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COMM 321

Unit 7: Inventory (Chapter 8)

Inventory is an asset that is either being held for sale or being held for use in production. The corporations that hold inventory are retailers, wholesalers and manufacturers. In all cases, inventory is included in Current Assets, and in North America, appears after Accounts Receivable. It is presented at the lower of cost and net realizable value.

Retailers and Wholesalers typically have one inventory account where cost includes all costs incurred to bring the goods to a saleable condition and/or location. This may include freight, non-refundable sales taxes, purchase discounts, import duties, preparation costs if applicable, storage, etc. Interest costs are also eligible if the loan is specifically related to inventory.

Manufacturers on the other hand have three inventory accounts: Raw Materials (RM), Work-in-Process (WIP) and Finished Goods (FG). The factory is typically divided into separate spaces for each, in some cases separated by a fence. The RM arrive from suppliers – these are the basic materials needed to make the product – and are released into WIP where direct labour and manufacturing overhead are added. Once complete, the goods go to FG where they remain until sold to a customer. Manufacturing overhead is all the costs incurred in the factory other than direct labour and direct materials, e.g. rent, depreciation, supervisory salaries, maintenance costs, insurance, etc. Again, interest costs can be included if the loan is specifically related to inventory.

It is useful for students to picture a manufacturer’s building as follows.

Factory   Raw Materials incl. material cost only

Factory   Work-in-Process incl. direct labour, direct materials, manufacturing overhead

Factory   Finished Goods incl. direct labour, direct materials, manufacturing overhead

Office   Selling, General and Administrative Expenses

It is very important for a student to recognize that all costs incurred in the factory go first into inventory, which is a Balance Sheet account. In contrast, all costs incurred in the office are SG&A expenses which appears on the Income Statement. Factory costs don’t impact the Income Statement until the goods are sold.

Cost of Goods Sold is the cost of inventory that has been sold and relates directly to sales. It can be calculated by compiling the actual costs or by using the Cost of Goods Sold equation. This depends on whether the company uses a perpetual inventory system or a periodic inventory system (see below).

The cost of goods sold equation is:

CGS = OI + P – EI

where: CGS = Cost of Goods Sold

OI = Beginning Inventory

P = Purchases

EI = Ending Inventory

**Note that OI + P = Goods Available for Sale

The equation is best illustrated by a market example. A vendor goes to a market with 5 handbags in a box for sale. On the way to the market he buys 100 more. Throughout the day, they are selling so fast the vendor loses track of how many have been sold. But at the end of the day there are 10 handbags left in the box. The CGS equation confirms how many were sold. The OI was 5, P were 100 and the EI was 10. Therefore, the CGS is 95. (If you’re thinking someone could have stolen some handbags, note that theft is considered part of CGS.)

Perpetual vs. Periodic Inventory System

Corporations use different methods to control their inventory. Duties are typically segregated between those responsible for the inventory records and those with access to the physical inventory. In that way, an individual who steals inventory cannot adjust the inventory records to conceal the theft. Further, inventory is stored in secure locations with restricted access – even in a manufacturer, the people with access to the raw materials will be different from the people with access to finished goods or work-in-process. Finally, companies maintain ongoing records of inventory, referred to as a perpetual inventory system, or periodically count inventory to determine the Balance Sheet value, referred to as a periodic inventory system.

The periodic system was used almost exclusively prior to the advent of computers. December 31 is the most common year-end and prior to 1980, many factories and warehouses throughout the country closed on New Years’ Eve for the sole purpose of counting inventory. Today, both systems are used in similar proportions.

The key features of a perpetual inventory system are:

Ø There is a detailed ongoing record of each inventory item which totals to the balance sheet value

Ø Records are updated when goods are sold and when purchased

Ø Purchase discounts and returns are recorded in the inventory account

Ø Cost of goods sold is recorded when the sale is made

Ø Test counts throughout the year are used to verify the accuracy of the ongoing balance

The key features of a periodic inventory system are:

Ø Inventory is physically counted once per period to determine the balance sheet value 

Ø Purchases, purchase returns and purchase discounts are recorded in separate accounts

