Intermediate Accounting
Thomas H. Beechy
Schulich School of Business,
York University
Joan E. D. Conrod
Faculty of Management,
Dalhousie University
PowerPoint slides by:
Bruce W. MacLean,
Faculty of Management,
Dalhousie University
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Chapter 9
Inventories
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Importance Of Inventories
■
■
■
■
■
Inventories typically represent the largest current asset
of manufacturing and retail firms. Inventory should be
considered a “high-risk” asset.
For many companies, inventories are a
significant portion of total assets as well.
Inventory accounting methods and management
practices can become profit-enhancing tools.
Inventory effects on profits are more noticeable
when business activity fluctuates
Topics: Types of inventory, Basic cost flow
assumptions,Valuation issues and Estimation methods
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Inventory Categories
■
■
■
■
Inventories consist of costs that have been incurred in an
earnings process that are held as an asset until the
earnings process is complete.
Inventory may include a wider range of costs incurred and
held in an inventory account for matching against revenue
that will be recognized later.
Items that may be capital assets to one company may be
inventory to another.
The major classifications of inventories depend on the
operations of the business.
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Inventory Categories
■
Merchandise inventory – Goods on hand purchased by a retailer or a trading company
such as an importer or exporter for resale.
■
Production inventory
– Raw materials inventory - Tangible goods purchased or obtained
in other ways (e.g., by mining) and on hand for direct use in the
manufacture or further processing of goods for resale. Parts or
subassemblies manufactured before use are sometimes classified
as component parts inventory.
– Work-in-process inventory - Goods or natural resources requiring
further processing before completion and sale. Work-in-process
inventory includes the cost of direct material and direct labour
incurred to date, and usually some allocation of overhead costs.
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Inventory Categories
■
■
■
■
Finished goods inventory - Manufactured or fully processed items
completed and held for sale. Finished goods inventory cost includes
the cost of direct material, direct labour, and allocated manufacturing
overhead related to its manufacture
Production supplies inventory - Items on hand, such as lubrication
oils for the machinery, cleaning materials, as well as small items that
make up an insignificant part of the finished product, such as bolts or
glue.
Contracts in progress - The accumulated costs of performing
services required under contract.
Miscellaneous inventories - Items such as office, janitorial, and
shipping supplies. Inventories of this type are typically used in the
near future and may be recorded as selling or general expense when
purchased instead of being accounted for as inventory.
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Inventory Policy Issues
■
Since cost of goods sold is often the largest single
expense category on the income statement, and
inventory is an integral part of current and total assets,
it makes sense that accounting policies in this area can
cause income and net assets to change materially. In
what areas can policies be set? We’ll look at:
– Items and costs to include in inventory
– Cost flow assumptions
– Application of LCM (lower of
cost or market) valuations
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Items And Costs Included In Inventory
■
All goods legally owned by the company on the inventory
date, regardless of their location
–
–
–
–
■
Goods in transit depending on the FOB terms
Goods on consignment
Repurchase agreements to sell and buy back inventory items
Special sales agreements
A strict legal determination is often
impractical. In such cases, the sales
agreement, industry practices, and
other evidence of intent should be
considered
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Elements Of Inventory Cost
■
Invoice price
– Total cash equivalent outlay made to acquire the goods and to
prepare them for sale or, for a service company, to fulfill the
requirements of the service contract.
■
■
■
■
Freight charges and other incidental costs
incurred in connection with the
purchase of tangible inventory
Purchase Discounts
Cash discounts on purchases to
encourage timely payment from buyers
Other costs to get the inventory ready for sale
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Items Not Included In Inventory
■
(On grounds of materiality), examples include:
–
–
–
–
■
■
insurance costs on goods in transit,
material handling expenses, and
import brokerage and excise fees
These costs may be included in overhead,
which may then be allocated to inventory.
General and administrative (G&A) expenses are normally
treated as period expenses because they relate more
directly to accounting periods than to inventory.
Distribution and selling costs are also considered to be
period operating expenses and are not allocated to
inventories.
