b a c k n e x t h o m e Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management, Dalhousie University PowerPoint slides by: Bruce W. MacLean, Bruce W. MacLean, Faculty of Management, Faculty of Management, Dalhousie University Dalhousie University Copyright 1998 McGraw-Hill Ryerson Limited, Canada Intermediate Accounting
71
Embed
Intermediate Accounting - McGraw-Hill Education · PDF fileChapter 9 Inventories. ... accounting policy choice, ... 9 January − Purchase 300 1.10 330 15 January − Purchase 400
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
b a c k n e x th o m e
Thomas H. BeechySchulich School of Business,
York University
Joan E. D. ConrodFaculty of Management,
Dalhousie University
PowerPoint slides by:Bruce W. MacLean,Bruce W. MacLean,
■ Merchandise inventory -� Goods on hand purchased by a retailer or a trading company
such as an importer or exporter for resale.
■ Production inventory� Raw materials inventory - Tangible goods purchased or obtained
in other ways (e.g., by mining) and on hand for direct use in themanufacture or further processing of goods for resale. Parts orsubassemblies manufactured before use are sometimes classified
as component parts inventory.
� Work-in-process inventory - Goods or natural resources requiringfurther processing before completion and sale. Work-in-processinventory includes the cost of direct material and direct labourincurred to date, and usually some allocation of overhead costs.
■ Finished goods inventory - Manufactured or fully processed itemscompleted and held for sale. Finished goods inventory cost includesthe cost of direct material, direct labour, and allocated manufacturingoverhead related to its manufacture
■ Production supplies inventory - Items on hand, such as lubricationoils for the machinery, cleaning materials, as well as small items thatmake up an insignificant part of the finished product, such as bolts orglue.
■ Contracts in progress - The accumulated costs of performingservices required under contract.
■ Miscellaneous inventories - Items such as office, janitorial, andshipping supplies. Inventories of this type are typically used in thenear future and may be recorded as selling or general expense when
purchased instead of being accounted for as inventory.
■ Since cost of goods sold is often the largest singleexpense category on the income statement, andinventory is an integral part of current and total assets,it makes sense that accounting policies in this area cancause income and net assets to change materially. Inwhat areas can policies be set? We�ll look at:
� Items and costs to include in inventory
� Cost flow assumptions
� Application of LCM (lower ofcost or market) valuations
■ All goods legally owned by the company on the inventorydate, 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 oftenimpractical. In such cases, the salesagreement, industry practices, andother evidence of intent should beconsidered
■ (On grounds of materiality), examples include:� 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 normallytreated as period expenses because they relate moredirectly to accounting periods than to inventory.
■ Distribution and selling costs are also considered to beperiod operating expenses and are not allocated toinventories.
■ Manufacturing companies and service firms engagedin long-term contracts often use variable costing(also called direct costing, although there are subtledifferences between the two approaches) for internalmanagement planning and control purposes.
■ The CICA Handbook recommends thatmanufacturers� inventories include an allocation ofoverhead:� In the case of inventories of work in process and finished
goods, cost should include the laid-down cost of materialplus the cost of direct labour applied to the product and theapplicable share of overhead expense properly chargeableto production. [CICA 3030.06]
■ Choosing a Recording Method✜ The choice of a periodic or perpetual system is not really an
accounting policy choice, although modest differences ininventory and cost of goods sold amounts can arise under theaverage cost assumption and under LIFO, depending onwhich recording method is used. Instead, the choice ofrecording method is one of practicality � which method givesthe best cost-benefit relationship?
■ Common Cost Flow Assumptions✜ Specific Identification
■ A perpetual inventory system is especially useful wheninventory consists of items with high unit values or when it isimportant to have adequate but not excessive inventory levels.
■ Perpetual inventory systems require detailed accountingrecords and therefore tend to be more costly to implement andmaintain than periodic systems. Computer technology hasmade perpetual inventory systems more popular today thanever before.
■ Theft and pilferage, breakage and other physical damage, mis-orders and mis-fills, and inadequate inventory supervisionpractices must be dealt with regardless of the type of inventoryaccounting system used.
■ LIFO is not a popular method in Canada, due largely to thefact that 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 servicecontracts. For other types of business, average cost andFIFO are the popular methods
■ According to the CICA Handbook, themethod selected for determining costshould be one which results in thefairest matching of costs againstrevenues [CICA 3030.09].
■ At the end of the year (periodic method) or on each sale(perpetual method) the specific units sold, and theirspecific cost, is identified to determine inventory and costof goods sold.� In the example in Exhibit 9-2, there are 300 units left in
closing inventory.
■ May be inconvenient and difficult to establish just whichitems were sold and what their specific initial cost was.
