Chapter 8 Inventory

Prepared in part by: Sarah McVay University of Washington

Introduction

Organization of ChapterIntroductionRecognition-risks and rewards of ownership have transferredGoods in Transit, Consigned goods, Buyback agreements, High rates of return, Purchase commitments-Onerous contractsInventory errorsMeasurement-Treatment of purchase discounts, Vendor rebates, Basket purchasesCost Formulas -Perpetual vs. PeriodicFIFO, Weighted Avg, Specific Identification, LIFO. Perpetual vs. PeriodicEstimating Inventory Gross Profit % and Retail Method (appendix A)

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IntroductionInventory ConceptsIntroduction/ReviewAsset- reported on the balance sheet (current or long term?)Held for sale in the ordinary course of business.Increases when we purchase inventory (or raw materials)Decreases when we sell goods

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IntroductionTypes of InventoryIntroduction/ReviewInventoryMerchandiseManufacturing???

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Journal Entries - ReviewIntroduction/ReviewJournal Entries for initial purchase of inventory/raw materials up to the sale of goods to customers.For a manufacturing firm?Wood-Workers R Us makes wooden spoons. They first buy raw wood ($10) and then work for one hour ($20 in labor), to make the spoon, then sell the spoon for $50For a merchandising firm? Spoons R Us sells wooden spoons it purchases from another company for $35, then sell the spoon for $50.

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What is included in Inventory?Introduction/ReviewInventory recognized when substantially all risks and rewards have transferred to the purchaser.Complications:Goods in transitdepends on whether title transfersFOB (free on board) Shipping Point buyers at the time of the delivery to common carrierFOB Destination buyers when they receive the goods from the common carrier

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What is included in Inventory?Introduction/ReviewComplications Continued:Consigned goodsSellers (title remains with seller)Sales with buyback agreementsSellersSales with high rates of returnsBuyers if you can estimate returns, Seller o/wSales with delayed payment terms (installments)Buyers, if you can estimate collectibility, Sellers o/w

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Purchase CommitmentsFormal, non-cancelable purchase contracts are not recognized as inventory but should be disclosed in the footnotes. If inventory prices rise no gain recorded but commitment is disclosedIf inventory prices fall and contract is not cancellable or renegotiable then you must recognize the loss on the commitment.

At time of loss:Dr. Loss on Purchase Contract 15Cr. Provision for Onerous Contracts 15

At time of inventory purchase:Dr. Provision for Onerous Contracts 15Dr. Inventory250Cr. Cash265

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Effects of ErrorsOther Inventory issuesWhat if you used the periodic method and didnt count inventory that was in a closet in year 1, then at the end of year 2, you counted it correctlyYear 1 Year 2Effect on Inventory Effect on COGS Effect on Net Income Effect on Retained Earnings

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*Costs Included in InventoryOther issues to consider: Purchases discounts: gross method vs. net methodVendor rebates: cash rebates related to inventory generally recorded as a reduction to the cost of inventoryBasket purchases and joint product costs: total cost allocated to units based on relative sales value

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Inventory Cost - ComponentsRecognition and MeasurementInventory Cost is measured by the total cash equivalent outlay to acquire the goods and prepare them for sale.

Treatment of purchase discounts: for inventory (but not PP&E), also have a gross and net method. The inverse of the A/R side.Example: A firm purchases inventory for $10,000 with terms of 2/10, n30

GROSS METHODNET METHODPurchases/Inventory10000Purchases/Inv9800A/P10000 A/P9800

If paid during discount period:A/P10000 A/P9800Purchase Discounts200 Cash9800Cash9800

If paid after discount period:A/P9800A/P10000Interest Exp 200Cash10000 Cash10000

Purchase Discounts is a contra-COGS/Purchases account Interest Expense is called Purchase Discounts Lost in the text

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E 8-3 Gross and Net MethodsTransactions for Whitehall Limited:March 10Purchased goods billed at $25,000, term 3/10, n/60 11 Purchased goods billed at $26,575, terms 1/15, n/30 12Paid invoice of March 10. 24Purchased goods billed at $11,500, terms 3/10, n/30Prepare j/e for the transactions assuming the net method is used and discounts lost are treated as a financial expense.Prepare adjusting entry required on March 31Prepare j/e for transactions above, assuming that purchases are recorded using the gross methodPrepare adjusting entry required on March 31Which method provides better information for managing the business?Recognition and Measurement

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Merchandise Inventory Cost - ComponentsRecognition and Measurement

Product costs: Direct costs of acquisition Freight charges on goods purchasedLabor and other production costs incurred in processing the goods up to the time of saleInterest if item takes extended period of time to producePeriod costs - generally excluded from Inventory simply because of the practical difficulties in allocating them (exception is interest expense for certain constructed assetsships, real estate projects):Storage costsExpenses of having a purchasing departmentLabor for people handling the inventory

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Obsolete and Excess InventoryRecognition and MeasurementOverriding principle for inventory valuation is the Lower of Cost or Net Realizable Value (NRV) done on an item-by-item basisNRV is the estimated selling price less the estimated costs to complete and sellWrite-downs can be done using the direct method or the firm can create a reserve for obsolete and excess inventory (an allowance method similar to allowance for doubtful accounts)Recovery of market value decline is recorded up to but not exceeding original cost

