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

2. 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

3. 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.”

4. 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

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

6. 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

7. 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)

8. 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

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

10. 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

11. 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

12. 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 $$$
Gross Profit $,$$$

13. 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?

14. 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

15. 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)

16. Example Given for the year 2007: COGS = $1.4 million
Retained Earnings (R/E) = $5.2 million
December 31st inventory errors both discovered after 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

17. Example COGS (as originally stated in 2007) $1,400,000
Add: December 31, 2007 over-
statement error ,000
1,445,000
Less: December 31, 2006 over-
statement error ,000
Corrected 2007 COGS $1,335,000
Retained Earnings (2007 original) $5,200,000
Less: correction for 2007 inventory ,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

18. 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

19. 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

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

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

22. 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

23. 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

24. Cost Formulas : Example
Call-Mart reports the following transactions for March:
Date Purchases Sales Balance (units)
Beginning
,500 units ,000
,000 units ,000
Sold 4,000 units ,000
,000 units ,000
Determine the cost of goods sold and the cost of ending inventory, under each cost formula

25. Weighted-Average Formula
Date Purchases Unit Cost Purchase Cost
March 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

26. Moving-Average Formula
Date Purchases Unit Cost Purchase Cost On Hand
March units $3.80 $ 1,900 $ 1,900
March 2 1,500 units $4.00 $ 6, ,900
March 15 6,000 units $4.40 $26, ,300
Mar. 19 New Unit Cost calculated – to use for Cost of Goods Sold
$34,300/8,000 units = $4.2875
and $ = $17,150
March 19 4,000 units remaining ,150
March 30 2,000 units $4.75 $ 9, ,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

27. 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

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

29. 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

30. 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

31. 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

32. Determining Lower of Cost and NRV
Item Cost NRV LCM
Spinach $80, $ 120, $ 80,000
Carrots , , ,000
Cut beans ,000 40, ,000
Peas ,000 72, ,000
Mixed vegetables 95,000 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

33. 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

34. 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 ,000

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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: %
Estimate the ending inventory using the gross profit method

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

42. 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 %)

43. 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)

44. 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

45. 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

46. COPYRIGHT
Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.