chapter3

8-1

TOPIC 3

INVENTORIES

8-2

PRE-LECTURE ASSIGNMENTS (PLEASE

ATTEMPT THESE QUESTIONS BEFORE

COMING TO CLASS):

BE8-8, BE8-13, E9-1, E9-14,

E9-22

8-3

1. Identify major classifications of inventory.

2. Distinguish between perpetual and periodic inventory

systems.

3. Identify the effects of inventory errors on the financial

statements.

4. Understand the items to include as inventory cost.

5. Describe and apply the lower-of-cost-or-net realizable

value rule.

Learning Objectives

8-4

6. Explain when companies value inventories at net realizable value.

7. Discuss accounting issues related to purchase commitments.

8. Determine ending inventory by applying the gross profit method.

9. Determine ending inventory by applying the retail inventory method.

10. Know what is consignment?

11. Explain how to report and analyze inventory.

Learning Objectives

8-5

Goods in transit

Consigned goods

Special sales

agreements

Inventory errors

Inventory Issues

Physical Goods

Included in

Inventory

Cost Included in

Inventory

Cost Flow

Assumptions

Classification

Cost flow

Control

Basic inventory

valuation

Product costs

Period costs

Purchase

discounts

Specific

identification

Average cost

FIFO

Summary analysis

Valuation of Inventories:

Cost-Basis Approach

8-6

Inventories are:

items held for sale, or

goods to be used in the production of goods to be sold.

FRS 102 defines::

- 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.

Inventory Issues

LO 1 Identify major classifications of inventory.

Classification

8-7Financial Accounting and Reporting 1 7

Inventory is one of the most important resources especially for trading companies.

Inventory accounting is very important because it affects the financial statement in two ways: the amount of inventory reported in the balance sheet

the determination of cost of goods sales and the net profit in the Income Statement. Cost of goods sold is usually the biggest type of expense incurred by a company

8-8

One inventory

account.

Purchase goods

in form ready for

sale.

Classification

Inventory Issues


Illustration 8-1

8-9

Three accounts

• Raw materials

• Work in process

• Finished goods

Classification

Inventory Issues

LO 1

Illustration 8-1


Raw Materials

unprocessed natural products used in the

manufacture of a product

Work in Progress

an incomplete inventory or partially complete

inventory

Finished Goods

inventory that is ready to be sold at any time

8-11

Inventory Cost Flow

Inventory Issues

Illustration 8-2



Costs of purchase

Costs of conversion

Other costs


Comprise the purchase price, import duties and other

taxes (other than those subsequently recoverable by

the entity from the taxing authorities), and transport,

handling and other costs directly attributable to the

acquisition of finished goods, materials, and services.

Trade discounts, rebates, and other similar items are

deducted in determining the costs of purchase.


Free On Board (FOB), is a transportation

term that indicates that the price of goods

includes delivery at the seller’s expense

to a specified point and no further.


Shipping Point Destination

The buyer assumes title and control of

the goods the moment the carrier

signs the bill of lading.

The seller retains title and control of

goods until they are delivered and

the contract of carriage has been

completed.

The buyer assumes risk of

transportation and is entitled to

route the shipment.

The seller selects the carrier and is

responsible for the risk of

transportation.

The buyer is responsible for filing claims

for loss or damage.

The seller is responsible for filing

claims for loss or damage.

The buyer bares the cost. The seller bares the cost.


The costs of conversion of inventories include:

costs directly related to the units of production,

such as direct labor and direct material

a systematic allocation of fixed and variable

production overheads that are incurred in

converting materials into finished goods.


Examples of costs excluded from the cost of inventories and recognized as expenses in the period in which they are incurred are: abnormal amounts of wasted materials, labor or other

production costs

storage costs, unless those costs are necessary in the production process before a further production stage

administrative overheads that do not contribute to bringing inventories to their present location and condition, and

selling costs.

