $4.40= 17,600 $25,500 $43,800 2,000 @ $4.40 = $ 8,800 2,000 @ $4.75 = 9,500 $18,300 $18,300 Cost of goods sold Cost of goods available Ending inventory

36. Advantages of LIFO Method Matches more recent costs with current revenuesMatches more recent costs with current revenues Under LIFO, the need to write down inventory to market is minimizedUnder LIFO, the need to write down inventory to market is minimized

37. Disadvantages of LIFO Method Results in lowest net income and hence reduced earningsResults in lowest net income and hence reduced earnings Ending inventory is understatedEnding inventory is understated Does not approximate physical flow of goods except in special situationsDoes not approximate physical flow of goods except in special situations LIFO liquidation may result in income that is not appropriateLIFO liquidation may result in income that is not appropriate May cause poor buying habits (layer liquidation)May cause poor buying habits (layer liquidation) Not accepted by CCRA for tax purposesNot accepted by CCRA for tax purposes Current (replacement) cost measurement lostCurrent (replacement) cost measurement lost

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