■ The first-in, first-out (FIFO) method treats the first goodspurchased or manufactured as the first units costed outon sale or issuance. Goods sold (or issued) are valued atthe oldest unit costs, and goods remaining in inventoryare valued at the most recent unit cost amounts.
■ Exhibit 9-5 demonstrates FIFO for the periodic system.
■ Exhibit 9-6 demonstrates the perpetual system.
■ Using the perpetual system, a sale is costed out eithercurrently throughout the period each time there is awithdrawal, or entirely at the end of the period, with thesame results.
Beginning inventory (200 units at $1) $ 200Add purchases during period (computed as in Exhibit 9-2) 920 Cost of goods available for sale 1,120Deduct ending inventory (300 units per physical inventory count): 100 units at $1.26 (most recent purchase − 24 January) $126 200 units at $1.16 (next most recent purchase − 15 January) 232 Total ending inventory cost 358Cost of goods sold $ 762*
* Can also be calculated as 200 units on hand 1 January at $1 plus 300 units purchased9 January at $1.10, plus 200 units purchased 15 January at $1.16.
Exhibit 9-5 FIFO Inventory Costing,Perpetual Inventory System
Page 7 GENERAL JOURNAL Periodic Perpetual
Date DescriptionPost. Ref. Debit Credit Debit Credit
Jan 9 Purchases 330
Inventory 330
Cash, etc. 330 330
Jan 10 Cost of goods sold 420
Inventory 420
Jan 15 Purchases 464
Inventory 464
Cash, etc. 464 464
Jan 18 Cost of goods sold 342
Inventory 342
Page 7 GENERAL JOURNAL Periodic Perpetual
Date DescriptionPost. Ref. Debit Credit Debit Credit
Jan 24 Purchases 126
Inventory 126
Cash, etc. 126 126
Jan 31 Cost of goods sold 762
Inventory (closing) 358
Inventory (opening) 200
Purchases 920
Accounting entries � Illustration
Purchases Sales Inventory BalanceUnit Total Unit Total Unit Total
Date Units Cost Cost Units Cost Cost Units Cost Cost 1 January 200 $1.00 $200
9 January 300 $1.10 $330 200 1.00 200300 1.10 330
10 January 200 $1.00 $200200 1.10 220 100 1.10 110
15 January 400 1.16 464 100 1.10 110400 1.16 464
18 January 100 1.10 110200 1.16 232 200 1.16 232
24 January 100 1.26 126 200 1.16 232100 1.26 126
Ending inventory ($232 + $126) $358Cost of goods sold $762 762Total cost allocated $1,120
Exhibit 9-6 FIFO Inventory Costing, Perpetual Inventory System
■ The last-in, first-out (LIFO) method of inventory costingmatches inventory valued at the most recent unitacquisition cost with current sales revenue.
■ The units remaining in ending inventory are costed atthe oldest unit costs incurred, and the units included incost of goods sold are costed at the newest unit costsincurred, the exact opposite of the FIFO costassumption.
■ Like FIFO, application of LIFO requires the use ofinventory cost layers for different unit costs.
Cost of goods available (see Exhibit 9-2) $1,120Deduct ending inventory (300 units per physical inventory count): 200 units at $1 (oldest costs available, from 1 January inventory) $200 100 units at $1.10 (next oldest costs available; from 9 January purchase) 110 Ending inventory 310Cost of goods sold $ 810*
* Can also be calculated as 100 units at $1.26 plus 400 units at $1.16 plus 200 units at $1.10.
■ Revenue Canada will not accept LIFO for tax purposes.Companies must use either the FIFO or the averagecost method when they compute their taxes payable. Ifa company uses LIFO for financial reporting, it mustmaintain two different inventory costing systems − onefor financial reporting (LIFO) and another for income tax(FIFO or average). Since there is a substantialadditional work load to maintaining two differentsystems, Canadian companies rarely use LIFO.Financial Reporting in Canada 1997 reported that onlyabout 3% of the sample companies use LIFO for anypart of their inventory.
■ FIFO will produce higher inventory, lower cost of goods sold, andhigher income. It�s probably popular with firms that would like tosee higher income and net assets in their financial statements.
■ LIFO has the opposite effect: lower inventories, higher cost ofgoods sold, and lower incomes.
■ Average cost methods provide inventory and cost of goods soldamounts between the LIFO and FIFO extremes, and is the nextbest thing to LIFO for income and tax minimization when inventorycosts are rising.
■ Canadian practice is about evenly divided between FIFO andaverage cost. LIFO is very seldom used in Canada, except byCanadian subsidiaries of U.S. companies that mandate its use inorder to be consistent with the parent�s accounting policies.
■ In manufacturing entities using a standard cost system, the inventoriesare valued, recorded, and reported for internal purposes on the basis ofa standard unit cost which approximates an ideal or expected cost.
■ This prevents the overstatement of inventory values because it excludesfrom inventory all losses and expenses that are due to inefficiency,waste, and abnormal conditions.
