1© Kolitz & Quinn, 2005

INVENTORY AND INVENTORY AND COST OF SALESCOST OF SALES

Recognition and measurement of Recognition and measurement of inventoryinventory

Relationship between cost, GP and Relationship between cost, GP and SPSP

Establishing cost of inventoryEstablishing cost of inventoryCost formulasCost formulas

Lower of cost and NRVLower of cost and NRVInventory errorsInventory errors

Estimating inventoryEstimating inventory

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OUTCOMESOUTCOMES Explain the recognition and measure Explain the recognition and measure

principles related to inventoryprinciples related to inventory Compute the relationship between Compute the relationship between

cost, GP and SPcost, GP and SP Determine the cost of inventory and Determine the cost of inventory and

account for goods in transit, goods on account for goods in transit, goods on consignment and inventory shortagesconsignment and inventory shortages

Use the inventory cost formulaeUse the inventory cost formulae Measure and record inventoriesMeasure and record inventories Calculate inventory errorsCalculate inventory errors Estimate the value of closing inventoryEstimate the value of closing inventory

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RECOGNITION AND RECOGNITION AND MEASUREMENT OF MEASUREMENT OF

INVENTORYINVENTORY Affects I/S and SOFPAffects I/S and SOFPInventory on

hand at beginning of period

Inventory onhand at end

of period(A on SOFP)

Purchases ofinventory

during the period

Inventory sold duringthe period

(COS on I/S)Cost of inventoryavailablefor sale

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Recognition and Recognition and measurement of inventory. . .measurement of inventory. . .

Inventories are assetsInventories are assets held held for salefor sale in ordinary course of business in ordinary course of business held as materials or supplies to be held as materials or supplies to be

consumedconsumed Important to distinguish between goods Important to distinguish between goods

held for resale and consumable storesheld for resale and consumable storesSalesSales

-- COSCOS

== GPGP

-- E E

== ProfitProfit

Cost of goods held for resale included in COS to determine GP

Cost of consumable stores included in expenses to determine profit

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RELATIONSHIP BETWEEN RELATIONSHIP BETWEEN COST, GP AND SPCOST, GP AND SP

Mark-up on costMark-up on costCostCost 100100 mark-up on costmark-up on cost = GP/C= GP/C = 25% = 25% (25/100) (25/100)

GPGP 25 25SPSP 125125 expected GP%expected GP% = GP/SP = = GP/SP =

20% 20% (25/125)(25/125)

Expected GP %Expected GP %CostCost 75 75 mark-up on costmark-up on cost = GP/C= GP/C = 33,3% = 33,3% (25/75)(25/75)

GPGP 2525SPSP 100100 expected GP%expected GP% = GP/SP = = GP/SP =

25%25% (25/100) (25/100)

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ESTABLISHING THE COST OF ESTABLISHING THE COST OF INVENTORYINVENTORY

Cost of inventory comprises all Cost of inventory comprises all costs costs of purchase of purchase and and other costs other costs incurred in bringing the inventory to incurred in bringing the inventory to its present location and condition.its present location and condition.

Cost of inventory

Costs of purchase

Othercosts= +

•purchase price (net of deferred finance expense)•import duties•non-recoverable taxes•transport costs•handling costs less•Cash & trade discounts

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Goods in transitGoods in transit Goods which have not physically Goods which have not physically

arrivedarrived Two problemsTwo problems

whether ownership has passed from whether ownership has passed from supplier to buyersupplier to buyer

whether buyer has processed the whether buyer has processed the purchase of the goodspurchase of the goods

OwnershipOwnership if ownership has not passed, goods if ownership has not passed, goods

remain property of sellerremain property of seller if ownership has passed (and goods not if ownership has passed (and goods not

delivered), then the goods are delivered), then the goods are in transit in transit

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Terms of the agreement

– FOB supplier’s warehouse

– FOB foreign airport / harbour

– FOR destination station

Supplier’swarehouse

Foreignport

Destinationport

Buyerspremises

Goods in transit . . .

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No entry processed for goods in No entry processed for goods in transittransit

Adjusting entry required to state the Adjusting entry required to state the asset (goods in transit) and liability asset (goods in transit) and liability (accounts payable) at correct amount(accounts payable) at correct amount

Entry same for periodic and perpetual Entry same for periodic and perpetual systemssystems two B/S items affectedtwo B/S items affected I/S not affectedI/S not affected

Adjusting entryAdjusting entryDr Goods in transitDr Goods in transit

Cr Accounts payableCr Accounts payable

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Entry processed for goods in transitEntry processed for goods in transit Periodic systemPeriodic system

Original entryOriginal entryDr PurchasesDr PurchasesCr Accounts payableCr Accounts payable

Adjusting entryAdjusting entryDr Goods in transitDr Goods in transitCr Purchases / COSCr Purchases / COS

Perpetual systemPerpetual system Original entryOriginal entry

Dr InventoryDr InventoryCr Accounts payableCr Accounts payable

Adjusting entryAdjusting entryDr Goods in transitDr Goods in transitCr InventoryCr Inventory