8-18

Inventory Cost Flow

Inventory Issues

Illustration 8-3


Companies use one of two types of systems for maintaining

inventory records — perpetual system or periodic system.

8-19

Inventory Cost Flow

LO 2 Distinguish between perpetual and periodic inventory systems.

Perpetual System

1. Purchases of merchandise are debited to Inventory.

2. Freight-in is debited to Inventory. Purchase returns and

allowances and purchase discounts are credited to Inventory.

3. Cost of goods sold is debited and Inventory is credited for each

sale.

4. Subsidiary records show quantity and cost of each type of

inventory on hand.

The perpetual inventory system provides a continuous

record of Inventory and Cost of Goods Sold.

8-20

Inventory Cost Flow


Periodic System

1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000

Purchases, net 800,000

Goods available for sale 900,000

Ending inventory 125,000

Cost of goods sold $ 775,000


Details Periodic Perpetual

(i) Purchase of

inventory

Debit : Purchase

Credit : Cash/Accounts payable

Debit : Inventory

Credit : Cash/Accounts payable

(i) Purchase

return and

allowance

Debit : Cash/Accounts payable

Credit : Purchase return and

allowance

Debit : Cash/Accounts payable

Credit : Inventory

(i) Purchase

discount

Debit : Accounts payable

Credit : Purchase discount

Cash

Debit : Accounts payable

Credit : Inventory

Cash

(i) Freight-in

cost

Debit : Freight–in

Credit : Cash

Debit : Inventory

Credit : Cash

(i) Sales Debit : Cash/Accounts receivable

Credit : Sales

------

Debit : Cash/Accounts receivable

Credit : Sales

And

Debit : Cost of goods sold

Credit : Inventory


(i)Sales return

and allowance

Debit : Sales return and allowance

Credit : Cash/Accounts receivable

------

Debit : Sales return and allowance

Credit : Cash/Accounts receivable

And

Debit : Inventory

Credit : Cost of good sold

(i)Sales discount Debit : Cash

Sales discount

Credit : Accounts receivable

Debit : Cash

Sales discount

Credit : Accounts receivable

(i)Closing

inventory

Determine through physical count Refer to the ending balance in inventory

account

Determine by calculation as below;

(i)Cost of goods

sold

Opening inventory xxx

(+) purchases xxx

(+) freight-in xxx xxx

Cost of inventory

available for sale xxx

(-) Ending inventory (xx)

Cost of goods sold xxx

Refer to the ending balance in cost of

goods sold account


When a company uses the perpetual system, and a

difference between the recorded inventory and the

physical inventory is apparent at the end, adjustment

needs to be made.

Usually, the physical amount tends to be less that the

amount recorded. If this is the case, the adjusting

entry will be:

Debit: Inventory deficit/excess

Credit: Inventory


The inventory deficit/excess will affect the

cost of goods sold. Thus, the inventory/deficit

account will be closed to cost of goods sold

as follows:

Debit: COGS

Credit: Inventory deficit/excess

8-25

Inventory Cost Flow


Illustration: Fesmire Company had the following transactions

during the current year.

Record these transactions using the Perpetual and Periodic

systems.

8-26

Inventory Cost Flow


Illustration 8-4Illustration:

8-27

Inventory Cost Flow


Illustration: Assume that at the end of the reporting period,

the perpetual inventory account reported an inventory balance

of $4,000. However, a physical count indicates inventory of

$3,800 is actually on hand. The entry to record the necessary

write-down is as follows.

Inventory Over and Short 200

Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies

sometimes report Inventory Over and Short in the “Other income and expense” section

of the income statement.

8-28

Inventory Control

Inventory Issues


All companies need periodic verification of the inventory

records by actual count, weight, or measurement, with the

counts compared with the detailed inventory records.

Companies should take the physical inventory near the

end of their fiscal year, to properly report inventory

quantities in their annual accounting reports.

8-29

Inventory Issues


Basic Issues in Inventory Valuation

Companies must allocate the cost of all the goods available

for sale (or use) between the goods that were sold or used

and those that are still on hand.

