afm 291 chapter 8.pdf

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Accounting & Financial Management
AFM 291
Robert Ducharme

Chapter 8: Inventory UNDERSTANDING  INVENTORY   Types  of  Companies  with  Inventory   • Companies  in  industries  such  as  manufacturing,  retail,  and  wholesale  have  a  significant  amount  of   inventories     • Some  companies  follow  a  strategy  of  producing  inventories  on  a  “just-­‐in-­‐time”  basis  à  wait  until  a   customer  orders  a  product  and  then  arrange  with  other  companies  to  actually  manufacture  the   product       Inventory  Categories     • Retailers  and  wholesalers  have  inventor  that  is  ready  for  sale     o Often  bought  most  of  its  merchandise  in  a  form  that  is  ready  for  sale     o Unsold  units  left  on  hand  are  each  reporting  date  à  merchandise  inventory   • Raw  materials  inventory  –  amounts  of  goods  and  materials  that  are  on  hand  but  have  not  yet  gone   into  production  à  can  be  traced  directly  to  the  end  product     • Work-­‐in-­‐process  inventory  –  the  cost  of  raw  material  on  which  production  has  started  but  is  not   yet  complete,  plus  the  direct  labour  cost  applied  specifically  to  this  material,  and  its  applicable   share  of  manufacturing  overhead  costs   • Finished  goods  inventory  –  the  costs  associated  with  the  completed  but  still  unsold  units  on  hand       Inventory  Planning  and  Control     • Management  wants  to  have  a  wide  variety  and  sufficient  quantities  on  hand  so  that  customers   have  the  greatest  selection  and  always  find  what  they  want  in  stock     o May  result  in  excessive  carrying  costs  à  higher  the  levels  of  inventoriesà  higher  cost     Low  inventory  levels  have  lower  carrying  costs  but  may  lead  to  stockouts,  lost  sales,  and  unhappy   customers     • Inefficient  purchasing  procedures,  faulty  manufacturing  techniques,  or  inadequate  sales  efforts   may  lead  to  excessive  and  unusable  inventories  à  reduces  profits     o Inventories  must  be  monitored  to  minimize  carrying  costs,  and  meet  customer  demand     Information  for  Decision-­‐Making   • External  users  of  financial  statements  want  to  know  how  management  is  controlling  and  managing   its  inventory  in  order  to  maximize  profits     • The  existence  of  various  types  of  inventory  that  the  company  owns  much  be  clearly  represented   and  how  this  inventory  has  been  measured  must  be  disclosed     • The  goods  sold/used  during  an  accounting  period  usually  never  correspond  with  the  goods  bought   or  produced  during  the  period  à  physical  inventory  either  increases/decreases     • Cost  of  goods  available  for  sale/use  is  the  total  of         1. The  cost  of  goods  on  hand  at  the  beginning  of  the  period     2. The  cost  of  goods  acquired/produced  during  the  period     • COGS  =  COGAS  –  EI     • Which  physical  goods  should  be  included  as  part  of  inventory?  (who  owns  inventory  in  transit)   • What  cost  should  be  included  as  part  of  inventory  cost?  (purchase  discounts,  product/periodic   costs  etc.)   • What  cost  formula  should  be  used?  (specific  ID,  average  cost,  FIFO)   • Has  there  been  an  impairment  in  value  of  any  of  the  inventory  items?     