■ Actual historical cost is used only once, on acquisition which simplifiesrecord-keeping significantly!
■ Under this method, the differences between actual cost and standardcost are recorded in separate variance accounts.
■ These accounts are usually written off as a current period loss ratherthan capitalized in inventory.
■ Under standard cost procedures there would be no need to considerinventory cost flow methods (such as LIFO, FIFO, and average)because only one cost − standard cost − appears
■ Just-in-time (JIT) inventory systems are a response to the highcosts associated with stockpiling inventories of raw materials,parts, supplies, and finished goods
■ The ultimate goal is to see goods and materials arrive at thecompany's receiving dock just in time to be moved directly to theplant's production floor for immediate use in the manufacturingor assembly process.
■ Finished goods roll off the production floor and move directly tothe 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 isnot maintained, the JIT system runs the risk of becoming a NQIT(not-quite-in-time)
■ When revenue is recognized at the point of production, inventory is writtenup to its net realizable value, prior to sale. This is the increase in netassets that substantiates revenue recognition.
� Gold Mining
� Farm products
■ Special inventory categories often include items for resale that aredamaged, shopworn, obsolete, defective, or are trade-ins orrepossessions. These inventory items are valued at current replacementcost, defined as the price for which the items can be purchased in theirpresent condition.
■ When the replacement cost cannot be determined reliably, such itemsshould be valued at their estimated net realizable value (NRV), definedas the estimated sale price less all costs expected to be incurred inpreparing the item for sale
■ Purchase commitments (contracts) To lock in pricesand ensure sufficient quantities, companies oftencontract with suppliers to purchase a specified quantityof materials during a future period at an agreed unitcost.
■ A loss must be accrued on a purchase contract when:• the purchase contract is not subject to revision or
■ The basic difficulty with determining market value is thatthere are two markets − the supplier market(replacement cost) and the customer market (salesprice).
■ Sales price is called net realizable value (NRV) whencosts expected to be incurred in preparing the item forsale are deducted.
■ Net realizable value can be taken further, deductingexpected costs and also a normal gross profit margin;use of net realizable value less a normal profitmargin will preserve normal profits when the item isfinally sold.
Exhibit 9-10 Net Realizable Value and Net Realizable ValueLess a Normal Profit Margin
a. Inventory item A, at original cost $ 70b. Inventory item A, at estimated current selling pricein completed condition $100c. Less: Estimated costs to complete and sell* −40d. Net realizable value $ 60e. Less: Allowance for normal profit (10% of sales price) −10f. Net realizable value less normal profit $ 50
* For goods already completed, as in a retail company, this amountwould be the cost to sell.
Exhibit 9-11 Methods of Market Determination, 1996
MethodNumber ofcompanies,
1996Net realizable value 142Replacement cost 43Net realizable value less normal profit margin 3Estimated net realizable value 4
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 ofinventory.
• Comparison of total cost with total market for the inventory.
■ Exhibit 9-12 shows the application of each approach.
■ Consistency in application over time is essential.
■ The individual unit basis produces the most conservativeinventory value because units whose market value exceedscost are not allowed to offset items whose market value is lessthan cost. This offsetting occurs to some extent in the otherapproaches. The more you aggregate, the less you write down.The less you aggregate, the more you write down.
Exhibit 9-12 Application of LCM to InventoryCategories
■ Two methods of recording and reporting the effects ofthe application of LCM are used in practice:
✜ Direct inventory reduction method. The LCM amount, if it isless than the original cost of the inventory, is recorded andreported each period. Thus, the inventory holding loss isautomatically included in cost of goods sold, and endinginventory is reported at LCM.
✜ Inventory allowance method. The inventory holding loss isseparately recorded using a contra inventory account,allowance to reduce inventory to LCM.
■ To determine the amount of cash provided byoperations, net income must be adjusted by the changein inventory during the period:
• an increase in inventory means that the cash flow topurchase inventory was higher than the amount of expensereported as cost of goods sold − the increase must besubtracted from net income in order to reflect higher cashoutflow.
• a decrease in inventory means that the cash flow to acquireinventory was less than the amount of expense reported incost of goods sold − the decrease must be added to netincome.
■ Many large companies rely on the periodic inventorymethod. Does this mean that they can�t preparemonthly or quarterly statements without also taking aphysical inventory?
■ So what can be done when statements are needed?The answer is quite simple: inventory can be estimated.
■ In a small business, the owner or inventory managermight be able to provide an accurate estimate.
■ Alternatively, a more formal calculation can be made,
■ The gross margin method (also known as the grossprofit method) assumes that a constant gross marginestimated on recent sales can be used to estimateinventory values from current sales.
■ That is, the gross margin rate (gross margin divided bysales), based on recent past performance, is assumedto be reasonably constant in the short run.
