Learning objectives

What is inventory?

Inventories are assets, held for sale in the ordinary course of business, or in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services. (FRS2-6)

Unsold inventory is an asset

Sold inventory is converted to COGS (expense)

Importance of inventory

• Why hold inventory?
  • Supply can be erratic
  • No inventory could mean missed sales
  • Can buy more in low cost periods
    • Low costs from shipping, production, purchasing, etc.
• Drawbacks of inventory
  • Cost of holding
    • Warehousing, electricity, …
  • Liquidity – Cash tied up as inventory
  • Inventory obsolescence
  • Adverse price changes
    • Buy low, sell lower

Firm types

How to account for individual items?

1. Inventories recorded at cost of purchase
   • Will need a price and quantity
2. Add any conversion costs (manufacturing)
3. Add delivery fees to get the item
4. Subtract any discounts received
5. Make sure the above is lower than the intended selling price
   • If it’s not, decrease the value to selling price
     • Like with treasury stock and retained earnings, the decrease in value can be reversed later

The above works for individual items, but we’ll need a way to track items purchased and used.

Inventory systems

Perpetual is better, but periodic is easier

Perpetual inventories

• Usually barcode based.
  • Allows efficient tracking
• Record two entries per transaction
  • DR Cash or A/R (↑), CR Revenue (↑)
  • DR COGS (↑), CR Inventory (↓)

Periodic inventory

• Relies on counts for data
• Simpler, but less efficient
• One entry to record revenue
  • DR Cash or A/R (↑), CR Revenue (↑)
• Adjusting entry at end of each period
  • DR COGS (↑), CR Inventory (↓)

Not practical for businesses that need close tracking of inventory

Simple case

• Buying on cash or A/P
• Paying full amount

Shipping

• If there are shipping costs to receive the inventory, we add those to the inventory value itself
  • Debit inventory
  • Credit cash

Returns

• Sometimes inventory needs to be returned
  • Wrong or faulty/broken items
• To record:
  • Directly credit the inventory account for the amount returned
    • OR: Credit “Purchase returns,” a contra-asset to inventory
  • Debit…
    • A/P if not yet paid
    • Cash if paid and receiving cash now
    • A/R if paid and receiving credit now or cash later

Payment and discounts

• Sometimes companies offer discounts for paying early
• There is a standard format for B2B discounts:

• Ex.: 2/10, n/30 =
  • Get a 2% discount if paid in 10 days
  • Pay the full amount by 30 days.

Discounts in journal entries

• Record discount as a decrease in inventory
  • Remember: we record assets at cost paid for them
  • Can also record to a “purchase discounts” contra-asset

Situation: Purchase inventory on account for $100 with 2/10 n/30 terms

Bringing it all together

General case

• Selling for cash or A/R
• Receiving full amount

Revenue for goods

• Recognize revenue when earned
  • Recall from lesson 2: Revenue recognition principle
• FOB shipping point: record when given to shipping company
• FOB destination: Record when customer receives goods
  • Since we will need to pay shipping, we will have a Delivery expense account, an operating expense

Returns, revisited

• Sometimes our sales are returned: Wrong or faulty/broken items
• To record, debit…
  • If faulty: sales returns and allowances
    • Contra-equity to revenue
• And credit…
  • A/R if not yet paid
  • Cash if paid and returning cash now
  • A/P if paid and giving credit now or returning cash later
• If reusable: also DR inventory and CR COGS

Discounts, revisited

• We use the same discount terminology here
• Record any discount as a debit to Sales discount
  • Another contra-equity to revenue

Situation: Sold inventory of $50 for $100 on account with 2/10 n/30 terms

Bringing it all together

Net Realizable Value

• At the end of the day, we need our inventory to be priced below what we can make from it
  • We call this “what we can make from it” net realizable value (NRV)

NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale. [IAS 2.6]

• If Inventory < NRV
  • Do nothing, unless we previously wrote it down
• If Inventory > NRV
  • Need to write down to NRV

Buy low, selling lower…

• Need to write down your inventory value
  • If book value of inventory > lower of cost or NRV

Situation: Inventory is valued at $1,500, but NRV is $1,000

• Can be reversed if the value goes back up
  • Only up to the amount originally written down
  • Credit gain when reversing

Note on conventions

• Using Inventory writedown is always correct
• Using COGS for inventory writedowns is fine for small adjustments
  • Usually when writing down by $<5\%$ of inventory
  • Can use COGS for small theft
  • Do not use COGS for major price drops

Wrong in some parts of the book. Use the slides here!