RECOGNITION   • Inventory  comes  in  many  forms:  securities  held  by  an  investment  dealer,  land  and  other  property   held  by  developers  for  resale,  unbilled  employee  and  partner  time  spent  on  client  files  in  a  law   office  or  professional  accounting  practice,  grain  in  silos,  salmon  in  a  fish  farming  operation,  and   long-­‐term  construction  projects       Accounting  Definition     • Inventories  are  assets:   a. Held  for  sale  in  the  ordinary  course  of  business;   b. In  the  process  of  production  for  such  sale;  or     c. In  the  form  of  materials  or  supplies  to  be  consumed  in  the  production  process  or  in  rendering  of   services     • Represent  future  benefità  the  entity  has  control  over  or  access  to  à  inventory  purchase  is  the   transaction  that  gives  rise  to  the  recognition  of  an  inventory  asset     • Accountants  recognize  a  sale  when  risks  and  rewards  of  ownership  are  passed  to  the  purchaser     Physical  Goods  Included  in  Inventory   • Inventory  is  recognized  when  all  risks  and  rewards  of  ownership  have  passed  to  the  purchaser   o Acquisitions  are  often  recorded  when  the  goods  are  received  because  it  may  be  difficult  for   the  buyer  to  identify  the  exact  time  when  the  legal  title  passes  to  the  buyer     Goods  in  Transit   • legal  title  is  determined  by  the  shipping  terms  that  have  been  agreed  upon  between  buyer  and   seller   • FOB  (free  on  board)  shipping  point  –  legal  title  passes  to  the  buyer  when  the  seller  delivers  the   good  to  the  common  carrier     • FOB  destination  –  legal  title  passes  when  goods  reach  the  destination     • Once  legal  title  passes,  purchaser  should  have  the  risks  of  ownership     • Goods  in  transit  at  end  of  fiscal  period  that  were  sent  FOB  shipping  point  are  recorded  by  the  buyer   as  purchases  of  the  period  and  included  in  ending  inventory         • Purchase  cut-­‐off  schedule  –  prepared  at  the  end  of  a  period  to  ensure  that  goods  received  from   suppliers  around  the  end  of  the  year  are  recorded  in  the  appropriate  period,  includes:   -­‐ Curtailing  and  controlling  the  receipt  and  shipment  of  goods  around  time  of  count   -­‐ Marking  freight  and  shipping  documents  as  “before”  or  “after”  inventory  count     -­‐ Ensure  that  receiving  reports  on  goods  received  before  counts  are  linked  to  invoices  that  are  also   recorded  in  the  same  period     Consigned  Goods     • Goods  out  on  consignment  remain  on  the  consignor’s  inventory  at  their  purchase  price/production   cost  plus  the  cost  of  handling  and  shipping  the  goods  to  the  consignee     • Consignor  has  risks  and  rewards  of  ownership   o Suffer  loss  if  inventory  becomes  an  obsolete   o If  sale  is  made,  revenue  less  selling  commission  and  expenses  is  remitted  to  consignor     • For  consignee,  no  adjusting  entry  is  made  to  inventory     Sales  with  Buyback  Agreements   • product  financing  arrangement  –  involves  a  transfer  of  the  inventory  with  either  a  real  or  implied   “buyback”  agreement     o purchaser  agrees  to  buy  the  inventory  and  sell  it  back  to  the  same  supplier     • risks  and  rewards  of  ownership  still  remain  on  seller’s  books   o parking  transaction  –  seller  only  parks  inventory  for  a  short  period  of  time   Sales  with  High  Rates  of  Return   • certain  industries  allow  buyers  to  return  inventory  for  a  full/partial  refund  –  vendor  retains   risks/rewards  for  items  expected  to  be  returned   • if  reasonable  prediction  of  returns  can  be  established,  goods  may  be  considered  sold,  and  an   allowance  for  returns  should  be  estimated  and  recognized.   