FINANCIAL ACCOUNTING a user perspective Sixth Canadian Edition Prepared by: Lynn de Grace C.A. Chapter 7 Inventory

 Any item purchased by a company for: Resale to customer, or Use in the manufacture of items to be sold to customers  Asset o Has probable future value o Ownership is evidenced by possession and/or legal title Cost of goods sold o Expense when inventory is sold John Wiley & Sons Canada, Ltd. © Suncor Energy Inc. Inventory Note

Inventory Valuation  Inventory is recorded at its cost on the date of acquisition  Income is recognized when inventory is sold  Inventory is carried on the balance sheet at lower of cost or NRV. John Wiley & Sons Canada, Ltd. © What is Net Realizable Value?

Lower of Cost and Net Realizable Value John Wiley & Sons Canada, Ltd. ©2011 LCM rule, can use either: Direct method Ending inventory is reduced to LCM Allowance method Uses contra inventory account: loss due to market decline of inventory 4

DISCUSSION QUESTION John Wiley & Sons Canada, Ltd. ©2011 If a write down of inventory is required, can it be written back up in a subsequent period ? ??? 5

Perpetual Inventory System John Wiley & Sons Canada, Ltd. ©2011  Continual tracking of units and/or costs  A unit sold is immediately removed from the inventory account  Ending inventory and cost of goods sold are up-to-date 6

Perpetual Inventory System John Wiley & Sons Canada, Ltd. ©2011  Entry #1 records the sale: Accounts receivablexx Sales revenuexx  Entry #2 records the cost of goods sold & the reduction in inventory Cost of goods soldxx Inventoryxx 7

Periodic Inventory System John Wiley & Sons Canada, Ltd. ©2011  No entry to record the reduction in inventory at the time of sale  End of the period: Count inventory to determine quantity on hand and assign costs Calculate cost of goods sold Up-to-date information 8

John Wiley & Sons Canada, Ltd. ©2011 Periodic Inventory System Beginning inventory + Purchases + Transportation in = Goods available for sale - Ending inventory = Cost of goods sold 9

Costs and Benefits John Wiley & Sons Canada, Ltd. ©2011  Perpetual system Better information, but higher cost Identifies inventory shrinkage Losses due to theft, damage, or spoilage  Counting inventory is necessary under both systems 10

Cost Flow Assumptions John Wiley & Sons Canada, Ltd. ©2011  First-in, first-out (FIFO) The first item purchased is the first item sold  Weighted average The cost of the items is determined using a weighted average of the cost of the items purchased  Last-in, first-out (LIFO) The last item purchased is the first item sold This method is no longer allowed under Canadian GAAP after IFRS does not permit this method, however it is acceptable under U.S. GAAP. 11

Rhoda’s Appliances Inc – Example Inventory Data John Wiley & Sons Canada, Ltd. ©2011

First-in, First-out (FIFO) John Wiley & Sons Canada, Ltd. ©2011 Sale#1Cost of units sold (16 units) $450 (beginning inventory)$ 2,700 $475 (first purchase) 4,750 16Units$7,450 Ending inventory (5 units) $475 (first purchase)$2,375 13

First-in, First-out (FIFO) John Wiley & Sons Canada, Ltd. ©2011 Sale#2Cost of units sold (10 units) $475 (leftover first purchase)$ 2,375 $480 (second purchase) 2,400 10Units$4,775 Ending inventory (7 units) $480 (second purchase)$3,360 Total Cost of Goods Sold for the period = $7,450 + $4,775 = $12,225 Ending Inventory at the end of the period = $3,360 14

Moving Average John Wiley & Sons Canada, Ltd. ©2011 Sale#1 Moving Average Cost: 6 $450 (beginning inventory)$2, $475 (first purchase) $7,125 = 21 units$9,825 Average unit cost $9,825 ÷ 21$ / unit Cost of Goods sold – First Sale 16 units x $ $7, Ending inventory 5 $ $2,

Moving Average John Wiley & Sons Canada, Ltd. ©2011 Sale#2 Moving Average Cost: 5 units (leftover first purchase)$2, $480(second purchase) $5, = 17 units$8, Average unit cost $8, ÷ 17$ / unit Cost of Goods sold – Second Sale 10 units x $ $4, Ending inventory 7 $ $3, Total Cost of Goods Sold for the period = $7, $4, = $12,250 Ending Inventory at the end of the period = $3,335 16

Financial Statement Results John Wiley & Sons Canada, Ltd. ©2011 Statement of Earnings FIFO Moving Average Sales revenue$19,100 Cost of goods sold 12,225 12,250 Gross profit$6,875 $6,850 Statement of Financial Position Inventory$3,360 $3,335 17

Cost Flow Assumptions and Changing Prices  Rising prices Weighted average: lower net income FIFO: higher net income  Declining prices Weighted average: higher net income FIFO: lower net income  Stable prices Same values for both assumptions John Wiley & Sons Canada, Ltd. ©

International Financial Reporting Standards  Both cost flow assumptions are in accordance with IFRS: Select the method that is the fairest matching of costs with revenues regardless of the actual physical flow of inventory Management objectives will influence choice: At Rhoda’s appliances, moving average will produce smaller profits and therefore result in a lower income tax liability Existence of a current ratio debt covenant can also influence decision Desire to show higher profits to increase management bonuses Disclose methods used in the notes to financial statements. John Wiley & Sons Canada, Ltd. ©

Suncor Energy Inc Annual Report John Wiley & Sons Canada, Ltd. © Excerpted from the Notes to the Financial Statements, Summary of significant accounting policies.

Inventory Issues for Management  Safeke ep ing the inventory Management is responsible for ensuring that internal controls are in place to safeguard the inventory Physical controls Segregation of duties  Cost of inventory storage  Cost of insurance  Cost of handling  Risk of Obsolescence  Auditors play an important role. John Wiley & Sons Canada, Ltd. ©

Inventory Estimation John Wiley & Sons Canada, Ltd. ©2011  Sometimes necessary to estimate inventory levels during the year  Cost-to-Sales Ratio Also called the gross margin estimation method Sales revenue x Normal cost-to-sales ratio = Cost of goods sold Beginning inventory + Purchases – COGS = Ending Inventory 22 from the accounting records

Inventory Ratios John Wiley & Sons Canada, Ltd. ©2011 Inventory turnover Average inventory Cost of goods sold = # Days to sell inventory = 365 Inventory Turnover 23 This ratio tells the user how fast inventory is sold or how long it is held before it is sold.

Inventory Turnover John Wiley & Sons Canada, Ltd. ©2011 Inventory turnover (SEK 10,240 + SEK 8,500) / 2 SEK 38,919 = = 4.15 # Days to sell inventory = = 88 days For H & M- 2009: 24 H&M Financial Statements Nov

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