Illustration 8-5

8-30

Basic Issues in Inventory Valuation


The physical goods (goods on hand, goods in transit,

consigned goods, special sales agreements).

The costs to include (product vs. period costs).

The cost flow assumption (specific Identification,

average cost, FIFO, retail, etc.).

Valuation requires determining

8-31

A company should record purchases when it obtains

legal title to the goods.

Physical Goods Included in Inventory


Illustration 8-6

8-32


LO 3 Identify the effects of inventory errors on the financial statements.

Effect of Inventory Errors

The effect of an error on net income in one year (2010) will be counterbalanced in

the next (2011), however the income statement will be misstated for both years.

Illustration 8-7

Ending

Inventory

Misstated

8-33


Illustration: Yei Chen Corp. understates its ending inventory by

HK$10,000 in 2010; all other items are correctly stated.Illustration 8-8

LO 3

8-34


LO 3 Identify the effects of inventory errors on the financial statements.


The understatement does not affect cost of goods sold and net income because the

errors offset one another.

Illustration 8-9

Purchases

and Inventory

Misstated

8-35

Costs Included in Inventory

LO 4 Understand the items to include as inventory cost.

Product Costs - costs directly connected with

bringing the goods to the buyer’s place of business

and converting such goods to a salable condition.

Period Costs – generally selling, general, and

administrative expenses.

Treatment of Purchase Discounts – Gross vs.

Net Method

8-36

Costs Included in Inventory

LO 4 Understand the items to include as inventory cost.

Treatment of Purchase Discounts

Illustration 8-11

* $4,000 x 2% = $80

*

** $10,000 x 98% = $9,800

**

8-37

Method adopted should be one that most clearly reflects periodic income.

Cost Flow Assumption Adopted

does not need to equal

Physical Movement of Goods

Which Cost Flow Assumption to Adopt?

Specific Identification --- Average Cost --- LIFO

LO 5 Describe and compare the methods used to price inventories.

8-38

Young & Crazy Company makes the following purchases:

1. One item on 2/2/11 for $10



Young & Crazy Company sells one item on 2/28/11 for $90.

What would be the balance of ending inventory and cost of

goods sold for the month ended February 2011, assuming

the company used the FIFO, Average Cost, and Specific

Identification cost flow assumptions? Assume a tax rate of

30%.

Example

Cost Flow Assumptions


8-39

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 45

Young & Crazy Company

Income Statement

For the Month of Feb. 2011

Sales $ 90

Cost of goods sold 0

Gross profit 90

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33

Income before tax 57

Taxes 17

Net Income $ 40


“First-In-First-Out (FIFO)”

LO 5

8-40

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20


Inventory Balance

= $ 35


Income Statement


Sales $ 90


Gross profit 80

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 14

Net Income $ 33

“First-In-First-Out (FIFO)”

LO 5

8-41

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 45


Income Statement


Sales $ 90


Gross profit 90

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 17

Net Income $ 40


“Average Cost”

LO 5

8-42

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 30



Income Statement


Sales $ 90


Gross profit 75

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 12

Net Income $ 30

“Average Cost”

LO 5

8-43

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 45


Income Statement


Sales $ 90


Gross profit 90

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 17

Net Income $ 40


“Specific Identification”

LO 5

8-44


Income Statement


Sales $ 90


Gross profit 90

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 17

Net Income $ 40

Depends which one is sold

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 45


“Specific Identification”

LO 5

8-45

Financial Statement Summary

FIFO Average

Sales 90$ 90$

Cost of goods sold 10 15

Gross profit 80 75

Operating expenses:

Administrative 14 14

Selling 12 12

Interest 7 7

Total expenses 33 33

Income before taxes 47 42

Income tax expense 14 12

Net income 33$ 30$

Inventory Balance 3035


LO 5

8-46


LO 5

Illustration: Call-Mart Inc. had the following transactions in

its first month of operations.