Sales  with  Delayed  Payment  Terms   • the  seller  often  retains  legal  title  to  the  merchandise  until  all  payments  have  been  received     o risk  of  loss  due  to  uncollectible  accounts  is  high   o but  bad  debts  can  be  reasonably  estimated  and  accrued   Purchase  Commitments     • It’s  common  for  companies  to  buy  inventory  in  advance  –  title  to  the  merchandise/materials  does   not  pass  to  the  buyer  until  delivery     • Ordinary  orders  –  prices  are  determined  at  the  time  of  shipment  à  buyer/seller  can  still  cancel  the   order  anytime  à  does  not  represent  an  asset/liability  to  buyer     • Non-­‐cancellable  purchase  contracts/executor  contract  –  no  asset/liability  is  recognized  on  the   date  when  the  contact  takes  effect  àneither  party  has  fulfilled  its  part  of  the  contract     • if  the  unavoidable  costs  of  completing  the  contract  are  higher  than  the  benefits  expected  from   receiving  contracted  goods/services,  a  loss  is  recognized  –  onerous  contract        Loss  on  Purchase  Contract  -­‐-­‐-­‐-­‐-­‐  DR                                                                          Liability  for  Onerous  Contracts  -­‐-­‐-­‐-­‐-­‐  CR   • when  goods  are  delivered      Inventory  -­‐-­‐-­‐-­‐-­‐  DR      Liability  for  Onerous  Contracts  -­‐-­‐-­‐-­‐-­‐  DR                                                                          Accounts  Payable  -­‐-­‐-­‐-­‐-­‐  CR     • if  price  has  partially  recovered  before  inventory  is  received,  the  liability  for  onerous  contract  is   reduced  –  the  resulting  gain  is  reported  in  the  period  of  price  increase  for  the  recovery     Summary  of  When  to  Recognize  Inventory  Based  on  Risks  and  Rewards   Transaction   Legal  title   Possession   All  risks/rewards   Who  recognizes   passed?   inventory?   Goods  in  transit  (FOB  shipping   Purchaser   Shipping   Yes   Purchaser   point)   company   Consignment  sale   Consignor   Consignee   No   Consignor   Sale  with  buyback     Purchaser     Purchaser     No(it  is  essentially  a   Vendor   financing  transaction)   Sales  with  high  rates  of   Purchaser     Purchaser   Yes   Purchaser   return(estimable  returns)   Sales  with  delayed  payment   Vendor   Purchaser   Yes   Purchaser   terms(vendor  retains  title  till   consideration  collected)   Purchaser  commitments  (non -­‐ Vendor   Vendor   No  (but  may  have  to   Vendor   cancellable)   (assuming   (assuming   accrue  losses  if   (assuming   inventory  exists)   inventory  exists)   onerous  contract)   inventory  exists)     Flow  of  Costs     • cost  of  goods  manufactured  –  product  costs  of  good  that  are  completed  and  transferred  to   Finished  Goods  Inventory     o similar  to  cost  of  goods  purchased  in  merchandising  company       Inventory  Errors   • incorrect  items  included/excluded  in  determining  EI  creates  errors  on  Income  Statement  and  SFP   Ending  Inventory  Misstated   • if  a  portion  of  ending  inventory  is  omitted,  working  capital  and  current  ratio  would  be  understated   o  Net  income  is  understated  as  cost  of  goods  sold  is  overstated     • effect  of  this  error  à  understatement  of  current  net  income  and  overstatement  of  net  income  the   following  year  à  beginning  inventory  of  following  year  is  understated         • correcting  entry  in  following  year              Inventory  -­‐-­‐-­‐-­‐-­‐  DR                                              Cost  of  Goods  Sold  -­‐-­‐-­‐-­‐-­‐  CR     • correcting  entry  if  error  is  not  discovered  until  the  year  after  above            Inventory  -­‐-­‐-­‐-­‐-­‐  DR                                              Retained  Earnings  -­‐-­‐-­‐-­‐-­‐  CR   • if  error  is  discovered  after  the  2  year  period,  no  entry  is  required  as  the  error  is  self-­‐correcting   over  the  two-­‐year  period     • if  ending  inventory  is  overstated  the  following  year(2014)  à  reverse  effect  à  inventory,  working   capital,  current  ratio,  and  net  income  are  overstated  and  cost  of  goods  sold  s  understated     o error’s  effect  on  net  income  will  be  counterbalanced  next  year     o net  income  figures  in  both  years  will  be  incorrect     Purchases  and  inventory  Misstated   • omitting  both  purchase  of  goods  and  inventory  à  understated  inventory  and  