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8 After studying this chapter, you should be able to: 8 After studying this chapter, you should be able to:

8 After studying this chapter, you should be able to: - PowerPoint Presentation

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8 After studying this chapter, you should be able to: - PPT Presentation

Understand inventory from a business perspective Define inventory from an accounting perspective Identify which inventory items should be included in ending inventory Identify the effects of inventory errors on the financial statements and adjust for them ID: 241792

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Slide1
Slide2

8

After studying this chapter, you should be able to:

Understand inventory from a business perspective.Define inventory from an accounting perspective.Identify which inventory items should be included in ending inventory.Identify the effects of inventory errors on the financial statements and adjust for them.Determine the components of inventory cost.Distinguish between perpetual and periodic inventory systems and account for them.Identify and apply GAAP cost formula options and indicate when each cost formula is appropriate.

Inventory

2Slide3

8

After studying this chapter, you should be able to:

(continued)Explain why inventory is measured at the lower of cost and market, and apply the lower of cost and net realizable value standard.Identify inventories that are or may be valued at amounts other than the lower of cost and net realizable value.Apply the gross profit method of estimating inventory.Identify how inventory should be presented and the type of inventory disclosures required by ASPE and IFRS.Explain how inventory analysis provides useful information and apply ratio analysis to inventory.

Identify differences in accounting between ASPE and IFRS, and what changes are expected in the near future.

Inventory

3Slide4

Inventory

Understanding Inventory

What types of companies have inventory?

Inventory categories

Inventory planning and control

Information for decision-making

Measurement

Costs included in inventory

Inventory accounting systems

Cost formulas

Lower of cost and net realizable value

Exceptions to the lower of cost and NRV model

Estimating inventory

Recognition

Accounting definition

Physical goods included in inventory

Inventory errors

Presentation, Disclosure, and AnalysisPresentation and disclosure of inventoriesAnalysis

IFRS / ASPE Comparison

Comparison of IFRS and ASPE

Looking aheadSlide5

Inventory Classification

Inventory is classified as a

current assetA 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 Slide6

Inventory Cost Flows

Manufacturing Operations

$$$

COGM

$$$

Raw Materials

Direct

Labour

Mfg. Overhead

COGS

$$$

Work in Process

Inventory

Finished

Goods

COGSSlide7

Inventory

Definition of Inventory:

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.”Slide8

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:

Goods in transit (if seller has title during shipment, i.e., if shipped f.o.b. destination)

Goods out on consignment

Goods sold under buyback agreements

Goods sold with high rates of return that cannot be estimatedSlide9

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)Slide10

Example

Given for the year 2014:

COGS = $1.4 million

Retained Earnings (R/E) = $5.2 million

December 31

st

inventory errors both discovered after 2014 books were closed:

2013: inventory overstated by $110,000

2014: inventory overstated by $45,000

Calculate correct 2014 COGS and R/E at Dec. 31, 2014Slide11

Example

COGS (as originally stated in 2014) $1,400,000

Add: December 31, 2014 over-

statement error

45,000

1,445,000

Less: December 31, 2013 over-

statement error

110,000

Corrected 2014 COGS

$1,335,000

Retained Earnings (2014 original) $5,200,000

Less: correction for 2014 inventory

45,000

Retained Earnings (2014 restated)

$5,155,000Note: 2013 inventory error is self-corrected as it was discovered after the books for 2014 were closedSlide12

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 costsSlide13

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 valueSlide14

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 ASPE, interest costs may be either capitalized or expensed, but policy must be disclosed. Slide15

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 ASPE)

Onerous contracts

are contracts where unavoidable costs to complete the contract are higher than expected benefits Slide16

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 periodicallySlide17

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)Slide18

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 accountsSlide19

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 $6Provide all journal entries under each system.Slide20

Perpetual System

7,200

Sales

(600 units x $12)

7,200

3,600

Inventory

(600 units x $6)

300

300

3,600

Accounts Payable

(900 units x $6)

5,400

5,400

Accounts Receivable

Accounts Payable

Inventory

(50 units x $6)

Cost of goods sold

Purchase Return

Sale

Inventory

Purchase

Record Sales Revenue

Record Inventory Changes

TransactionSlide21

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

300

5,400

Accounts Receiv.

No entry

Sale

Purchases

Purchase

Return

Record Sales Revenue

Record Inventory Changes

DateSlide22

Cost Formulas

IFRS and ASPE recognize three acceptable cost formulas:

1. Specific identification 2.

First-in, First-out (FIFO)

3.

Weighted average costSlide23

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 methodsSlide24

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 projectsAdvantages:

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 itemsSlide25

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)Slide26

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 Slide27

Choice of Cost Formula

Inventory standards

limit the choice of cost formulaSpecific 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 characteristicsSlide28

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 CRASlide29

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 formulaSlide30

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 = 17,5206,000 X $4.38 = $26,280Slide31

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 determinedSlide32

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

$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 availableSlide33

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:

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?

Has there been an impairment in value of inventory items held?Slide34

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 sellSlide35

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 50,000 40,000 40,000

Peas 90,000 72,000 72,000

Mixed vegetables 95,000 92,000

92,000

Final inventory value $

384,000

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 circumstancesSlide36

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 statementSlide37

Recording Decline in NRV– Direct Method (Perpetual Inventory System)

Inventory

At Cost At 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 Sold 12,000

Cr. Inventory 12,000Slide38

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 costSlide39

Recording Decline in NRV: Indirect Method (Perpetual Inventory System)

Inventory

At Cost At NR

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 12,000Slide40

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 ASPE guidance on measurement of these assetsSlide41

Gross Profit Method of Estimating Inventory

Gross profit method is used to

estimate ending inventoryEstimates 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 inventorySlide42

Gross Profit Method: Example

Given:

Beginning inventory (at cost): $ 60,000Purchases (at cost) : $ 200,000

Sales (at selling price) : $ 280,000

Gross profit percentage on sales: 30%

Estimate the ending inventory using the gross profit methodSlide43

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) = $64,000Slide44

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 %)0

Assume you are given markup on cost

What is gross profit on selling price?Slide45

Disclosure and Presentation

Examples of required disclosures:

Measurement policy

Total inventory, as well as inventory by classification

Amount of inventory recognized as expense on the income statement (usually reported as cost of goods sold)

Any amount of inventory pledged as security for liabilities

IFRS has more disclosure requirements than ASPESlide46

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

Slide47

Comparison of IFRS and ASPE

Major different between IFRS and ASPE relates to a specific IFRS standard covering biological assets and agricultural produce at the point of harvest

ASPE has no specific guidance in this areaSlide48

Looking Ahead

No major changes are expected in the standardsSlide49

COPYRIGHT

Copyright © 2013 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.