Inventories and Cost of sales

1. Inventories andCost of sales BUS320 Fall 2010

10. Inventory Definition of Inventory: Inventories are “assets: held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.”

11. Types of Inventory Merchandising Manufacturing merchandise finished goods inventory work in process raw materials production supplies Contracts in process Supplies inventory

12. Inventory Cost Flows Raw Materials Direct Labour Mfg. Overhead Manufacturing Operations Work in Process Inventory Finished Goods $$$ COGM $$$ COGS COGS $$$

13. Management concerns revenue earning component sensitivity to economic conditions critical nature of ‘price’ protection/control of the goods want to: minimize: obsolescence, over/under stocking, spoilage, damage, theft maximize: sales techniques, inventory management, market share, brand loyalty

14. Items and costs to be included in inventory All goods for sale or reuse regardless of location goods purchased and in transit if title has passed FOB shipping point FOB destination goods owned but out on consignment BUT not goods on consignment that the entity is selling for someone else ALSO not count goods received from a supplier but tagged for return to the supplier

15. Special sales agreements Sales with buyback agreement agree to sell and then buy back at fixed prices on a specific date – if buyer does not sell the goods, they can be returned to the seller e.g. book publishing inventory must remain on sellers books until it is known how many goods will be bought back can recognize sale if returns can be reasonably estimated may need to look beyond legal ownership

16. Sale with buyback agreement Hill sells inventory to Chase agrees to re-purchase at specified price over specified time Chase borrows against inventory and remits to Hill Cash Hill buys back inventory Chase uses proceeds to pay off loan True effect: financing However, shows no liability assets up loan will be paid

17. costs of purchase, costs of conversion, and other costs Costs to be included in inventory all costs incurred to bring the inventories to their present location and condition purchase costs, excise costs, transportation costs, insurance, storage, handling costs, costs to assemble [transportation often listed separately because of the difficulty of allocating it among pieces of inventory] cash discounts (2/10, net 30) inventory should be recorded at the lower (discount taken) price. If discount not taken, the extra (to reach gross price) is recognized as a financing cost many companies, however, record at gross with purchase discount if taken to a condition and place ready for sale

18. BE8-4 (a) (1) Gross method (2) Net method

19. BE8-4 (contd.) (b) Payment made on July 31 instead of July 15 (1) Gross method (2) Net method

20. Service contracts direct costs – direct labour, materials, equipment overhead costs – costs necessary to complete service but which cannot be assigned to any one contract work in process OR work in progress Manufactured goods raw materials direct labour overhead – allocated on basis of normal capacity can use standard costs if based on normal capacity Supplies inventory used during production – lubricant, nuts, bolts, etc. often combined with raw materials

21. Interest or borrowing costs • Under IFRS, interest costs are included as product costs if the interest costs are incurred for an inventory item that takes a long time to produce or manufacture • however, if the financing relates to inventories manufactured in large quantity and on a repetitive basis, company has a choice whether to capitalize the interest costs or not • Under PE-GAAP, interest costs may be either capitalized or expensed, but policy must be disclosed

22. Other issues to consider: • 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 • Period costs (selling, general, and administrative) are not inventoriable costs

23. E8-4

24. E8-4 (contd.) (a) (b) Private company: (c) A public company:Under IFRS, interest costs incurred for inventory are capitalized if the inventory takes a long time to produce or manufacture – such as wine production. Additionally, if the interest costs relate to inventory manufactured in large quantities on a repetitive basis, a choice is permitted for capitalization.

25. 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

26. Periodic System Uses Inventory accountto hold inventory at the beginning of the year During year, Purchases account used when goods are purchased Purchases discounts Purchase returns and allowance Freight-in (transportation-in) When items sold, record only the sales side of transaction Accounts not contain information about inventory on hand during the period End of period – count inventory - assign a cost Then subtract from goods available for sale to get cost of goods sold } reduce purchases

27. Beginning inventory • + Purchases • Purchase discounts • Purchase returns and allowances • + Transportation-in • = Goods available for sale • - Ending inventory • = Cost of goods sold

28. Perpetual System Uses Inventory account for beginning inventory and for purchases throughout the period new inventory purchases increase inventory account sales reduce inventory account Inventory Cost of goods sold Beginning bal New goods New goods New goods Sold items Sold items Sold items Sold items Sold items Sold items Sold items Sold items Uses Cost of goods sold account each time inventory is sold Cost of goods sold xx,xxx Inventory xx,xxx

29. Perpetual System • A subsidiary ledger is maintained for individual inventory items on hand • Periodic inventory counts are still required to ensure reliability • 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) • 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)

30. Cost flow assumptions Specific identification FIFO (first-in, first-out) Average weighted average (periodic) moving average (perpetual) IFRS and PE-GAAP recognize only these three acceptable cost formulas • The ending inventory in units is the same under 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 LIFO is not acceptable because: • LIFO does not represent actual inventory flows reliably • Costs assigned to ending inventory (oldest costs) do not represent recent cost of inventory on hand • Can distort reported income on the income statement LIFOhas never been allowed by CRA

31. 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 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 Weighted average • 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 weighted-average method used with perpetual records (both units and dollars)

32. Choice of Cost Flow Assumptions IFRS and PE-GAAP limit the choice of cost formula Specific identification is required in some cases Should choose the best method that: - best reflects the physical flow - reflects the most recent costs in the inventory account, and - use this method for all inventory assets with same characteristics

