Inventories

 Assets held for sale

o Critical for revenue-generating processes (companies selling tangible goods)
o Three issues: initial recognition and measurement, derecognition,
measurement
Information Systems for Inventory Control
 Two general methods: perpetual and periodic
o Determine nature and quality of information available to account for inventories
and cost of sales
Perpetual System
 Directly keeps track of additions to and withdrawals from inventory
o Inventory quantity on hand and cost of goods sold from accounting records at any
point in time
 Advancing technology and decreasing data management costs => popularity increases
o Information on a timely basis but inventory count still needed (perpetual records
may not be accurate representation
Periodic System
 Does not keep continual track of inventories and COGS
 Financial statement date => inventory count to determine ending inventory (applicable
product costs)
 Use of perpetual or periodic system does not affect amounts reported in financial
statements
o Implementation of different cost flows assumption will differ
Difference
 Perpetual has the ability to identify both expected and actual amounts of COGS,
whereas the periodic system can only identify the actual amount
 Periodic systems uses an account called purchases (temporary account closed at the
end of each year
o Purchases go into this account rather than directly into the inventory account
so that the company can distinguish changes in inventory arising from
purchases rather than adjustments to balance resulting from the inventory
count
 Perpetual inventory system allows better management of inventories
Purchased goods
 For goods purchased for resale, inventory cost includes the purchases prices, taxes not
recoverable from government, shipping and handling costs and any other costs incurred
up to the point where product is at desired location for sale
 Subsequent costs e.g. retail space and sales staff, cannot be included in inventory
 Transportation times in a globalized economy, can be substantial
 Free on board (F.O.B) -> the point at which buyer takes legal possession of the goods
o FOB origin (shipping point) => buyer takes possession as soon as goods leave
supplier’s premises
o FOB destination => buyer takes possession when the goods reach the buyer’s
premises
 At the year-end, an enterprise should include in inventories not only goods that are on its
premises, but also inbound goods in transit that are F.O.B origin and outbound goods in
transit that are FOB destination
 Some companies work on a consignment basis => sell products on behalf of the
producer’s owners (and take a commission in the process)
Manufactured Goods
 Inventory costing is more complicated
o Involves conversion of raw materials into finished goods using labour, machines,
and other resources
 All costs incurred in the acquisition of raw materials and in the conversion process are
products costs
o Includes materials, production labour including factory supervision, variable
overhead e.g. electricity, and fixed overhead such as heating costs
 Periods costs are not closed related to production
o Marketing, administration, accounting, and finance
 Two views in determining whether an expenditure on fixed overhead is a product or a
period cost
o Variable costing- considers fixed manufacturing overhead to be a period cost
because such costs do not vary according to production level (by definition of
fixed cost)
o Absorption costing- fixed overhead as a product cost because production cannot
take place without these costs
 Managerial accounting and internal decision-making => variable costing
o IFRS and ASPE => absorption costing
 Enterprises incur fixed overhead costs to produce goods that generate
revenue in the future -> costs meet the definition of the asset
 Later expensing of these costs through COGS when the products are sold
matches costs to the revenues generated, which is more timely
Fixed overhead capitalization when production is above normal
 Under absorption costing, an enterprise can lower COGS by increasing production
volume
 Analyst or investor should be careful when interpreting gross margin figures and take
into consideration the impact of possible changes in inventory levels
o Important to distinguish increasing gross margins that are due to improved cost
management from the portion due to changes in production levels
Fixed overhead capitalization when production levels are below normal
 Unusually low production volumes will result in unusually high fixed costs per unit
being capitalized into inventory, and this outcome potentially overstates the value of
inventory
 Enterprises should allocate fixed overhead based on the normal production level expected
over several periods
o If actual production volume is significantly below normal, some fixed overhead
would remain unallocated (should be expensed)
Subsequent Measurement and Derecognition: Cost Allocation between the balance sheet and the
income statement
 Once enterprise capitalizes costs into inventories, these costs eventually need to be
removed
o Enterprise needs to determine how much of these costs should remain on the
balance sheet versus being derecognized (expense through income statement)
o All methods are governed through inventory cost flow equation BI + P = COGS
+ EI
o All costs that go into the inventory costing system must either
 Be derecognized by being expensed
 Remain in ending inventory
o Purchases include goods manufactured by reporting enterprise and also as net of
any purchase discounts and returns

Specific identification
 Method of assigning costs to inventories and cost of sales based on actual costs of each
item
o Usually applied to high-value items
 Drawback is that it is prone to earnings management
o When enterprise sells items that are indistinguishable from each other
o Specific identification should be used only for items that are distinguishable from
each other
Cost Flow Assumptions
 Systematic method for allocating between COGS and ending inventory
 Remove the oldest costs first (FIFO)
 Remove the newest costs first (LIFO)
 Do something in between- weighted average

