FA2: Module 7
Inventories and Cost of Goods Sold
1.
2.
3.
4.
5.
6.
7.
8.
9.
Definition of inventory
Cost of inventory
Inventory systems
Effect of inventory errors
Costing inventory
Inventory valuation
The gross profit method
Retail inventory method
Valuation of inventory at NRV
1. Definition of inventory
Inventory includes goods awaiting sale, goods
in various stages of production and supplies.
Inventory is a current asset.
Type of firm
Manufacturing
Composition of inventory
Retail/wholesale
Raw materials, work in
process, finished goods,
supplies
Merchandise, supplies
Service
Supplies
Inventory definition problems
Any inventory items held for resale or use by
company should be included in inventory if it
is owned by the company, regardless of
location:
-items out on consignment (held by an agent
who pays for items only if they sell)
-purchased items in transit that are FOB (free
on board) shipping point
-sold items in transit that are FOB destination
Inventory definition problems (cont’d)
The following items should be excluded from
inventory:
-items belonging to another firm that are held
on consignment
-purchased items that are awaiting return to
vendor for credit
-items purchased with a repurchase
agreement, when it is likely that the items will
be returned
2. Cost of inventory
Inventory is initially valued at historical cost,
which includes all costs necessary to acquire
the inventory and prepare it for sale (laiddown cost); plus transportation. (e. g., A8-1)
Type of firm
Retail and
Wholesale
Items included in cost of inventory
Purchase price less discounts,
sales tax, import tariffs,
packaging, transportation
Manufacturing Cost of raw materials, direct
labour cost, factory overhead
3. Inventory systems
Periodic inventory system
System of recording inventory-related
transactions (purchases, sales) wherein
Inventory and Cost of Goods Sold are updated
only once per period.
Perpetual inventory system
System of recording inventory-related
transactions (purchases, sales) wherein
Inventory and Cost of Goods Sold are updated
after each inventory-related transaction.
Bookkeeping: Periodic vs. perpetual systems
Event
Purchase
Sale
Perpetual
Dr. Inventory
Cr. AP
Dr. AR/Cash
Cr. Revenue
Dr. COGS
Cr. Inventory
Physical count Dr. Inv shrinkage
of closing
Cr. Inventory
inventory
(if necessary)
Periodic
Dr. Purchases
Cr. AP
Dr. AR/Cash
Cr. Revenue
Dr. Inv (ending)
Dr. COGS
Cr. Purchases
Cr. Inv (beg.)
Inventory vs. cost of goods sold
Beginning inventory
+
Purchases or Goods manufactured
=
Cost of goods available for sale
=
Cost of goods sold
+
Ending inventory
4. Effect of inventory errors
Inventory errors affect both the balance sheet
(inventory is misstated) and the income
statement (COGS or inventory shortage is
misstated). Inventory errors are
counterbalancing (reverse over time).
Year 1
Year 2
Beginning inv
OK
Error
+ Purchases
OK
OK
-Ending inventory
Error
OK
= Cost of goods sold Error
Error
Effect of inventory errors (periodic)
This year’s
financial
statements
Ending
inventory
overstated
Next year’s
financial statements
COGS understated COGS overstated
Inc overstated
Inc understated
Assets overstated Assets OK
Ending
COGS overstated COGS understated
inventory Inc understated
Inc overstated
understated Assets understated Assets OK
Example: Storm Company
Year 1 Year 2
Sales
$120 $131
Cost of goods sold
96
76
Other expenses
20
20
Net income
4
35
Retained earnings, January 1
47
51
Retained earnings, December 31
$51
$86
Year 1 ending inventory was understated by $12.
The error was not discovered until year 2. Storm
uses a periodic inventory system. What is the
effect of the error on income and cost of goods
sold?
5. Costing inventory (and COGS)
a. Specific identification
b. First-in, first-out (FIFO)
c. Average cost
Example: A8-25
a. Specific identification
Definition: Keep track of each item in
inventory (e. g., by serial number). Identify
each item sold (and its cost) to determine
COGS; identify items left in inventory (and
their costs) to determine ending inventory.
Comments:
•best possible matching of revenue and COGS
but vulnerable to manipulation by management
•administratively cumbersome
•used for valuable and easily identifiable
merchandise
b. First-in, first-out (FIFO)
Definition: Assume that oldest units in
inventory are first ones sold (e. g., perishable
goods in a grocery store).
