INVENTORY Inventory Categories Merchandise inventory
CHAPTER 8: INVENTORY Inventory Categories Merchandise inventory - ready for sale units that are unsold at the end of the fiscal period raw materials inventory - costs assigned to goods and materials on hand, but not yet placed into production work-in-process inventory - cost of the raw material on which production has been started but not completed, plus the direct labour cost applied specifically to this material, and an applicable share of manufacturing overhead costs finished goods inventory - reporting of the costs associated with the completed but unsold units at the end of the fiscal period cost of goods available for sale or use - total of (1) the cost of goods on hand at the beginning of the period + (2) the cost of the goods acquired or produced during the period cost of goods sold - difference between those available for sale during the period and those on hand at the end of the period COGS = beginning inventory + purchases – ending inventory Gross profit or net income = sales – COGS Reporting Ending Inventory 1. Determine inventory that should be included 2. Cost that should be included in inventory 3. Cost formula 4. Test for impairment Ending Inventory
Understated
Overstated
COGS Net income Retained earnings
Effect on current year Overstated Understated Understated
Effect on next year Understated Overstated No effect
Working capital Current ratio
Understated Understated
No effect No effect
COGS Net income Retained earnings
Understated Overstated Overstated
Overstated Understated No effect
Working capital Current ratio
Overstated Overstated
No effect No effect
Correcting Inventory Errors Assume 2014 ending inventory is understated by $10,000 Error discovered before 2014 books are closed: Inventory 10,000 Cost of goods sold
10,000
Error discovered in 2015: Inventory Retained Earnings
10,000
10,000
Error discovered in 2015 after 2015 books are closed: No journal entry, but comparative statements must use corrected figures for presentation purposes Example: 2014 -
COGS = $1,400,000 R/E = $5,200,000
December 31st inventory errors both discovered after 2014 books were closed: 2013: ending inventory overstated by $110,000 2014: ending inventory overstated by $45,000 2014 COGS
= = =
2013 ending inventory + 2014 purchases over by 110,000 over by 65,000 (110,000 – 45,000) 1,335,000 (1,400,000 – 65,000)
2014 ending inventory over by 45,000
Net income and retained earnings will be overstated by 45,000. 2014 Retained Earnings should be 5,155,000. Since the 2014 books have already been closed, journal entry to correct overstatement would be: Retained Earnings 45,000 Inventory 45,000 Inventories - “assets” o Held for sale in the ordinary course of business (finished goods) o In the process of production for such sale (work-in-process) o In the form of materials or supplies to be consumed in the production process or in the rendering of services (raw materials) - Represent a future benefit, which the entity has control over or access to - Recognition is through transaction arising from an inventory purchase and risks and rewards of ownership have passed to the purchaser Physical Goods Included in Inventory - generally determined by legal title to goods - purchase commitments should not be included, but should be disclosed if material Items included in seller’s inventory: Goods in transit o FOB shipping point legal title passes to the buyer when seller delivers the goods to the common carrier o FOB destination
legal title passes when the goods reach destination Goods out on consignment o Possession is with consignee but legal title held by consignor Goods sold under buyback agreements Goods sold with high rates of return that cannot be estimated
