Intermediate Accounting

Transcription

1 Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management, Dalhousie University PowerPoint slides by: Bruce W. MacLean, Faculty of Management, Dalhousie University

2 Chapter 9 Inventories

3 Importance Of Inventories Inventories typically represent the largest current asset of manufacturing and retail firms. Inventory should be considered a high-risk asset. For many companies, inventories are a significant portion of total assets as well. Inventory accounting methods and management practices can become profit-enhancing tools. Inventory effects on profits are more noticeable when business activity fluctuates Topics: Types of inventory, Basic cost flow assumptions,valuation issues and Estimation methods

4 Inventory Categories Inventories consist of costs that have been incurred in an earnings process that are held as an asset until the earnings process is complete. Inventory may include a wider range of costs incurred and held in an inventory account for matching against revenue that will be recognized later. Items that may be capital assets to one company may be inventory to another. The major classifications of inventories depend on the operations of the business.

5 Inventory Categories 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 the manufacture or further processing of goods for resale. Parts or subassemblies manufactured before use are sometimes classified as component parts inventory. Work-in-process inventory - Goods or natural resources requiring further processing before completion and sale. Work-in-process inventory includes the cost of direct material and direct labour incurred to date, and usually some allocation of overhead costs.

6 Inventory Categories Finished goods inventory - Manufactured or fully processed items completed and held for sale. Finished goods inventory cost includes the cost of direct material, direct labour, and allocated manufacturing overhead related to its manufacture Production supplies inventory - Items on hand, such as lubrication oils for the machinery, cleaning materials, as well as small items that make up an insignificant part of the finished product, such as bolts or glue. Contracts in progress - The accumulated costs of performing services required under contract. Miscellaneous inventories - Items such as office, janitorial, and shipping supplies. Inventories of this type are typically used in the near future and may be recorded as selling or general expense when purchased instead of being accounted for as inventory.

7 Inventory Policy Issues Since cost of goods sold is often the largest single expense category on the income statement, and inventory is an integral part of current and total assets, it makes sense that accounting policies in this area can cause income and net assets to change materially. In what areas can policies be set? We ll look at: Items and costs to include in inventory Cost flow assumptions Application of LCM (lower of cost or market) valuations

8 Items And Costs Included In Inventory All goods legally owned by the company on the inventory date, 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 often impractical. In such cases, the sales agreement, industry practices, and other evidence of intent should be considered

9 Elements Of Inventory Cost Invoice price Total cash equivalent outlay made to acquire the goods and to prepare them for sale or, for a service company, to fulfill the requirements of the service contract. Freight charges and other incidental costs incurred in connection with the purchase of tangible inventory Purchase Discounts Cash discounts on purchases to encourage timely payment from buyers Other costs to get the inventory ready for sale

10 Items Not Included In Inventory (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 normally treated as period expenses because they relate more directly to accounting periods than to inventory. Distribution and selling costs are also considered to be period operating expenses and are not allocated to inventories.

11 Variable Vs. Fixed Overhead Manufacturing companies and service firms engaged in long-term contracts often use variable costing (also called direct costing, although there are subtle differences between the two approaches) for internal management planning and control purposes. The CICA Handbook recommends that manufacturers inventories include an allocation of overhead: In the case of inventories of work in process and finished goods, cost should include the laid-down cost of material plus the cost of direct labour applied to the product and the applicable share of overhead expense properly chargeable to production. [CICA ] Material Labour Overhead

12 Cost Flow Assumptions Periodic inventory system Inventory value is determined only at particular times, such as end of the accounting period. Perpetual inventory system The ongoing physical flow of inventory is monitored, and the cost of the inventory items is maintained on a continual basis. PERIODIC METHOD vs. PERPETUAL METHOD

13 Periodic Vs. Perpetual Illustration Lea Company Unit Units Cost Total Beginning inventory 500 $4.00 $2,000 Purchases 1, ,000 Goods available for sale 1,500 $6,000 Less: Sales 900 Ending inventory, as calculated 600 Ending inventory, based on physical count 580 Shrinkage 20