Beginning inventory (2,000 x $4) $ 8,000

Purchases:

6,000 x $4.40 26,400

2,000 x 4.75 9,500

Goods available for sale $43,900

Calculate Goods Available for Sale

8-47

Specific Identification

Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory

consists of 1,000 units from the March 2 purchase, 3,000 from the March

15 purchase, and 2,000 from the March 30 purchase. Compute the

amount of ending inventory and cost of goods sold.Illustration 8-12

8-48

Average Cost

Illustration 8-13Weighted-Average


8-49

Average Cost

Illustration 8-14

In this method, Call-Mart computes a new average unit

cost each time it makes a purchase.

Moving-Average


8-50

First-In, First-Out (FIFO)

Illustration 8-15

Periodic Method

Determine cost of ending inventory by taking the cost of the most recent

purchase and working back until it accounts for all units in the inventory.


8-51

First-In, First-Out (FIFO)

Illustration 8-16

Perpetual Method

In all cases where FIFO is used, the inventory and cost of goods sold would

be the same at the end of the month whether a perpetual or periodic system

is used.


8-52

Inventory Valuation Methods - Summary

Illustration 8-17


8-53


Illustration 8-18

Balances of Selected Items

under Alternative Inventory

Valuation Methods


8-54 LO 6 Describe the LIFO cost flow assumption.

Under IFRS, LIFO is not permitted for financial reporting

purposes.

Nonetheless, LIFO is permitted for financial reporting

purposes in the United States, it is permitted for tax purposes

in some countries, and its use can result in significant tax

savings.

8-55 LO 6

Illustration: Call-Mart Inc. had the following transactions in

its first month of operations.

Beginning inventory (2,000 x $4) $ 8,000

Purchases:

6,000 x $4.40 26,400

2,000 x 4.75 9,500

Goods available for sale $43,900

Calculate Goods Available for Sale

Last-In, First-Out (LIFO)

8-56


Illustration 8A-1

Periodic Method

The cost of the total quantity sold or issued during the month comes from the

most recent purchases.

LO 6 Describe the LIFO cost flow assumption.

8-57


Illustration 8A-2

Perpetual Method

The LIFO method results in different ending inventory and cost of goods sold

amounts than the amounts calculated under the periodic method.


8-58

Illustration 8A-3


Notice that gross profit and net income are lowest under LIFO, highest under

FIFO, and somewhere in the middle under average cost.


8-59

Illustration 8A-4


LIFO results in the highest cash balance at year-end (because taxes are

lower). This example assumes that prices are rising. The opposite result

occurs if prices are declining.



FRS 102 in paragraph 23 states that:

The cost of inventories of items that are not

ordinarily interchangeable and goods or

services produced and segregated for

specific projects shall be assigned by using

specific identification of their individual costs.


PARA 25:

The cost of inventories, other than those dealt with in

paragraph 23, shall be assigned by using the first-in,

first-out (FIFO) or weighted average cost formula. An

entity shall use the same cost formula for all

inventories having a similar nature and use to the

entity. For inventories with a different nature or use,

different cost formulas may be justified


FRS102 paragraph IN13:

“The Standard does not permit the use of the

last-in, first-out (LIFO) formula to measure the

cost of inventories.”

8-63

A company abandons the historical cost principle

when the future utility (revenue-producing ability)

of the asset drops below its original cost.

Lower-of-Cost-or-Net Realizable Value

LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

LCNRV

8-64

Net Realizable Value


Estimated selling price in the normal course of

business less estimated costs to complete and

estimated costs to make a sale.

Illustration 9-1


8-65

Net Realizable Value


Illustration 9-2

LCNRV Disclosures


8-66

Illustration of LCNRV: Regner Foods computes its

inventory at LCNRV.


Illustration 9-3


8-67

Illustration 9-4

Methods of Applying LCNRV



8-68

Methods of Applying LCNRV



► In most situations, companies price inventory on an

item-by-item basis.

► Tax rules in some countries require that companies use

an individual-item basis.