Inventory Cost - all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition o product costs invoice, freight, and other direct acquisition costs; borrowing cost (interest expense) o conversion costs direct labour and fixed and variable overhead (must always report actual costs but may use standard costs if they approximate actual costs) - does not include period costs (selling, general, and administrative) - purchase discounts - vendor rebates - “basket” purchases and joint product costs Purchase Discounts Assume Company A purchases goods for $10,000 with terms 2/10, net 30. Company A pays for $4,000 of this amount within the discount period and the rest after the discount period. Gross Method Purchase: Purchases A/P
Net Method
10,000
Payment w/in discount period: A/P Purchase Discounts Cash Payment after discount period A/P Cash
4,000
6,000
Purchase: Purchases 10,000 A/P
9,800 9,800
Payment w/in discount period: A/P 80 Cash 3,920 Payment after discount period A/P Purchase Discounts Lost 6,000 Cash
E8-3 March 10 11 19 24
purchases = 25,000, 3/10 n/60 purchases = 26,575, 1/15 n/30 paid (25,000 x 97%) = 24,250 purchases = 11,500, 3/10 n/30
discount until march 20 discount until march 26 discount until april 3
a) net method March 10 March 11
Purchases A/P
24,250
Purchases
26,309
24,250
3,920 3,920 5,880 120 6,000
A/P March 19
A/P
26,309 24,250
Cash March 24
Purchases A/P
24,250 11,155 11,155
b) no purchase or payment transactions as at march 31 March 31
Purchase Discounts Lost A/P
266
Purchases A/P
25,000
Purchases A/P
26,575
A/P
25,000
266
c) gross method March 10 March 11 March 19
25,000 26,575
Cash Purchase Discounts March 24
Purchases A/P
24,250 750 11,500 11,500
d) no additional entries as at march 31 under the gross method e) net method is more theoretically correct and has faithful representation compared to gross method. Also, discounts lost can be tracked for a more effective cash management. However, gross method is more cost-effective. Vendor Rebates - cash rebates related to inventory generally recorded as a reduction to the cost of inventory - record as reduction to inventory if: o non-discretionary on part of supplier o probable and amount reasonably estimated BE8-6 a) volume rebate from Traders can only be accrued if (1) the rebate is non-discretionary on the part of Traders and (2) the receipt of the rebate is probable and its value can be reasonably estimated. b) Amount of rebate to be accrued at June 30, 2014 Current units on hand Estimated number of units to be purchased Less: number of units Units that will qualify for rebate Rebate = 2,500 x $0.25 = 625
3,000 3,000 (3,500) 2,500
Jun 30/14
rebate receivable Inventory
625 625
c) Unit cost of wood frames Current inventory on hand (3,000 x $2.50) Add: Estimated inventory to be purchased Less: Rebate to be received Total cost of inventory
7,500 7,500 (625) 14,375
Unit cost = 14,375/(3,000 + 3,000) = $2.40 per unit Basket Purchases and Joint Product Costs - total costs allocated to units based on relative sales value BE8-8 Group 1 2 3 total
# of CDs 100 800 100 1,000
price per CD 5 10 15
total price 500 8,000 1,500 10,000
% share 5 80 15 100
cost allocated 5% x 7,500 = $375 80% x 7,500 = $6,000 15% x 7,500 = $1,125 $7,500
cost/unit $3.75 $7.50 $11.25
Inventory Accounting System 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 - helped reduce inventory levels (minimize storage costs) - only purchase inventory when needed - made to order; Dell, car manufacturers (customized) perpetual system - maintains a continuous record of inventory changes - costly to implement but gives up-to-date information at any given time periodic system - updates inventory records in the ledger only periodically - recommended for smaller businesses perpetual system Purchases, cost of freight, purchase returns, discounts are all directly debited to the Inventory account COGS and Inventory accounts are up to date Physical count is still required periodically to ensure physical stock = accounting stock BE8-3
periodic system Purchases, cost of freight, purchase returns, discounts are debited to their respective accounts COGS and Inventory accounts are updated after the physical inventory count COGS is a residual amount COGS = beg. inventory + purchases – end. inventory