14 Calculating Cost Of Goods Sold (COGS) Lea Company Beginning Inventory 500 x $4.00 $2,000 + Purchases (net) 1000 X $4.00 4,000 = Cost of Goods Available for Sale 6,000 - Ending Inventory 580 x $4.00 2,320 = Cost of Goods Sold (residual amount) $3,680

15 Periodic Recording Lea Company Date Description July 31 Purchases Accounts Payable To Record the purchases GENERAL JOURNAL Page 7 Post. Ref. Debit Credit $4,000 $4,000 Cost of Goods sold Inventory ( closing, per count) Inventory ( opening) Purchases $3,680 $2,320 $2,000 $4,000

16 Perpetual Recording Lea Company Date Description July 31 Inventory [$1,000 x $4] Accounts Payable GENERAL JOURNAL Page 7 Post. Ref. Debit Credit $4,000 $4,000 Accounts receivable [900 x $10] Sales Revenue $9,000 $9,000 Cost of goods sold [900 x $4] Inventory $3,600 $3,600

17 Periodic Vs. Perpetual Recording Methods Choosing a Recording Method The choice of a periodic or perpetual system is not really an accounting policy choice, although modest differences in inventory and cost of goods sold amounts can arise under the average cost assumption and under LIFO, depending on which recording method is used. Instead, the choice of recording method is one of practicality which method gives the best cost-benefit relationship? Common Cost Flow Assumptions Specific Identification Average Cost First-In, First-Out Last-In, First-Out

18 Choosing A Recording Method A perpetual inventory system is especially useful when inventory consists of items with high unit values or when it is important to have adequate but not excessive inventory levels. Perpetual inventory systems require detailed accounting records and therefore tend to be more costly to implement and maintain than periodic systems. Computer technology has made perpetual inventory systems more popular today than ever before. Theft and pilferage, breakage and other physical damage, misorders and mis-fills, and inadequate inventory supervision practices must be dealt with regardless of the type of inventory accounting system used.

19 Common Cost Flow Assumptions LIFO is not a popular method in Canada, due largely to the fact 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 service contracts. For other types of business, average cost and FIFO are the popular methods According to the CICA Handbook, the method selected for determining cost should be one which results in the fairest matching of costs against revenues [CICA ].

20 Specific Identification At the end of the year (periodic method) or on each sale (perpetual method) the specific units sold, and their specific cost, is identified to determine inventory and cost of 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 which items were sold and what their specific initial cost was.

21 Average Cost When the average cost method is used in a periodic system, it is called a weighted average system. Exhibit 9-3 illustrates Weighted-average unit cost = beginning inventory cost + total current period purchase costs number of units in the beginning inventory + units purchased during the period

22 Exhibit 9-3 Weighted-Average Inventory Cost Method (Periodic Inventory System): Unit Total Units Price Cost Goods available: 1 January Beginning inventory 200 $1.00 $ January Purchase January Purchase January Purchase January Total available 1,000 $1,120 Weighted-average unit cost ($1,120 1,000) 1.12 Ending inventory at weighted-average cost: 31 January Cost of goods sold at weighted-average cost: Sales during January 700* Total cost allocated $ 1,120 * 400 units on January 10 plus 300 units on January 18.

23 Exhibit 9-4 Moving-Average Inventory Cost, Perpetual Inventory System Purchases Sales Inventory Balance Unit 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 $ (a) January 400 $1.06 $ January (b) January January (c) 354 Ending inventory $354 Cost of goods sold $ Total cost allocated $1,120 (a) $ = $1.06. (b) $ = $1.14. (c) $ = $1.18.

24 First-In, First-Out The first-in, first-out (FIFO) method treats the first goods purchased or manufactured as the first units costed out on sale or issuance. Goods sold (or issued) are valued at the oldest unit costs, and goods remaining in inventory are 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 either currently throughout the period each time there is a withdrawal, or entirely at the end of the period, with the same results.

25 Exhibit 9-5 FIFO Inventory Costing, Perpetual Inventory System Beginning inventory (200 units at $1) $ 200 Add purchases during period (computed as in Exhibit 9-2) 920 Cost of goods available for sale 1,120 Deduct ending inventory (300 units per physical inventory count): 100 units at $1.26 (most recent purchase 24 January) $ units at $1.16 (next most recent purchase 15 January) 232 Total ending inventory cost 358 Cost of goods sold $ 762* * Can also be calculated as 200 units on hand 1 January at $1 plus 300 units purchased 9 January at $1.10, plus 200 units purchased 15 January at $1.16.

