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
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53