INVENTORY

CHAPTER 7
 WHAT IS INVENTORY?

• Items purchased for resale to customers (merchandisers or

retailers)
OR
• Items to be used in manufacturing a product (manufacturers):
• Raw materials
• Work-in-process
• Finished goods
 WHAT IS INCLUDED IN INVENTORY?

Companies include what they own

- just because it is physically on site, does not mean it is owned
- just because it is not physically on site, does not mean it is not
owned
 GOODS IN TRANSIT

Nova Scotia Truck Parts Inc. (NS) ships an order to British

Columbia Trucking Ltd (BC). BC has a December 31 year end.
On that day, the parts, worth $230,000 are on a truck in Regina.
- is this BC’s inventory or NS’s?

Depends….
- if the goods were FOB shipping?
- if the goods were FOB destination?
 CONSIGNED GOODS

In some businesses, goods are held by one party but owned by

another
- the holder (consignee) does not own the goods
- they pay for them once sold
- the owner (consignor) keeps title to the goods until they are
sold/paid for

Inventory on the statement of financial position should include items

that are owned or controlled (definition)
- consigned goods are reported by the consignor as inventory
 INVENTORY

Merchandising companies will keep track of their inventory

using 1 of 2 methods:
• Perpetual
• Periodic

When we talk about “inventory” we will be talking about goods

purchased or held for resale.
A company may have supplies that they maintain an inventory of,
but those will usually be handled separately.
 Flow of Merchandise Inventory
Sold:
Cost of
goods sold
Cost of
Opening goods OR
inventory + Purchases = available
for sale
On Hand:
Ending inv.
 Periodic Inventory

No continuous records of inventories or COGS

• update “periodically”
• don’t know ending inventory (nor COGS) until
inventory is physically counted
• Then when it is counted, we use the beginning
and ending inventory counts plus purchases
to deduce COGS
 The Periodic Count Method
When inventory is purchased:

Purchase : DR Purchases (expense)

CR Cash or accounts payable
There is no impact to the inventory account; any
purchases are immediately expensed.
When inventory is sold:
No entry needed re: inventory

Still record revenue collected or collectible

 The Periodic Method
At the end of an accounting period

Adjust the accounts to recognize the inventory that is on hand.

• Adjust ending inventory to actual

• “Close” purchases to COGS

• Update COGS
 Inventory Example
Umbra Inc. wholesales a particular style of umbrella to a variety of
retail stores. During the last fiscal period, the following events took
place:

• Inventory at the start of the year was $13,000

• Sales of umbrellas in the period were $30,000, all on credit.

Those umbrellas sold had a cost of $18,000

• Additional umbrellas were purchased for $14,000 on credit

• An inventory count at the end of the period revealed that

umbrellas costing $8,000 were on hand at the end of the period.
Event #1: The company purchased umbrellas for $14,000
on account.
Event #2: The company had sales revenue of $30,000, on
account.
Revenue:

Cost of goods sold:

Event #3: In the Periodic Method, we must count ending
inventory and adjust the account balance to match. We also
“close” purchases to COGS.
The beginning inventory was $13,000 and the ending is
$8,000.
 PERIODIC

“Close” purchases to Cost of Goods sold account and adjust

inventory to actual
 PERIODIC – CALCULATING COST OF GOODS
SOLD

Beginning inventory 13,000

+ purchases in the period 14,000
Cost of goods available for sale 27,000
Less: ending inventory (8,000)
Cost of goods sold 19,000
 PERPETUAL INVENTORY CONTROL

Every time a sale is made, inventory is reduced and COGS is

recorded
• Inventory purchases are added to the inventory account
• Continuous record keeping provides us with an up to date
inventory balance (ie. A “perpetual” record of inventory)
• This allows a business to take a final inventory count to
check for shortages
• Any shortages or excesses indicate control (in)effectiveness
 The Perpetual Method
When inventory is purchased:
DR Inventory
CR Cash or accounts payable

When inventory is sold:

DR COGS (expense)
CR Inventory
 PERPETUAL METHOD

• At the end of the accounting period the balance in the

inventory account should equal what is on hand: count it
and see.
• If it doesn’t agree, then we need to adjust the inventory
account for any shortage identified.

Let’s redo the example using the perpetual method

Event #1: The company purchased umbrellas for $14,000 on
account.
Event #2: The company records sales revenue of $30,000 all
on account with a corresponding COGS of $18,000.
Revenue:

Cost of goods sold:

 Perpetual Inventory System

Adjust inventory for count:

DR Shortage expense
CR Inventory
 PERPETUAL – CALCULATING LOSSES

Beginning inventory 13,000

+ purchases in the period 14,000
Cost of goods available for sale 27,000
Less: cost of goods sold (18,000)
Ending inventory (per accounts/system) 9,000
Ending inventory (per count) 8,000
Shrinkage 1,000
 Perpetual vs. Periodic

Perpetual Inventory System:

• More expensive – often relies on computerized system
- but better information
• Know amount of inventory on hand at all times
• Better information for re-stocking

Periodic Inventory System:

• Simpler and less expensive to use this system
• Often manual systems

Both systems require periodic inventory counts.

 HOW TO DETERMINE THE COST OF INVENTORY

What goes into “cost” or “purchases”

- all costs that are incurred to bring inventory to its present
location and get them ready for sale

- Retailers:

- Manufacturers
 COST PER ITEM

Up to now our examples have been straightforward.

- we’ve either been told the cost of the goods sold, or assumed
the costs were consistent (umbrella example)
- What happens if the purchase costs fluctuate?
- How do we know the cost per unit?
 EXAMPLE – HOME DEPOT

 For example, Home Depot sells thousands of 2” nails in the year.