26 Page Accounting entries Illustration 7 GENERAL JOURNAL Periodic Perpetual Date Description Post. Re f. De bit Credit De bit Credit Jan 24 9 Purchases Inventory Cash, etc Jan Cost of goods sold Inventory Inventory (closing) Inventory (opening) 200 Jan 15 Purchases Purchases Inventory 464 Cash, etc Jan 18 Cost of goods sold 342 Inventory 342

27 Exhibit 9-6 FIFO Inventory Costing, Perpetual Inventory System Purchases Sales Inventory Balance Unit 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 $ January 200 $1.00 $ January January January Ending inventory ($232 + $126) $358 Cost of goods sold $ Total cost allocated $1,120

28 Last-In, First-Out The last-in, first-out (LIFO) method of inventory costing matches inventory valued at the most recent unit acquisition cost with current sales revenue. The units remaining in ending inventory are costed at the oldest unit costs incurred, and the units included in cost of goods sold are costed at the newest unit costs incurred, the exact opposite of the FIFO cost assumption. Like FIFO, application of LIFO requires the use of inventory cost layers for different unit costs.

29 Exhibit 9-7 LIFO Inventory Costing Periodic Inventory System: Cost of goods available (see Exhibit 9-2) $1,120 Deduct ending inventory (300 units per physical inventory count): 200 units at $1 (oldest costs available, from 1 January inventory) $ units at $1.10 (next oldest costs available; from 9 January purchase) 110 Ending inventory 310 Cost 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.

30 Exhibit 9-8 LIFO Inventory Costing Perpetual Inventory System: Purchases Sales Inventory Unit 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 $ January 300 $1.10 $ January January January Ending inventory ($100 + $116 + $126) $342 Cost of goods sold $ Total cost allocated $1,120 * Beginning inventory.

31 Income Tax Factors Revenue Canada will not accept LIFO for tax purposes. Companies must use either the FIFO or the average cost method when they compute their taxes payable. If a company uses LIFO for financial reporting, it must maintain two different inventory costing systems one for financial reporting (LIFO) and another for income tax (FIFO or average). Since there is a substantial additional work load to maintaining two different systems, Canadian companies rarely use LIFO. Financial Reporting in Canada 1997 reported that only about 3% of the sample companies use LIFO for any part of their inventory.

32 Review When prices are rising, as they often are: FIFO will produce higher inventory, lower cost of goods sold, and higher income. It s probably popular with firms that would like to see higher income and net assets in their financial statements. LIFO has the opposite effect: lower inventories, higher cost of goods sold, and lower incomes. Average cost methods provide inventory and cost of goods sold amounts between the LIFO and FIFO extremes, and is the next best thing to LIFO for income and tax minimization when inventory costs are rising. Canadian practice is about evenly divided between FIFO and average cost. LIFO is very seldom used in Canada, except by Canadian subsidiaries of U.S. companies that mandate its use in order to be consistent with the parent s accounting policies.

33 Exhibit 9-9 Comparison of the Effects of FIFO vs. LIFO If purchase prices are: The impact on Ending inventory is: The impact on Cost of goods sold is: The impact on Net income and retained earnings is: Rising Falling FIFO > LIFO FIFO < LIFO FIFO > LIFO FIFO < LIFO FIFO > LIFO FIFO < LIFO

34 Evaluation Of FIFO Advantages Easy to apply Inventory value approximates current cost Flow of costs tends to be consistent with usual physical flow of goods Systematic and objective Not subject to manipulation Disadvantages Does not match current cost of goods sold with current revenues Inventory (or phantom) profits In periods of rising prices, pay higher income taxes.

