MGACO1 INTERMEDIATE ACCOUNTING I S. Daga Topic: INVENTORY TEXT: Chapter 8 (excl. appendix) TEXT QUESTIONS: E8-11, E8-22, P8-3, Case IC8-1 LEARNING GOALS: 1. RECOGNITION - Understand key inventory concerns. 2. MEASUREMENT - Know what costs are included in inventory and how cost formulas work. 3. Be able to estimate Inventory amounts using the Gross Profit method. CLASS OUTLINE LEARNING GOAL 1: RECOGNITION - Understand key inventory concerns. Inventory - A critically important asset items that are held for sale to make a profit - Management is very interested in inventory quantities in order to prevent stocking up on excessive and un-saleable inventories or being caught without items for sale. - Since inventory amounts affect balance sheet and income statement amounts, they are important in terms of management bonus contracts linked to income earned, and bank covenants requiring specific current or debt to equity ratios. - Inventories are valued at lower of cost and net realizable value. 1
What s included in Physical Inventory? - Be careful of what is included and excluded in the inventory amount. 1. Goods in transit consider the shipping terms - FOB shipping point or FOB destination 2. Consigned goods 3. Special Sale agreements a. Product financing arrangements b. Sales with high rates of return c. Sales with delayed payment terms LEARNING GOAL 2: MEASUREMENT - Know what costs are included in inventory and how cost formulas work. What Costs are included In Inventory? Charges directly connected with bringing goods to the place of business of the buyer and converting such goods to a saleable condition are inventoriable, or product costs. 1. IFRS allows borrowing costs to be capitalized for inventory items that take an extended period of time to produce. Interest costs, however, are generally expensed as incurred because they are considered a cost of financing for ongoing production. 2. Vendor rebates these are deducted from the inventory cost 3. Purchase Discounts these are deducted 4. Standard Costs reporting a predetermined unit cost for material, labour and manufacturing overhead is acceptable if these costs result in approximating the actual cost. 2
Costs excluded from inventory: storage costs, abnormal spoilage or wastage of materials, labour, interest costs on inventories that are ready for sale. Period expenses selling expenses, general and administration cost are also not included. Inventory Recording Systems: Perpetual vs. Periodic EXAMPLE: Record the following: INVENTORY RECORDING SYSTEMS using T-ACCOUNTS Transaction A: Beginning Inventory 100 units at $6 = $ 600 B: Purchases 900 units at $6 = $5,400 C: Sales 600 units at $12 = $7,200 D: Ending inventory 400 units at $6 = $2,400 PERIODIC SALES ACCOUNTS RECEIVABLE INVENTORY COST OF GOODS SOLD ACCOUNTS PAYABLE PURCHASES PERPETUAL SALES ACCOUNTS RECEIVABLE INVENTORY COST OF GOODS SOLD ACCOUNTS PAYABLE 3
COST FORMULAS used to track inventory costs. 1. Specific identification 2. First-In, First-Out (FIFO) 3. Average Cost (weighted average-periodic- or moving weighted averageperpetual) -LIFO is not an option under ASPE or IFRS EXAMPLE: Calculate ending inventory: Inventory Data 1/1 Begin with 1,000 units @ $5 1/10 Purchase 200 units @ $8 1/15 Sell 400 units 1/20 Purchase 300 units @ $6 1/31 Ending inventory is 1,100 units (1,000 + 200-400 + 300) Ending inventory calculations for 1,100 units, FIFO VS. WEIGHTED-AVERAGE: 4
Lower of Cost and Net Realizable Value - If inventory values slip below the initial cost a write down is required. -Valuation at net realizable value (NRV) even though cost may be lower than NRV may be acceptable in certain instances eg. Gold, silver Effect of Inventory Errors - The three most common types of inventory errors: 1. Correct recording of purchases but incorrect measurement and/or recording of ending inventory count. 2. Recording purchase transactions in the wrong accounting period. However, ending inventory is measured and recorded correctly. 3. Failure to include an item as a recorded purchase combined with failure to include the item in the ending inventory count. These errors must be corrected otherwise they impact both the balance sheet and income statement and various ratios such as the current ratio. (Practice class discussion question E8-11 on inventory errors) 5
