understanding financial accounting by absxc

Understanding
Financial Accounting
Third Canadian Edition
By Christopher D. Burnley
Prepared by Debbie Musil, FCPA, FCMA
Chapter 7
Inventory
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Copyright ©2022 John Wiley & Sons, Canada, Ltd.

Copyright ©2022 John Wiley & Sons, Canada, Ltd. 2
Learning Objectives (1 of 4)
LO1 – Discuss the importance of inventory to a
company’s overall success.
LO2 – Distinguish between the different inventory
classifications and determine which goods should
be included in a company’s inventory.
LO3 – Explain the differences between perpetual
inventory systems and periodic inventory systems

LO4 – Explain why cost formulas are necessary and
calculate the cost of goods sold and ending
inventory under the specific identification,
weighted-average, and first-in, first-out cost
formulas under a perpetual inventory system.
LO5 – Explain the value at which inventory is carried on
the statement of financial position and determine
the impact of inventory valuation errors.

LO6 – Explain how a company’s gross margin is
determined and why it is an important measure.
LO7 – Describe management’s responsibility for internal
control measures related to inventory.

LO8 – Calculate the inventory turnover ratio and the
days to sell inventory ratio and explain how they
can be interpreted by users.
LO9 – Calculate the cost of goods sold and ending
inventory under the specific identification,
weighted-average and first-in, first-out cost
formulas under a periodic system.

Inventory
• Any item purchased by a company for:
o Resale to customers, or
o Use in the manufacture of a product to be sold to
customers
• Companies that sell finished goods inventory are
known as merchandisers or retailers
• Companies that make products are known as
manufacturers

Significance of Inventory
• For retailers and manufacturers, inventory is a
significant current asset and the largest asset to be
converted into cash within the next year

Significance of Inventory –
Management’s Objective
• Management’s objective is to sell inventory at a
higher price than it was purchased for. This involves:
o Selecting appropriate suppliers
o Determining necessary inventory levels & avoiding
stock outs
o Pricing for profit
o Protecting inventory from damage and loss due to
theft

Inventory Classifications
• A manufacturer’s inventory may consist of:
o Raw materials
o Work-in-process
o Finished goods
• A merchandiser’s and retailer’s inventory consists of
finished goods that have been purchased for resale

Inventory Ownership
• A key factor in determining inventory ownership is
who has title to the goods. Considerations in
determining ownership include:
o FOB shipping point – buyer owns the inventory when
it leaves the seller’s premises
o FOB destination – buyer owns the inventory when it
arrives at the buyer’s premises
o Consignment arrangements - consignor vs consignee

Inventory Systems
• A company begins its accounting period with the
inventory from the previous period. This is known as
the company’s opening or beginning inventory.
• The cost of the opening inventory plus the cost of
purchases is known at the Cost of goods available for
sale or COGAS
• Therefore:
o COGAS = Beginning Inventory + Purchases

Periodic Inventory System
• Update of inventory information periodically
• Inventory purchases recorded in a Purchases account
• No entry to record the reduction in inventory at the
time of sale
• Requires regular inventory counts and does NOT
provide management with up to date information
regarding inventory quantities or costs

Periodic Inventory System – Determining
cost of ending inventory and Cost of
Goods Sold
• End of the period:
o Count inventory to determine quantity on hand and
assign costs
o Calculate cost of goods sold

Periodic Inventory System – Cost of
Goods Sold Model
Beginning Inventory
+ Purchases
= Cost of Goods available
for Sale
- Ending Inventory
= Cost of Goods Sold
(last period’s ending
inventory)
(based on invoices during the
period)
(based on a physical count)
(COGS: goods that are not on
hand are assumed to have
been sold)

Perpetual Inventory System
• Continual (perpetual) tracking of units and/or costs
• Inventory and cost of goods sold (COGS) is updated
after every transaction
• A unit sold is immediately removed from the
inventory account
• Ending inventory and cost of goods sold are up-to-
date

Perpetual Inventory System – Cost of
Goods Sold Model
Beginning Inventory
+ Purchases
= Cost of Goods Available
for Sale
− Cost of Goods Sold
= Ending Inventory
− Actual Ending Inventory
Shrinkage / Theft
(last period’s ending inventory)
(based on invoices during the
period)
(updated after each sale)
(ending inventory that should be
on hand)
(actual ending inventory on
hand per count)

Key Distinctions between Inventory
Systems

Advantages of Each Type of System

Choosing an Inventory System
Considerations for management when choosing a
perpetual or periodic inventory system:
• Importance of complete, timely inventory
information, and
• Identification of inventory shrinkage
versus
• The cost of purchasing and maintaining the
inventory system