35 Special Aspects Standard Cost Just-In-Time Inventory Systems Inventories Carried At Market Value Losses On Purchase Commitments

36 Standard Cost In manufacturing entities using a standard cost system, the inventories are valued, recorded, and reported for internal purposes on the basis of a standard unit cost which approximates an ideal or expected cost. This prevents the overstatement of inventory values because it excludes from inventory all losses and expenses that are due to inefficiency, waste, and abnormal conditions. Actual historical cost is used only once, on acquisition which simplifies record-keeping significantly! Under this method, the differences between actual cost and standard cost are recorded in separate variance accounts. These accounts are usually written off as a current period loss rather than capitalized in inventory. Under standard cost procedures there would be no need to consider inventory cost flow methods (such as LIFO, FIFO, and average) because only one cost standard cost appears

37 Just-In-Time Inventory Systems Just-in-time (JIT) inventory systems are a response to the high costs associated with stockpiling inventories of raw materials, parts, supplies, and finished goods The ultimate goal is to see goods and materials arrive at the company's receiving dock just in time to be moved directly to the plant's production floor for immediate use in the manufacturing or assembly process. Finished goods roll off the production floor and move directly to the 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 is not maintained, the JIT system runs the risk of becoming a NQIT (not-quite-in-time)

38 Inventories Carried At Market Value When revenue is recognized at the point of production, inventory is written up to its net realizable value, prior to sale. This is the increase in net assets that substantiates revenue recognition. Gold Mining Farm products Special inventory categories often include items for resale that are damaged, shopworn, obsolete, defective, or are trade-ins or repossessions. These inventory items are valued at current replacement cost, defined as the price for which the items can be purchased in their present condition. When the replacement cost cannot be determined reliably, such items should be valued at their estimated net realizable value (NRV), defined as the estimated sale price less all costs expected to be incurred in preparing the item for sale

39 Losses On Purchase Commitments Purchase commitments (contracts) To lock in prices and ensure sufficient quantities, companies often contract with suppliers to purchase a specified quantity of materials during a future period at an agreed unit cost. A loss must be accrued on a purchase contract when: the purchase contract is not subject to revision or cancellation, and when a loss is likely and material and when the loss can be reasonably estimated.

40 Lower Of Cost Or Market Valuation GAAP requires that inventories be valued either at cost or at current market value, whichever is less. Assets should always be substantiated by some kind of future economic benefit. For inventory, it s clear that if you can t sell the asset, the inventory can t really be called an asset. LCM tests are complicated by a couple of policy choices: What is the definition of market value? Should the LCM test be applied to individual inventory items, to categories, or to totals? The question of aggregation is not trivial.

41 Definition of market value The basic difficulty with determining market value is that there are two markets the supplier market (replacement cost) and the customer market (sales price). Sales price is called net realizable value (NRV) when costs expected to be incurred in preparing the item for sale are deducted. Net realizable value can be taken further, deducting expected costs and also a normal gross profit margin; use of net realizable value less a normal profit margin will preserve normal profits when the item is finally sold.

42 Exhibit 9-10 Net Realizable Value and Net Realizable Value Less a Normal Profit Margin a. Inventory item A, at original cost $ 70 b. Inventory item A, at estimated current selling price in completed condition $100 c. Less: Estimated costs to complete and sell* 40 d. Net realizable value $ 60 e. Less: Allowance for normal profit (10% of sales price) 10 f. Net realizable value less normal profit $ 50 * For goods already completed, as in a retail company, this amount would be the cost to sell.

43 Exhibit 9-11 Methods of Market Determination, 1996 Number of Method companies, 1996 Net realizable value 142 Replacement cost 43 Net realizable value less normal profit margin 3 Estimated net realizable value 4 Source: Boyd & Chen, Financial Reporting in Canada 1997 (Toronto: CICA, 1997), p. 169.

44 9 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 of inventory. 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 conservative inventory value because units whose market value exceeds cost are not allowed to offset items whose market value is less than cost. This offsetting occurs to some extent in the other approaches. The more you aggregate, the less you write down. The less you aggregate, the more you write down.

