Download Intermediate Accounting - McGraw Hill Higher Education

Intermediate Accounting
Thomas H. Beechy
Schulich School of
Business,
York University
Joan E. D. Conrod
Faculty of Management
Dalhousie University
Powerpoint slides by:
Michael L. Hockenstein  Commerce Department • Vanier College
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
Inventories
Chapter 9
9-2
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Importance of Inventories
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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
9-3
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Inventory Categories
 Inventories consist of costs that have been incurred
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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
9-4
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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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
9-5
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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
9-6
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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
We will look at:
 Items and costs to include in inventory
 Cost flow assumptions
 Application of LCM (lower of
cost or market) valuations
9-7
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Items and Costs Included in Inventory
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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
9-8
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Elements of Inventory Cost
 Invoice price: Total cash equivalent outlay
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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
9-9
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Items Not Included in Inventory
 Examples include: (on grounds of materiality),
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9-10
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 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
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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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
9-11
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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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]
9-12
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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
9-13
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Periodic vs. Perpetual–Illustration
Lea Company
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Beginning inventory
Purchases
Goods available for sale
Less: Sales
Ending inventory, as calculated
Ending inventory,
based on physical count
Shrinkage
500
1,000
1,500
900
600
$4.00 $2,000
4.00 4,000
$6,000
580
20
9-14
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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
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
$4,000
$2,000
$4,000
9-16
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Credit
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Perpetual Recording Lea Company (cont.)
GENERAL JOURNAL
Date
July 31
Description
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
$4,000
$9,000
$3,600
9-17
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Credit
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Periodic vs. Perpetual Recording Methods
 The choice of recording method is one of

practicality–which method gives the best costbenefit relationship?
Common Cost Flow Assumptions
 Specific Identification
 Average Cost
 First-In, First-Out
 Last-In, First-Out
9-18
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Choosing a Recording Method
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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
9-19
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Common Cost Flow Assumptions
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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
9-20
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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]
9-21
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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
 May be inconvenient and difficult to establish just
which items were sold and what was their specific
initial cost
9-22
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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
9-23
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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
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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
9-24
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Last-In, First-Out
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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
9-25
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Income Tax Factors
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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.
9-26
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Review
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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
9-27
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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
9-28
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Special Aspects
 Standard cost
 Just-In-time inventory systems
 Damaged and obsolete goods
 Losses on purchase commitments
 Inventories carried at market value
9-29
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Standard Cost
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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
9-30
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Standard Cost (cont.)
 Actual historical cost is used only once, on acquisition,
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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
9-31
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Just-In-Time Inventory Systems
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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
9-32
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Just-In-Time Inventory Systems (cont.)
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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-quitein-time)
9-33
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Damaged and Obsolete Inventory
 Special inventory categories often include items for
resale that are damaged, shopworn, obsolete,
defective, or are trade-ins or repossessions
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These inventory items are valued at current
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
9-34
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Losses on Purchase Commitments
 Purchase commitments (contracts)---to lock in
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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
9-35
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Lower of Cost or Market Valuation
 GAAP requires that inventories be valued either at
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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?
9-36
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
Definition of Market Value
 The basic difficulty with determining market value is
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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
9-37
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
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
9-38
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Extent of Grouping (cont.)
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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
9-39
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
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
$1,000
Allowance to reduce inventory to LCM $1,000
9-40
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
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
9-41
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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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]
9-42
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

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]
9-43
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
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
9-44
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
Gross Margin Method
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
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
9-45
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
Gross Margin Method Steps to Follow
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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
9-46
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
Exhibit 9-12
9-47
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
Retail Inventory Method
 The retail inventory method is often used by retail
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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
9-48
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
Markups and Markdowns
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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
9-49
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
Retail Method Steps to Follow
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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
9-50
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
Exhibit 9-15
9-51
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