Patricia Zima, CA Mohawk College of Applied Arts and Technology Chapter 8 Inventory Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology

Inventory Introduction GAAP update What is inventory? Types of inventory Inventory accounting systems Inventory issues Determining Inventory Cost Physical goods included in inventory Effect of inventory errors What is “cost”? Cost formulas Exceptions to “cost” Balance Sheet Valuation Rationale for lower of cost and net realizable value Application of lower of cost and net realizable value Evaluation of lower of cost and net realizable value Purchase commitment issues Estimating Inventory The need for estimates Applying the gross profit method Gross profit percentage vs. markup on cost Using the results Presentation, Perspectives, and International Standards Disclosures and presentation of inventories Perspectives and analysis Comparison: Canadian and international GAAP Appendices 8A and 8B A-Retail method of estimating inventory cost B-U.S. methods: LIFO and LCM

Inventory Definition of Inventory (Section 3031.06): 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.”

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

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

Inventory Control 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

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)

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

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

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

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

Financial Statement Presentation Perpetual Periodic 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 $$$ Gross Profit $,$$$

Basic Valuation Issues 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? Is cost the appropriate balance sheet value?

Items to Be Included in Inventory Legal title to goods 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 FOB Destination) Goods out on consignment Goods sold under buyback agreements Goods sold with high rates of return that cannot be estimated

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)

Example Given for the year 2007: COGS = $1.4 million Retained Earnings (R/E) = $5.2 million December 31st inventory errors both discovered after 2007 books were closed: 2006: inventory overstated by $110,000 2007: inventory overstated by $45,000 Calculate correct 2007 COGS and R/E at Dec. 31, 2007

Example COGS (as originally stated in 2007) $1,400,000 Add: December 31, 2007 over- statement error 45,000 1,445,000 Less: December 31, 2006 over- statement error 110,000 Corrected 2007 COGS $1,335,000 Retained Earnings (2007 original) $5,200,000 Less: correction for 2007 inventory 45,000 Retained Earnings (2007 restated) $5,155,000 Note: 2006 inventory error is self-corrected as it was discovered after the books for 2007 were closed

Costs Included in Inventory Inventory cost includes “all costs of purchases, 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

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 Interest or borrowing costs: generally expensed if routinely manufactured “Basket” purchases and joint product costs: total cost allocated to units based on relative sales value

Cost Formulas GAAP recognizes three acceptable cost formulas: 1. Specific identification 2. First-in, First-out (FIFO) 3. Weighted average cost

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 LIFO is no longer an acceptable cost formula (see next slide)

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

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

Cost Formulas : Example Call-Mart reports the following transactions for March: Date Purchases Sales Balance (units) 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

Weighted-Average Formula Date Purchases Unit Cost Purchase Cost March 1 500 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 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

Moving-Average Formula Date Purchases Unit Cost Purchase Cost On Hand March 1 500 units $3.80 $ 1,900 $ 1,900 March 2 1,500 units $4.00 $ 6,000 7,900 March 15 6,000 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 19 4,000 units remaining 17,150 March 30 2,000 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

Average Cost Formula Justification for using 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

First-In, First-Out Formula Date Purchases Unit Cost Purchase Cost March 1 500 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 2,000 @ $4.75 = $ 9,500 4,000 @ $4.40 = 17,600 $27,100 Ending inventory $43,800 Cost of goods available $43,800 - $27,100 = $16,700 Cost of goods sold

First-In, First-Out Formula 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

Choice of Cost Formula The new inventory standards limit the choice 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

Valuation of Inventory Inventory is initially recorded at cost Inventory is valued at the lower of cost and net realizable value (“market” is defined as net realizable value as per HB section 3031 – effective in 2007) Net realizable value (NRV) is the estimated selling price less the estimated disposal costs Previously, inventory was valued at lower of cost and market where “market” had several different meanings

Determining Lower of Cost and NRV Item Cost NRV LCM Spinach $80,000 $ 120,000 $ 80,000 Carrots 100,000 100,000 100,000 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 The new accounting standard says to compare cost and NRV on an item-by-item basis (same as CRA rules) A comparison of total inventory cost and total market is permitted only under certain circumstances

Recording Market vs. Cost 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

Recording Decline in Market – Direct Method (Perpetual Inventory System) Inventory At Cost At Market 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 12,000

Recording Market vs. Cost 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

Recording Decline in Market: Indirect Method (Perpetual Inventory System) Inventory At Cost At Market 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

Purchase Commitments Where a company commits to purchase inventory, but title has not passed to the buyer Purchase commitments are disclosed in the notes to the financial statements If the agreement is subject to cancellation, purchase commitments are not disclosed

Purchase Commitments Non-cancellable purchase contracts are not recorded, but if material, they are disclosed in the notes to the financial statements If the contracted price exceeds market price at the balance sheet date and the loss is likely to occur at time of purchase and loss is reasonably determinable, then record loss in the period in which the decline in price occurs

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

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

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

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) If Sales is $1, Gross profit % = $1 x (.25/1.25) = 20% Gross Profit % = Markup % / (1 + markup %)

Disclosure and Presentation Disclosures required: Cost formula used (e.g., FIFO Method) The basis of inventory valuation on the balance sheet (i.e., lower of cost and NRV) Any amount of inventory pledged as security for liabilities Amount of inventory recognized as expense on the income statement (usually reported as cost of goods sold)

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

Canadian and International GAAP Canadian and international GAAP for inventory are substantially converged Significant differences exist for: construction contracts, borrowing costs, purchase commitments, and the measurement of agricultural products, some of which are not addressed in primary Canadian GAAP

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