Chapter 8 Inventory Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Inventory Introduction •Definition Recognition and Measurement Other Inventory Issues •Inventory categories •Physical goods included in inventory •Inventory errors •Accounting guidance •Costs included in inventory cost •Inventory under the lower of cost and NRV model •Inventory accounting systems •Estimating inventory Presentation, Disclosure, and Analysis IFRS / Private Entity GAAP Comparison •Presentation and disclosure of inventories •Comparison of IFRS and private entity GAAP •Looking ahead •Analysis •Cost formulas •Lower of cost and net realizable value •Recognition of inventory costs as an expense •Exceptions to the lower of cost and NRV model 2 Inventory Introduction •Definition Recognition and Measurement Other Inventory Issues •Inventory categories •Physical goods included in inventory •Inventory errors •Accounting guidance •Costs included in inventory cost •Inventory under the lower of cost and NRV model •Inventory accounting systems •Estimating inventory Presentation, Disclosure, and Analysis IFRS / Private Entity GAAP Comparison •Presentation and disclosure of inventories •Comparison of IFRS and private entity GAAP •Looking ahead •Analysis •Cost formulas •Lower of cost and net realizable value •Recognition of inventory costs as an expense •Exceptions to the lower of cost and NRV model 3 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.” 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 Inventory Cost Flows Manufacturing Operations Raw Materials Direct Labour Work in Process Inventory $$$ COGM Finished Goods $$$ COGS Mfg. Overhead $$$ COGS 6 Inventory Introduction •Definition Recognition and Measurement Other Inventory Issues •Inventory categories •Physical goods included in inventory •Inventory errors •Accounting guidance •Costs included in inventory cost •Inventory under the lower of cost and NRV model •Inventory accounting systems •Estimating inventory Presentation, Disclosure, and Analysis IFRS / Private Entity GAAP Comparison •Presentation and disclosure of inventories •Comparison of IFRS and private entity GAAP •Looking ahead •Analysis •Cost formulas •Lower of cost and net realizable value •Recognition of inventory costs as an expense •Exceptions to the lower of cost and NRV model 7 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? 8 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 consignment 3. Goods sold under buyback agreements 4. Goods sold with high rates of return that cannot be estimated 9 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 10 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 value 11 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 private entity GAAP, interest costs may be either capitalized or expensed, but policy must be disclosed. 12 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 13 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 14 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 15 Perpetual and Periodic Systems: Example Fesmire Limited reports the following data: Beginning Inventory : Purchases: (all credit) Defective units (returned) Sales: (all credit) Ending Inventory: 100 units at $6 900 units at $6 50 units at $6 600 units at $12 350 units at $6 Provide all journal entries under each system. 16 Perpetual System Transaction Purchase Record Inventory Changes Inventory 5,400 Accounts Payable (900 units x $6) Purchase Return Sale Accounts Payable Inventory (50 units x $6) Cost of goods sold Inventory (600 units x $6) Record Sales Revenue 5,400 300 300 Accounts Receivable 3,600 3,600 Sales (600 units x $12) 7,200 7,200 17 Periodic System Date Purchase Record Inventory Changes Purchases 5,400 Accounts Payable (900 units x $6) Return Sale Accounts Payable Purch. Returns and Allowances Record Sales Revenue 5,400 300 300 No entry Accounts Receiv. Sales (600 units x $12) Year-End Adjusting Entry 7,200 7,200 Cost of goods sold 3,600 Inventory (end - count) 2,100 Purchases Returns 300 Purchases Inventory (beg.) 5,400 600 18 Financial Statement Presentation Perpetual Net Sales $,$$$ Cost of Goods Sold $$$ Gross Profit $,$$$ Periodic Net Sales Cost of Goods Sold: Opening Inventory Add: Net Purchases Cost of Goods for Sale $,$$$ Less: Ending Inventory Cost of Goods Sold Gross Profit $,$$$ $$$ $$$ Available $$$ $$$ $,$$$ 19 Cost Formulas IFRS and private entity GAAP recognize three acceptable cost formulas: 1. Specific identification 2. First-in, First-out (FIFO) 3. Weighted average cost 20 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 21 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 22 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 weightedaverage method used with perpetual records (both units and dollars) 23 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 24 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 25 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 26 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) 2,000 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 formula 27 Weighted-Average Formula Date March 1 March 2 March 15 March 30 Purchases 500 units 1,500 units 6,000 units 2,000 units Unit Cost $3.80 $4.00 $4.40 $4.75 10,000 units Purchase Cost $ 1,900 $ 6,000 $26,400 $ 9,500 $43,800 Unit Cost = $43,800 10,000 = $4.38 Cost of goods available $43,800 Cost of goods sold 4,000 X $4.38 = 17,520 Ending inventory 6,000 X $4.38 = $26,280 28 Moving-Average Formula Date • March 1 • March 2 • March 15 Purchases 500 units 1,500 units 6,000 units Unit Cost $3.80 $4.00 $4.40 Purchase Cost $ 1,900 $ 6,000 $26,400 On Hand $ 1,900 7,900 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 March 30 4,000 units remaining 2,000 units $4.75 $ 9,500 17,150 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 29 