7.9 Chapter Summary

LO 1 Define inventory, and identify those characteristics that distinguish it from other assets.

Inventories can be a significant asset for many businesses. The key feature of inventory is that it is held for sale in the normal course of business, which distinguishes it from financial instruments and long-lived assets, such as property, plant, and equipment.

LO 2: Identify the types of costs that should be included in inventory.

Recognition of the initial cost of purchase should include transportation, discounts, and other nonrecoverable taxes and fees that need to be paid to transport the goods to the place of business. FOB terms of purchase need to be considered when applying cut-off procedures at the end of the accounting period. This is important for determining when the responsibility for the inventory passes from the seller to the buyer. For manufacturers, conversion costs must also be included in inventory. For direct materials and labour, this allocation is fairly straightforward. However certain issues with overhead allocations can occur with low or high production levels. With abnormally low production levels, overheads should be allocated at the rate used for normal production levels. With abnormally high production levels, overheads should be allocated using the actual level of production. Other costs required to bring the inventory to the place of business and get into a saleable condition may also be included. The accountant will need to exercise judgment when considering other costs to include.

LO 3: Identify accounting issues and treatments applied to inventory subsequent to its purchase.

LO 3.1: Describe the differences between periodic and perpetual inventory systems.

Perpetual inventory systems are those that instantly update accounting records for sales and purchases of goods. These types of systems are commonly used today and are facilitated by advances in computer and other technologies. Periodic inventory systems do not allow for the real-time updating of accounting records. Rather, these systems require a periodic inventory count (at least annually) that is then used to derive the cost of goods sold. These types of systems are less useful for management purposes. Even under a perpetual inventory system, annual inventory counts are still required to detect spoilage, theft, or other unaccounted inventory changes.

LO 3.2: Identify the appropriate criteria for selection of a cost flow formula, and apply different cost flow formulas to inventory transactions.

The cost flow formula determines how to allocate inventory costs between the income statement and the balance sheet. Although specific identification of individual inventory items is the most precise way to allocate these costs, this method would only be appropriate with inventory items whose characteristics uniquely differentiate them from other inventory units. For homogeneous inventory products, weighted average or first in, first out (FIFO) are appropriate choices. Weighted average (or moving average, when used with a perpetual inventory system) recalculates the average cost of the inventory every time a new purchase is made. This revised cost is used to determine the cost of goods sold. With FIFO, the oldest inventory items are assumed to be sold first. Each method has certain advantages and disadvantages, and each has a different effect on the balance sheet and income statement. The choice of method will depend on the actual physical movement of goods, financial reporting objectives, tax considerations, and other factors. Whatever method is chosen, it should be applied consistently.

LO 3.3: Determine when inventories are overvalued, and apply the lower of cost and net realizable value rule to write-down those inventories.

When economic circumstances change, such as a shift in consumer preferences, a company may find itself holding inventory that cannot be sold for its carrying value. In this case, the inventory should be written-down to its net realizable value (selling price less estimated costs required to complete and sell the goods) in order to ensure the balance sheet is not reporting a current asset at a value greater than the amount of cash that can be realized from its sale. Generally, this technique should be applied on an individual-item basis, but in certain cases where a group of products all belong to one product line, are produced and marketed in one geographic area, have similar end uses, or are difficult to segregate, it may be appropriate to apply the test on a grouped basis. Judgment is required in applying this technique, as net realizable values are estimates that may not be easy to verify.

One unique application of fair value inventory accounting relates to biological assets. These are assets that are living plants or animals used to produce an agricultural product. Under IFRS these assets are adjusted to their fair value, less selling costs, each year. This can result in increases as well as decreases in value.

LO 4: Describe the presentation and disclosure requirements for inventories under both IFRS and ASPE.

Inventory should be described separately on the balance sheet, with separate disclosure of major categories such as raw materials, work in process, and finished goods. Accounting policies used should also be disclosed, as well as the amount of any inventory that has been pledged as collateral for any liability. The amount of inventory expensed during the period should be disclosed as cost of goods sold on the income statement, but other categories, if material, could be disclosed separately, such as significant write-downs or reversals of write-downs.

LO 5: Identify the effects of inventory errors on both the balance sheet and income statement, and prepare appropriate adjustments to correct the errors.

Due to the nature and relative volume of inventory transactions, material errors in financial reporting can occur. To correct these errors, the accountant must have a firm understanding of the cost of goods sold formula and its effects on both the current and subsequent years. If inventory errors are discovered after the closing of the books, an adjustment to retained earnings may be required. If an error is not discovered until two years after its occurrence, it is quite likely that the error has corrected itself. In this case, no adjusting entry would be required, but restatement of prior-year comparative results would still be necessary.

LO 6: Calculate estimated inventory amounts using the gross profit method.

The gross profit method can be useful for estimating inventory amounts when a physical count is impractical or impossible. This could be the case when for interim reporting periods or when the inventory is destroyed in a disaster. The technique uses past gross profit percentages and applies it to purchases and sales during the period to estimate the amount of inventory on hand. The method is not appropriate for annual financial reporting purposes, as the estimate could be subject to error as a result of using past gross profit percentages that are not representative of current margins or are not representative of the current product mix. Considerable judgment and care should be applied when using this method.

LO 7: Calculate gross profit margin and inventory turnover period, and evaluate the significance of these results with respect to the profitability and efficiency of the business’s operations.

Managers are concerned about the profitability of the company’s core business of buying and selling products. Managers are also concerned with the efficiency with which products are moved through the production and sales process. Calculating gross profit margin can identify trends in the profitability of the company’s core operations. Calculating inventory turnover period can identify problems with the efficiency movement of inventories, including raw materials, work in progress, and finished goods. Ratio calculations need to be compared with some type of benchmark to be meaningful.

LO 8: Identify differences in accounting for inventories between ASPE and IFRS.

Inventory accounting standards under IFRS and ASPE are substantially the same. The primary difference relates to biological assets. IFRS has a complete set of standards (IAS 41) for these types of assets, whereas ASPE does not separately identify this category. As well, IFRS requires certain additional disclosures that ASPE does not, including a description of qualitative reasons for inventory write-ups and write-downs.