Beginning inventory = 50 x $100 = $5,000 Sept purchase = 200 x $100 = $20,000 (AP) Sept purchase returns = 6 x $100 = $600 credit Sept sales = 150 x $200 = $30,000 (AR) Perpetual system: Purchase Purchase returns
Inventory A/P
20,000
A/P
600
20,000
Inventory Sales
A/R
600 30,000
Sales revenue
Periodic System: Purchase Purchase returns
30,000
COGS (150 x $100) Inventory
15,000
Purchases A/P
20,000
A/P
600
15,000
20,000
Purchase returns Sales
A/R
600 30,000
Sales revenue
30,000
Month-end adj = ending inventory – beginning inventory = (94 – 50) x $100 = $4,400 COGS = 5,000 + (20,000 – 600) – 9,400 = 15,000 Month-end adj
Inventory Purchase returns COGS Purchases
4,400 600 15,000 20,000
Cost Formula - determines the costs that should be assigned to ending inventory and COGS o specific identification o weighted average cost o first-in, first-out (FIFO) Special 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 repeated at specific cost
Disadvantages: May be costly to implement and maintain May lead to income manipulation May be difficult to allocate certain costs (storage, shipping) to specific inventory items Weighted Average Cost - 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 - (for periodic inventory) moving average cost formula - refers to average method used with perpetual records (both units and dollars) Example: March transactions Date Purchases 1 beginning (500 @3.80) 2 1,500 @ 4.00 15 6,000 @ 4.40 19 30 2,000 @ 4.75 total 10,000
Cost $1,900 $6,000 $26,400
Sales
4,000 $9,500 $43,800
Balance (units) 500 2,000 8,000 4,000 6,000
weighted average: inventory cost = 43,800/10,000 = $4.38/unit ending inventory = $4.38 x 6,000 = $26,280 COGS = $4.38 x (10,000 – 6,000) = $17,520 Moving average: Date 1 2 15 19 30 total
Purchases beginning (500 @3.80) 1,500 @ 4.00 6,000 @ 4.40
Cost $1,900 $6,000 $26,400
2,000 @ 4.75 10,000
$9,500 $43,800
Sales
4,000
Balance (units) 500 2,000 8,000 4,000 6,000
COGS = $4.2875 x 4,000 = $17,150 Ending inventory = ($4.2875 x 4,000) + $9,500 = $26,650 ($4.4417/unit)
FIFO Advantages:
cost/unit $4.2875
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 Example: Date Mar 1 Mar 2 Mar 15 Mar 30
Purchases 500 1500 6000 2000 10,000
Unit Cost $3.80 $4.00 $4.40 $4.75
Purchase Cost $1,900 $6,000 $26,400 $9,500 $43,800
Units Sold on Mar 19 500 1500 2000
Mar 19 – 4000 units sold COGS = $1,900 + $6,000 + (2000 x $4.40) = $16,700 Ending Inventory = (4000 x $4.40) + $9,500 = $27,100 E8-16 The following information is for the inventory of mini kettles at Funnell Company Ltd for the month of May: Date Transaction Units In Unit Cost Total Units Sold Unit Price Total May 1 Balance 100 $ 4.10 $ 410 6 Purchase 800 4.20 3,360 7 Sale 300 $ 7.00 $ 2,100 10 Sale 300 7.30 2,190 12 Purchase 400 4.50 1,800 15 Sale 200 7.40 1,480 18 Purchase 300 4.60 1,380 22 Sale 400 7.40 2,960 25 Purchase 500 4.58 2,290 30 Sale 200 7.50 1,500 Totals 2,100 $ 9,240 1,400 $ 10,230 1) FIFO Ending inventory = 2,100 - 1,400 = 700 units Cost of ending inventory = (500 x $4.58) + (200 x $4.60) = $3,210 * higher cost of ending inventory – higher gross profit/net income 2) Weighted average Average unit cost = ($9,240/2,100) = $4.40/unit COGS = $4.40 x 1,400 = $6,160 Ending inventory = $4.40 x (2,100 - 1,400) = $3,080 Ending Inventory – Valuation Inventory is initially recorded at cost Inventory is valued at the lower of cost and NRV (LC&NRV)
NRV is the estimated selling price less the estimated costs to complete and sell Compare cost with NRV, item by item, or if appropriate, group similar items then compare by groups
Example Item Spinach Carrots Cut beans Peas Mixed vegetables Final inventory value
Cost 80,000 100,000 50,000 90,000 95,000
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
Item Spinach Carrots Cut beans Frozen
Cost 80,000 100,000 50,000 230,000
NRV 120,000 100,000 40,000 260,000
LC&NRV
Peas Mixed vegetables Canned
90,000 95,000 185,000
72,000 92,000 164,000
230,000 $394,000 $164,000