LEARNING GOAL 3: Be able to estimate Inventory amounts using the Gross Profit method. Gross Profit Method of Estimating Inventory - used when only an ESTIMATE of a firm s inventory is required. - this method is not appropriate when a company handles different lines of merchandise with widely varying rate of gross profit. (practice class discussion question E8-22 on gross profit method) Inventory Analysis Inventory turnover = Cost of Goods Sold/ average inventory on hand # Days Required to sell inventory = 365/ inventory turnover 6
Class Discussion Questions: E8-11 (Lower of Cost and Net Realizable Value Effect of Error) Iqbal Corporation uses the lower of FIFO cost and net realizable value method on an individual item basis, applying the direct method. The inventory at December 31, 2014, included product AG. Relevant per-unit data for product AG follow: Estimated selling price $50 Cost 45 Replacement cost 51 Estimated selling expense 19 Normal profit 14 There were 1,000 units of product AG on hand at December 31, 2014. Product AG was incorrectly valued at $35 per unit for reporting purposes. All 1,000 units were sold in 2015. Instructions Assume that Iqbal follows the reporting under ASPE and answer the following questions. (a) Was net income for 2014 overstated or understated? By how much (ignore income tax aspects)? (b) Was net income for 2015 overstated or understated? By how much? (c) Indicate whether the current ratio, inventory turnover ratio, and debt-to-total-assets ratio would be overstated, understated, or not affected for the years ended December 31, 2014, and December 31, 2015. Explain briefly. (d) Assume that management did not discover the error in inventory until after the end of the fiscal year but before the closing entries were made and the financial statements were released. Should the adjustment be recorded? How would the error be treated if it were discovered after the financial statements were released? (e) How would your responses above change if Iqbal followed the reporting under IFRS? 7
E8-22 (Gross Profit Method) (LO 4, 10 ) Linsang Corporation's retail store and warehouse closed for the entire weekend while the year-end inventory was counted. When the count was finished, the controller gathered all the count books and information from the clerical staff, completed the ending inventory calculations, and prepared the following partial income statement for the general manager for Monday morning: Sales $2,750,000 Beginning inventory $ 650,000 Purchases 1,550,000 Total goods available for sale 2,200,000 Less ending inventory 650,000 Cost of goods sold 1,550,000 Gross profit $1,200,000 The general manager called the controller into her office after quickly reviewing the preliminary statements. You've made an error in the inventory, she stated. My pricing all year has been carefully controlled to provide a gross profit of 35%, and I know the sales are correct. Instructions (a) How much should the ending inventory have been? (b) If the controller's ending inventory amount was due to an error, suggest where the error might have occurred. 8
P8-3 Ianthe Limited, a manufacturer of small tools, provided the following information from its accounting records for the year ended December 31, 2014: Inventory at December 31, 2014 (based on physical count of goods in $1,720,000 Ianthe's plant, at cost, on December 31, 2014) Accounts payable at December 31, 2014 1,300,000 Total current assets 2,680,000 Total current liabilities 1,550,000 Net sales (sales less sales returns) 8,550,000 Additional information: 1. Included in the physical count were tools billed to a customer FOB shipping point on December 31, 2014. These tools had a cost of $37,000 and were billed at $57,000. The shipment was on Ianthe's loading dock waiting to be picked up by the common carrier. 2. Goods were in transit from a vendor to Ianthe on December 31, 2014. The invoice cost was $51,000, and the goods were shipped FOB shipping point on December 29, 2014. Ianthe will sell these items in 2015 for $87,500. These were excluded from the inventory count. 3. Work-in-process inventory costing $38,000 was sent to an outside processor for plating on December 30, 2014. This was excluded from the inventory count. 4. Tools that were returned by customers and awaiting inspection in the returned goods area on December 31, 2014, were not included in the physical count. On January 8, 2015, these tools, costing $38,000, were inspected and returned to inventory. Credit memos totalling $48,000 were issued to the customers on the same date. 5. Tools shipped to a customer FOB destination on December 26, 2014, were in transit at December 31, 2014, and had a cost of $21,000. When it was notified that the customer received the goods on January 2, 2014, Ianthe issued a sales invoice for $42,000. These were excluded from the inventory count. 