► Individual-item approach gives the lowest valuation for

statement of financial position purposes.

► Method should be applied consistently from one period

to another.

8-69

Cost of goods sold (before adj. to NRV) $ 108,000

Ending inventory (cost) 82,000

Ending inventory (at NRV) 70,000

Inventory 12,000

Loss due to decline to NRV 12,000

Inventory 12,000

Cost of goods sold 12,000

Loss

Method

COGS

Method


Recording Net Realizable Value Instead of Cost


8-70

COGS Loss

Method Method

Current assets:

Inventory 70,000$ 70,000$

Prepaids 20,000 20,000

Accounts receivable 350,000 350,000

Cash 100,000 100,000

Total current assets 540,000 540,000

Statement of Financial Position Presentation



Partial Statement

8-71

COGS Loss

Method Method

Sales 200,000$ 200,000$

Cost of goods sold 108,000 120,000

Gross profit 92,000 80,000

Operating expenses:

Selling 45,000 45,000

General and administrative 20,000 20,000

Total operating expenses 65,000 65,000

Other income and expense:

Loss due to NRV on inventory 12,000 -

Interest income 5,000 5,000

Total other (7,000) 5,000

Income from operations 20,000 20,000

Income tax expense 6,000 6,000

Net income 14,000$ 14,000$

Income Statement Presentation

LO 1


8-72

Use of an Allowance



Instead of crediting the Inventory account for net realizable

value adjustments, companies generally use an

allowance account.

Allowance to reduce

inventory to NRV 12,000

Loss due to decline to NRV 12,000Loss

Method

8-73

COGS Loss

Method Method

Current assets:

Inventory 70,000$ 82,000$

Allowance to reduce inventory (12,000)

Inventory at NRV 70,000

Prepaids 20,000 20,000

Accounts receivable 350,000 350,000

Cash 100,000 100,000

Total current assets 540,000 540,000

Statement of Financial Position Presentation



Partial Statement

8-74

Recovery of Inventory Loss



►Amount of write-down is reversed.

►Reversal limited to amount of original write-down.

Continuing the Ricardo example, assume the net realizable

value increases to $74,000 (an increase of $4,000). Ricardo

makes the following entry, using the loss method.

Recovery of inventory loss 4,000

Allowance to reduce inventory to NRV 4,000

8-75

Recovery of Inventory Loss



Allowance account is adjusted in subsequent periods,

such that inventory is reported at the LCNRV.

Illustration 9-8

Inventory should not be reported at a value

above original cost.

8-76

Decreases in the value of the asset and the charge to expense are

recognized in the period in which the loss in utility occurs—not in the

period of sale.

Increases in the value of the asset (in excess of original cost)

recognized only at the point of sale.

Inconsistency because a company may value inventory at cost in one

year and at net realizable value in the next year.

LCNRV values inventory conservatively. Net income for the year in

which a company takes the loss is definitely lower. Net income of the

subsequent period may be higher than normal if the expected

reductions in sales price do not materialize.

Some Deficiencies:


Evaluation of LCM Rule


8-77

P9-1: Remmers Company manufactures desks. Most of the

company’s desks are standard models and are sold on the basis of

catalog prices. At December 31, 2010, the following finished desks

appear in the company’s inventory.

Instructions: At what amount should the desks appear in the company’s

December 31, 2010, inventory, assuming that the company has adopted

a lower-of-FIFO-cost-or-net realizable value approach for valuation of

inventories on an individual-item basis?

Finished Desks A B C D

FIFO cost inventory at 12/31/10 470$ 450$ 830$ 960$

Est. cost to complete and sell 50 110 260 200

Catalog selling price 500 540 900 1,200



8-78

P9-1: Remmers Company manufactures desks. Most of the

company’s desks are standard models and are sold on the basis of

catalog prices. At December 31, 2010, the following finished desks

appear in the company’s inventory.