LC&NRV: Periodic vs Perpetual Inventory Beginning End of year
At Cost $65,000 $82,000
At NRV $65,000 $70,000 Direct method
Periodic
Perpetual
COGS Inventory
65,000
Inventory COGS
70,000
COGS Inventory
Allowance method COGS 65,000 Inventory 70,000
12,000
Exceptions to LC&NRV Inventories measured at Net Realizable Value if:
Inventory COGS
65,000 65,000 82,000 82,000
Loss on Inventory 12,000 Allowance to reduce Inventory to NRV
12,000
Loss on Inventory 12,000 12,000 Allowance to reduce Inventory to NRV
12,000
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 o There is no specific ASPE guidance on measurement of these assets E8-19 The following information is for Takin Enterprises Ltd.: Jan. 31 Inventory at cost 25,000 Inventory at the lower of cost and NRV 24,500 Allowance balance 500 Purchases for the month Sales for the month Jan 31 Feb 28 Mar 31 Apr 30
Feb. 28 25,100 17,600 7,500 20,000 29,000
Loss on Inventory Allow. to reduce Inventory to NRV
500
Loss on Inventory Allow. to reduce Inventory to NRV
7,000
Allow. to reduce Inventory to NRV Gain on Inventory
1,100
Allow. to reduce Inventory to NRV Gain on Inventory
700
Mar. 31 29,000 22,600 6,400 24,000 35,000
Apr. 30 23,000 17,300 5,700 26,500 40,000
500 7,000 1,100 700
Takin Enterprises Ltd. Statement of Income Sales Revenue Less: COGS Beginning Inventory Purchases Cost of Goods Available for Sale Ending Inventory COGS Gross Profit
February 28 29,000 25,000 20,000 49,100 (25,100)
Gain (loss) due to market fluctuation of inventory Net Income Gross Profit Method to estimate Ending Inventory Estimates may be required in such situations:
March 31 35,000 25,100 24,000 45,000 (29,000)
April 30 40,000 29,000 26,500 55,500 (23,000)
19,900 9,100
20,100 14,900
32,500 7,500
(7,000)
1,100
700
2,100
16,000
8,200
interim reporting fire loss testing reasonableness of cost from an actual inventory count
Method is based on 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 Example: Beginning inventory (at cost): Purchases (at cost): Sales (at selling price): Gross profit percentage on sales:
$60,000 $200,000 $280,000 30%
Beginning Inventory + Purchases – COGS = Estimated Ending Inventory COGS = sales – gross profit = sales – (30% x sales) = 70% x sales Ending inventory = 60,000 + 200,000 – (0.7 x 280,000) = $64,000 Understanding Markups • Assume you are given markup on cost • What is gross profit on selling price? Assume markup on cost is 25%: Sales = COGS + Gross Profit = COGS + (25% x COGS) = 125% x COGS COGS = Sales/125% Gross Profit = Sales x (1 - (1/1.25)) = sales x 20% If Sales is $1: Gross profit % = 1 - (1/1.25) = (1.25 – 1)/1.25 = 0.25/1.25 = 20% Gross Profit % = Markup % / (1 + markup %) E8-22 Linsang Corporation's retail store and warehouse closed for the entire weekend while the year-end inventory was counted. When the count was finished, the controller gathered all the count books and information from the clerical staff, completed the ending inventory calculations, and prepared the following partial income statement for the general manager for Monday morning: Sales Beginning inventory Purchases Total goods available for sale Less ending inventory Cost of goods sold Gross profit
2,750,000 650,000 1,550,000 2,200,000 650,000 1,550,000 1,200,000
The general manager called the controller into her office after quickly reviewing the preliminary statements. “You've made an error in the inventory,” she stated. “My pricing all year has been carefully controlled to provide a gross profit of 35%, and I know the sales are correct.” Gross profit = 0.35 x 2,750,000 = 962,500 COGS = sales – gross profit = 2,750,000 – 962,500 = 1,787,500 ending inventory = 650,000 + 1,550,000 – 1,787,500 = $412,500 Presentation and Disclosure Examples of required disclosures: 1. Measurement policy (using FIFO or weighted average?) 