FIFO
 Expenses the oldest costs first
 Most recent costs remain on the balance sheet, so that this method is equivalently called
last-in-still here (LISH)
 Uses oldest costs in computation of cost of sales
 Determined by starting with purchases until we obtain the required number of units sold
Last-in, first out (LIFO)
 IFRS and ASPE prohibits the use of LIFO
o LIFO permitted by many companies in the United States
o When costs are rising, LIFO shows higher COGS, and lower income compared
with FIFO
Weighted-average cost

 𝑊𝐴𝐶 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 / 𝑈𝑛𝑖𝑡𝑠 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒
 FIFO results in the lowest COGS => highest income
o LIFO results in the lowest income

Comparison of the cost flow assumptions

 Amounts reported on financial statements for inventory and COGS depend on the cost
flow assumption employed
 Balance sheet is most relevant for valuation if the amount reported for an asset
approximates current value
o FIFO leaves the cost of the most recent purchase in ending inventory => it
provides high-quality information about the value of inventory
o LIFO values for ending inventory are low quality because they consist of the
oldest costs, potentially years or decades old, which have little resemblance to
current value
 Income statement is most relevant for evaluating performance if the basis for recognizing
expenses matches the basis for revenue recognition
o Sales revenue will generally reflect marketing conditions in the reporting period,
so inventory costs that also come from the reporting period are the most relevant
 o LIFO COGS consists of costs from the most recent purchases => better matching
of COGS with revenue
o LIFO methods provide the most relevant information in the income statement
depends on there being a decrease in inventory level
o Canadian companies cannot use LIFO for income tax reporting
Retail Inventory Method
 Popular method for retailers
 Method of estimating the cost of ending inventory by applying an average sales margin
to the retail price of products
o Relatively easy to identify the products’ selling prices, and more laborious to
obtain their costs
o Uses average profit margin to estimate the cost of each product by discounting the
retail price by that average profit margin
 Multiplying these costs by quantities obtained from an inventory count produces the
amount for ending inventory
o Management can then determine COGS using the inventory cost flow equation
 Validity of the retail inventory method depends on the accuracy of the average profit
margin
o If an enterprise has significantly different margins on different categories of
products, then these different categories would need to be separately tabulated and
a different margin applied to each
 Discounted products would also need to be segregated from regular, non-
discounted products
o Gross margin method – reverses the process from retail inventory method
 Applying an average gross margin to the amount of sales recorded for
the period
 Computing the estimated ending inventory balance by using the inventory
cost flow equation
Subsequent Measurement: Avoiding Overvaluation of Inventories
 Representational faithfulness requires assets to not be overvalued on the balance sheet
o Inventory is to be reported at the lowest of cost and market value (LOCM)
o If the prevailing market price of inventory declines below cost, lowest value
should be used, and a loss is recorded
o if market price exceeds cost, no upward adjustment is made
Journal entry for inventory write-down
Dr. Loss from decline in inventory value (COGS)
Cr. Inventory

Unit of Evaluation
  In order to evaluate inventories for impairment, it is necessary to define the size of the
unit or group for that evaluation
o E.g. if there are two products in inventory, can the LOCM evaluation be
conducted for both products together such that higher valuations of one
product offset lower valuation of the other
 Inventories should be evaluated for write-downs at the most detailed level possible
o E.g. bicycle manufacturer => consider products separately
o All the parts that go into assembling a particular bicycle would be considered
together
Accounting for Inventory Errors
 Inventory account is one where the effects of mistakes are sometimes not clearly evident,
at least not initially
 Inventory account is involved twice in calculation of COGS in periodic inventory system
o One inventory error usually affects two periods
o Misstatements of transactions involving inventories are often accompanied by
errors in related accounts e.g. purchases and accounts payable
Potential Earnings Management Using Inventories
1. Overproduction
 Good inventory management can give a boost to income
 Production volume over normal level results in lower per-unit costs because more units to
absorb fixed costs
o Lower per-unit costs => less COGS => increasing net income
 Build-up of inventory at year end => excessive production for the purpose of earnings
management

2. Including non-production costs in inventory

 Including cost that would otherwise be expensed would keep cost flowing through
income statement temporarily until the inventory is sold
o E.g. including in inventory cost wages of management staff not involved in
production => inflate cost of inventory, decrease wage expense
o Decrease in gross margin percentage as hint => too much cost in inventories =>
higher COGS

3. Not identifying impaired or discounted items

 Inventories need to be assessed for impairment using lower of cost and net realizable
value of the inventories
o Not recording write-down on impaired inventory will increase income
o Auditors should verify recent sale prices support value of items in inventory