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■
■
Variable Vs. Fixed Overhead
Manufacturing companies and service firms engaged
in long-term contracts often use variable costing
(also called direct costing, although there are subtle Material
differences between the two approaches) for internal Labour
Overhead
management planning and control purposes.
The CICA Handbook recommends that
manufacturers’ inventories include an allocation of
overhead:
– In the case of inventories of work in process and finished
goods, cost should include the laid-down cost of material
plus the cost of direct labour applied to the product and the
applicable share of overhead expense properly chargeable
to production. [CICA 3030.06]
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Cost Flow Assumptions
■
■
Periodic inventory system
– Inventory value is determined only at particular times,
such as end of the accounting period.
Perpetual inventory system
– The ongoing physical flow of inventory is monitored,
and the cost of the inventory items is maintained on a
continual basis.
PERIODIC METHOD
vs.
PERPETUAL METHOD
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Periodic Vs. Perpetual – Illustration
Lea Company
Unit
Units Cost
■
■
■
■
■
■
■
Beginning inventory
Purchases
Goods available for sale
Less: Sales
Ending inventory, as calculated
Ending inventory,
based on physical count
Shrinkage
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500
1,000
1,500
900
600
Total
$4.00 $2,000
4.00 4,000
$6,000
580
20
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Calculating Cost Of Goods Sold (COGS) Lea
Company
■
■
■
■
■
Beginning Inventory 500 x $4.00
+ Purchases (net)
1000 X $4.00
= Cost of Goods Available for Sale
- Ending Inventory 580 x $4.00
= Cost of Goods Sold (residual amount)
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$2,000
4,000
6,000
2,320
$3,680
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Periodic Recording
Lea Company
GENERAL JOURNAL
Date
July
Description
31
Post.
Ref.
Page 7
Debit
Purchases
Accounts Payable
To Record the purchases
$4,000
Cost of Goods sold
Inventory ( closing, per count)
Inventory ( opening)
Purchases
$3,680
$2,320
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Credit
$4,000
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$4,000
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Perpetual Recording
Lea Company
GEN ER AL JOU RNAL
Date
July
Description
31
Post.
Ref.
Page 7
Debit
Inventory [$1,000 x $4]
Accounts Payable
$4,000
Accounts receivable [900 x $10]
Sales Revenue
$9,000
Cost of goods sold [900 x $4]
Inventory
$3,600
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Credit
$4,000
$9,000
$3,600
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Periodic Vs. Perpetual Recording Methods
■
Choosing a Recording Method
✜
■
The choice of a periodic or perpetual system is not really an
accounting policy choice, although modest differences in
inventory and cost of goods sold amounts can arise under the
average cost assumption and under LIFO, depending on
which recording method is used. Instead, the choice of
recording method is one of practicality – which method gives
the best cost-benefit relationship?
Common Cost Flow Assumptions
✜
✜
✜
✜
Specific Identification
Average Cost
First-In, First-Out
Last-In, First-Out
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■
■
■
Choosing A Recording Method
A perpetual inventory system is especially useful when
inventory consists of items with high unit values or when it is
important to have adequate but not excessive inventory levels.
Perpetual inventory systems require detailed accounting
records and therefore tend to be more costly to implement and
maintain than periodic systems. Computer technology has
made perpetual inventory systems more popular today than
ever before.
Theft and pilferage, breakage and other physical damage, misorders and mis-fills, and inadequate inventory supervision
practices must be dealt with regardless of the type of inventory
accounting system used.
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Common Cost Flow Assumptions
■
■
LIFO is not a popular method in Canada, due largely to the
fact that it is not acceptable for income tax purposes.
Specific identification is used mainly for large, unique items,
such as custom-built equipment, or in accounting for service
contracts. For other types of business, average cost and
FIFO are the popular methods
According to the CICA Handbook, the
method selected for determining cost
should be one which results in the
fairest matching of costs against
revenues [CICA 3030.09].
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Specific Identification
■
At the end of the year (periodic method) or on each sale
(perpetual method) the specific units sold, and their
specific cost, is identified to determine inventory and cost
of goods sold.
– In the example in Exhibit 9-2, there are 300 units left in
closing inventory.