2. Total inventory, as well as inventory by classification (raw materials, work-in-process, finished goods) 3. Amount of inventory recognized as expense on the income statement (usually reported as COGS) 4. Any amount of inventory pledged as security for liabilities (collateral for borrowing) * IFRS has more disclosure requirements than ASPE Activity 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 Accounts Receivable Turnover = Net Sales/Revenue / Average Trade Receivables (Net) Days Sales Uncollected = 365 Days / A/R Turnover Recommended Practice Problems Inventory error: E8-5 Relative Sales Value Method: E8-12 FIFO, Moving Average Cost – Perpetual: E8-17 FIFO, Weighted Average – Periodic: P8-6 Lower of cost and net realizable value: E8-13, P8-11 Gross Profit Method: E8-21
Understated
Overstated
COGS Net income Retained earnings
Effect on current year Overstated Understated Understated
Effect on next year Understated Overstated No effect
Working capital Current ratio
Understated Understated
No effect No effect
COGS Net income Retained earnings
Understated Overstated Overstated
Overstated Understated No effect
Working capital Current ratio
Overstated Overstated
No effect No effect
Correcting Inventory Errors Assume 2014 ending inventory is understated by $10,000 Error discovered before 2014 books are closed: Inventory 10,000 Cost of goods sold
10,000
Error discovered in 2015: Inventory Retained Earnings
10,000
10,000
Error discovered in 2015 after 2015 books are closed: No journal entry, but comparative statements must use corrected figures for presentation purposes Example: 2014 -
COGS = $1,400,000 R/E = $5,200,000
December 31st inventory errors both discovered after 2014 books were closed: 2013: ending inventory overstated by $110,000 2014: ending inventory overstated by $45,000 2014 COGS
= = =
2013 ending inventory + 2014 purchases over by 110,000 over by 65,000 (110,000 – 45,000) 1,335,000 (1,400,000 – 65,000)
2014 ending inventory over by 45,000
Net income and retained earnings will be overstated by 45,000. 2014 Retained Earnings should be 5,155,000. Since the 2014 books have already been closed, journal entry to correct overstatement would be: Retained Earnings 45,000 Inventory 45,000 Inventories - “assets” o Held for sale in the ordinary course of business (finished goods) o In the process of production for such sale (work-in-process) o In the form of materials or supplies to be consumed in the production process or in the rendering of services (raw materials) - Represent a future benefit, which the entity has control over or access to - Recognition is through transaction arising from an inventory purchase and risks and rewards of ownership have passed to the purchaser Physical Goods Included in Inventory - generally determined by legal title to goods - purchase commitments should not be included, but should be disclosed if material Items included in seller’s inventory: Goods in transit o FOB shipping point legal title passes to the buyer when seller delivers the goods to the common carrier o FOB destination
legal title passes when the goods reach destination Goods out on consignment o Possession is with consignee but legal title held by consignor Goods sold under buyback agreements Goods sold with high rates of return that cannot be estimated
Inventory Cost - all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition o product costs invoice, freight, and other direct acquisition costs; borrowing cost (interest expense) o conversion costs direct labour and fixed and variable overhead (must always report actual costs but may use standard costs if they approximate actual costs) - does not include period costs (selling, general, and administrative) - purchase discounts - vendor rebates - “basket” purchases and joint product costs Purchase Discounts Assume Company A purchases goods for $10,000 with terms 2/10, net 30. Company A pays for $4,000 of this amount within the discount period and the rest after the discount period. Gross Method Purchase: Purchases A/P
Net Method
10,000
Payment w/in discount period: A/P Purchase Discounts Cash Payment after discount period A/P Cash
4,000
6,000
