Chapter 8 Inventory

Prepared in part by: Sarah McVay University of

Washington

Organization of Chapter
Recognition-risks and rewards of ownership have

transferred
Goods in Transit, Consigned goods, Buyback

agreements, High rates of return, Purchase

commitments-Onerous contracts
Inventory errors
Measurement-Treatment of purchase discounts,

Vendor rebates, Basket purchases

Cost Formulas -Perpetual vs. Periodic
FIFO, Weighted Avg, Specific Identification, LIFO.

Perpetual vs. Periodic

Estimating Inventory Gross Profit % and Retail

Method (appendix A)
Introduction

Introduction
Inventory Concepts

Asset- reported on the balance sheet (current or long

term?)
Held for sale in the ordinary course of business.
Increases when we purchase inventory (or raw
materials)
Decreases when we sell goods
Beginning balance
Purchases

BALANCE SHEET /ASSET

INCOME STATEMENT/ EXPENSE

Inventory

COGS

$420,000
50,000

280,000

$190,000
Introduction/Review

280,000

Introduction
Types of Inventory
Merchandise
?
Inventory
Manufacturing

?
?

Introduction/Review

Journal Entries - Review

Journal Entries for initial purchase of

inventory/raw materials up to the sale of

goods to customers.
For a manufacturing firm?

Wood-Workers R Us makes wooden spoons. They

first buy raw wood ($10) and then work for one
hour ($20 in labor), to make the spoon, then
sell the spoon for $50
For a merchandising firm?
Spoons R Us sells wooden spoons it purchases
from another company for $35, then sell the
spoon for $50.
Introduction/Review

What is included in Inventory?

Inventory recognized when substantially all
risks and rewards have transferred to the
purchaser.
Complications:
Goods in transitdepends on whether title

transfers
FOB (free on board) Shipping Point

buyers at the time of the delivery to common carrier

FOB Destination
buyers when they receive the goods from the
common carrier

Introduction/Review

What is included in Inventory?

Complications Continued:
Consigned goods
Sellers (title remains with seller)
Sales with buyback agreements
Sellers

Sales with high rates of returns

Buyers if you can estimate returns, Seller o/w
Sales with delayed payment terms (installments)
Buyers, if you can estimate collectibility, Sellers o/w

Introduction/Review

Purchase Commitments
Formal, non-cancelable purchase contracts are
not recognized as inventory but should be
disclosed in the footnotes.
If inventory prices rise no gain recorded but
commitment is disclosed
If inventory prices fall and contract is not
cancellable or renegotiable then you must
recognize the loss on the commitment.
At time of loss:
Dr. Loss on Purchase Contract
Cr. Provision for Onerous Contracts
At time of inventory purchase:
Dr. Provision for Onerous Contracts
Dr. Inventory
250
Cr. Cash
265

15

15
15

Effects of Errors
What if you used the periodic method and didnt
count inventory that was in a closet in year 1,
then at the end of year 2, you counted it correctly

Year 1
Year 2
Effect on
Effect on
Effect on
Effect on

Inventory
COGS
Net Income
Retained Earnings

Other Inventory issues

Costs Included in Inventory

Other issues to consider:
Purchases discounts: gross method vs.

net method
Vendor rebates: cash rebates related to
inventory generally recorded as a
reduction to the cost of inventory
Basket purchases and joint product
costs: total cost allocated to units
based on relative sales value

10

Inventory Cost - Components

Inventory Cost is measured by the total cash equivalent outlay to
acquire the goods and prepare them for sale.
Treatment of purchase discounts: for inventory (but not PP&E), also
have a gross and net method. The inverse of the A/R side.
Example: A firm purchases inventory for $10,000 with terms of 2/10, n30
GROSS METHOD NET METHOD
Purchases/Inventory
10000
A/P
10000
A/P

Purchases/Inv
9800

If paid during discount period:

A/P
10000
A/P
9800
Purchase Discounts
200
Cash 9800
If paid after discount period: A/P
A/P
10000
Interest Exp
Cash 10000
Cash

Cash

9800

9800

9800
200
10000

Purchase Discounts is a contra-COGS/Purchases account

Interest Expense is called Purchase Discounts Lost in the text
Recognition and Measurement

E 8-3 Gross and Net Methods

Transactions for Whitehall Limited:
March 10
Purchased goods billed at $25,000, term 3/10, n/60
11
Purchased goods billed at $26,575, terms 1/15, n/30
12
Paid invoice of March 10.
24
Purchased goods billed at $11,500, terms 3/10, n/30
a)Prepare j/e for the transactions assuming the net method is used
and discounts lost are treated as a financial expense.
b)Prepare adjusting entry required on March 31
c)Prepare j/e for transactions above, assuming that purchases are
recorded using the gross method
d)Prepare adjusting entry required on March 31
e)Which method provides better information for managing the
business?