■
May be inconvenient and difficult to establish just which
items were sold and what their specific initial cost was.
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Average Cost
■
■
When the average cost method is used in a periodic
system, it is called a weighted average system.
Exhibit 9-3 illustrates
Weighted-average unit cost
=
beginning inventory cost
+ total current period purchase costs
number of units in the beginning inventory
+ units purchased during the period
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Exhibit 9-3 Weighted-Average Inventory Cost Method
(Periodic Inventory System):
Goods available:
1 January − Beginning inventory
9 January − Purchase
15 January − Purchase
24 January − Purchase
Units
Unit
Price
Total
Cost
200
300
400
100
$1.00
1.10
1.16
1.26
$ 200
330
464
126
January − Total available
Weighted-average unit cost ($1,120 ÷ 1,000)
1,000
1.12
Ending inventory at weighted-average cost:
31 January
300
1.12
336
700*
1.12
784
$ 1,120
Cost of goods sold at weighted-average cost:
Sales during January
Total cost allocated
* 400 units on January 10 plus 300 units on January 18.
$1,120
Exhibit 9-4 Moving-Average Inventory Cost,
Perpetual Inventory System
Date
1 January
9 January
10 January
15 January
18 January
24 January
Units
Purchases
Unit
Total
Cost
Cost
300
$1.10
400
100
Ending inventory
Cost of goods sold
Total cost allocated
(a) $530 ÷ 500 = $1.06.
(b) $570 ÷ 500 = $1.14.
(c) $354 ÷ 300 = $1.18.
1.16
1.26
Units
Sales
Unit
Cost
Total
Cost
400
$1.06
$424
300
1.14
342
$330
464
126
$766
Inventory Balance
Unit
Total
Units Cost
Cost
200
$1.00 $200
500
1.06(a) 530
100
1.06
106
500
1.14(b) 570
200
1.14
228
300
1.18(c) 354
$354
766
$1,120
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First-In, First-Out
■
■
■
■
The first-in, first-out (FIFO) method treats the first goods
purchased or manufactured as the first units costed out
on sale or issuance. Goods sold (or issued) are valued at
the oldest unit costs, and goods remaining in inventory
are valued at the most recent unit cost amounts.
Exhibit 9-5 demonstrates FIFO for the periodic system.
Exhibit 9-6 demonstrates the perpetual system.
Using the perpetual system, a sale is costed out either
currently throughout the period each time there is a
withdrawal, or entirely at the end of the period, with the
same results.
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Exhibit 9-5 FIFO Inventory Costing,
Perpetual Inventory System
Beginning inventory (200 units at $1)
Add purchases during period (computed as in Exhibit 9-2)
Cost of goods available for sale
Deduct ending inventory (300 units per physical inventory count):
100 units at $1.26 (most recent purchase − 24 January)
200 units at $1.16 (next most recent purchase − 15 January)
Total ending inventory cost
Cost of goods sold
$ 200
920
1,120
$126
232
358
$ 762*
* Can also be calculated as 200 units on hand 1 January at $1 plus 300 units purchased
9 January at $1.10, plus 200 units purchased 15 January at $1.16.
Accounting entries – Illustration
Page
7 GENERAL JOURNAL
Date
Jan
Description
24
9 Purchases
Periodic
Post.
Ref.
Debit
Perpetual
Credit
330
126
Cash, etc.
330
126
10
31 Cost of goods sold
762
Inventory
Inventory
(closing)
358
Inventory (opening)
Jan
15 Purchases
Purchases
Jan
18 Cost of goods sold
Inventory
330
126
420
420
200
464
920
Inventory
Cash, etc.