Purchase: Purchases 10,000 A/P
9,800 9,800
Payment w/in discount period: A/P 80 Cash 3,920 Payment after discount period A/P Purchase Discounts Lost 6,000 Cash
E8-3 March 10 11 19 24
purchases = 25,000, 3/10 n/60 purchases = 26,575, 1/15 n/30 paid (25,000 x 97%) = 24,250 purchases = 11,500, 3/10 n/30
discount until march 20 discount until march 26 discount until april 3
a) net method March 10 March 11
Purchases A/P
24,250
Purchases
26,309
24,250
3,920 3,920 5,880 120 6,000
A/P March 19
A/P
26,309 24,250
Cash March 24
Purchases A/P
24,250 11,155 11,155
b) no purchase or payment transactions as at march 31 March 31
Purchase Discounts Lost A/P
266
Purchases A/P
25,000
Purchases A/P
26,575
A/P
25,000
266
c) gross method March 10 March 11 March 19
25,000 26,575
Cash Purchase Discounts March 24
Purchases A/P
24,250 750 11,500 11,500
d) no additional entries as at march 31 under the gross method e) net method is more theoretically correct and has faithful representation compared to gross method. Also, discounts lost can be tracked for a more effective cash management. However, gross method is more cost-effective. Vendor Rebates - cash rebates related to inventory generally recorded as a reduction to the cost of inventory - record as reduction to inventory if: o non-discretionary on part of supplier o probable and amount reasonably estimated BE8-6 a) volume rebate from Traders can only be accrued if (1) the rebate is non-discretionary on the part of Traders and (2) the receipt of the rebate is probable and its value can be reasonably estimated. b) Amount of rebate to be accrued at June 30, 2014 Current units on hand Estimated number of units to be purchased Less: number of units Units that will qualify for rebate Rebate = 2,500 x $0.25 = 625
3,000 3,000 (3,500) 2,500
Jun 30/14
rebate receivable Inventory
625 625
c) Unit cost of wood frames Current inventory on hand (3,000 x $2.50) Add: Estimated inventory to be purchased Less: Rebate to be received Total cost of inventory
7,500 7,500 (625) 14,375
Unit cost = 14,375/(3,000 + 3,000) = $2.40 per unit Basket Purchases and Joint Product Costs - total costs allocated to units based on relative sales value BE8-8 Group 1 2 3 total
# of CDs 100 800 100 1,000
price per CD 5 10 15
total price 500 8,000 1,500 10,000
% share 5 80 15 100
cost allocated 5% x 7,500 = $375 80% x 7,500 = $6,000 15% x 7,500 = $1,125 $7,500
cost/unit $3.75 $7.50 $11.25
Inventory Accounting System 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 - helped reduce inventory levels (minimize storage costs) - only purchase inventory when needed - made to order; Dell, car manufacturers (customized) perpetual system - maintains a continuous record of inventory changes - costly to implement but gives up-to-date information at any given time periodic system - updates inventory records in the ledger only periodically - recommended for smaller businesses perpetual system Purchases, cost of freight, purchase returns, discounts are all directly debited to the Inventory account COGS and Inventory accounts are up to date Physical count is still required periodically to ensure physical stock = accounting stock BE8-3
periodic system Purchases, cost of freight, purchase returns, discounts are debited to their respective accounts COGS and Inventory accounts are updated after the physical inventory count COGS is a residual amount COGS = beg. inventory + purchases – end. inventory
Beginning inventory = 50 x $100 = $5,000 Sept purchase = 200 x $100 = $20,000 (AP) Sept purchase returns = 6 x $100 = $600 credit Sept sales = 150 x $200 = $30,000 (AR) Perpetual system: Purchase Purchase returns
Inventory A/P
20,000
A/P
600
20,000
Inventory Sales
A/R
600 30,000
Sales revenue
Periodic System: Purchase Purchase returns
30,000
COGS (150 x $100) Inventory
15,000
Purchases A/P
20,000
A/P
600
15,000
20,000
Purchase returns Sales
A/R
600 30,000
Sales revenue
30,000
Month-end adj = ending inventory – beginning inventory = (94 – 50) x $100 = $4,400 COGS = 5,000 + (20,000 – 600) – 9,400 = 15,000 Month-end adj
