1. Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 8 Inventory Chapter 8 Inventory

2. 2 Inventory Introduction Definition Inventory categories Accounting guidance Inventory under the lower of cost and NRV model Other Inventory Issues Inventory errors Estimating inventory Recognition and Measurement Physical goods included in inventory Costs included in inventory cost Inventory accounting systems Cost formulas Lower of cost and net realizable value Recognition of inventory costs as an expense Exceptions to the lower of cost and NRV model Presentation, Disclosure, and Analysis Presentation and disclosure of inventories Analysis IFRS / Private Entity GAAP Comparison Comparison of IFRS and private entity GAAP Looking ahead

3. 3 Inventory Introduction Definition Inventory categories Accounting guidance Inventory under the lower of cost and NRV model Other Inventory Issues Inventory errors Estimating inventory Recognition and Measurement Physical goods included in inventory Costs included in inventory cost Inventory accounting systems Cost formulas Lower of cost and net realizable value Recognition of inventory costs as an expense Exceptions to the lower of cost and NRV model Presentation, Disclosure, and Analysis Presentation and disclosure of inventories Analysis IFRS / Private Entity GAAP Comparison Comparison of IFRS and private entity GAAP Looking ahead

4. 4 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.”

5. 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

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

7. 7 Inventory Introduction Definition Inventory categories Accounting guidance Inventory under the lower of cost and NRV model Other Inventory Issues Inventory errors Estimating inventory Recognition and Measurement Physical goods included in inventory Costs included in inventory cost Inventory accounting systems Cost formulas Lower of cost and net realizable value Recognition of inventory costs as an expense Exceptions to the lower of cost and NRV model Presentation, Disclosure, and Analysis Presentation and disclosure of inventories Analysis IFRS / Private Entity GAAP Comparison Comparison of IFRS and private entity GAAP Looking ahead

8. 8 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?

9. 9 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: 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

10. 10 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

11. 11 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

12. 12 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 private entity GAAP, interest costs may be either capitalized or expensed, but policy must be disclosed.

13. 13 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

14. 14 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)

15. 15 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

16. 16 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.

17. 17 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

18. 18 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) 7,200 Accounts Payable (900 units x $6) Accounts Payable Purch. Returns and Allowances 5,400 300 5,400 Accounts Receiv.No entrySale PurchasesPurchase Return Record Sales RevenueRecord Inventory ChangesDate

19. 19 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 $,$$$ Less: Ending Inventory $$$ Cost of Goods Sold $$$ Gross Profit $,$$$ PerpetualPeriodic

20. 20 Cost Formulas IFRS and private entity GAAP recognize three acceptable cost formulas: 1. Specific identification 2. First-in, First-out (FIFO) 3. Weighted average cost

21. 21 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

22. 22 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

23. 23 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)

24. 24 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

25. 25 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

26. 26 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

27. 27 Cost Formulas : Example Call-Mart reports the following transactions for March: Date Purchases SalesBalance (units) 1 Beginning (500 @$3.80) 500 2 1,500 units (@$4.00) 2,000 15 6,000 units (@$4.40) 8,000 19 Sold 4,000 units 4,000 30 2,000 units (@$4.75) 6,000 Determine the cost of goods sold and the cost of ending inventory, under each cost formula

28. 28 Weighted-Average Formula Date PurchasesUnit CostPurchase Cost March 1 500 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

29. 29 Moving-Average Formula Date PurchasesUnit Cost Purchase CostOn Hand March 1 500 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 = $4.2875 and 4,000 @ $4.2875 = $17,150 March 194,000 units remaining 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 NOTE: With each new purchase, a new average unit cost is determined

30. 30 First-In, First-Out Formula Date PurchasesUnit CostPurchase Cost March 1 500 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

31. 31 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

32. 32 Determining Lower of Cost and NRV Item Cost NRV LC&NRV Spinach $80,000 $ 120,000 $ 80,000 Carrots 100,000 100,000 100,000 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

33. 33 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

34. 34 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

35. 35 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

36. 36 Recording Decline in NRV: Indirect Method (Perpetual Inventory System) InventoryAt CostAt NRVAdjustment 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 Inventory12,000

37. 37 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 private entity GAAP) –Onerous contracts are contracts where unavoidable costs to complete the contract are higher than expected benefits

38. 38 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 private entity GAAP guidance on measurement of these assets

39. 39 Inventory Introduction Definition Inventory categories Accounting guidance Inventory under the lower of cost and NRV model Other Inventory Issues Inventory errors Estimating inventory Recognition and Measurement Physical goods included in inventory Costs included in inventory cost Inventory accounting systems Cost formulas Lower of cost and net realizable value Recognition of inventory costs as an expense Exceptions to the lower of cost and NRV model Presentation, Disclosure, and Analysis Presentation and disclosure of inventories Analysis IFRS / Private Entity GAAP Comparison Comparison of IFRS and private entity GAAP Looking ahead

40. 40 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)

41. 41 Example Given for the year 2011: COGS = $1.4 million Retained Earnings (R/E) = $5.2 million December 31 st inventory errors both discovered after 2011 books were closed: 2010: inventory overstated by $110,000 2011: inventory overstated by $45,000 Calculate correct 2011 COGS and R/E at Dec. 31, 2011

42. 42 COGS (as originally stated in 2011)$1,400,000 Add: December 31, 2011 over- statement error 45,000 1,445,000 Less: December 31, 2010 over- statement error 110,000 Corrected 2011 COGS$1,335,000 Retained Earnings (2011 original) $5,200,000 Less: correction for 2011 inventory 45,000 Retained Earnings (2011 restated)$5,155,000 Note: 2010 inventory error is self-corrected as it was discovered after the books for 2011 were closed Example

43. 43 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

44. 44 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

45. 45 Gross Profit Method: Example Beg. Inventory + Purchases – COGS = Estimated Ending Inventory Cost of goods sold = Sales x (1 - 0.3) = Sales x 70% $60,000 + $200,000 - ($280,000x0.7) = Ending Inventory $60,000 + $200,000 - ($196,000)= $64,000

46. 46 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 %) Assume you are given markup on cost What is gross profit on selling price?

47. 47 Inventory Introduction Definition Inventory categories Accounting guidance Inventory under the lower of cost and NRV model Other Inventory Issues Inventory errors Estimating inventory Recognition and Measurement Physical goods included in inventory Costs included in inventory cost Inventory accounting systems Cost formulas Lower of cost and net realizable value Recognition of inventory costs as an expense Exceptions to the lower of cost and NRV model Presentation, Disclosure, and Analysis Presentation and disclosure of inventories Analysis IFRS / Private Entity GAAP Comparison Comparison of IFRS and private entity GAAP Looking ahead

48. 48 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 private entity GAAP

49. 49 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

50. 50 Inventory Introduction Definition Inventory categories Accounting guidance Inventory under the lower of cost and NRV model Other Inventory Issues Inventory errors Estimating inventory Recognition and Measurement Physical goods included in inventory Costs included in inventory cost Inventory accounting systems Cost formulas Lower of cost and net realizable value Recognition of inventory costs as an expense Exceptions to the lower of cost and NRV model Presentation, Disclosure, and Analysis Presentation and disclosure of inventories Analysis IFRS / Private Entity GAAP Comparison Comparison of IFRS and private entity GAAP Looking ahead

51. 51 Comparison of IFRS and private entity GAAP Major different between IFRS and private entity GAAP relates to a specific IFRS standard covering biological assets and agricultural produce at the point of harvest Private entity GAAP has no specific guidance in this area

52. 52 Looking Ahead No major changes are expected in the standards

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