Finished Desks A B C D

FIFO cost inventory at 12/31/10 470$ 450$ 830$ 960$

Est. cost to complete and sell 50 110 260 200

Catalog selling price 500 540 900 1,200

Net realizable value 450 430 640 1,000

Lower-of-cost-or-NRV 450 430 640 960



8-79

Relies on Three Assumptions:

Gross Profit Method of Estimating Inventory

LO 5 Determine ending inventory by applying the gross profit method.

Substitute Measure to Approximate Inventory

(1) Beginning inventory plus purchases equal total goods to

be accounted for.

(2) Goods not sold must be on hand.

(3) The sales, reduced to cost, deducted from the sum of the

opening inventory plus purchases, equal ending

inventory.

8-80

Gross Profit Method


Illustration: Cetus Corp. has a beginning inventory of €60,000 and

purchases of €200,000, both at cost. Sales at selling price amount

to €280,000. The gross profit on selling price is 30 percent. Cetus

applies the gross margin method as follows.

Illustration 9-13

8-81

Gross Profit Method


Computation of Gross Profit Percentage

Illustration 9-16

8-82

E9-14: Astaire Company uses the gross profit method to estimate

inventory for monthly reporting purposes. Presented below is

information for the month of May.

Instructions:

(a) Compute the estimated inventory at May 31, assuming that the

gross profit is 25% of sales.

(b) Compute the estimated inventory at May 31, assuming that the

gross profit is 25% of cost.

Inventory, May 1 € 160,000

Purchases (gross) 640,000

Freight-in 30,000

Sales 1,000,000

Sales returns 70,000

Purchase discounts 12,000

Gross Profit Method

LO 5

8-83

E9-14 (Solution):

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000

Purchase discounts (12,000)

Freight-in 30,000

Goods available (at cost) 818,000

Sales (at selling price) € 1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000

Less gross profit (25% of €930,000) 232,500

Sales (at cost) 697,500

Approximate inventory, May 31 (at cost) € 120,500

(a) Compute the estimated inventory assuming gross profit is 25% of sales.

Gross Profit Method


8-84

(b) Compute the estimated inventory assuming gross profit is 25% of cost.

E9-14 (Solution):

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000

Purchase discounts (12,000)

Freight-in 30,000

Goods available (at cost) 818,000

Sales (at selling price) € 1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000

Less gross profit (20% of €930,000) 186,000

Sales (at cost) 744,000

Approximate inventory, May 31 (at cost) € 74,000

Gross Profit Method


25%

100% + 25%= 20% of sales

8-85

Disadvantages:

Gross Profit Method


Evaluation

(1) Provides an estimate of ending inventory.

(2) Uses past percentages in calculation.

(3) A blanket gross profit rate may not be representative.

(4) Normally unacceptable for financial reporting purposes.

IFRS requires a physical inventory as additional

verification.

8-86

Retail Inventory Method

LO 6 Determine ending inventory by applying the retail inventory method.

A method used by retailers, to value inventory without a

physical count, by converting retail prices to cost.

(1) Total cost and retail value of goods purchased.

(2) Total cost and retail value of the goods available for sale.

(3) Sales for the period.

Requires retailers to keep:

Conventional Method or Cost Method

(based on

LCNRV)

8-87

P9-9: Fuque Inc. uses the retail inventory method to estimate

ending inventory for its monthly financial statements. The

following data pertain to a single department for the month of

October 2011.


COST RETAIL

Beg. inventory, Oct. 1 52,000$ 78,000$

Purchases 272,000 423,000

Freight in 16,600

Purchase returns 5,600 8,000

Additional markups 9,000

Markup cancellations 2,000

Markdowns (net) 3,600

Normal spoilage 10,000

Sales 390,000

Instructions:

Prepare a schedule

computing estimate

retail inventory using

the following

methods:

(1) Conventional

(2) Cost


8-88



P9-9 Solution - CONVENTIONAL Method:Cost to

COST RETAIL Retail %

Beg. inventory 52,000$ 78,000$

Purchases 272,000 423,000

Freight in 16,600

Purchase returns (5,600) (8,000)