Inventory Purchase returns COGS Purchases
4,400 600 15,000 20,000
Cost Formula - determines the costs that should be assigned to ending inventory and COGS o specific identification o weighted average cost o first-in, first-out (FIFO) Special 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 repeated at specific cost
Disadvantages: May be costly to implement and maintain May lead to income manipulation May be difficult to allocate certain costs (storage, shipping) to specific inventory items Weighted Average Cost - 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 - (for periodic inventory) moving average cost formula - refers to average method used with perpetual records (both units and dollars) Example: March transactions Date Purchases 1 beginning (500 @3.80) 2 1,500 @ 4.00 15 6,000 @ 4.40 19 30 2,000 @ 4.75 total 10,000
Cost $1,900 $6,000 $26,400
Sales
4,000 $9,500 $43,800
Balance (units) 500 2,000 8,000 4,000 6,000
weighted average: inventory cost = 43,800/10,000 = $4.38/unit ending inventory = $4.38 x 6,000 = $26,280 COGS = $4.38 x (10,000 – 6,000) = $17,520 Moving average: Date 1 2 15 19 30 total
Purchases beginning (500 @3.80) 1,500 @ 4.00 6,000 @ 4.40
Cost $1,900 $6,000 $26,400
2,000 @ 4.75 10,000
$9,500 $43,800
Sales
4,000
Balance (units) 500 2,000 8,000 4,000 6,000
COGS = $4.2875 x 4,000 = $17,150 Ending inventory = ($4.2875 x 4,000) + $9,500 = $26,650 ($4.4417/unit)
FIFO Advantages:
cost/unit $4.2875
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 Example: Date Mar 1 Mar 2 Mar 15 Mar 30
Purchases 500 1500 6000 2000 10,000
Unit Cost $3.80 $4.00 $4.40 $4.75
Purchase Cost $1,900 $6,000 $26,400 $9,500 $43,800
Units Sold on Mar 19 500 1500 2000
Mar 19 – 4000 units sold COGS = $1,900 + $6,000 + (2000 x $4.40) = $16,700 Ending Inventory = (4000 x $4.40) + $9,500 = $27,100 E8-16 The following information is for the inventory of mini kettles at Funnell Company Ltd for the month of May: Date Transaction Units In Unit Cost Total Units Sold Unit Price Total May 1 Balance 100 $ 4.10 $ 410 6 Purchase 800 4.20 3,360 7 Sale 300 $ 7.00 $ 2,100 10 Sale 300 7.30 2,190 12 Purchase 400 4.50 1,800 15 Sale 200 7.40 1,480 18 Purchase 300 4.60 1,380 22 Sale 400 7.40 2,960 25 Purchase 500 4.58 2,290 30 Sale 200 7.50 1,500 Totals 2,100 $ 9,240 1,400 $ 10,230 1) FIFO Ending inventory = 2,100 - 1,400 = 700 units Cost of ending inventory = (500 x $4.58) + (200 x $4.60) = $3,210 * higher cost of ending inventory – higher gross profit/net income 2) Weighted average Average unit cost = ($9,240/2,100) = $4.40/unit COGS = $4.40 x 1,400 = $6,160 Ending inventory = $4.40 x (2,100 - 1,400) = $3,080 Ending Inventory – Valuation Inventory is initially recorded at cost Inventory is valued at the lower of cost and NRV (LC&NRV)
NRV is the estimated selling price less the estimated costs to complete and sell Compare cost with NRV, item by item, or if appropriate, group similar items then compare by groups
Example Item Spinach Carrots Cut beans Peas Mixed vegetables Final inventory value
Cost 80,000 100,000 50,000 90,000 95,000
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
Item Spinach Carrots Cut beans Frozen
Cost 80,000 100,000 50,000 230,000
NRV 120,000 100,000 40,000 260,000
LC&NRV
Peas Mixed vegetables Canned
90,000 95,000 185,000
72,000 92,000 164,000
230,000 $394,000 $164,000
LC&NRV: Periodic vs Perpetual Inventory Beginning End of year
At Cost $65,000 $82,000
At NRV $65,000 $70,000 Direct method
Periodic
Perpetual
COGS Inventory
65,000
Inventory COGS
70,000
COGS Inventory
Allowance method COGS 65,000 Inventory 70,000
12,000
Exceptions to LC&NRV Inventories measured at Net Realizable Value if:
Inventory COGS
65,000 65,000 82,000 82,000
Loss on Inventory 12,000 Allowance to reduce Inventory to NRV
12,000
Loss on Inventory 12,000 12,000 Allowance to reduce Inventory to NRV
12,000