Recognition and Measurement

Merchandise Inventory
Cost - Components
Product costs:
Direct costs of acquisition
Freight charges on goods purchased
Labor and other production costs incurred in processing

the goods up to the time of sale

Interest if item takes extended period of time to produce

Period costs - generally excluded from Inventory

simply because of the practical difficulties in

allocating them (exception is interest expense for
certain constructed assetsships, real estate
projects):
Storage costs
Expenses of having a purchasing department
Labor for people handling the inventory
Recognition and Measurement

Obsolete and Excess

Inventory

Overriding principle for inventory valuation is the

Lower of Cost or Net Realizable Value (NRV) done

on an item-by-item basis
NRV is the estimated selling price less the
estimated costs to complete and sell
Write-downs can be done using the direct method
or the firm can create a reserve for obsolete and
excess inventory (an allowance method similar to
allowance for doubtful accounts)
Recovery of market value decline is recorded up
to but not exceeding original cost

Recognition and Measurement

Obsolete and Excess

Inventory

Direct Method (buries the write-down in COGS)

Dr. COGS
Cr. Inventory
Allowance Method (separates out the special
loss)
Dr. Loss
Cr. Inventory Allowance
If inventory is sold, remove both the inventory
and the inventory allowance (just like PPE &
ADA)
LCNRV

Inventory Systems
Perpetual Inventory System
Continuous record of inventory is maintained.
JIT requires perpetual system
Still count (not necessarily at period end) and adjust
perpetual records if there are differences
Dr. Inventory over or short (short is akin to Shrinkage
Expense)
Cr. Inventory

Periodic Inventory System

Actual physical count is taken at the end of each

accounting period
Recognition and Measurement

Cost Formulas
1.

Specific cost identification

2.

Each item in stock is specifically marked e.g.

diamonds, real estate

Average Cost

Weighted Average Cost

Beginning Inventory Cost + Current Purchase Cost

Beginning Inventory units + Current Purchase units

Moving Average Cost (when using perpetual

method)

First-in, first-out (FIFO)

Last-in, first-out (LIFO) allowed under US GAAP
3.

Cost flow assumption and actual movement of

the inventory units do not have to match.
Recognition and Measurement

Inventory Practice Problem

(Perpetual)

Beginning inventory (1/1) 200 units @ 5.00

1000
Purchase #1
(3/1) 200 units @ 6.00
1200
Purchase #2
(7/1) 200 units @ 7.00
1400

Sales were 200 units on 4/1 and 200 units on 7/5.

What is COGS and the dollar value of ending
inventory?
FIFO
2. Weighted Average
3. LIFO
1.

Periodic Journal Entries

Purchase Inventory
Purchases (temporary account) 5,400
Accounts Payable/Cash
5,400
Sales
Accounts Rec./Cash
7,200
Sales
7,200
* Do not record COGS at time of sale
End of period (after inventory count)
Inventory 1,800 (to get to physical count)
COGS
3,600 (plug)
Purchases 5,400 (purchases account goes to zero)

COGS = Goods available for sale ending inventory

Goods available for sale = beginning inventory +
purchases
Recognition and Measurement

Inventory Practice Problem (Periodic)

Beginning inventory (1/1/08)
500 units @ 2.00
= 1,000
Purchase #1
(1/14/08) 500 units @ 3.00 =
1,500

Sale of inventory:
1/2/08: 300 units

1/15/08: 200 units

Using the periodic method, what is COGS and

the dollar value of ending inventory under:
FIFO

Recognition and Measurement

W.Avg.

During inflationary time periods,

the weighted average cost flow
assumption results in the highest
COGS, lowest net income, and
1. True
lowest
taxes.
2. False

Other Inventory Issues

Illustration of Differences
The choice of a valuation method affects gross
profit. If, in the above example, revenues are
$3000, then gross profit figures are as follows:
FIFO WAvg
Revenues $3,000
$3,000
COGS
2,200
2,350
Gross Profit
800 650
Ending Inv.
Other Inventory Issues

14001250

If a companys highest priority was

paying the least amount of taxes in the
current year, then which inventory
valuation method would management
choose assuming prices are rising?
1.
2.

FIFO
Weighted Average

Other Inventory Issues

Estimating Inventory
Gross Profit Method Information needed:
Gross Profit % or GP/Sales
Beginning Inventory(costs) and Purchases

(cost)
Sales
Sales * (1-GP%) = est. of Cost of Goods Sold
Beg. Inv + Purchases est. of Cost of Goods
Sold=est. of Ending Inventory

Estimating Inventory

Gross Profit Method

Sales
$2,750,000
Inv. (Begin)
$ 650,000
Purchases 1,550,000
Goods Avail
??
Less Inv. (Ending)
??
COGS
??
Gross Profit % is 35%

Estimating Inventory

Estimating Inventory

Estimating Inventory

Retail Inventory Example

Cost

Retail
$

Beg Inventory
$30,000
46,500
Purchases (net) 48,000
88,000
What is the cost/retail ratio?
What is the value of ending inventory if
sales are $95,000?

Estimating Inventory

Disclosure and Presentation

Examples of required disclosures:
1. Measurement policy
2. Total inventory, as well as inventory by

classification
3. Amount of inventory recognized as expense
on the income statement (usually reported as
cost of goods sold)
4. Any amount of inventory pledged as
security(collateral) for liabilities

Presentation Disclosure & Analysis

28

Comparison of IFRS and private

entity GAAP
Major difference between IFRS and private

entity GAAP (ASPE) relates to a specific

IFRS standard covering biological assets
and agricultural produce at the point of
harvest
Private entity GAAP has no specific
guidance in this area
IFRS has more disclosure requirements
than private entity GAAP
IFRS/Private Entity GAAP
29
Comparison