Section 7 Inventory

7.01 Accounting for Inventory

Cost of Inventory
-

All costs of acquisition and preparation for sale

o Warehousing costs prior to sale
o Insurance, repackaging, modifications
o Freight in paid by buyer
o Transportation costs paid by seller on consignment arrangements
Do NOT include abnormal costs
o Idle factory expense
o Unallocated fixed overhead costs
o Excessive spoilage
o Double freight
o Re-handling costs

Goods in transit
FOB:
-

Shipping point
o Title passes to buyer when seller delivers good to common carrier
o Included in buyers books @ year end
Destination
o Title passes to buyer when the buyer receives the goods from common carrier
o Included in sellers books until received by buyer

If goods sold have been returned

-

Seller reduces net sales, add cost of items back to inventory

Take place as soon as seller has authorized the goods for return

All costs associated with inventories remain on the balance sheet until the point of sale
(matching principle)
Financing costs NOT part of cost of inventory report as INTEREST EXPENSE
-

Interest on loans obtain to purchase inventory

Example: goods purchased with $100 invoice 2/10, n30
o Client entitled to 2% discount if payment is made within 10 days, and
records inventory @$98 (net method)
o If payment made after 10 days, extra amounts paid will be recognized as
financing expense and NOT included in inventory

Costs incurred @ time of sale (freight OUT paid by seller, sales commissions) recognized
as selling expenses at time of sale (matching principle)

Consignment Inventory
Consignor consignee
Consignor:
-

Includes inventory on balance sheet

Ownership, but no possession
Costs incurred in transferring goods to consignee considered inventory until sold
include
o Cost of goods
o Freight for shipping to consignee
o Warehousing costs
o Advertising
o In transit insurance

Consignee:
-

Items NOT included in inventory balance

Has possession, but NOT ownership
When sold:
o Sales price given to consignor after deducting reimbursable costs and
commissions earned by consignee

COST OF GOODS SOLD

Sales
<COGS>
= Gross Margin
<SGA>
=Operating Income

Beginning Inventory

+ Purchases
= Goods available for sale
<Ending Inventory>
= COGS

Two systems for measuring inventory quantities

Periodic Inventory system
-

Inventory quantity determined by a physical count, usually @ year end

o Inventory purchases debited to purchases
o No adjustment made to inventory until end of the period
o COGS is the plug
Exact amount of inventory shortages cannot be determined since it is
buried in COGS
At time of purchase
Purchases

XXX

A/P
-

XXX

At year end
Ending Inventory

XXX

COGS (plug @yearend)

XXX

Purchases

XXX

Perpetual Inventory system

-

Inventory purchases debited to inventory

Quantity on hand can be determined at any point in time
At time of purchase
Inventory

XXX

A/P
-

XXX

As sales occur
A/R

XXX
Sales Rev

COGS

XXX

XXX
Inventory

XXX

Advantage of perpetual inventory system

o Enables entity to determine how much inventory is on hand at any point in
time
o Assists in
Management of inventory
Performing inventory reconciliation
Compare reported amounts to physical counts
Identifying errors in recording transactions
Finding potential theft

Inventory reconciliation may either required a reconciliation of the recorded amount to a

physical count or vice versa
Reconciliation:
Recorded amount physical count:
Recorded amount
+ goods held on consignment
+ goods sold FOB shipping point and set aside, but included in count
<goods in transit sold FOB destination>
<goods in transit purchased FOB shipping point>
= physical count

Any differences will be due to error or fraud

Physical count recorded amount

Physical count
+ goods in transit purchased FOB shipping point
+ goods in transit sold FOB destination
<subtract goods sold FOB shipping point set aside but included in count>
<goods held on consignment>
= recorded amount

Any differences will be due to error or fraud

7.02 Inventory Costing Method

Specific identification
Must be able to identify each unit sold
Used when inventory is:
-

Few in number
Very expensive
Can be clearly identified
Heterogeneous items

FIFO: First in First Out

Inventory remaining on hand is presumed to consist of most recent purchases.
Periods of rising prices:
-

Highest ending inventory

Lowers COGS
Highest Net income

Assumes goods sold in order of acquisition

Closely relates to actual physical flow of goods
First items acquired are first items sold
Last items acquired still in ending inventory (LISH)
Perpetual = periodic

LIFO: Last in First out

Most recent costs are expensed and matched with current revenues.
Inventory remaining on hand presumed to consist of items acquired first.
In periods of rising prices:
-

Lowest ending inventory

Highest COGS
Lowest Net Income

Better represents the flow of cash

Last items required first sold
First items required still in inventory (FISH)
Perpetual and periodic not the same
The use of the most recently acquired item as COGS is an attempt to approximate the
replacement cost of the item.