Markups, net 7,000

Current year additions 283,000 422,000

Goods available for sale 335,000 500,000 67.00%

Markdowns, net (3,600)

Normal spoilage (10,000)

Sales (390,000)

Ending inventory at retail 96,400$

Ending inventory at Cost:

96,400$ x 67.00% = 64,588$

=/

8-89



P9-9 Solution - Cost Method Cost to

COST RETAIL Retail %

Beg. inventory 52,000$ 78,000$

Purchases 272,000 423,000

Freight in 16,600

Purchase returns (5,600) (8,000)

Markdowns, net (3,600)

Markups, net 7,000

Current year additions 283,000 418,400

Goods available for sale 335,000 496,400 67.49%

Normal spoilage (10,000)

Sales (390,000)

Ending inventory at retail 96,400$

Ending inventory at Cost:

96,400$ x 67.49% = 65,056$

=/

8-90

Special Items



Freight costs

Purchase returns

Purchase discounts and allowances

Transfers-in

Normal spoilage

Abnormal shortages

Employee discounts

8-91

Special

Items



Illustration 9-22

8-92

Widely used for the following reasons:

Evaluation

(1) To permit the computation of net income without a

physical count of inventory.

(2) Control measure in determining inventory shortages.

(3) Regulating quantities of merchandise on hand.

(4) Insurance information.



Some companies refine the retail method by computing inventory

separately by departments or class of merchandise with similar gross

profits.


inventory cost is estimated through:

the ratio calculation between cost of goods

available for sale recorded at cost and

recorded at retail price (cost : retail), or

the percentage of goods available for sale at

cost over goods available for sale at retail

(cost/retail x 100)


In order to use this method we need the following information:

- the opening inventory value at cost and retail

- purchase of inventory at cost and retail

- sales value

- changes in sales price due to mark-up and markdown

Cost of ending inventory = Ending inventory at retail price x

Cost/Retail ratio


Original retail price - the initial retail price after taking into account the mark-up over cost.

Additional mark-up - the increase in selling price over original retail price

Mark-up cancellation - the reduction in selling price after the additional mark-up

Net mark-up - the additional mark-up minus the mark-up cancellation

Markdown - the reduction in selling price below original retail price

Markdown cancellation - the reduction in markdown (price increases, but not over the original retail price)

Net markdown - markdown minus markdown cancellation


freight-in is included in the purchasing costs

a purchase discount will reduce the purchasing costs

purchase returns will reduce purchase value at both cost and retail price

purchase allowance will reduce purchase value at cost only, unless there is a retail price change due to this allowance

sales returns reduce the value of sales at retail

no adjustment is made for sales discounts and sales allowance


Under certain circumstances, valuation of inventory based on cost is impractical.

The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined.

The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale have increased.

If the market price of goods drops below the purchase price, the lower of cost or market method of valuation is recommended.


FRS 102, paragraph 9 states that:

“Inventories shall be measured at the lower of

cost and net realizable value.”


Arrangement whereby merchandise owned by one

party (the consignor) is sold by another party (the

consignee), usually on a commission basis.

Consignment inventories are recorded in the

consignor’s books but not the consignee’s.

Since the consignor has full ownership of the goods,

he bears all related costs such as storage, damage,

and selling cost.


consignor holds ownership of goods until consignee sells them

consignee stores the goods until they are sold; cost incurred in relation to the sale of the goods will be refunded later by the consignor

consignee receives a commission for his work when the goods are sold.

consignee receives payment from buyer

consignee pays the consignor the balance of the amount received after deducting his expenses and commission

consignee produces an account sales (see Illustration 7) for the consignor; this is a statement that provides the details of the transactions.