When in doubt, use Inventory writedown. This is always a correct answer.

Inventory errors

An error in 1 year leads to an error in the following year in the opposite direction

Gross profit method

• When you have a fixed margin, you can use this to determine COGS
  • Fixed margin means that COGS = constant % of sales
• Allows you to avoid counting inventory

• Example:
  • Coffee corp always sells bags of beans at a 25% markup. Revenue from selling bags of beans for the year was $10,000. What was the COGS for selling bags of beans?
  • $Gross\ Margin = 1 - \frac{1}{1+25\%} = 20\%$
  • $COGS \% = 1 - Margin = 80\%$
  • $COGS = Sales \times COGS \% = \$10,000 \times 80\% = \$8,000$

Practice: Gross profit method

Situation: Coffee Corp sells all of their products using fixed margins. Determine the COGS for each product below, using the given revenues.

1. $50,000 worth of lattes were sold with a fixed gross margin of 70%
2. $9,000 worth of travel mugs were sold at a 50% mark-up
3. $1,000 worth of espresso cups were sold, comprising 50 cups each sold with $8 profit (all cups cost the same)

Inventory tracking methods

LIFO is not allowed under IFRS – but you need to know it

First three only require minimal tracking, and are used when you have multiple orders of the same thing at different prices

Specific identification

Record COGS with revenue

FIFO

LIFO

Average cost

$$\begin{equation*} Price = \frac{P_1 \times N_1 + P_2\times N_2 + \cdots}{N_1 + N_2 + \cdots} \end{equation*}$$

Mixing in perpetual/periodic

Note: Perpetual and Periodic give the same answer under FIFO!

Comparison

• Profit depends on method choice!
  • FIFO typically leads to higher net income
  • Real effect: taxes depend on net income!
    • Use LIFO to minimize taxes?
• Choice can affect important ratios used in debt contracting
• Changing methods is allowed, but you need to report using both then
  • From our enhancing characteristic of comparability
• Reliability
  • FIFO leaves the most recent purchases in inventory, so the balance sheet numbers are more reliable
  • LIFO puts the most recent purchases in COGS, so the income statement numbers are more reliable
  • Average cost is between the two

Example: FIFO, Perpetual

Started with 10 bags of coffee beans at $10 each. Then: 1) purchased 5 bags at $12 each; 2) Sold 7 bags; 3) Bought 10 bags at $8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS.

Example: LIFO, Perpetual

Started with 10 bags of coffee beans at $10 each. Then: 1) purchased 5 bags at $12 each; 2) Sold 7 bags; 3) Bought 10 bags at $8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS.

Example: Average cost, Perpetual

Started with 10 bags of coffee beans at $10 each. Then: 1) purchased 5 bags at $12 each; 2) Sold 7 bags; 3) Bought 10 bags at $8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS.

Example: FIFO, Periodic

Started with 10 bags of coffee beans at $10 each. Then: 1) purchased 5 bags at $12 each; 2) Sold 7 bags; 3) Bought 10 bags at $8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS.

Example: LIFO, Periodic

Started with 10 bags of coffee beans at $10 each. Then: 1) purchased 5 bags at $12 each; 2) Sold 7 bags; 3) Bought 10 bags at $8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS.

Example: Average cost, Periodic

Started with 10 bags of coffee beans at $10 each. Then: 1) purchased 5 bags at $12 each; 2) Sold 7 bags; 3) Bought 10 bags at $8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS.

Inventory: Effects on Financial statements

• Inventory goes to the balance sheet
  • Almost always a current asset
    • Slow moving inventories can be non-current assets
• Purchase discounts decrease inventory
• COGS is an expense $\Rightarrow$ goes to income statement
• Sales returns and allowance, sales discount affect income statement
  • Decrease net revenue
• Inventory write-downs decrease net income
  • Reversals are gains $\Rightarrow$ increase OCI

Practice

Situation: Coffee Corp started the year with 100 coffee cups for sale, each originally purchased at $8. Determine the cost of goods sold under each inventory system given the transactions on the right.

An Excel template for this is on eLearn

Wrap up

• For next week
  1. Read the pages for next week
     • Chapter 7 (PP&E, Intangibles)
  2. No homework
  3. Practice on eLearn: Journal entries and inventory
     • Focuses on inventory
     • Automatic feedback provided