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Obsolete and Excess InventoryLCNRVDirect Method (buries the write-down in COGS)Dr. COGSCr. Inventory

Allowance Method (separates out the special loss)Dr. Loss Cr. Inventory AllowanceIf inventory is sold, remove both the inventory and the inventory allowance (just like PPE & ADA)

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Inventory SystemsRecognition and MeasurementPerpetual Inventory SystemContinuous record of inventory is maintained. JIT requires perpetual system Still count (not necessarily at period end) and adjust perpetual records if there are differencesDr. Inventory over or short (short is akin to Shrinkage Expense)Cr. Inventory

Periodic Inventory SystemActual physical count is taken at the end of each accounting period

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Cost FormulasRecognition and MeasurementSpecific cost identificationEach item in stock is specifically marked e.g. diamonds, real estateAverage CostWeighted Average CostBeginning Inventory Cost + Current Purchase CostBeginning Inventory units + Current Purchase unitsMoving Average Cost (when using perpetual method)First-in, first-out (FIFO)Last-in, first-out (LIFO) allowed under US GAAP

Cost flow assumption and actual movement of the inventory units do not have to match.

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Inventory Practice Problem (Perpetual)Beginning inventory (1/1)200 units @ 5.001000Purchase #1(3/1)200 units @ 6.001200Purchase #2(7/1)200 units @ 7.001400

Sales were 200 units on 4/1 and 200 units on 7/5. What is COGS and the dollar value of ending inventory?

FIFOWeighted AverageLIFO

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Periodic Journal EntriesRecognition and MeasurementPurchase InventoryPurchases (temporary account) 5,400Accounts Payable/Cash 5,400SalesAccounts Rec./Cash7,200Sales 7,200* Do not record COGS at time of sale

End of period (after inventory count)Inventory 1,800 (to get to physical count)COGS3,600 (plug)Purchases5,400 (purchases account goes to zero)

COGS = Goods available for sale ending inventoryGoods available for sale = beginning inventory + purchases

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Inventory Practice Problem (Periodic)Recognition and MeasurementBeginning inventory (1/1/08)500 units @ 2.00 = 1,000Purchase #1(1/14/08)500 units @ 3.00 = 1,500Sale of inventory:1/2/08: 300 units 1/15/08: 200 units

Using the periodic method, what is COGS and the dollar value of ending inventory under:

FIFO

W.Avg.

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During inflationary time periods, the weighted average cost flow assumption results in the highest COGS, lowest net income, and lowest taxes.Other Inventory IssuesTrueFalse

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Illustration of DifferencesOther Inventory IssuesThe choice of a valuation method affects gross profit. If, in the above example, revenues are $3000, then gross profit figures are as follows:

FIFOWAvgRevenues$3,000$3,000COGS2,2002,350Gross Profit800650

Ending Inv.14001250

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If a companys highest priority was paying the least amount of taxes in the current year, then which inventory valuation method would management choose assuming prices are rising?Other Inventory IssuesFIFOWeighted Average

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Estimating InventoryEstimating InventoryGross Profit Method Information needed:Gross Profit % or GP/SalesBeginning Inventory(costs) and Purchases (cost)Sales

Sales * (1-GP%) = est. of Cost of Goods SoldBeg. Inv + Purchases est. of Cost of Goods Sold=est. of Ending Inventory

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Gross Profit MethodSales$2,750,000Inv. (Begin)$ 650,000Purchases 1,550,000Goods Avail?? Less Inv. (Ending)??COGS??

Gross Profit % is 35%Estimating Inventory

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Estimating InventoryEstimating Inventory

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Retail Inventory ExampleEstimating Inventory CostRetailBeg Inventory $30,000$ 46,500Purchases(net) 48,000 88,000What is the cost/retail ratio?What is the value of ending inventory if sales are $95,000?

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Presentation Disclosure & Analysis*Disclosure and PresentationExamples of required disclosures:Measurement policyTotal inventory, as well as inventory by classificationAmount of inventory recognized as expense on the income statement (usually reported as cost of goods sold)Any amount of inventory pledged as security(collateral) for liabilities

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IFRS/Private Entity GAAP Comparison*Comparison of IFRS and private entity GAAPMajor difference between IFRS and private entity GAAP (ASPE) relates to a specific IFRS standard covering biological assets and agricultural produce at the point of harvestPrivate entity GAAP has no specific guidance in this areaIFRS has more disclosure requirements than private entity GAAP

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*Whats the journal entry when we make purchase?Whats the journal entry(s) when we sell inventory?*Cost of goods sold versus cost of goods manufactured.Do you remember these concepts from 102?Raw materials materials used to make the product to be sold. The material is in its raw state and not yet in the production phase.Work in Progress-The raw materials are now in he manufacturing phase, however the end product is not yet finished.Finished Goods-The product is now finished and ready for sale. *****Using the periodic method, can we identify the loss of inventory from theft, damage or misplacement?*****