They would make several purchases of this item in a year – likely at
different costs
 At the end of the year, Home Depot must have
a way of figuring out the cost of the items that were sold and the cost
of the items remaining in inventory.
 How do we do this?
• By using an inventory cost policy
 Allocation of Available Cost

Sold:
Cost of
goods sold
Cost of
Cost of Cost of
goods OR
beginning + goods = available
inventory purchased
for sale On Hand:
Cost of
ending inv.
 INVENTORY COST POLICIES

The main costing methods (and the only ones we’ll

look at) are:
• Specific item
• First in, first out (FIFO)
• Average cost
FIFO and Average cost can be applied under both
the perpetual and periodic systems.
We will only cover the periodic system.
 SPECIFIC ITEM

• Use it when the specific inventory items can be identified

and it is useful to do so
• Usually used for a relatively small number of costly, easily
distinguishable items
• Serially numbered items like cars, jewelry, houses, art
 FIFO ASSUMPTION (FIRST IN, FIRST
OUT)

• Assumes that older items are sold first

• The items on hand, in inventory, are the newest
• This is used (usually) for goods that are for sale

What type of business might use FIFO?

 Average Assumption

• Those items on hand and sold were all taken from the
same mixed-together group
• This is used (usually) for raw materials, natural resources
(e.g. gas), non perishable items
 Example
Fashion Scarves Inc. sells a single product. During a recent
period, the company’s records showed:
Units on hand, beginning of period 1,000 @ $10 cost
Units in Purchase A 2,000 @ $14 cost
Units sold in Sale 1 (1,400)
Units in Purchase B 1,200 @ $15 cost
Units sold in Sale 2 (1,500)
Units on hand, end of period 1,300
 Fashion Scarves
Let’s first calculate total Cost of Goods Available for Sale
for the period
We can then allocate that cost between COGS expense and
ending inventory by each of the indicated methods:

COGAS = sum (quantities * unit price)

=

=
 Fashion Scarves – FIFO (periodic)
a) Ending inventory cost (at most recent cost)

b) COGS expense (at oldest costs)

 Fashion Scarves Inc.- Weighted Average
(periodic)
a) Average cost = Total Available Cost/Total Units

b) Ending inventory cost (at average cost)

c) COGS expense (at average cost)

 Summary of Fashion Scarves Inc.

I/S B/S Total

(COGS) Inv Asset Avail.
FIFO 36,600 + 19,400 = 56,000

AVGE 38,667 + 17,333 = 56,000

 HOW DOES A COMPANY SELECT A POLICY?

A company’s decision maker should consider:

- which policy best reflects economic reality (how
goods really move)
- which policy best reflects the value of inventory
on hand?
- consistency – use similar policies for similar types
of inventory and apply it consistently year over year
 SPECIFIC IDENTIFICATION

• The exception to the previous slide information is a situation

where a company has goods that are unique and identifiable
• MUST use specific identification

• If good are interchangeable, homogenous, etc.

• Choose between average and FIFO
What are the effects of Accounting Cost Policies?

When purchase prices are rising (the usual case):

Inventory COGS Income

FIFO

Average
 VALUING INVENTORY

The idea is that we will be able to sell our inventory for

more than we paid for it, but sometimes that isn’t the case:
- obsolete
- damaged
- price decreases created by market factors
 VALUING INVENTORY

Part of the definition of an asset is that it is expected to have

a future economic benefit

If we have inventory that cost us $1,000 but we believe we

can only sell it for $750, how much is the economic
benefit?

 Both IFRS and ASPE require that inventory be valued at

the lower of cost or net realizable value (LCNRV)
 VALUING INVENTORY
• We’ve already looked at how to determine “cost”

• Net realizable value

= expected selling price less expected costs to sell

• Relying on management estimates of expected future

selling price
 APPLICATION OF LOWER OF COST AND NRV

• Inventories are usually written down to net realizable value

item by item.
• In some circumstances, however, it may be appropriate to
group similar or related items.
Inventories: Lower of Cost or Market
Inv. Item Quantity Total Cost Total NRV LCNRV

Part #4-A 500 units $2,000 $2,600

Part #499 60 kilos 4,320 4,100

Product 1,000
60,000 75,000
#239 units
Product 700
200 units 3,000
#240

Totals $69,320 $82,400

 Inventories: Lower of Cost or NRV
This gives two versions of lower of cost or NRV:
• Total cost $69,320 < total NRV $82,400
• By individual items, or groups LCNRV = $66,800

The individual comparisons result in a lower valuation.

Total is not allowed because one product’s profit does
not offset another one’s loss
 ACCOUNTING FOR INVENTORY
WRITE DOWNS

Inventory is normally in the accounts at cost, therefore, we need to

adjust inventory by:
 INVENTORY ERRORS

You do not need to know this material

 INVENTORY TURNOVER

• It is not enough to simply assess if a company’s inventory

levels have increased or decreased from a prior year. This
does not properly consider the volume of activity.
• This ratio relates the level of inventories to the volume of
activity
• Helps to spot a company having sales trouble or
overproducing/overstocking (both cause inventory
turnover to fall).
• A company with low turnover may be risking
obsolescence or deterioration in its inventory, and/or
maybe incurring excessive storage and insurance costs
 Inventory Turnover
How is it calculated?
Cost of Goods Sold Expense
= Average Inventory
 Days sales in Inventory
How is it calculated?
365
= Inventory turnover ratio