45 Exhibit 9-12 Application of LCM to Inventory Categories LCM Applied to Individual Inventory Types Cost Market Items Classifications Total Classification A: Item 1 $10,000 $ 9,500 $ 9,500 Item 2 8,000 9,000 8,000 18,000 18,500 $18,000 Classification B: Item 3 21,000 22,000 21,000 Item 4 32,000 29,000 29,000 53,000 51,000 51,000 Total $71,000 $69,500 Inventory valuation under different approaches $67,500 $69,000 $69,500

46 LCM Recording and reporting Two methods of recording and reporting the effects of the application of LCM are used in practice: Direct inventory reduction method. The LCM amount, if it is less than the original cost of the inventory, is recorded and reported each period. Thus, the inventory holding loss is automatically included in cost of goods sold, and ending inventory is reported at LCM. Inventory allowance method. The inventory holding loss is separately recorded using a contra inventory account, allowance to reduce inventory to LCM. Holding loss on inventory 1,000 Allowance to reduce inventory to LCM 1,000

47 Cash Flow Statement To determine the amount of cash provided by operations, net income must be adjusted by the change in inventory during the period: an increase in inventory means that the cash flow to purchase inventory was higher than the amount of expense reported as cost of goods sold the increase must be subtracted from net income in order to reflect higher cash outflow. a decrease in inventory means that the cash flow to acquire inventory was less than the amount of expense reported in cost of goods sold the decrease must be added to net income.

48 Disclosure According to the inventory section of the CICA Handbook, recommended disclosures are as follows: the basis for valuation (e.g., historical cost, lower of cost or market, market value) [CICA ]; major categories of inventory (desirable, not required) [CICA ]; method of determining cost, if the method used for determining cost differs from recent cost of the inventory items [CICA ]; a definition of market value (desirable, not required), if market is used in some aspect of inventory valuation [CICA ]; and any change in valuation from that used in the prior period, and the effect of a change on net income [CICA ].

49 Inventory Estimation Methods Many large companies rely on the periodic inventory method. Does this mean that they can t prepare monthly or quarterly statements without also taking a physical 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 manager might be able to provide an accurate estimate. Alternatively, a more formal calculation can be made, Gross Margin Method Retail Inventory Method

50 Gross Margin Method The gross margin method (also known as the gross profit method) assumes that a constant gross margin estimated on recent sales can be used to estimate inventory values from current sales. That is, the gross margin rate (gross margin divided by sales), based on recent past performance, is assumed to be reasonably constant in the short run. The gross margin method has two basic characteristics (1) it requires the development of an estimated gross margin rate for different lines or products, and (2) it applies the rate to relevant groups of items.

51 Gross Margin Method Steps To Follow Estimate historical gross margin rate. Add beginning inventory and net purchases to get cost of goods available for sale(cogas). Multiply sales by the gross margin rate to get estimate gross margin in dollars. Subtract gross margin in dollars from net sales to get cost of goods sold(cogs). Subtract COGS from COGAS to get the estimated cost of ending inventory.

52 Gross Margin Method - Example NoteCo, Inc. uses the gross margin method to estimate end of month inventory value. At the end of May the controller develops the following information: Gross margin 43% of sales; Inventory at May 1 $237,400; net purchases for May $728,300; net sales for May $1,213,000. Estimate Inventory at May 31.

53 Gross Margin Method Solution Proof of Estimate 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

54 Retail Inventory Method The retail inventory method is often used by retail stores, especially department stores that sell a wide variety of items. In such situations, perpetual inventory procedures may be impractical, and a complete physical inventory count is usually taken only once annually. The retail inventory method is appropriate when items sold within a department have essentially the same markup rate and articles purchased for resale are priced immediately. Two major advantages of the retail inventory method are its ease of use and reduced record-keeping requirements.

55 Markups And Markdowns To apply the retail inventory method, it is important to distinguish 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 early calculations that determine goods available for sale at cost and at retail. However, in order to provide a conservative cost ratio that will approximate lower of cost or market (LCM), the denominator of the cost ratio excludes net markdowns.

56 Gross Margin Method Steps To Follow Estimate historical gross margin rate. Add beginning inventory and net purchases to get cost of goods available for sale(cogas). Multiply sales by the gross margin rate to get estimate gross margin in dollars. Subtract gross margin in dollars from net sales to get cost of goods sold(cogs). Subtract COGS from COGAS to get the estimated cost of ending inventory.

57 Gross Margin Method - Example NoteCo, Inc. uses the gross margin method to estimate end of month inventory value. At the end of May the controller develops the following information: Gross margin 43% of sales; Inventory at May 1 $237,400; net purchases for May $728,300; net sales for May $1,213,000. Estimate Inventory at May 31.