First-In, First-Out Formula Date March 1 March 2 March 15 March 30 Purchases 500 units 1,500 units 6,000 units 2,000 units Ending inventory Cost of goods available Cost of goods sold Unit Cost $3.80 $4.00 $4.40 $4.75 Purchase Cost $ 1,900 $ 6,000 $26,400 $ 9,500 6,000 units 2,000 @ $4.75 = $ 9,500 4,000 @ $4.40 = 17,600 $27,100 $43,800 $43,800 - $27,100 = $16,700 30 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 31 Determining Lower of Cost and NRV Item Cost Spinach $80,000 Carrots 100,000 Cut beans 50,000 Peas 90,000 Mixed vegetables 95,000 Final inventory value NRV $ 120,000 100,000 40,000 72,000 92,000 LC&NRV $ 80,000 100,000 40,000 72,000 92,000 $ 384,000 Comparison of cost and NRV should be done on an item-byitem basis Grouping inventory for purposes of valuation is permitted only under certain circumstances 32 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 33 Recording Decline in NRV– Direct Method (Perpetual Inventory System) Inventory Beginning End of year At Cost $65,000 $82,000 Under the Direct method: Dr. Cost of Goods Sold Cr. Inventory At NRV Adjustment $65,000 $70,000 $-0$12,000 12,000 12,000 34 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 35 Recording Decline in NRV: Indirect Method (Perpetual Inventory System) Inventory Beginning End of year At Cost $65,000 $82,000 At NRV $65,000 $70,000 Under the Allowance method: Dr. Loss Due to Decline in NRV 12,000 Cr. Allowance to Reduce Inventory Adjustment $-0$12,000 12,000 36 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 private entity GAAP) – Onerous contracts are contracts where unavoidable costs to complete the contract are higher than expected benefits 37 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 private entity GAAP guidance on measurement of these assets 38 Inventory Introduction •Definition Recognition and Measurement Other Inventory Issues •Inventory categories •Physical goods included in inventory •Inventory errors •Accounting guidance •Costs included in inventory cost •Inventory under the lower of cost and NRV model •Inventory accounting systems •Estimating inventory Presentation, Disclosure, and Analysis IFRS / Private Entity GAAP Comparison •Presentation and disclosure of inventories •Comparison of IFRS and private entity GAAP •Looking ahead •Analysis •Cost formulas •Lower of cost and net realizable value •Recognition of inventory costs as an expense •Exceptions to the lower of cost and NRV model 39 Effect of Inventory Errors Error in End Inv. Effect on Income Statement Items Effect on Balance Sheet Items Understated -COGS (over) -Retained Earnings (under) -Net Income (under) -Working Capital (under) -Current ratio (under) Overstated -COGS (under) -Retained Earnings (over) -Net Income (over) -Working Capital (over) -Current ratio (over) 40 Example Given for the year 2011: COGS = $1.4 million Retained Earnings (R/E) = $5.2 million December 31st inventory errors both discovered after 2011 books were closed: 2010: inventory overstated by $110,000 2011: inventory overstated by $45,000 Calculate correct 2011 COGS and R/E at Dec. 31, 2011 41 Example COGS (as originally stated in 2011) $1,400,000 Add: December 31, 2011 overstatement error 45,000 1,445,000 Less: December 31, 2010 overstatement error 110,000 Corrected 2011 COGS $1,335,000 Retained Earnings (2011 original) $5,200,000 Less: correction for 2011 inventory 45,000 Retained Earnings (2011 restated) $5,155,000 Note: 2010 inventory error is self-corrected as it was discovered after the books for 2011 were closed 42 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 43 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 44 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 45 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 %) 46 Inventory Introduction •Definition Recognition and Measurement Other Inventory Issues •Inventory categories •Physical goods included in inventory •Inventory errors •Accounting guidance •Costs included in inventory cost •Inventory under the lower of cost and NRV model •Inventory accounting systems •Estimating inventory Presentation, Disclosure, and Analysis IFRS / Private Entity GAAP Comparison •Presentation and disclosure of inventories •Comparison of IFRS and private entity GAAP •Looking ahead •Analysis •Cost formulas •Lower of cost and net realizable value •Recognition of inventory costs as an expense •Exceptions to the lower of cost and NRV model 47 Disclosure and Presentation • Examples of required disclosures: 1. Measurement policy 2. Total inventory, as well as inventory by classification 3. 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 private entity GAAP 48 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 49 Inventory Introduction •Definition Recognition and Measurement Other Inventory Issues •Inventory categories •Physical goods included in inventory •Inventory errors •Accounting guidance •Costs included in inventory cost •Inventory under the lower of cost and NRV model •Inventory accounting systems •Estimating inventory Presentation, Disclosure, and Analysis IFRS / Private Entity GAAP Comparison •Presentation and disclosure of inventories •Comparison of IFRS and private entity GAAP •Looking ahead •Analysis •Cost formulas •Lower of cost and net realizable value •Recognition of inventory costs as an expense •Exceptions to the lower of cost and NRV model 50 Comparison of IFRS and private entity GAAP • Major different between IFRS and private entity GAAP relates to a specific IFRS standard covering biological assets and agricultural produce at the point of harvest • Private entity GAAP has no specific guidance in this area 51 Looking Ahead • No major changes are expected in the standards 52 COPYRIGHT Copyright © 2010 John Wiley & Sons Canada, Ltd. 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