Comments
•“Favours” the balance sheet: Most current
costs are included in cost of inventory, while
oldest costs are in COGS. Net income is
therefore (perhaps) less relevant.
•Eliminates opportunities for income
manipulation by management.
c. Average cost
Definition
Compute one average cost figure for all units
of inventory = total cost of goods available for
sale divided by total number of units available
for sale. COGS = units sold X average cost.
Inventory = units left X average cost.
Comments
•Single, convenient, cost
6. Inventory valuation: Lower of cost or
net realizable value
Historical cost vs. market value
Historical cost is one of the basic principles of
Canadian financial accounting. Historical
cost is abandoned, however, when the future
utility (revenue-generating ability) of the asset
is no longer as great as its original cost.
For inventory, market value is generally taken
to be net realizable value, expected selling
price less predictable completion and selling
costs.
Applying the lower of cost or NRV rule
1. Determine cost using acceptable method
2. Compare the cost to net realizable value
and adjust carrying value if necessary
The lower of cost or NRV rule is usually
applied on an item-by-item basis, but can be
applied on a category-by-category basis if
goods within category are very similar.
Previous writedowns should be recovered as
reduction in COGS, although amount of
recovery must be disclosed in notes.
Lower of cost or NRV: Bookkeeping
1. Direct method
If NRV < cost, ending inventory is recorded at
NRV. Any valuation loss is buried in Cost of
Goods Sold.
2. Indirect (Allowance) method
Ending inventory is recorded at cost. If NRV
< cost, a valuation allowance (contra-asset
account) is established to record any decline
below cost; and a loss is recorded.
Lower of cost or NRV: Bookkeeping
2. Indirect (Allowance) method
• The valuation allowance is only adjusted
once per period
• The valuation allowance can never have a
debit balance (i. e., inventory cannot be
written up to some value greater than its
cost)
Example: The allowance method
Assume allowance Account balances at Dec. 31,
balance is 0 before
2011 2012 2013 2014
Dec. 31, 2011
Inventory @ cost
$900
$700
Inventory @ NRV
850
730
Req’d allowance
Adj to allowance
Increase (decrease)
in income
$800 $700
770
680
Lower of cost or NRV example
A8-8
7. The gross profit method
On occasion, estimation methods are used to
approximate inventory on hand. The gross
profit method is one of these and is usually
not acceptable for annual financial statement
purposes. However, it is useful when a
physical count of inventory is impractical or
impossible, e. g.,:
-interim financial reports
-Estimates of damaged or lost inventory
The gross profit method: Nuts and bolts
Beginning inventory
BI
+ Net purchases
P
Goods available for sale (at cost)
BI+P
Net sales (at selling price)
REV
Less gross profit
GP= % x REV
- Cost of goods sold
REV-GP
Approximate inv. (at cost) BI+P – (REV-GP)
*Assumes it is possible to estimate GP%.
Example: A8-21
8. The retail inventory method
Basic steps
1. Determine cost of goods available for sale
at cost and retail.
2. Compute cost ratio (ratio of cost to retail
value of goods available for sale)
3. Compute closing inventory at retail (goods
available at retail, less sales)
4. Compute closing inventory at cost
(closing inv. at retail X cost ratio)
Markups and markdowns
Markup: initial amount added to cost to
determine selling price
Additional markup: increase in selling price
above original selling price
Additional markup cancellation: Cancellation of
some or all of additional markup
Markdown: Reduction in original sales price
Markdown cancellation: Increase in sales price
after markdown (not above original sales
price)
Markups and markdowns and retail method
A standard application of the retail method
includes net additional markups and net
markdowns (markups/markdowns less
cancellations) in the retail value of goods
available for sale (in step 3), but excludes net
markdowns from the denominator of the cost
ratio (in step 2).
This results in a lower cost ratio that
approximates the application of the lower of cost
or NRV rule.
Example: A8-21
9. Valuation of inventory at NRV
Under certain, relatively rare, circumstances,
inventory is valued at net realizable value
regardless of cost. This can occur when:
• Revenue is recognized at the point of
production (e. g., biological assets,
agricultural produce, minerals) if this is
widely use in the industry
• Financial instruments held for trading (by
securities dealers)
• Damaged or obsolete goods