Capital maintenance concept presumes that a company that wishes to remain a

going concern must maintain a basic level of investment in the assets that comprise
the business

If used for tax purposes, must also be used for financial reporting purposes
= LIFO conformity rule

FIFO = COGS; (LISH= ENDING INV.)

LIFO =COGS; (FISH = ENDING INV.)
(LAST IN STILL HERE)
(FIRST IN STILL HERE)
IF COSTS ARE GOING UP
COGS understated
COGS OK
Net income Overstated
Profits OK I/S is fair
Ending inventory OK
Ending inventory Understated
Balance sheet OK (I/S not OK)
Income statement OK (BS not OK)

Average Inventory Methods

Assign the same unit price to similar goods available during the period
-

Perpetual (moving average)

o Computes the average after each purchase
Periodic (weighted average)
o Takes total cost of all inventory purchases during the year and divides them
by the total number of inventory units available during the year.

Example: Assume a company had the following activity during January:

Date:
Beg. Inventory, January 1
Purchase, January 5
Sale, January 12
Purchase, January 19
Sale, January 26
Ending Inventory

Using the PERPETUAL approach:

Units Purchased (Sold)

2 A, B
2 C, D
(1)
2 E, F
(1)
4

Each transaction is process as it happens.

Units after transaction
Start of Month
January 5, plus 2
January 12, minus 1
January 19, plus 2
January 26, minus 1

FIFO
A+B
A+B+C+D
B+C+D
B+C+D+E+F
C+D+E+F

LIFO
A+B
A+B+C+D
A+B+C
A+B+C+E+F
A+B+C+E

Using the PERIODIC approach:

All purchases are recorded first, then the sales.
Units after transaction
Start of Month
Purchases, plus 4
Sales, minus 2

FIFO
A+B
A+B+C+D+E+F
C+D+E+F

LIFO
A+B
A+B+C+D+E+F
A+B+C+D

Dollar Value LIFO

Inventory is measured in terms of dollars, not units, and is adjusted for changing prince
levels
Inventory is combined into inventory pools and each pool is valued separately
A price level index is used to convert the inventory value from LIFO to DV LIFO
related inventory items are grouped in pools and an overall price index is used to
approximate changes in inventory costs.
Addresses both difficulties in applying LIFO
It is only necessary to keep track of annual layers of inventory costs and prices indexes for
each inventory pool
Substantially reduces the probability that older inventory layers will be liquidated and
reported in COGS.
To apply DV LIFO: two figures needed:
1. Total current cost of inventory in the pool at end of each year
2. Price index indicating overall price level compared to base date ( date the method
was first adopted)
Price level indexesapproaches
1. Simplified
a. CPI for your industrygiven
b. Generally available index of prices

i. Typically, a government index

2. Link chain
a. Single cumulative index, compare with previous year
b. Similar to double extension method
c. Year to year price changes are computed, then the annual changes are linked
together to determine a price index
i. Current Q x End of year unit cost = Current cost
ii. Current Q x start of year unit cost = prior year cost
iii. Current cost / prior year cost = annual cost index
3. Double extension
a. Requires client to count the inventory and extend inventory prices twice
b. Two results are compared to determine a price index
i. Current Q X Current unit cost = current cost
ii. Current Q x Base date unit cost = base cost
iii. Current cost/base cost = price index

Lower of Cost or market Rule (LCM)

Conservatism & Matching Principle
Cost = original cost
Market = middle of 3 numbers
1. Market ceiling = NRV (selling price disposal costs)
a. Disposal costs
i. Costs to complete
ii. Freight out
iii. Sales commissions
2. Replacement Cost = purchase or reproduction
3. Market floor = NRV normal profit margin
Inventory valuation may be based upon
-

Individual items
Categories
Total inventory

LOSSES recognized immediately on the income statement

-

Do NOT recover loss

Loss on inventory due to market decline

Inventory

Lower of Cost or NRV (LCNRV)

XXX
XXX

For periods after 12/31/2016 -- > ASC 330 requires that all inventory, other than inventory
accounted for under LIFO and retail methods, be reported on the Balance sheet at LCNRV
A company must consider the need to account for declines in the market value of unsold
inventories.
Based on conservatism principle a company will normally carry inventories on the
balance sheet at LCM.
Problem: there are 2 different markets in which a company operates
-

Market for purchases of inventories

Market for sales of inventories

The term market usually refers to replacement cost.