accounts  payable  on   SFP,  understated  purchases  and  ending  inventory    on  income  statement     • net  income  for  the  period  is  not  affected  by  omitting  such  items  à  purchases  and  ending   inventory  are  both  understated  by  the  same  amount  à  error  offsets  itself  in  cost  of  goods  sold   • total  working  capital  is  unchanged,  but  current  ratio  is  overstated  –  equal  amounts  were  omitted   from  inventory  and  accounts  payable     • purchases  and  ending  inventory  are  both  overstated  à  effects  on  SFP  exactly  reverse       MEASUREMENT   Costs  Included  in  Inventory   • IFRS/ASPEà  inventory  cost  is  made  up  of  all  costs  of  purchase,  costs  of  conversion,  and  other  costs   incurred  in  bringing  the  inventories  to  their  present  location  and  condition   Purchase  Discounts   • Gross  method  –  both  purchases  and  payables  are  recorded  at  gross  amount  of  the  invoice,     purchase  discounts  that  are  later  taken  are  credited  to  a  Purchase  Discounts  account  (contra   account  to  Purchases)   • Net  method  –  records  purchases  and  A/P  at  an  amount  net  of  cash  discounts   o if  A/P  is  paid  within  discount  period,  cash  payment  =  amount  originally  set  up  for  A/P     o if  A/P  is  paid  after  discount  period,  discount  lost  is  recorded  in  Purchase  Discounts  Lost   Vendor  Rebates   • Cash  rebates  are  generally  a  reduction  of  the  purchase  cost  of  inventory     • If  “rebate  receivable”  meets  a  definition  as  an  asset  à  rebate  is  recognized  before  it  is  received   • Rebate  is  discretionary  on  part  of  supplier:  no  rebate  is  recognized  till  it  is  paid  or  supplier  becomes   obligated  to  make  payment       • Rebate  is  probable/reasonable  estimated  amount:  recognized  as  reduction  in  cost  of  purchase  in   the  period,  allocated  between  the  goods  remaining  in  inventory  and  goods  sold     • Amount  of  receivable  recognized  is  based  on  proportion  of  total  rebate  relative  to  transactions  to   date   Product  Costs   • Product  costs  –  costs  that  “attach”  to  inventory,  recorded  in  inventory  account     • Include  freight  charges  on  goods  purchased,  other  direct  costs  of  acquisition,  and  labour  and  other   product  costs  that  are  incurred  in  processing  the  goods  up  to  the  time  they  are  ready  for  sale,  may   include  decommissioning/restoration  costs  for  production  (IFRS)   • Taxes  that  cannot  be  recovered  from  government  by  purchaser  are  cost  of  inventory   • Conversion  costs  –  direct  labour  and  an  allocation  of  the  fixed/variable  production  overhead  costs   incurred  in  processing  direct  materials  into  finished  goods   • Costs  of  idle  capacity/low  production  levels  are  charged  to  expenses     o Abnormally  high  production  levels,  fixed  costs  are  spread  over  the  larger  number  of  units   that  are  produced,  inventory  is  not  measured  at  a  higher  amount  than  its  cost     • Borrowing  costs  –  interest  costs  incurred  to  finance  an  inventory  item  that  takes  an  extended   period  to  produce/manufacture  are  product  costs  –  materials,  labour,  and  overhead     • Standard  costs  –  based  on  costs  that  should  be  incurred  per  unit  of  finished  goods  when  plant  is   operating  at  normal  levels  of  efficiency  and  capacity   o Difference  between  actual  costs  and  standard  costs  are  recorded  in  variance  accounts     • Cost  of  Service  Provider’s  Work  in  Process  –  major  production  costs  à  service  personnel  and   overhead  costs  associated  with  “direct  labour”   • Cost  Excluded  from  Inventory  –  storage  costs/abnormal  spoilage  or  wastage  of  materials,  labour,   or  other  production  costs,  inter
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