FA2: Module 7Inventories and Cost of Goods Sold
Definition of inventoryCost of inventoryInventory systemsEffect of inventory errorsCostinginventoryInventory valuationThe gross profit methodRetail inventory methodValuation of inventory at NRV
1. Definition of inventory
Inventoryincludes goods awaiting sale, goods in various stages of production and supplies. Inventory is a current asset.
Inventory definition problems
Any inventory items held for resale or use by company should be included in inventory if it is owned by the company, regardless of location:-items out on consignment (held by an agent who pays for items only if they sell)-purchased items in transit that are FOB (free on board) shipping point-sold items in transit that are FOB destination
Inventory definition problems (cont’d)
The following items should be excluded from inventory:-items belonging to another firm that are held on consignment-purchased items that are awaiting return to vendor for credit-items purchased with a repurchase agreement, when it is likely that the items will be returned
2. Cost of inventory
Inventoryis initially valued at historical cost, which includes all costs necessary to acquire the inventory andprepare it for sale (laid- down cost); plus transportation.(e. g., A8-1)
3. Inventory systems
Periodic inventory systemSystem of recording inventory-related transactions (purchases, sales) wherein Inventory and Cost of Goods Sold are updated onlyonce per period.Perpetual inventory systemSystem of recording inventory-related transactions (purchases, sales) wherein Inventory and Cost of Goods Sold are updatedafter each inventory-related transaction.
Bookkeeping: Periodic vs. perpetual systems
Inventory vs. cost of goods sold
Beginning inventory+Purchases or Goods manufactured=Cost of goods available for sale=Cost of goods sold+Ending inventory
4. Effect of inventory errors
Inventory errors affect both the balance sheet (inventory is misstated) and the income statement (COGS or inventory shortage is misstated). Inventory errors are counterbalancing (reverse over time).Year 1Year 2Beginning inv OKError+ Purchases OK OKEnding inventoryErrorOK= Cost of goods sold Error Error
Effect of inventory errors (periodic)
5.Costinginventory (and COGS)
Specific identificationFirst-in, first-out (FIFO)Average costExample:A8-25
a. Specific identification
Definition:Keep track of each item in inventory (e. g., by serial number). Identify each item sold (and its cost) to determine COGS; identify items left in inventory (and their costs) to determine ending inventory.Comments:best possible matching of revenue and COGS but vulnerable to manipulation by managementadministratively cumbersomeused for valuable and easily identifiable merchandise
b. First-in, first-out (FIFO)
Definition: Assume that oldest units in inventory are first ones sold (e. g., perishable goods in a grocery store).Comments“Favours” the balance sheet: Most current costs are included in cost of inventory, while oldest costs are in COGS. Net income is therefore (perhaps) less relevant.Eliminates opportunities for income manipulation by management.
c. Average cost
DefinitionCompute one average cost figure for all units of inventory = total cost of goods available for sale divided by total number of units available for sale. COGS = units sold X average cost. Inventory = units left X average cost.CommentsSingle, convenient, cost
6.Inventory valuation: Lowerof cost ornetrealizablevalue
Historical cost vs. market valueHistorical cost is one of the basic principles of Canadian financial accounting. Historical cost is abandoned, however, when the future utility (revenue-generating ability) of the asset is no longer as great as its original cost.For inventory, market value is generally taken to benet realizable value, expected selling price less predictable completion and selling costs.
Applying thelower of cost or NRV rule
Determine cost usingacceptable methodComparethe cost tonet realizable value andadjust carrying value if necessaryThe lower of cost or NRV rule is usuallyapplied on an item-by-itembasis, but can be applied ona category-by-categorybasis if goods within category are very similar.Previouswritedownsshouldberecovered as reduction in COGS, although amount of recovery must be disclosed in notes.
Lower of cost or NRV:Bookkeeping
Direct methodIfNRV< cost, ending inventory is recorded atNRV.Any valuation loss is buried in Cost of Goods Sold.Indirect (Allowance) methodEnding inventory is recorded at cost. IfNRV< cost, a valuation allowance (contra-asset account) is established to record any decline below cost; and a loss is recorded.
Lower of cost or NRV:Bookkeeping
Indirect (Allowance) methodThe valuation allowance is only adjusted once per periodThe valuation allowance can never have a debit balance (i. e., inventory cannot be written up to some value greater than its cost)
Example: The allowance method
Lower of cost orNRVexampleA8-8
7. The gross profit method
On occasion, estimation methods are used to approximate inventory on hand. Thegross profit methodis one of these and is usually not acceptable for annual financial statement purposes. However, it is useful when a physical count of inventory is impractical or impossible, e. g.,:interim financial reportsEstimates of damaged or lost inventory
The gross profit method: Nuts and bolts
Beginning inventory BI+ Net purchasesPGoods available for sale (at cost) BI+PNet sales (at selling price) REVLess gross profitGP= % x REV-Cost of goods soldREV-GPApproximate inv. (at cost) BI+P – (REV-GP)*Assumes it is possible to estimate GP%.Example:A8-21
8. The retail inventory method
Basic stepsDetermine cost of goods available for sale at cost and retail.Compute cost ratio (ratio of cost to retail value of goods available for sale)Compute closing inventory at retail (goods available at retail, less sales)Compute closing inventory at cost (closing inv. at retail X cost ratio)
Markups and markdowns
Markup: initial amount added to cost to determine selling priceAdditional markup: increase in selling price above original selling priceAdditional markup cancellation: Cancellation of some or all of additional markupMarkdown: Reduction in original sales priceMarkdown cancellation: Increase in sales price after markdown (not above original sales price)
Markups and markdowns and retail method
A standard application of the retail method includes net additional markups and net markdowns (markups/markdowns less cancellations) in the retail value of goods available forsale (in step 3),butexcludes netmarkdownsfrom the denominator of the costratio (in step 2).This results in a lower cost ratio that approximates the application of the lower of costor NRVrule.Example:A8-21
9. Valuation of inventory at NRV
Under certain, relatively rare, circumstances, inventory is valued at net realizable value regardless of cost. This can occur when:Revenue is recognized at the point of production (e. g.,biological assets, agricultural produce, minerals) if this is widely use in the industryFinancial instruments held for trading (by securities dealers)Damagedor obsolete goods