Credit
126
330
Inventory
Jan
Jan
Debit
464
464
464
342
342
Exhibit 9-6 FIFO Inventory Costing, Perpetual Inventory System
Date
1 January
Units
Purchases
Unit
Total
Cost
Cost
9 January
300
$1.10
200
200
400
1.16
100
200
100
1.26
Ending inventory ($232 + $126)
Cost of goods sold
Total cost allocated
$1.00
1.10
$200
220
464
18 January
24 January
Total
Cost
$330
10 January
15 January
Units
Sales
Unit
Cost
1.10
1.16
110
232
126
$762
Inventory Balance
Unit
Total
Units Cost
Cost
200
$1.00 $200
200
300
1.00
1.10
200
330
100
1.10
110
100
400
1.10
1.16
110
464
200
1.16
232
200
100
1.16
1.26
232
126
$358
762
$1,120
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Last-In, First-Out
■
■
■
The last-in, first-out (LIFO) method of inventory costing
matches inventory valued at the most recent unit
acquisition cost with current sales revenue.
The units remaining in ending inventory are costed at
the oldest unit costs incurred, and the units included in
cost of goods sold are costed at the newest unit costs
incurred, the exact opposite of the FIFO cost
assumption.
Like FIFO, application of LIFO requires the use of
inventory cost layers for different unit costs.
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Exhibit 9-7
LIFO Inventory Costing Periodic Inventory System:
Cost of goods available (see Exhibit 9-2)
Deduct ending inventory (300 units per physical inventory count):
200 units at $1 (oldest costs available, from 1 January inventory)
100 units at $1.10 (next oldest costs available; from 9 January purchase)
Ending inventory
Cost of goods sold
$1,120
$200
110
310
$ 810*
* Can also be calculated as 100 units at $1.26 plus 400 units at $1.16 plus 200 units at $1.10.
Exhibit 9-8 LIFO Inventory Costing Perpetual Inventory
System:
Inventory
Purchases
Sales
Date
1 January*
9 January
Units
Unit
Cost
Total
Cost
300
$1.10
$330
10 January
15 January
300
100
400
1.16
300
100
1.26
$330
100
1.16
348
126
Ending inventory ($100 + $116 + $126)
Cost of goods sold
Total cost allocated
* Beginning inventory.
$1.10
1.00
Total
Cost
464
18 January
24 January
Units
Unit
Cost
$778
Unit
Cost
$1.00
Total
Cost
$200
200
300
1.00
1.10
200
330
100
1.00
100
100
400
1.00
1.16
100
464
100
100
1.00
1.16
100
116
100
100
100
1.00
1.16
1.26
100
116
126
Units
200
$342
778
$1,120
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Income Tax Factors
■
Revenue Canada will not accept LIFO for tax purposes.
Companies must use either the FIFO or the average
cost method when they compute their taxes payable. If
a company uses LIFO for financial reporting, it must
maintain two different inventory costing systems − one
for financial reporting (LIFO) and another for income tax
(FIFO or average). Since there is a substantial
additional work load to maintaining two different
systems, Canadian companies rarely use LIFO.
Financial Reporting in Canada 1997 reported that only
about 3% of the sample companies use LIFO for any
part of their inventory.
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Review
■
■
■
■
■
When prices are rising, as they often are:
FIFO will produce higher inventory, lower cost of goods sold, and
higher income. It’s probably popular with firms that would like to
see higher income and net assets in their financial statements.
LIFO has the opposite effect: lower inventories, higher cost of
goods sold, and lower incomes.
Average cost methods provide inventory and cost of goods sold
amounts between the LIFO and FIFO extremes, and is the next
best thing to LIFO for income and tax minimization when inventory
costs are rising.
Canadian practice is about evenly divided between FIFO and
average cost. LIFO is very seldom used in Canada, except by
Canadian subsidiaries of U.S. companies that mandate its use in
order to be consistent with the parent’s accounting policies.
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Exhibit 9-9
Comparison of the Effects of FIFO vs. LIFO
The impact on
If purchase Ending
prices are: inventory is:
The impact on
Cost of goods
sold is:
The impact on
Net income and
retained
earnings is:
Rising
FIFO > LIFO FIFO < LIFO FIFO > LIFO
Falling
FIFO < LIFO FIFO > LIFO FIFO < LIFO
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■
■
■
■
■
■
Evaluation Of FIFO
Advantages
Easy to apply
Inventory value approximates current
cost
Flow of costs tends to be consistent
with usual physical flow of goods
Systematic and objective
Not subject to manipulation
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■
■
■
Disadvantages
Does not match current cost
of goods sold with current
revenues
Inventory (or phantom) profits
In periods of rising prices, pay
higher income taxes.