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 o There is no specific ASPE guidance on measurement of these assets E8-19 The following information is for Takin Enterprises Ltd.: Jan. 31 Inventory at cost 25,000 Inventory at the lower of cost and NRV 24,500 Allowance balance 500 Purchases for the month Sales for the month Jan 31 Feb 28 Mar 31 Apr 30
Feb. 28 25,100 17,600 7,500 20,000 29,000
Loss on Inventory Allow. to reduce Inventory to NRV
500
Loss on Inventory Allow. to reduce Inventory to NRV
7,000
Allow. to reduce Inventory to NRV Gain on Inventory
1,100
Allow. to reduce Inventory to NRV Gain on Inventory
700
Mar. 31 29,000 22,600 6,400 24,000 35,000
Apr. 30 23,000 17,300 5,700 26,500 40,000
500 7,000 1,100 700
Takin Enterprises Ltd. Statement of Income Sales Revenue Less: COGS Beginning Inventory Purchases Cost of Goods Available for Sale Ending Inventory COGS Gross Profit
February 28 29,000 25,000 20,000 49,100 (25,100)
Gain (loss) due to market fluctuation of inventory Net Income Gross Profit Method to estimate Ending Inventory Estimates may be required in such situations:
March 31 35,000 25,100 24,000 45,000 (29,000)
April 30 40,000 29,000 26,500 55,500 (23,000)
19,900 9,100
20,100 14,900
32,500 7,500
(7,000)
1,100
700
2,100
16,000
8,200
interim reporting fire loss testing reasonableness of cost from an actual inventory count
Method is based on 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 Example: Beginning inventory (at cost): Purchases (at cost): Sales (at selling price): Gross profit percentage on sales:
$60,000 $200,000 $280,000 30%
Beginning Inventory + Purchases – COGS = Estimated Ending Inventory COGS = sales – gross profit = sales – (30% x sales) = 70% x sales Ending inventory = 60,000 + 200,000 – (0.7 x 280,000) = $64,000 Understanding Markups • Assume you are given markup on cost • What is gross profit on selling price? Assume markup on cost is 25%: Sales = COGS + Gross Profit = COGS + (25% x COGS) = 125% x COGS COGS = Sales/125% Gross Profit = Sales x (1 - (1/1.25)) = sales x 20% If Sales is $1: Gross profit % = 1 - (1/1.25) = (1.25 – 1)/1.25 = 0.25/1.25 = 20% Gross Profit % = Markup % / (1 + markup %) E8-22 Linsang Corporation's retail store and warehouse closed for the entire weekend while the year-end inventory was counted. When the count was finished, the controller gathered all the count books and information from the clerical staff, completed the ending inventory calculations, and prepared the following partial income statement for the general manager for Monday morning: Sales Beginning inventory Purchases Total goods available for sale Less ending inventory Cost of goods sold Gross profit
2,750,000 650,000 1,550,000 2,200,000 650,000 1,550,000 1,200,000
The general manager called the controller into her office after quickly reviewing the preliminary statements. “You've made an error in the inventory,” she stated. “My pricing all year has been carefully controlled to provide a gross profit of 35%, and I know the sales are correct.” Gross profit = 0.35 x 2,750,000 = 962,500 COGS = sales – gross profit = 2,750,000 – 962,500 = 1,787,500 ending inventory = 650,000 + 1,550,000 – 1,787,500 = $412,500 Presentation and Disclosure Examples of required disclosures: 1. Measurement policy (using FIFO or weighted average?) 2. Total inventory, as well as inventory by classification (raw materials, work-in-process, finished goods) 3. Amount of inventory recognized as expense on the income statement (usually reported as COGS) 4. Any amount of inventory pledged as security for liabilities (collateral for borrowing) * IFRS has more disclosure requirements than ASPE Activity 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 Accounts Receivable Turnover = Net Sales/Revenue / Average Trade Receivables (Net) Days Sales Uncollected = 365 Days / A/R Turnover Recommended Practice Problems Inventory error: E8-5 Relative Sales Value Method: E8-12 FIFO, Moving Average Cost – Perpetual: E8-17 FIFO, Weighted Average – Periodic: P8-6 Lower of cost and net realizable value: E8-13, P8-11 Gross Profit Method: E8-21