•COS overstated•GP & P understated

•COS correct•GP & P correct

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Solution : Goods in transitSolution : Goods in transit

Periodic No entry madefor goods in

transit

Entry for thepurchase of

goods intransit already

made

Sales 400 000 400 000

Cost of sales (320 000) (320 000)

Opening inventory 90 000 90 000

Purchases 330 000 400 000

COGAFS 420 000 490 000

Closing inventory (100 000) (100 000)

GIT (70 000)

GP 80 000 80 000

Gross profit % 20% 20%

Mark up % 25% 25%

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Goods on consignmentGoods on consignment

Goods on consignment areGoods on consignment are goods delivered by entity owning the goods delivered by entity owning the

goods (consignor)goods (consignor) to another entity who sells the goods to another entity who sells the goods

on behalf of the owner (consignee) on behalf of the owner (consignee) Risks and rewards of ownership Risks and rewards of ownership

remains with consignorremains with consignor included in included in consignor’sconsignor’s inventory inventory not not included in included in consignee’sconsignee’s inventory inventory

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Inventory shortagesInventory shortages Detection and prevention of Detection and prevention of

inventory shortages is a key inventory shortages is a key area of management area of management responsibilityresponsibility

Physical inventory needs to Physical inventory needs to be counted at regular be counted at regular intervalsintervals GP% computed for periodic GP% computed for periodic

systemsystem cost of inventory counted is cost of inventory counted is

compared to balance in compared to balance in inventory a/c for perpetual inventory a/c for perpetual systemsystem

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Periodic systemPeriodic system Need to compare Need to compare actual GP%actual GP% with with

expected GP%expected GP% Reconciliation:Reconciliation:

Expected GP%Expected GP% 50,00%50,00%Actual GP%Actual GP% 48,75%48,75%DifferenceDifference 1,25%1,25%Known shortageKnown shortage 0,50%0,50%Unknown shortageUnknown shortage 0,25%0,25%

1,25%1,25%

Cost of shortage is Cost of shortage is included in COSincluded in COS as as cost of inventory lost is cost of inventory lost is included in included in opening inventory or purchasesopening inventory or purchases and and not not included in closing inventoryincluded in closing inventory

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Perpetual systemPerpetual system Cost of physical count of inventory Cost of physical count of inventory

compared to GL balance in compared to GL balance in inventory a/cinventory a/c

Inventory a/c adjusted to reflect Inventory a/c adjusted to reflect physical count by recording physical count by recording difference as inventory shortagedifference as inventory shortage

Adjusting entryAdjusting entryDrDr COSCOSCrCr InventoryInventory

Reconciliation between expected GP% and Reconciliation between expected GP% and actual GP%actual GP%

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Solution : Inventory shortages Solution : Inventory shortages - Periodic- Periodic

Periodic 20 units on hand

(no inventory shortage)

19 units on hand

(inventory shortage)

Sales 40 X R10 000 400 000 40 X R10 000 400 000 Cost of sales

(200 000) (205 000)

Opening inventory

10 X R5000

50 000 10 X R5 000

50 000

Purchases 50 X R5 000

250 000 50 X R5 000

250 000

COGAFS 60 X R5 000

300 000 60 X R5 000

300 000

Closing inventory

20 X R5 000

(100 000) 19 X R5 000

(95 000)

Gross profit

200 000 195 000

Other expenses

(75 000) (75 000)

Profit 125 000 120 000 Mark up % 100% 100% Gross profit %

50% 50%

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COST FORMULAECOST FORMULAE Several different methods for Several different methods for

determining COS and cost of determining COS and cost of inventoriesinventories Specific identificationSpecific identification FIFOFIFO Weighted averageWeighted average

All All cost flow assumptionscost flow assumptions, and , and do not necessarily conform to the do not necessarily conform to the actual actual physical movement physical movement of of the goodsthe goods

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Specific identificationSpecific identification

Used where items Used where items of inventory are of inventory are dissimilardissimilar and and notnot interchangeableinterchangeable

Feasible when Feasible when inventory items are inventory items are uniquely uniquely identifiable and of identifiable and of sufficient value to sufficient value to keep detailed keep detailed recordsrecords

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FIFOFIFO

FIFO method based on theFIFO method based on the cost flow cost flow assumption assumption that the first units that the first units acquired are the first units soldacquired are the first units sold

When using FIFOWhen using FIFO COS is represented by the COS is represented by the costcost of the of the

earliestearliest purchasespurchases CI is represented by the CI is represented by the costcost of the of the

latestlatest purchases purchases

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Weighted averageWeighted average

Weighted average method is based Weighted average method is based on the on the cost flow assumption cost flow assumption of of the weighted average costthe weighted average cost

Weighted averageWeighted average Cost of inventory at beginning +Cost of inventory at beginning +

cost per item cost per item == cost of inventory purchasedcost of inventory purchasedTotal units available for saleTotal units available for sale

