FINANCIAL ACCOUNTING A USER PERSPECTIVE Hoskin Fizzell Davidson Second Canadian Edition

Inventory Chapter Seven

Inventory Any item purchased by a company for –resale to customers, or –use in the manufacture of items to be sold to customers

Inventory Asset: has probable future value Ownership is evidenced by possession Cost of goods sold: the expense when inventory is sold

Valuation Criteria Historical Cost –Inventory recorded at its cost on the date it was acquired –Income recognized when inventory is sold

Valuation Criteria Market Value –Wholesale market –Input or entry market Replacement cost –Output or exit market Net realizable value (NRV)

Valuation Criteria Canadian practice –Historical cost –Apply a lower of cost or market (LCM) rule at the end of the period Market is either replacement cost or net realizable value

Acquisition Costs Inventory value –Include all laid-down costs invoice price, plus duties, tariffs, freight and cartage costs –Transportation in (freight in) may be assigned to inventory or treated as a period cost

Manufacturing Company Raw materials purchased –used to make new products Work-in-process inventory –includes raw materials used, direct labour, and overhead costs Finished goods inventory –transferred in costs of finished goods

Manufacturing Cost Flows A-Raw materials A-Work- in-process A-Finished goods XX +Labour costs + Overhead YY SE-Cost of goods sold YY

Lower of Cost and Market Lower of cost or market for inventories, using either: –Direct method Ending inventory is reduced –Allowance method Uses Loss Due to Market Decline of Inventory account

Lower of Cost and Market Cost of beginning inventory + Purchases + Transportation in = Goods available for sale – Ending inventory = Cost of goods sold

Inventory Systems Perpetual Inventory System Periodic Inventory System

Perpetual Inventory System Keeps track of units and/or costs on a continual basis When a unit is sold, it is immediately removed from the inventory account Inventory ending balance can be computed at any time

Perpetual Inventory System Ending inventory balances and cost of goods sold accounts are always up to date Information is most timely for decision-making purposes

Periodic Inventory System No entry to record the reduction in inventory at the time of sale Count inventory to determine quantity on hand and assign costs Cost of goods sold is calculated Information is not up to date during the period

Costs and Benefits Perpetual system –provides better information, but at higher cost –can identify inventory shrinkage losses due to theft, damage or spoilage Counting inventory is necessary under both systems

Cost Flow Assumptions Assumptions for cost flows, not physical flows of goods Methods: –Specific identification –First-in, first-out (FIFO) –Last-in, first-out (LIFO) –Weighted average

Cost Flow Assumptions Specific Identification –Each unit of inventory is identifiable –The cost of each unit is matched to the specific unit FIFO –The first item purchased is the first item sold

Cost Flow Assumptions LIFO –The last 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

Ted’s Toasters, Inc. Inventory of toasters

Ted’s Toasters, Inc. Sale Record

First-In, First-Out (FIFO) Purchases First-in, first-out FIFO Cost of goods sold Last-in, still-here LISH Ending inventory

First-In, First-Out (FIFO)

Last-In, First-Out (LIFO) Purchases Last-in, first-out LIFO Cost of goods sold First-in, still-here FISH Ending inventory Layer 3 Layer 2 Layer 1

Last-In, First-Out (LIFO)

Weighted Average Purchases Weighted average Cost of goods sold Weighted average Ending inventory

Weighted Average

Financial Statement Results

Cash Flow Assumption Choice All three assumptions are in accordance with GAAP GAAP –select the method that represents the fairest match of costs with revenues regardless of the actual physical flow of inventory

Cost Flow Assumptions and Changing Prices Rising prices –LIFO: lowest net income –FIFO: highest net income Deflation –opposite to rising prices Stable prices –same values for each assumption

Inventory Estimation Cost-to-Sales Ratio –Also called the gross margin estimation method Sales revenue x Normal cost-to-sales ratio = Cost of goods sold

Inventory Turnover Inventory turnover Average Inventory Cost of goods sold = Days of inventory = 365 Inventory Turnover

Inventory turnover ($2,050,703 + $2,270,909) / 2 $7,691,231 = Days of inventory = = = days

Inventory Turnover Inventory turnover 1999 Days of inventory days days