33. E8-14

34. E8-14 (a) Periodic inventory system with FIFO cost flow assumption: #units Beginning inventory 1,000 Purchases (2,000 + 3,000) 5,000 Goods available for sale 6,000 Sold (2,500 + 2,000) 4,500 Goods on hand 1,500 1,000 x $12 $12,000 2,000 x $18 $36,000 3,000 x $23 $69,000 Available for sale $117,000 Cost of goods sold (FIFO): 1,000 x $12 $12,000 2,000 x $18 36,000 1,500 x $23 34,500 4,500$82,500

35. E8-14 (b) Periodic inventory system with weighted average cost flow assumption: #units Beginning inventory 1,000 Purchases (2,000 + 3,000) 5,000 Goods available for sale 6,000 Sold (2,500 + 2,000) 4,500 Goods on hand 1,500 1,000 x $12 $12,000 2,000 x $18 $36,000 3,000 x $23 $69,000 6,000 $117,000 Weighted average cost per unit = $117,000/6,000 = $19.50 Cost of goods sold (weighted average): 4,500 x $19.50 $87,750

36. E8-14 (b) Perpetual inventory system with moving average cost flow assumption: b 500 x $16 = $8,000 3,000 x $23 = $69,000 3,500$77,000 Moving average cost per unit: $77,000 ÷3,500 = $22 a 1,000 x $12 = $12,000 2,000 x $18 = $36,000 3,000$48,000 Moving average cost per unit: $48,000 ÷3,000 = $16

37. Lower of cost and “market” IFRS (IAS2) requires that it be applied on individual items but allows similar items to be lumped together – similar characteristics, same product line IFRS (IAS2) requires the use Net realizable value (NRV) as “market” i.e., normal selling price less selling costs If “market” lower than cost: assign the lower “market” value to the ending inventory (direct method) causes COGS to rise and the loss is ‘buried’ OR assign calculated cost to ending inventory, then record a loss and reduce the ending inventory or use an allowance similar to allowance on the valuation of investments (indirect or allowance method) If “market” value recovers in an accounting period after the write-down, inventory can be written back up, through reduction to COGS, in the period that the recovery occurs (change in economic circumstances or situation that caused the write-down no longer exists)

38. Lower of Cost and NRV - example Item Cost NRV LC&NRV Spinach $ 80,000 $120,000 $ 80,000 Carrots 100,000 100,000 100,000 Cut beans 50,000 40,000 40,000 Peas 90,000 72,000 72,000 Mixed vegetables 95,000 92,000 92,000 Final inventory value $ 384,000 Under IFRS (IAS2): Comparison of cost and NRV should be done on an item-by-item basis Grouping inventory for purposes of valuation is permitted only under certain circumstances Do you know why IFRS has this specific requirement?

39. Recording Decline in NRV– Direct Method (Perpetual Inventory System) Example: InventoryAt CostAt NRVAdjustment Beginning $65,000 $65,000 $ -0- End of year $90,000 $72,000 $18,000 Under the Direct method, at the end of year: Cost of Goods Sold 18,000 Inventory 18,000

40. Recording Decline in NRV: Indirect Method (Perpetual Inventory System) Example: InventoryAt CostAt NRVAdjustment Beginning $65,000 $65,000 $ -0- End of year $90,000 $72,000 $18,000 Under the Allowance method, at the end of year: Loss Due to Decline in NRV 18,000 Allowance to Reduce Inventory 18,000

41. Inventory excluded from IAS 2 Investment held for trading Commodities agricultural inventories (IAS 41) agricultural and forest products minerals and mineral products commodity inventories held by broker-traders items often measured at NRV rather than cost Construction contracts

42. Other issues Damaged or obsolete inventory valued at NRV remove from regular inventory Inventory, damaged goods (NRV) xx,xxx Loss from damage xx,xxx Inventory (original cost) xx,xxx Losses on purchase commitments contract with a supplier for specific amount at specific prices loss when: purchase contract not subject to revision or cancellation loss is likely and material loss can be reasonably estimated

43. Recognize loss on purchase commitments when discovered: Estimated loss xx,xxx Estimated liability on noncancellable contract xx,xxx When receive goods, record at replacement cost: Inventory (or Purchases) xx,xxx Estimated liability on noncancellable contract xx,xxx Cash xx,xxx If replacement cost has dropped below estimated amount, recognize further loss Inventory xx,xxx Estimated liability on noncancellable contract xx,xxx Loss on purchase contract xx,xxx Cash xx,xxx

44. Inventory errors Not estimation errors – estimation errors are possible and are not considered to be errors Cut-off errors goods in transit goods on premises for which title has passed goods missed in an inventory count Assume ending inventory overstated by $500 at the end of 2009 error discovered in 2010. In 2009 Inventory on B/S too high COGS too low Net income too high R/E too high If do nothing to fix the 2009 error, In 2010 Inventory on B/S not affected COGS too high because Beg. Inv. too high Net income too low R/E not affected

45. E8-8 Item 1

46. E8-8 Item 2

47. E8-8 Item 3

48. E8-8 (contd.)

49. E8-8 (contd.)

50. Inventory estimation methods Why estimate inventory? Under periodic system may want to know inventory balance without doing an inventory count Inventory may be destroyed, stolen, etc. and you need to know for insurance purposes If using periodic system may want an estimate of inventory before you count it – judge reasonableness of inventory count Gross margin method requires the development of an estimated gross margin rate applies the rate to appropriate group of items