Thus, in times of rising prices,Thus, in times of rising prices, COS is reported above theCOS is reported above the FIFO FIFO

amountamount CI is reported below theCI is reported below the FIFO amount FIFO amount

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Solution : Cost formulasSolution : Cost formulas(Periodic) (Periodic)

(a) (i)

FIFO

(ii)

Weighted Average

Periodic Qty R Total Qty R Total

OI 150 11.00 1 650 150 11.00 1 650 Purchase 150 12.00 1 800 150 12.00 1 800 Purchase 150 13.00 1 950 150 13.00 1 950 COGAFS 450 5 400 450 5 400 CI (1)* 160 2 070 160 12.00 1 920 COS (2)* 290 3 330 290 12.00 3 480

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Solution : Cost formulasSolution : Cost formulas(Perpetual)(Perpetual)

(b) (i)

FIFO

(ii)

Weighted Average

Perpetual Qty R Total Qty R Total

1/7 OI 150 11.00 1 650 150 11.00 1 650 15/7 Purchases 150 12.00 1 800 150 12.00 1 800

15/7 Bal 300 3 450 300 11.50 3 450 10/8 Sale (1) (200) (2 250) (200) 11.50 (2 300)

10/8 Bal (2) 100 1 200 100 11.50 1 150 8/9 Purchases 150 13.00 1 950 150 13.00 1 950 20/9 Sale (3) (90) (1 080) (90) 12.40 (1 116)

CI (4) 160 2 070 160 12.40 1 984

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LOWER OF COST OR NET LOWER OF COST OR NET REALISABLE VALUEREALISABLE VALUE

IAS 2 requires inventory is measured at IAS 2 requires inventory is measured at thethe lowerlower ofof costcost NRVNRV

Cost comprises all costs of purchase Cost comprises all costs of purchase and other costs and is computed based and other costs and is computed based on one of the cost formulason one of the cost formulas

NRV is determined is determined NRV is determined is determined according to estimates of the net according to estimates of the net proceeds which will result from the sale proceeds which will result from the sale of the inventoryof the inventory

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Accounting for the write-down of Accounting for the write-down of inventoryinventory

(periodic system)(periodic system)

Closing inventory entered into Closing inventory entered into accounting system at accounting system at reduced valuereduced value

Lower closing inventory leads toLower closing inventory leads to Higher COSHigher COS Lower GP and profitLower GP and profit

Reconciliation needed between expected Reconciliation needed between expected GP% and actual GP%GP% and actual GP%

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Accounting for the write-down of Accounting for the write-down of inventoryinventory

(perpetual system)(perpetual system) Balance on inventory a/c Balance on inventory a/c

represents cost of inventory at represents cost of inventory at end of period - no specific entry end of period - no specific entry required to introduce closing required to introduce closing inventory into accounting systeminventory into accounting system

Adjusting entryAdjusting entryDr COSDr COSCr InventoryCr Inventory Higher COS leads to lower GP and profitHigher COS leads to lower GP and profit Reconciliation needed between expected Reconciliation needed between expected

GP% and actual GP%GP% and actual GP%

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INVENTORY ERRORSINVENTORY ERRORS

Periodic systemPeriodic systemCICI CICI

overstatedoverstated understatedunderstated

OIOI 55 55 55

++ PP 1010 1010 1010

-- CICI (8)(8) (9)(9) (7)(7)

== COSCOS 77 66 (8)(8)

SalesSales 2020 2020 2020

GPGP 1313 1414 1212

GPoverstated

GPunderstated

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Inventory errors ...Inventory errors ...

Perpetual systemPerpetual system

COSCOS COSCOS

understatedunderstated overstatedoverstated

OIOI 55 55 55

++ PP 1010 1010 1010

-- COSCOS (7)(7) (6)(6) (8)(8)

== CICI 88 99 (7)(7)CI

understatedCI

overstated

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ESTIMATING INVENTORYESTIMATING INVENTORY Value of closing Value of closing

inventory may need inventory may need to be estimated in to be estimated in relation to two points relation to two points in timein time closing inventory at closing inventory at

some point in current some point in current period (eg, fire or period (eg, fire or theft)theft)

closing inventory at closing inventory at end of a previous end of a previous period (eg, inventory period (eg, inventory not counted at end of not counted at end of previous periodprevious period

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Estimating inventory...Estimating inventory...

Typicalperiodic

inventorycomputationof COS & GP

Insuranceclaim

Inventory notcounted at the

end ofpreviousperiod

Openinginventory

Openinginventory

Openinginventory (?)

+ Purchases + Purchases + Purchases= Cost of goods

available forsale

= Cost of goodsavailable forsale

= Cost of goodsavailable forsale

- Closinginventory

- Inventorysalvaged

- Closinginventory

- Inventorydestroyed (?)

= Cost of sales = Cost of sales = Cost of salesSales Sales Sales

= Gross profit = Gross profit = Gross profit