58 Gross Margin Method Solution Proof of Estimate 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

59 Retail Method To use this method we must know: Sales for the period. Beginning inventory at retail and cost. Net purchases at retail and cost. Adjustments to the original retail price: Additional markups and markdowns, markup and markdown cancellations, employee discounts

60 Retail Method Steps To Follow Determine cost of goods sold and retail value of goods sold. Calculate the cost to retail percentage. Subtract retail value of goods available for sale from sales to get ending inventory at retail. Multiply the cost to retail percentage times ending inventory at retail to get ending inventory at cost.

61 Retail Method Example Webb Clothiers, Inc. uses the retail method to estimate inventory at the end of each month. For the month of May 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; net sales for May $300,000. Estimated inventory at May 31.

62 RETAIL METHOD - SOLUTION Cost Retail Inventory, May 1 $ 60,000 $ 92,000 Net purchases for May 200, ,000 Goods available for sale 260, ,000 Cost ratio (260, ,000) 65% Sales for May 300,000 Ending inventory at retail $ 100,000 Cost ratio 65% Ending inventory at cost $ 65,000

63 Retail Method Markups And Markdowns Original Sales Price - sale price first marked on the merchandise. Markup - original amount by which item is marked up above cost. Additional Markup - Increase in sales price above the original sales price. Additional Markup Cancellation - cancellation of some or all of an additional markup. Markdown - reduction in original sales price Markdown Cancellation - increase is sales price after a markdown

64 Retail Method Markups And Markdowns Estimating Inventory on a FIFO Basis Exclude beginning inventory from the cost ratio. FIFO cost ratio = Cost of net purchases Retail value of (net purchases + net markups - net markdowns)

65 Retail Method Markups And Markdowns Average Cost Basis Average cost = ratio Cost of (beginning inventory + net purchases) Retail value of (beginning inventory + net purchases + net markups - net markdowns)

66 Retail Method Markups And Markdowns Lower-of-Cost-or-Market Basis LCM cost = ratio Cost of (beginning inventory + net purchases) Retail value of (beginning inventory + net purchases - net markups) Exclude net markdowns from the ratio.

67 Summary Of Key Points Inventories are assets consisting of goods owned by the business and held for future sale or for use in the manufacture of goods for sale. Cost at acquisition, including the costs to obtain the inventory, such as freight, is used to value inventory. Work in process and finished goods inventories of manufacturers should include raw materials, direct labour, and at least the variable portion of manufacturing overhead.

68 Summary Of Key Points All goods owned at the inventory date, including those on consignment, should be counted and valued. Either a periodic or a perpetual inventory system may be used for merchandise inventories and for manufacturer s inventories of raw materials and finished goods, but computer technology now makes it easier and less costly to use a perpetual system, which also provides up- to- date inventory records.

69 Summary Of Key Points Several cost flow assumptions are in current use, including specific identification, average cost, FIFO, and LIFO. LIFO is very rarely used in Canada, except by subsidiaries of U.S. parent companies that also use that method. Special accounting problems are encountered by firms using standard cost, just-in-time inventory systems, or net realizable value to recognize inventory. Losses on firm purchase commitments, when they can be reasonably estimated and are material, are recognized in the accounts if the loss is likely and can be estimated. Otherwise, such commitments are often disclosed only in the notes.

70 Summary Of Key Points The lower-of-cost-or-market (LCM) method of estimating inventory recognizes declines in market value in the period of decline. The lower-of-cost-or-market method values inventories at market if market is below cost. Market may be interpreted to be net realizable value, net realizable value less a normal profit margin, or replacement cost. Use of net realizable value is most common. The gross margin method is used to estimate inventory values when it is difficult or impractical to take a physical count of the goods. The method is most accurate when profit margins are stable.

71 Summary Of Key Points The retail method of estimating inventory applies the ratio of actual cost to sales value to the ending inventory at sales value to estimate the inventory value at lower of cost or market. The cash flow from operations is affected by (1) changes in inventory levels and (2) amortization that has been included in the inventory. Cash flow must be adjusted to reflect the amount of inventory purchased rather than sold, and must be adjusted by adding back any amortization.