If prices of goods of inventory have been consistently rising, valuation under a LCM
approach will usually be at COST, regardless of which costing method was used.
If falling, will usually be at market, regardless of which costing method was used.
Under normal circumstances, RC is lower than NRV and higher than NRV Normal profit
margin, and is used as market.

7.07 Inventory Estimation Methods

Gross (profit) margin method
GP can be used to prepare interim FS or as an estimate if EI is missing or destroyed.
First, calculate estimate of COGS using historical gross profit percentage, then back into
inventory.
Beginning Inventory

100

+ purchases

300

= Goods available for sale

400

<ending inventory>

<220> plugged

= COGS

180

GP = 40%

so if sales = 300(60%) = 180

COGS = 60%

Retail Inventory Methods

Rarely used, extremely complicated

Conventional Retain Inventory method

Company keeps tract of inventory costs at both cost and retail
Sales, theft losses, employee discounts recorded at retail
And end of year, converts ending inventory from retail back to cost using a cost/retail
percentage.
Net markups are included in cost to retail percentage calculation
Net markdowns--- NOT included in cost to retail percentage calculation
LIFO retail inventory method
Approximates the original cost of the merchandise

Firm purchase commitments

Noncancelable agreement to buy inventory in the future.
If a loss is expected, loss is recognized at time of decline in price
-

Loss = difference between contract price and market price of minimum required
amount of inventory that must be purchased in the future

Estimated Loss (I/S)

Estimated Liability

XXX
XXX

7.09 Inventory Under IFRS

IFRS principles apply to most inventories, but do NOT apply to WIP from construction
contracts, financial instruments, biological assets of an ag entity.
IFRS requires that inventory be reported at LCNRV
Cost includes
-

Cost of purchase
Costs of conversion
o Calculated similarly to US GAAP
o In limited circumstances, IFRS allows capitalization of borrowing costs
Other costs incurred in bringing the inventory to current location and condition

Method for determining cost depends on the nature of the inventory

Specific ID method required for items that are not interchangeable and for items
that are produced and segregated for specific projects
Cost is determined using FIFO or weighted average for all other inventories
o LIFO IS NOT ALLOWED
o Standard cost or retail methods allowed if the results approximate cost under
either FIFO or weighted average
For periods after 12/15/2016, ASC 330 requires that under US GAAP all inventory,
other than inventory accounted for under LIFO or retail inventory methods, be
reported on BS at LCNRV

Inventories are charged to expense, generally in the form of cost of sales, in the same period
as related revenues are recognized.
Losses and write-downs are recognized in period of occurrence
-

Period in which the NRV falls below cost

Reversals of write-downs also recognized as a reduction of expense

Primary differences between GAAP and IFRS:

-

IFRS does not allow LIFO

IFRS requires inventories be reported at LCNRV
IFRS allows recoveries in the value of inventory when NRV increases after
inventory has been written down.

In limited circumstances, IFRS allows borrowing costs to be capitalized as part of the cost
of conversion when measuring the cost of inventory. Only allowed in circumstances where
inventory requires a substantial period of time to get ready for sale.
Under IFRS, a loss may be recovered.
Example: LCNRV - $80, with a corresponding expense on the income statement. If the
inventory value at the end of year 2 was $90, a recovery of the loss of $10 would be
recorded by debiting inventory and crediting an income account (COGS)
Inventory

XXX

Recovery of inventory loss (I/S)

XXX

Inventory:
US GAAP
-

Allows FIFO, LIFO, or average cost flow assumption

Inventories are valued at LCM where market is considered RC, subject to floor and
ceiling limitations (until 12/16)
Any impairment write downs create a new cost basis; previously recognized
impairment losses are NOT reversed

IFRS
-

Allows FIFO or average, NOT LIFO

Inventories are valued at LCNRV
Previously recognized impairment losses MAY BE REVERSED