6. Goods with an invoice cost of $27,000 that were received from a vendor at 5:00 p.m. on December 31, 2014, were recorded on a receiving report dated January 2, 2015. The goods were not included in the physical count, but the invoice was included in accounts payable at December 31, 2014. 7. Goods that were received from a vendor on December 26, 2014, were included in the physical count. However, the vendor invoice of $56,000 for these goods was not included in accounts payable at December 31, 2014, because the accounts payable copy of the receiving report was lost. 8. On January 3, 2015, a monthly freight bill in the amount of $7,000 was received. The bill specifically related to merchandise purchased in December 2014, and half of this merchandise was still in the inventory at December 31, 2014. The freight charges were not included in either the inventory account or accounts payable at December 31, 2014. 9
10 Instructions (a) Using the format shown below, prepare a schedule of adjustments to the initial amounts in Ianthe's accounting records as at December 31, 2014. Show separately the effect, if any, of each of the eight transactions on the December 31, 2014 amounts. If the transaction has no effect on the initial amount that is shown, write NONE. Inventory Accounts Payable Net Sales Initial amounts $1,720,000 $1,300,000 $8,550,000 Adjustments increase (decrease) Total adjustments Adjusted amounts $ $ $ (b) After you arrive at the adjusted balance for part (a) above, determine if the following ratios have improved or if they have deteriorated: 1. Working capital 2. Current ratio 3. Gross profit 4. Profit margin (AICPA adapted)
IC8-1 Grappa Grapes Inc. (GGI) grows grapes and produces fine champagne. The company is located in a very old area of town with easy access to fertile farmland that is excellent for growing grapes. It is owned by the Grappa family. The company has been in operation for 100 years and a large part of its success lies in the excellent vineyards and unique process for producing vintage wines. The winery sits at the edge of a range of hills that are composed of chalk. GGI has dug caves into the side of the hills at a significant cost and the chalk caves provide the perfect temperature and humidity for the maturing wines. All of the vintage wines are produced, aged, and stored in these chalk caves. People come from all over the country to visit the caves. As a matter of fact, 25% of the company's revenues are from winery tours. The company has had three years where it has managed to produce vintage wines. Vintage wines are of higher quality and sell for a higher price. In addition, they contribute to the prestige of the winery. Because of this success, GGI has started to sell wine futures. Under the terms of the contract, large wholesalers pay GGI upfront and agree to take delivery of a certain number of bottles in two years at 20% off the pre-determined future price. A market for trading these contracts now exists for the buyers of the futures. During the year, in anticipation of increasing costs, the entity placed a purchase order for a significant number of oak barrels from France. The barrels are used to age the wines. Due to the declining value of the dollar during a current economic recession and the demand for wines in general over the past year, the value of the barrels has actually declined below the price locked in under the purchase commitments. The supplier is confident that this is only a temporary decline in value and that the price of the barrels will increase within the next couple of months. GGI may get out of the purchase commitment either by taking delivery of the barrels at the agreed-upon price or by settling net in cash for the difference between the agreed-upon price and the market price (times the number of barrels ordered). The year has been a very rainy one and some of the very old chalk caves have begun to leak and deteriorate. One of the caves holding a large number of vintage wines collapsed. It is unclear whether the wine is salvageable. The company's insurance will not cover the expected loss, although GGI has hired its lawyers to challenge this as it feels that the insurance company should cover the loss. GGI has decided to follow GAAP for the current year's financial statements as it is planning to go to the bank for a loan. Instructions Assume the role of the controller and analyze the financial reporting issues. 11