Inventories

2. Inventories Chapter 9

3. 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 • Inventory accounting methods and management practices can become profit-enhancing tools • Inventory effects on profits are more noticeable when business activity fluctuates

4. 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

5. Inventory Categories (cont.) • Merchandise inventory:Goods on hand purchased by a retailer or a trading company such as an importer or exporter for resale • Production inventory: The combined inventories of a manufacturing or resource entity, consisting of: • Raw materials inventory • Work-in-process inventory • Finished goods inventory • Production supplies inventory

6. Inventory Categories (cont.) • Contracts in progress:the accumulated costs of performing services required under contract • Miscellaneous inventories: e.g., 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

7. 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 • We will look at: • Items and costs to include in inventory • Cost flow assumptions • Application of LCM (lower of cost or market) valuations

8. 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

9. 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 fulfil the requirements of the service contract • Freight charges and other incidental costs incurred in connection with the purchase of tangible inventory • Purchase discounts • Other costs to get the inventory ready for sale

10. Items Not Included in Inventory • Examples include: (on grounds of materiality), • 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

11. Variable vs. Fixed Overhead • Manufacturing companies and service firms engaged in long-term contracts often use variable costing for internal management planning and control purposes • Variable costing (direct costing method) A method of assigning cost to inventory that includes variable overhead as well as direct material and direct labour; fixed overhead costs are excluded and treated as period costs

12. Variable vs. Fixed Overhead (cont.) • 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]

13. Cost Flow Assumptions • Periodic inventory system: inventory value is determined only at particular times, such as at the 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

14. Periodic vs. Perpetual–Illustration Lea Company • Beginning inventory 500 $4.00 $2,000 • Purchases 1,000 4.00 4,000 • Goods available for sale 1,500 $6,000 • Less: Sales 900 • Ending inventory, as calculated 600 • Ending inventory, based on physical count 580 • Shrinkage 20

15. Calculating Cost of Goods Sold (COGS) Lea Company Beginning Inventory 500 x $4.00 $2,000 + Purchases (net) 1000 X $4.00 $4,000 = Cost of Goods Available for Sale $6,000 - Ending Inventory 580 x $4.00 $2,320 = Cost of Goods Sold (residual amount) $3,680

16. $4,000 Purchases $4,000 Accounts Payable To Record the purchases $3,680 Cost of Goods sold Inventory ( closing, per count) $2,320 $2,000 Inventory ( opening) Purchases $4,000 Periodic Recording Lea Company

17. $4,000 Inventory [$1,000 x $4] $4,000 Accounts Payable Accounts receivable [900 x $10] $9,000 Sales Revenue $9,000 Cost of goods sold [900 x $4] $3,600 Inventory $3,600 Perpetual Recording Lea Company (cont.)

18. Periodic vs. Perpetual Recording Methods • 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

19. 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

20. Common Cost Flow Assumptions • LIFO is not a popular method in Canada because 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

21. Common Cost Flow Assumptions (cont.) • 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]

22. 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 • May be inconvenient and difficult to establish just which items were sold and what was their specific initial cost

23. Average Cost • When the average cost method is used in a periodic system, it is called a weighted average system = Weighted-average unit cost beginning inventory cost + total current period purchase costs number of units in the beginning inventory + units purchased during the period

24. 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 • 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

25. 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

26. Income Tax Factors • Canada Customs and Revenue Agency 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) • Financial Reporting in Canada 1997 reported that only about 3% of the sample companies use LIFO for any part of their inventory.

27. Review • When prices are rising, FIFO will produce higher inventory, lower cost of goods sold, and higher income • 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

28. Review (cont.) • Canadian practice is 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

29. Special Aspects • Standard cost • Just-In-time inventory systems • Damaged and obsolete goods • Losses on purchase commitments • Inventories carried at market value

30. 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 that 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

31. Standard Cost (cont.) • 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

32. 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

33. Just-In-Time Inventory Systems (cont.) • 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)

34. Damaged and Obsolete Inventory • 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 atcurrent replacement cost: 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):the estimated sale price less all costs expected to be incurred in preparing the item for sale

35. 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 • when a loss is likely and material • when the loss can be reasonably estimated

36. 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, 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?

37. 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

38. 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 • Consistency in application over time is essential

39. Extent of Grouping (cont.) • 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

40. 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 • 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 $1,000Allowance to reduce inventory to LCM $1,000

41. 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

42. 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]

43. Disclosure (cont.) • 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] • any change in valuation from that used in the prior period, and the effect of a change on net income [CICA 3030.13]

44. Inventory Estimation Methods • When statements are needed and it is difficult, or impractical, to take a physical inventory, inventory can be calculated by the • Gross Margin Method • Retail Inventory Method

45. 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 • The gross margin method has two basic characteristics (1) it requires the development of an estimated gross margin rate for different lines or products (2) it applies the rate to relevant groups of items

46. Gross Margin Method Steps to Follow • 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 estimated 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

47. Exhibit 9-12

48. 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

49. Markups and Markdowns • 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 • 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

50. Retail Method Steps to Follow • 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