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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Slide1Slide2
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
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