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Special Aspects
■
■
■
■
Standard Cost
Just-In-Time Inventory Systems
Inventories Carried At Market Value
Losses On Purchase Commitments
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Standard Cost
■
■
■
■
■
■
In manufacturing entities using a standard cost system, the inventories
are valued, recorded, and reported for internal purposes on the basis of
a standard unit cost which approximates an ideal or expected cost.
This prevents the overstatement of inventory values because it excludes
from inventory all losses and expenses that are due to inefficiency,
waste, and abnormal conditions.
Actual historical cost is used only once, on acquisition which simplifies
record-keeping significantly!
Under this method, the differences between actual cost and standard
cost are recorded in separate variance accounts.
These accounts are usually written off as a current period loss rather
than capitalized in inventory.
Under standard cost procedures there would be no need to consider
inventory cost flow methods (such as LIFO, FIFO, and average)
because only one cost − standard cost − appears
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Just-In-Time Inventory Systems
■
■
■
■
■
Just-in-time (JIT) inventory systems are a response to the high
costs associated with stockpiling inventories of raw materials,
parts, supplies, and finished goods
The ultimate goal is to see goods and materials arrive at the
company's receiving dock just in time to be moved directly to the
plant's production floor for immediate use in the manufacturing
or assembly process.
Finished goods roll off the production floor and move directly to
the shipping dock just in time for shipment to the customers.
The ideal result is zero inventory levels and zero inventory costs.
Minimum inventories are needed. If a small buffer inventory is
not maintained, the JIT system runs the risk of becoming a NQIT
(not-quite-in-time)
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■
■
■
Inventories Carried At Market Value
When revenue is recognized at the point of production, inventory is written
up to its net realizable value, prior to sale. This is the increase in net
assets that substantiates revenue recognition.
– Gold Mining
– Farm products
Special inventory categories often include items for resale that are
damaged, shopworn, obsolete, defective, or are trade-ins or
repossessions. These inventory items are valued at current replacement
cost, defined as the price for which the items can be purchased in their
present condition.
When the replacement cost cannot be determined reliably, such items
should be valued at their estimated net realizable value (NRV), defined
as the estimated sale price less all costs expected to be incurred in
preparing the item for sale
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Losses On Purchase Commitments
■
■
Purchase commitments (contracts) To lock in prices
and ensure sufficient quantities, companies often
contract with suppliers to purchase a specified quantity
of materials during a future period at an agreed unit
cost.
A loss must be accrued on a purchase contract when:
•
•
•
the purchase contract is not subject to revision or
cancellation, and
when a loss is likely and material and
when the loss can be reasonably estimated.
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Lower Of Cost Or Market Valuation
■
■
■
■
GAAP requires that inventories be valued either at cost
or at current market value, whichever is less.
Assets should always be substantiated by some kind of
future economic benefit.
For inventory, it’s clear that if you can’t sell the asset,
the inventory can’t really be called an asset.
LCM tests are complicated by a couple of policy
choices:
✜
✜
What is the definition of market value?
Should the LCM test be applied to individual inventory
items, to categories, or to totals? The question of
aggregation is not trivial.
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Definition of market value
■
■
■
The basic difficulty with determining market value is that
there are two markets − the supplier market
(replacement cost) and the customer market (sales
price).
Sales price is called net realizable value (NRV) when
costs expected to be incurred in preparing the item for
sale are deducted.
Net realizable value can be taken further, deducting
expected costs and also a normal gross profit margin;
use of net realizable value less a normal profit
margin will preserve normal profits when the item is
finally sold.
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Exhibit 9-10 Net Realizable Value and Net Realizable Value
Less a Normal Profit Margin
a. Inventory item A, at original cost
b. Inventory item A, at estimated current selling price
in completed condition
c. Less: Estimated costs to complete and sell*
d. Net realizable value
e. Less: Allowance for normal profit (10% of sales price)
f. Net realizable value less normal profit
$ 70
$100
−40
$ 60
−10
$ 50
* For goods already completed, as in a retail company, this amount
would be the cost to sell.