■ The gross margin method has two basic characteristics
� (1) it requires the development of an estimated grossmargin rate for different lines or products, and
� (2) it applies the rate to relevant groups of items.
■ NoteCo, Inc. uses the gross margin method to estimateend of month inventory value. At the end of May thecontroller develops the following information: Grossmargin 43% of sales; Inventory at May 1 $237,400; netpurchases for May $728,300; net sales for May$1,213,000.
Sales for May 1,213,000$ Cost of goods sold: Beginning inventory 237,400$ Net purchases 728,300 Cost of goods available for sale 965,700 Estimated ending inventory 274,290 Cost of goods sold 691,410 Gross margin for May 521,590$
■ The retail inventory method is often used by retailstores, especially department stores that sell a widevariety of items.
■ In such situations, perpetual inventory procedures maybe impractical, and a complete physical inventory countis usually taken only once annually.
■ The retail inventory method is appropriate when itemssold within a department have essentially the samemarkup rate and articles purchased for resale arepriced immediately. Two major advantages of the retailinventory method are its ease of use and reducedrecord-keeping requirements.
■ To apply the retail inventory method, it is important todistinguish among the following terms:
✜ Original sales price..
✜ Markup.
✜ Additional markup.
✜ Additional markup cancellation.
✜ Markdown..
✜ Markdown cancellation.
■ In the application of the retail method, markups and markup cancellations,markdowns and markdown cancellations are all included in the earlycalculations that determine goods available for sale at cost and at retail.However, in order to provide a conservative cost ratio that will approximatelower of cost or market (LCM), the denominator of the cost ratio excludes netmarkdowns.
■ NoteCo, Inc. uses the gross margin method to estimateend of month inventory value. At the end of May thecontroller develops the following information: Grossmargin 43% of sales; Inventory at May 1 $237,400; netpurchases for May $728,300; net sales for May$1,213,000.
Sales for May 1,213,000$ Cost of goods sold: Beginning inventory 237,400$ Net purchases 728,300 Cost of goods available for sale 965,700 Estimated ending inventory 274,290 Cost of goods sold 691,410 Gross margin for May 521,590$
■ Webb Clothiers, Inc. uses the retail method to estimateinventory at the end of each month. For the month ofMay the controller gathers the following information:Beginning inventory at cost $60,000, at retail $92,000,net purchases at cost $200,000, at retail $308,000; netsales for May $300,000.
Cost RetailInventory, May 1 60,000$ 92,000$ Net purchases for May 200,000 308,000 Goods available for sale 260,000 400,000 Cost ratio (260,000 ÷ 400,000)
65%Sales for May 300,000 Ending inve ntory at retail 100,000$ Cost ratio 65%Ending inve ntory at cost 65,000$
■ Inventories are assets consisting of goods owned bythe business and held for future sale or for use in themanufacture of goods for sale.
■ Cost at acquisition, including the costs to obtain theinventory, such as freight, is used to value inventory.
■ Work in process and finished goods inventories ofmanufacturers should include raw materials, directlabour, and at least the variable portion ofmanufacturing overhead.
■ All goods owned at the inventory date, including thoseon consignment, should be counted and valued.
■ Either a periodic or a perpetual inventory system maybe used for merchandise inventories and formanufacturer�s inventories of raw materials and finishedgoods, but computer technology now makes it easierand less costly to use a perpetual system, which alsoprovides up- to- date inventory records.
■ Several cost flow assumptions are in current use, includingspecific identification, average cost, FIFO, and LIFO. LIFOis very rarely used in Canada, except by subsidiaries ofU.S. parent companies that also use that method.
■ Special accounting problems are encountered by firmsusing standard cost, just-in-time inventory systems, or netrealizable value to recognize inventory.
■ Losses on firm purchase commitments, when they can bereasonably estimated and are material, are recognized inthe accounts if the loss is likely and can be estimated.Otherwise, such commitments are often disclosed only inthe notes.
■ The lower-of-cost-or-market (LCM) method of estimatinginventory recognizes declines in market value in the periodof decline. The lower-of-cost-or-market method valuesinventories at market if market is below cost. Market maybe interpreted to be net realizable value, net realizablevalue less a normal profit margin, or replacement cost. Useof net realizable value is most common.
■ The gross margin method is used to estimate inventoryvalues when it is difficult or impractical to take a physicalcount of the goods. The method is most accurate whenprofit margins are stable.
■ The retail method of estimating inventory applies the ratioof actual cost to sales value to the ending inventory at salesvalue to estimate the inventory value at lower of cost ormarket.
■ The cash flow from operations is affected by (1) changes ininventory levels and (2) amortization that has been includedin the inventory. Cash flow must be adjusted to reflect theamount of inventory purchased rather than sold, and mustbe adjusted by adding back any amortization.