Consignment - journal

Details Consignor Consignee

Goods consigned Dt Consignment a/c

Kt Goods sent on

consignment a/c

----

Expenses paid by consignor Dt Consigment a/c

Kt Cash

----

Consignee’s payment of

consignment expenses

Dt Consignment a/c

Kt Consignee’s a/c

Dt Consignor’s a/c

Kt Cash

Sales Dt Consignee’s a/c

Kt consignment a/c

Dt Cash

Kt Consignor’s a/c

Commission Dt Consignment a/c



Kt Consignment-in a/c

(commission earned)

Cash settlement Dt Cash


(cash received)


Kt Cash book

(balance settlement as per

account sales)


According to FRS 102, financial statements shall disclose:

accounting policies adopted in measuring inventories, including the cost formula used

the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity

the carrying amount of inventories carried at fair value less costs to sell

the amount of inventories recognized as an expense during the period

the amount of any write-down of inventories recognized as an expense in the period

the amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period

the circumstances or events that led to the reversal of a write-down of inventories, and

the carrying amount of inventories pledged as security for liabilities

8-103

Accounting standards require disclosure of:

Presentation and Analysis

LO 7 Explain how to report and analyze inventory.

Presentation of Inventories

(1) Accounting policies adopted in measuring inventories,

including the cost formula used (weighted-average, FIFO).

(2) Total carrying amount of inventories and the carrying amount

in classifications (merchandise, production supplies, raw

materials, work in progress, and finished goods).

(3) Carrying amount of inventories carried at fair value less costs

to sell.

(4) Amount of inventories recognized as an expense during the

period.

8-104

Accounting standards require disclosure of:



Presentation of Inventories

(5) Amount of any write-down of inventories recognized as an

expense in the period and the amount of any reversal of

write-downs recognized as a reduction of expense in the

period.

(6) Circumstances or events that led to the reversal of a write-

down of inventories.

(7) Carrying amount of inventories pledged as security for

liabilities, if any.

8-105



Common ratios used in the management and evaluation of

inventory levels are inventory turnover and average days to

sell the inventory.

Analysis of Inventories

8-106

Measures the number of times on average a company

sells the inventory during the period.



Inventory Turnover Ratio

Illustration 9-25

Illustration: In its 2009 annual report Tate & Lyle plc (GBR)

reported a beginning inventory of £562 million, an ending inventory

of £538 million, and cost of goods sold of £2,019 million for the

year.

8-107

Measure represents the average number of days’ sales

for which a company has inventory on hand.



Average Days to Sell Inventory

365 days / 3.67 times = every 99.5 days

Average Days to Sell

Illustration 9-25

8-108

The requirements for accounting for and reporting inventories are more

principles-based under IFRS. That is, U.S. GAAP provides more

detailed guidelines in inventory accounting.

Who owns the goods—goods in transit, consigned goods, special sales

agreements—as well as the costs to include in inventory are essentially

accounted for the same under IFRS and U.S. GAAP.

U.S. GAAP permits the use of LIFO for inventory valuation. IFRS

prohibits its use. FIFO and average cost are the only two acceptable

cost flow assumptions permitted under IFRS. Both sets of standards

permit specific identification where appropriate.

8-109

In the lower-of-cost-or-market test for inventory valuation, IFRS defines

market as net realizable value. U.S. GAAP, on the other hand, defines

market as replacement cost subject to the constraints of net realizable

value (the ceiling) and net realizable value less a normal markup (the

floor). IFRS does not use a ceiling or a floor to determine market.

Under U.S. GAAP, if inventory is written down under the LCM valuation,

the new basis is now considered its cost. As a result, the inventory may

not be written back up to its original cost in a subsequent period. Under

IFRS, the write-down may be reversed in a subsequent period up to the

amount of the previous write-down. Both the write-down and any

subsequent reversal should be reported on the income statement.

8-110

Unlike property, plant, and equipment, IFRS

does not permit the option of valuing

inventories at fair value. As indicated above,

IFRS requires inventory to be written down,

but inventory cannot be written up above its

original cost.

As indicated, IFRS requires both biological

assets and agricultural produce at the point of

8-111

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