Exhibit 9-11 Methods of Market Determination, 1996
Method
Net realizable value
Replacement cost
Net realizable value less normal profit margin
Estimated net realizable value
Number of
companies,
1996
142
43
3
4
Source: Boyd & Chen, Financial Reporting in Canada 1997 (Toronto: CICA, 1997), p.
169.
9
■
Extent of grouping
Application of LCM can follow one of three approaches:
•
•
•
■
■
■
Comparison of cost and market separately for each item of inventory.
Comparison of cost and market separately for each classification of
inventory.
Comparison of total cost with total market for the inventory.
Exhibit 9-12 shows the application of each approach.
Consistency in application over time is essential.
The individual unit basis produces the most conservative
inventory value because units whose market value exceeds
cost are not allowed to offset items whose market value is less
than cost. This offsetting occurs to some extent in the other
approaches. The more you aggregate, the less you write down.
The less you aggregate, the more you write down.
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Exhibit 9-12 Application of LCM to Inventory
Categories
LCM Applied to
Inventory Types
Classification A:
Item 1
Item 2
Classification B:
Item 3
Item 4
Cost
Individual
Market Items
Classifications
$10,000 $ 9,500 $ 9,500
8,000
9,000
8,000
18,000 18,500
21,000
32,000
53,000
$71,000
Total
Inventory valuation
under different approaches
22,000
29,000
51,000
$69,500
Total
$18,000
21,000
29,000
51,000
$67,500
$69,000
$69,500
9
LCM Recording and reporting
■
Two methods of recording and reporting the effects of
the application of LCM are used in practice:
✜
Direct inventory reduction method. The LCM amount, if it is
less than the original cost of the inventory, is recorded and
reported each period. Thus, the inventory holding loss is
automatically included in cost of goods sold, and ending
inventory is reported at LCM.
✜
Inventory allowance method. The inventory holding loss is
separately recorded using a contra inventory account,
allowance to reduce inventory to LCM.
– Holding loss on inventory
1,000
–
Allowance to reduce inventory to LCM
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
1,000
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9
Cash Flow Statement
■
To determine the amount of cash provided by
operations, net income must be adjusted by the change
in inventory during the period:
•
•
an increase in inventory means that the cash flow to
purchase inventory was higher than the amount of expense
reported as cost of goods sold − the increase must be
subtracted from net income in order to reflect higher cash
outflow.
a decrease in inventory means that the cash flow to acquire
inventory was less than the amount of expense reported in
cost of goods sold − the decrease must be added to net
income.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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9
■
Disclosure
According to the inventory section of the CICA Handbook,
recommended disclosures are as follows:
•
•
•
•
•
the basis for valuation (e.g., historical cost, lower of cost or market,
market value) [CICA 3030.10];
major categories of inventory (desirable, not required) [CICA
3030.10];
method of determining cost, if the method used for determining cost
differs from recent cost of the inventory items [CICA 3030.11];
a definition of market value (desirable, not required), if ‘market’ is
used in some aspect of inventory valuation [CICA 3030.11]; and
any change in valuation from that used in the prior period, and the
effect of a change on net income [CICA 3030.13].
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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9
Inventory Estimation Methods
■
■
■
■
Many large companies rely on the periodic inventory
method. Does this mean that they can’t prepare
monthly or quarterly statements without also taking a
physical inventory?
So what can be done when statements are needed?
The answer is quite simple: inventory can be estimated.
In a small business, the owner or inventory manager
might be able to provide an accurate estimate.
Alternatively, a more formal calculation can be made,
– Gross Margin Method
– Retail Inventory Method
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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9
Gross Margin Method
■
■
■
The gross margin method (also known as the gross
profit method) assumes that a constant gross margin
estimated on recent sales can be used to estimate
inventory values from current sales.
That is, the gross margin rate (gross margin divided by
sales), based on recent past performance, is assumed
to be reasonably constant in the short run.