Ø There is no entry to record cost of goods sold when the sale is made

Ø Cost of goods sold is calculated at end of period based on CGS equation

Accounting Entries: Perpetual vs. Periodic

Perpetual System			Periodic System
1. Purchase Inventory			1. Purchase Inventory
DR  Inventory	$$		DR  Purchases	$$
CR  Accounts Payable		$$	CR  Accounts Payable		$$
2. Purchase Returns			2. Purchase Returns
DR  Accounts Payable	$		DR  Accounts Payable	$
CR  Inventory		$	CR  Purchase Returns		$
3. Purchase Discounts			3. Purchase Discounts
DR  Accounts Payable	$		DR  Accounts Payable	$
CR  Inventory		$	CR  Purchase Discounts		$
4. Sales			4. Sales
DR  Accounts Receivable	$$$		DR  Accounts Receivable	$$$
CR  Sales		$$$	CR  Sales		$$$
DR  Cost of Goods Sold	$$		(no entry)
CR  Inventory		$$

Inventory Costing Methods:

Because it is practically difficult to determine which actual items were taken from which physical inventory locations, companies employ different assumptions to arrive at inventory cost. The three alternatives are:

Ø Specific Identification

Ø Weighted Average

Ø First-in, First-out (FIFO)

GAAP allows corporations to choose any of these alternatives but the method chosen should be rational and should provide the best matching of revenues and expenses.

Specific identification obviously provides the best matching but is usually not practical. It can only be used when the company is able to specifically identify the exact item that was sold and its cost. Hence this method is typically used only for big ticket sales like cars, trucks, expensive jewellery, etc. It is used almost exclusively with perpetual inventory system.

The weighted average method assumes the cost of goods sold is the average of all inventory purchases during the period. Under a periodic inventory system, the average is calculated at the end of the year. When using a perpetual inventory system however, the average cost is calculated every time a purchase is made.

The FIFO method assumes the oldest goods are sold first. Under a periodic inventory system, ending inventory is valued using the most recent purchases, and the cost of goods sold is calculated based on the opening balance and the remainder of purchases (i.e. the CGS equation). Under a perpetual inventory system, the cost of goods sold is calculated when goods are sold, based on the oldest purchase. In an inflationary environment, FIFO will produce the lowest CGS and therefore the highest Net Income.

Illustration: Assume ABC Corporation has the following inventory transactions for the month of January:

	Number of Units	Cost per Unit
Jan 1 Opening Balance	400	$1.10
Jan 4 Purchase	300	$1.20
Jan 5 Purchase	250	$1.25
Jan 6 Sale	200
Jan 9 Purchase	150	$1.30
Jan 10 Sale	300
Jan 16 Purchase	100	$1.35
Jan 25 Sale	150
Jan 29 Sale	150

 

Calculate the balance in Inventory at the end of January and the Cost of Goods Sold for January under both FIFO and Weighted Average using both the perpetual and periodic inventory systems.

1. Perpetual Inventory System:

FIFO:  Jan 6 sale from opening balance; cost = 200*1.1 = 220

Jan 10 sale from opening balance (200) and Jan 4 purchase (100); cost = 200*1.1+100*1.20 = $340

Jan 25 sale from Jan 4 purchase; cost = 150*1.2 = 180

Jan 29 sale from Jan 4 purchase (50) and Jan 5 purchase (100); cost = 50*1.2+100*1.25 = $185

Ending inventory = 400 units; cost = 150 from Jan 5 purchase + Jan 9 and 16 purchases = 150*1.25+150*1.3+100*1.35 = $517.50

Jan Cost of Goods Sold = 220+340+180+185 = $925

Weighted Average:

Jan 4 weighted avg. = (400*1.1+300*1.2)/700 = 1.142857

Jan 5 weighted avg. = (700*1.142857+250*1.25)/950 = 1.171053

Jan 6 cost of goods sold = 200*1.171053 = $234.21

Jan 9 weighted avg. = (750*1.171053+150*1.3)/900 = 1.192544

Jan 10 cost of goods sold = 300*1.192544 = $357.76

Jan 16 weighted avg. = (600*1.192544+100*1.35)/700 = 1.215038

Jan 25 cost of goods sold = 150*1.215038 = $182.26

Jan 29 cost of goods sold = 150*1.215038 = $182.26

Ending inventory = 400*1.215038 = $486.02

Jan Cost of Goods Sold = $956.48

Note:  517.50 + 925 = $1,442.50

486.02 + 956.48 = $1,442.50

2. Periodic Inventory System:

FIFO: Ending Inventory = 400 units = 100 from Jan 16 purchase + 150 from Jan 9 purchase + 150 from Jan 5 purchase = $517.50

Cost of Goods Sold = 400*1.1+300*1.2+250*1.25+150*1.3+100*1.35 – 517.50 = $925

Wtd Avg: Avg Cost for period = (400*1.1+300*1.2+250*1.25+150*1.3+100*1.35)/1200=1.202083

Cost of Goods Sold = 800*1.202083 = $961.67

Ending Inventory = 400*1.202083 =  $480.83

Note: 961.67 + 480.83 = $1,442.50

Effect on Income of different choices in Costing Method:

In the above example Cost of Goods Sold varied from low of $925.00 to high of $961.67 – a difference of $36.67 or 4%. This difference goes directly to the bottom line. Therefore the choice of inventory costing method has a direct impact on income. It also affects the amount of income tax paid since income tax expense is usually a % of income.

