INTERMEDIATE ACCOUNTING
TENTH CANADIAN EDITION
Kieso • Weygandt • Warfield • Young • Wiecek • McConomy
CHAPTER 8
Inventory
Prepared by:
Dragan Stojanovic, CA
Rotman School of Management,
University of Toronto
CHAPTER 8
Inventory
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.
Copyright © John Wiley & Sons Canada, Ltd.
2
CHAPTER 8
Inventory
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.
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Inventory
Understanding
Inventory
•What types of
companies have
inventory?
•Inventory
categories
•Inventory planning
and control
•Information for
decision-making
Recognition
Measurement
Presentation, IFRS / ASPE
Comparison
•Accounting definition •Costs included in Disclosure,
and Analysis •Comparison of
inventory
•Physical goods
included in inventory •Inventory
accounting
•Inventory errors
systems
•Cost formulas
IFRS and
•Presentation
and disclosure ASPE
of inventories •Looking ahead
•Analysis
•Lower of cost
and net
realizable value
•Exceptions to the
lower of cost and
NRV model
•Estimating
inventory
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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
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Inventory Cost Flows
Manufacturing Operations
Raw Materials
Direct Labour
Work in Process
Inventory
$$$
COGM
Finished
Goods
$$$
COGS
Mfg. Overhead
$$$
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COGS
6
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.”
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7
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
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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)
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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
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Example
COGS (as originally stated in 2014)
$1,400,000
Add: December 31, 2014 overstatement error
45,000
1,445,000
Less: December 31, 2013 overstatement error
110,000
Corrected 2014 COGS
$1,335,000
Retained Earnings (2014 original)
$5,200,000
Less: correction for 2014 inventory
45,000
Retained Earnings (2014 restated)
$5,155,000
Note: 2013 inventory error is self-corrected as it was
discovered after the books for 2014 were closed
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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
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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
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13
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 ASPE, interest costs may be either
capitalized or expensed, but policy must be
disclosed.
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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
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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
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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)
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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
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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.
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Perpetual System
Transaction
Purchase
Record Inventory Changes
Inventory
5,400
Accounts Payable
(900 units x $6)
Purchase
Return
Sale
Record Sales Revenue
5,400
Accounts Payable
Inventory
(50 units x $6)
300
Cost of goods sold
3,600
Inventory
(600 units x $6)
300
Accounts
Receivable
3,600
Sales
(600 units x $12)
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7,200
7,200
20
Periodic System
Date
Record Inventory Changes
Purchase
Purchases
5,400
Accounts Payable
5,400
(900 units x $6)
Return
Accounts Payable
Purch. Returns
and Allowances
No entry
Sale
Year-End
Adjusting
Entry
Record Sales Revenue
300
300
Cost of goods sold
3,600
Inventory (end - count) 2,100
Purchases Returns
300
Purchases
5,400
Inventory (beg.)
600
Accounts Receiv.
Sales
(600 units x $12)
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7,200
7,200
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Cost Formulas
IFRS and ASPE recognize three acceptable
cost formulas:
1. Specific identification
2. First-in, First-out (FIFO)
3. Weighted average cost
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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
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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
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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)
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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
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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
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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
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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
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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
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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
17,150
March 30
4,000 units remaining
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
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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
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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?
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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
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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 itemby-item basis
Grouping inventory for purposes of valuation is permitted
only under certain circumstances
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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
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Recording Decline in NRV– Direct
Method (Perpetual Inventory System)
Inventory
At Cost
At NRV Adjustment
Beginning
End of year
$65,000
$82,000
$65,000
$70,000
Under the Direct method:
Dr. Cost of Goods Sold
Cr.
Inventory
$-0$12,000
12,000
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12,000
37
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
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Recording Decline in NRV: Indirect
Method (Perpetual Inventory System)
Inventory
Beginning
End of
year
At Cost
$65,000
At NR Adjustment
$65,000
$-0-
$82,000
$70,000
Under the Allowance
method:
Dr. Loss Due to Decline in NRV 12,000
Cr. Allowance to Reduce Inventory
12,000
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$12,000
39
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
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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:
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
1.
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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
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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
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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 %)0
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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
ASPE
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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
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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
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Looking Ahead
• No major changes are expected in the
standards
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