The gross margin method has two basic characteristics
– (1) it requires the development of an estimated gross
margin rate for different lines or products, and
– (2) it applies the rate to relevant groups of items.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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Gross Margin Method
Steps To Follow
9
■
■
■
■
■
Estimate historical gross margin rate.
Add beginning inventory and net purchases to get cost
of goods available for sale(COGAS).
Multiply sales by the gross margin rate to get estimate
gross margin in dollars.
Subtract gross margin in dollars from net sales to get
cost of goods sold(COGS).
Subtract COGS from COGAS to get the estimated cost
of ending inventory.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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9
Gross Margin Method - Example
■
■
NoteCo, Inc. uses the gross margin method to estimate
end of month inventory value. At the end of May the
controller develops the following information: Gross
margin 43% of sales; Inventory at May 1 $237,400; net
purchases for May $728,300; net sales for May
$1,213,000.
Estimate Inventory at May 31.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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Gross Margin Method
Solution
9
■
Proof of Estimate
Sa les for Ma y
Cost of goods sold:
Be ginning inve ntory
Ne t purcha se s
Cost of goods ava ilable for sa le
Estima te d ending inventory
Cost of goods sold
Gross m a rgin for Ma y
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
$ 1,213,000
$ 237,400
728,300
965,700
274,290
$
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521,590
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9
Retail Inventory Method
■
■
■
The retail inventory method is often used by retail
stores, especially department stores that sell a wide
variety of items.
In such situations, perpetual inventory procedures may
be impractical, and a complete physical inventory count
is usually taken only once annually.
The retail inventory method is appropriate when items
sold within a department have essentially the same
markup rate and articles purchased for resale are
priced immediately. Two major advantages of the retail
inventory method are its ease of use and reduced
record-keeping requirements.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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9
■
Markups And Markdowns
To apply the retail inventory method, it is important to
distinguish among the following terms:
Original sales price..
✜ Markup.
✜ Additional markup.
✜ Additional markup cancellation.
✜ Markdown..
✜ Markdown cancellation.
■ In the application of the retail method, markups and markup cancellations,
markdowns and markdown cancellations are all included in the early
calculations that determine goods available for sale at cost and at retail.
However, in order to provide a conservative cost ratio that will approximate
lower of cost or market (LCM), the denominator of the cost ratio excludes net
markdowns.
Copyright
 1998 McGraw-Hill Ryerson Limited, Canada
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✜
Gross Margin Method
Steps To Follow
9
■
■
■
■
■
Estimate historical gross margin rate.
Add beginning inventory and net purchases to get cost
of goods available for sale(COGAS).
Multiply sales by the gross margin rate to get estimate
gross margin in dollars.
Subtract gross margin in dollars from net sales to get
cost of goods sold(COGS).
Subtract COGS from COGAS to get the estimated cost
of ending inventory.
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9
Gross Margin Method - Example
■
■
NoteCo, Inc. uses the gross margin method to estimate
end of month inventory value. At the end of May the
controller develops the following information: Gross
margin 43% of sales; Inventory at May 1 $237,400; net
purchases for May $728,300; net sales for May
$1,213,000.
Estimate Inventory at May 31.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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Gross Margin Method
Solution
9
■
Proof of Estimate
Sa les for Ma y
Cost of goods sold:
Be ginning inve ntory
Ne t purcha se s
Cost of goods ava ilable for sa le
Estima te d ending inventory
Cost of goods sold
Gross m a rgin for Ma y
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
$ 1,213,000
$ 237,400
728,300
965,700
274,290
$
home
691,410
521,590
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9
Retail Method
■
To use this method we must know:
– Sales for the period.
– Beginning inventory at retail and cost.
– Net purchases at retail and cost.
– Adjustments to the original retail price:
✜
Additional markups and markdowns, markup and markdown
cancellations, employee discounts
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Retail Method
Steps To Follow
9
■
■
■
■
Determine cost of goods sold and retail value of goods
sold.
Calculate the cost to retail percentage.
Subtract retail value of goods available for sale from
sales to get ending inventory at retail.