Items Included in the “Cost” of
Inventory

Cost Formulas
• Cost formulas are necessary because inventory
purchase costs change
• COGAS is the same regardless of cost formula used
• The three cost formulas result in different allocations
of COGAS between ending inventory and COGS

Cost Formula Mechanics
• Specific Identification
o Specific costs are allocated to the cost of good sold
• Weighted average
o The cost of the items is determined using a weighted
average of the cost of the items purchased
• First-in, first-out (FIFO)
o The first item purchased is the first item sold

Amon Ltd. – Data for Cost Formula
Example

Specific Identification Cost Formula
Illustration
Assume that on the Sept 15 sale, 4 units were from
beginning inventory and 5 units were from the Sept 5
purchase.
COGS = (4 units × $65) + (5 units × $74) = $260 + $370 = $630
EI = 12 units = COGAS − COGS = $1,551 − $630 = $921
or
= (1 unit × $65) + (5 units × $74) + (6 units × $81)
= $65 + $370 + $486
= $921

Weighted Average Cost Formula
Illustration

First-in, First-out (FIFO) Cost Formula
Illustration

Comparison of Cost Formulas

Choosing the Appropriate Cost Formula
Cost Formula Decision Tree

Inventory Valuation
• Inventory is recorded at its cost on the date of
acquisition
• Inventory is carried on the statement of financial
position at lower of cost and net realizable value
(NRV)
o Inventory should reflect a value that is not more than
the economic benefits management expected to flow
from it

Inventory Valuation Writedown
• Net Realizable Value (NRV) = Expected Selling Price –
Estimated Costs to Make Sale
• If the NRV is lower than the inventory’s cost, the
inventory must be written down, the entry is:
Dr. Cost of Goods Sold
Cr. Inventory

Application of the Lower of Cost and
NRV
Note that the historical costs of Products B and C are less than the net realizable value, so
no adjustment is required. However, the historical cost of Product A is higher than its net
realizable value. Therefore, we need to make an entry as follows:
DR Cost of Goods Sold [4,550 − 4,050] 500
CR Inventory 500
This entry has the effect of immediately reducing net income by the amount of the
inventory writedown even though the inventory has yet to be sold. In other words, the loss
in the value of the inventory is included in the cost of goods sold in the period in which it is
realized rather than when the product is subsequently sold.

Inventory Valuation Errors
• Inventory valuation errors can result for a variety of
reasons; some are:
o Errors during inventory count
o Inclusion/exclusion of items that should be
excluded/included (goods on consignment; FOB
terms)

Effect of Inventory Valuation Errors
• Will result in misstatement of both statement of
financial position and income statement
• If not corrected will also affect statements of the
subsequent period
• Errors offset over a two-year period

Determining Gross Margin
• Gross Margin = Sales Revenue – COGS
• Gross Margin Ratio= Gross Margin / Sales Revenue
• Used to analyze a company’s performance over time
• Also used as a comparative against other companies
or industry standards

Internal Controls & Inventory
• Safekeeping the inventory
o Management is responsible for ensuring that internal
controls are in place to safeguard the inventory
• Physical controls
• Separation of duties
• Regular inventory counts

Internal Controls & Inventory
Management
• Cost of inventory storage and insurance
• Cost of handling
• Risk of Obsolescence
• Auditors play an important role

Inventory Ratios
• This ratio tells the user how fast inventory is sold or
how long it is held before it is sold.

Estimating Inventory
• Sometimes necessary to estimate inventory levels
during the year
• Several techniques, but focus is on gross margin
estimation method

Estimating Inventory – Gross Margin
Method
• Gross Margin Estimation Method
o Calculated as follows:
Sales revenue × Normal cost-to-sales ratio = Cost of
goods sold
o Beginning inventory + Purchases** – COGS = Ending
Inventory
(**from accounting records)

Appendix – Periodic Inventory System
Weighted-Average Cost Formula
Data for Weighted-Average Cost Formula/Periodic Inventory System Example

Appendix – Periodic Inventory System
FIFO Cost Formula
Using the data from Amon Ltd:
• Cost of Goods Sold:
5 units × $65 / unit = $325
4 units × $74 / unit = $296
9 units $621
• Ending Inventory = COGAS – COGS
$1,551 − $621 = $930
• Note that Cost of Goods Sold and Ending inventory values
under FIFO are the SAME under both perpetual and periodic
inventory systems

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