TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 8 CHAPTER 8 Inventory

TENTH CANADIAN EDITION

INTERMEDIATE ACCOUNTING

Prepared by:

Dragan Stojanovic, CARotman School of Management,

University of Toronto

CHAPTER 8Inventory

Kieso • Weygandt • Warfield • Young • Wiecek • McConomy

CHAPTER

Copyright © John Wiley & Sons Canada, Ltd.

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

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CHAPTER

Copyright © John Wiley & Sons Canada, Ltd.

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

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4Copyright © John Wiley & Sons Canada, Ltd.

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 Analysis•Presentation and disclosure of inventories

•Analysis

IFRS / ASPE Comparison•Comparison of IFRS and ASPE

•Looking ahead


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


Inventory Cost Flows

Manufacturing Operations

$$$ COGM $$$

Raw Materials

Direct Labour

Mfg. Overhead

COGS

$$$

Work in Process

Inventory

Finished

Goods

COGS


Inventory

• Definition of Inventory:

Inventories are “assets:(a) held for sale in the ordinary course of

business;

(b) in the process of production for such sale; or

(c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.”


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:1. Goods in transit (if seller has title during

shipment, i.e., if shipped f.o.b. destination)2. Goods out on consignment3. Goods sold under buyback agreements4. Goods sold with high rates of return that

cannot be estimated


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)


Example

Given for the year 2014:

COGS = $1.4 million

Retained Earnings (R/E) = $5.2 million

December 31st 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, 2014


Example

COGS (as originally stated in 2014) $1,400,000Add: 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) $5,200,000Less: correction for 2014 inventory 45,000Retained Earnings (2014 restated) $5,155,000Note: 2013 inventory error is self-corrected as it was discovered after the books for 2014 were closed


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 costs



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 value



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.


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


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 periodically


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)


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


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 $6

Provide all journal entries under each system.


Perpetual System

7,200 Sales

(600 units x $12)

7,2003,600Inventory

(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

InventoryPurchase

Record Sales RevenueRecord Inventory ChangesTransaction


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 entrySale

PurchasesPurchase

Return

Record Sales RevenueRecord Inventory ChangesDate


Cost Formulas

IFRS and ASPE recognize three acceptable cost formulas:

1. Specific identification

2. First-in, First-out (FIFO)

3. Weighted average cost


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


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


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)


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


Choice of Cost Formula

• Inventory standards limit the choice of cost formula

• 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


Cost Formulas

• LIFO is not acceptable because:1. LIFO does not represent actual inventory

flows reliably

2. Costs assigned to ending inventory (oldest costs) do not represent recent cost of inventory on hand

3. Can distort reported income on the income statement

• LIFO has never been allowed by CRA


Cost Formulas : Example

Call-Mart reports the following transactions for March:

Date Purchases Sales Balance (units)

1 Beginning (500 @$3.80) 500

2 1,500 units (@$4.00) 2,00015 6,000 units (@$4.40) 8,00019 Sold 4,000 units 4,00030 2,000 units (@$4.75) 6,000

Determine the cost of goods sold and the cost of ending inventory, under each cost formula


Weighted-Average Formula

Date Purchases Unit Cost Purchase CostMarch 1 500 units $3.80 $ 1,900March 2 1,500 units $4.00 $ 6,000March 15 6,000 units $4.40 $26,400March 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


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 determined


First-In, First-Out Formula

Date Purchases Unit Cost Purchase CostMarch 1 500 units $3.80 $ 1,900March 2 1,500 units $4.00 $ 6,000March 15 6,000 units $4.40 $26,400March 30 2,000 units $4.75 $ 9,500

$43,800 - $27,100 = $16,700

6,000 units2,000 @ $4.75 = $ 9,5004,000 @ $4.40 = 17,600

$27,100

$43,800

Ending inventory

Cost of goods sold

Cost of goods available


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:

1. Which physical goods should be included as part of inventory?2. What costs should be included as part of inventory cost?3. What cost formula should be adopted?4. Has there been an impairment in value of inventory items held?


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 sell


Determining Lower of Cost and NRV

Item Cost NRV LC&NRVSpinach $80,000 $ 120,000 $ 80,000Carrots 100,000 100,000 100,000Cut beans 50,000 40,000 40,000Peas 90,000 72,000 72,000Mixed vegetables 95,000 92,000 92,000Final 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 circumstances


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 statement


Recording Decline in NRV– Direct Method (Perpetual

Inventory System)Inventory At Cost At NRV

AdjustmentBeginning $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 12,000


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 cost


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 Inventory12,000


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 assets


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:1. Beginning inventory + purchases = cost of goods

available for sale

2. Goods not sold are in ending inventory

3. Cost of goods available for sale – cost of goods sold = ending inventory


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: 30%

• Estimate the ending inventory using the gross profit method


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)= $64,000


Understanding Markups

• Assume markup on cost is 25%

Cost + Gross Profit = Sales ==> C + 25%C = Sales

Cost of goods sold (1 + 25%) = SalesCost 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?


Disclosure and Presentation

• Examples of required disclosures:1. Measurement policy2. Total inventory, as well as inventory by classification3. Amount of inventory recognized as expense on the

income statement (usually reported as cost of goods sold)

4. Any amount of inventory pledged as security for liabilities

• IFRS has more disclosure requirements than ASPE


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


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 area


Looking Ahead

• No major changes are expected in the standards


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.

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TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 8 CHAPTER 8 Inventory