Multiply the cost to retail percentage times ending
inventory at retail to get ending inventory at cost.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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Retail Method
Example
9
■
■
Webb Clothiers, Inc. uses the retail method to estimate
inventory at the end of each month. For the month of
May the controller gathers the following information:
Beginning inventory at cost $60,000, at retail $92,000,
net purchases at cost $200,000, at retail $308,000; net
sales for May $300,000.
Estimated inventory at May 31.
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9
RETAIL METHOD - SOLUTION
Inventory, May 1
Net purchases for May
Goods available for sale
Cost ratio (260,000 ÷ 400,000)
65%
Sales for May
Ending inve ntory at retail
Cost ratio
Ending inve ntory at cost
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
Cost
$ 60,000
200,000
260,000
Retail
$
92,000
308,000
400,000
$
300,000
100,000
65%
$ 65,000
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Retail Method
Markups And Markdowns
9
■
■
■
■
■
■
Original Sales Price - sale price first marked on the
merchandise.
Markup - original amount by which item is marked up
above cost.
Additional Markup - Increase in sales price above the
original sales price.
Additional Markup Cancellation - cancellation of some
or all of an additional markup.
Markdown - reduction in original sales price
Markdown Cancellation - increase is sales price after a
markdown
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Retail Method
Markups And Markdowns
9
■
■
Estimating Inventory on a FIFO Basis
Exclude beginning inventory from the cost ratio.
Cost of net purchases
FIFO cost ratio =
Retail value of (net purchases +
net markups - net markdowns)
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9
Retail Method
Markups And Markdowns
■
Average Cost Basis
Average
cost
=
ratio
Cost of (beginning inventory + net purchases)
Retail value of (beginning inventory + net
purchases + net markups - net markdowns)
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9
Retail Method
Markups And Markdowns
■
Lower-of-Cost-or-Market Basis
LCM
cost =
ratio
Cost of (beginning inventory + net purchases)
Retail value of (beginning inventory
+ net purchases - net markups)
Exclude net markdowns from the ratio.
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9
Summary Of Key Points
■
■
■
Inventories are assets consisting of goods owned by
the business and held for future sale or for use in the
manufacture of goods for sale.
Cost at acquisition, including the costs to obtain the
inventory, such as freight, is used to value inventory.
Work in process and finished goods inventories of
manufacturers should include raw materials, direct
labour, and at least the variable portion of
manufacturing overhead.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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9
Summary Of Key Points
■
■
All goods owned at the inventory date, including those
on consignment, should be counted and valued.
Either a periodic or a perpetual inventory system may
be used for merchandise inventories and for
manufacturer’s inventories of raw materials and finished
goods, but computer technology now makes it easier
and less costly to use a perpetual system, which also
provides up- to- date inventory records.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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9
Summary Of Key Points
■
■
■
Several cost flow assumptions are in current use, including
specific identification, average cost, FIFO, and LIFO. LIFO
is very rarely used in Canada, except by subsidiaries of
U.S. parent companies that also use that method.
Special accounting problems are encountered by firms
using standard cost, just-in-time inventory systems, or net
realizable value to recognize inventory.
Losses on firm purchase commitments, when they can be
reasonably estimated and are material, are recognized in
the accounts if the loss is likely and can be estimated.
Otherwise, such commitments are often disclosed only in
the notes.
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9
Summary Of Key Points
■
■
The lower-of-cost-or-market (LCM) method of estimating
inventory recognizes declines in market value in the period
of decline. The lower-of-cost-or-market method values
inventories at market if market is below cost. Market may
be interpreted to be net realizable value, net realizable
value less a normal profit margin, or replacement cost. Use
of net realizable value is most common.
The gross margin method is used to estimate inventory
values when it is difficult or impractical to take a physical
count of the goods. The method is most accurate when
profit margins are stable.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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9
Summary Of Key Points
■
■
The retail method of estimating inventory applies the ratio
of actual cost to sales value to the ending inventory at sales
value to estimate the inventory value at lower of cost or
market.
The cash flow from operations is affected by (1) changes in
inventory levels and (2) amortization that has been included
in the inventory. Cash flow must be adjusted to reflect the
amount of inventory purchased rather than sold, and must
be adjusted by adding back any amortization.
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