Periodic Inventory Adjusting Entry

At the end of the period, in a periodic system, there needs to be an adjusting entry to record the correct ending inventory and the correct Cost of Goods Sold for the period. Recall that for the entire period, the entries have only recorded Purchases, Purchase Discounts and Purchase Returns (and the balance in the inventory account pre-adjustment is the opening inventory value for the period). All of the purchase accounts will be brought to zero, as these amounts will now be allocated to Cost of Goods Sold and Ending Inventory, along with the opening inventory value. The entry will be the following.

DR Inventory Ending Inventory Value (per physical count)

DR Cost of Goods Sold Calculated using costing method

DR Purchase Returns to bring balance to zero

DR Purchase Discounts to bring balance to zero

CR Purchases to bring balance to zero

CR Inventory Opening Inventory Value

 

Note that the entry does reflect the Cost of Goods Sold formula. The adjusting entry for the January data shown in the FIFO example above, assuming that the ending inventory was counted, would be:

 

DR Inventory $517.50

DR Cost of Goods Sold $925.00

CR Purchases $1,002.50

CR Inventory    $440.00

Inventory Errors

Because the ending inventory of one period is the opening inventory in the next period, an error in one period affects the next one too. However, the effect on income in each period is opposite. Recall the CGS formula.

CGS = OI + P – EI

If the ending inventory in Period 1 is overstated by $1,000 (i.e. too high), CGS will be understated by $1,000 (too low) since the deduction was too high. If CGS is understated, income is overstated by the same $1,000 (too high). However, in Period 2, opening inventory is again overstated by $1,000 but this time, due to the CGS equation, CGS will be overstated by $1,000 (i.e. too high) since the addition is too high. Income will be understated by $1,000 (too low). In summary, the error has produced income that is too high in Period 1 and too low in Period 2. However, assuming Period 2 ending inventory is correct, there is no further affect on subsequent periods.

Retained Earnings is impacted by Net Income (and dividends) so in the above example, Retained Earnings will be overstated in Period 1 since Net Income was overstated. However, by the end of Period 2, Retained Earnings will be correct (assuming no other errors).

Practice Question: A company discovers the following errors in its accounting records. (A positive number indicates the item was overstated.)

	2012	2013
Opening Inventory	($12,000)	$5,000
Salary Expense	$8,000	($14,000)

 

Determine the impact on the company’s income and retained earnings for both 2012 and 2013, ignoring taxes and assuming no other errors.

In 2012, income will be overstated by $9,000 but retained earnings will be understated by $3,000. In 2013, income will be overstated by $9,000 again and retained earnings will be overstated by $6,000. (Hint: don’t forget the opening inventory of one year is the ending inventory of the previous year.)

Other Issues and Disclosures

Lower of Cost and Net Realizable Value

Inventory is held for resale. The readers of F/S assume it will be sold for more than its Balance Sheet value. When the realizable value of the inventory (i.e. the amount the company expects to sell it for) is less than its cost, the inventory should be written down to the lower value. It is misleading to present inventory at a value in excess of what the inventory can be sold for. The write-down will reduce income in the period the write-down occurs in, usually through Cost of Goods Sold. Typically, this sort of adjustment affects high tech companies where the value of inventories can shift rapidly as technology changes. However, the rule is applied to all companies, regardless of industry.  

Inventory and the Cash Flow Statement

Inventory effects the cash flow statement in the Operating Activities section, through both Cost of Goods Sold (reflected in Net Income) and in the adjustment to cash flow for increases or decreases in inventory balances. However, the choice of costing method will not impact the cash flow from operating activities (why?).

Inventory Exceptions

There are some exceptions to valuing inventory at the lower of cost or NRV. Financial instruments, construction contract work-in-process, agricultural inventories, mining and forestry inventories and inventories of commodity-brokers are all generally presented at their fair value less costs to sell. It is felt that the market value is more relevant for these sorts of inventories.

Estimating Inventory Value

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