Inventory

Inventory Systems help companies to track companies track inventory in order to know the
quantities of product on hand and the quantities sold.

The cost of the opening inventory plus the cost of purchases is known as the cost of goods available
for sale (COGAS)

Type 1 – Periodic Inventory System - As the name implies, periodic inventory systems are systems
that update a company’s inventory information periodically (once in a while). These updates only
happen when the company physically counts its inventory, which may be done only at the end of
each month, each quarter, or even each year.

Companies that use periodic systems record all inventory purchases in a Purchases account (rather
than updating the Inventory account). When goods are sold, an entry is made to record the sale to
the customer, but no entries are made to the Inventory or Cost of Goods Sold accounts until the end
of the accounting period when a physical count of inventory has been performed.

Advantages – Easy to operate, less costly as do not require the use of computer hardware or
software.

Disadvantages- do not provide management with up-to-date information about inventory quantities
or costs.

Companies using periodic systems must have regular inventory counts conducted, which requires
additional wage costs for staff or payments to outside contractors. Companies may also have to
close for business in order to conduct counts, which can result in lost sales

Companies using periodic inventory systems are unable to quantify the cost of inventory that has
been lost to theft. This is because periodic inventory systems assume that whatever items are not
remaining in ending inventory were sold. This may not always be the case, because goods may have
been stolen rather than sold.

Type 2 - Perpetual Inventory System - A company’s inventory information is updated perpetually

(continuously or all the time). As such, inventory and cost of goods sold information is updated after
every transaction (after each purchase or sale of goods). These systems are computerized and
generally require the use of bar code scanners.

It is important to note that, while inventory counts are not required for companies using perpetual
inventory systems, they are still conducted at least once per year (at year end). They are needed for
companies to determine if the actual amount of physical goods on hand is equal to the ending
inventory information according to the computer. It is virtually certain that these two amounts will
not correspond due to the theft of goods. This difference is known as inventory shrinkage.

Factors on deciding which system to use –

 Perpetual is usually used for goods with short shelf life or for inventory items that are in high
demand or subject to seasonal fluctuations. Management does not want to experience
stockouts related to high-demand items, such as the newest model of a smart phone, or
have to reorder a large quantity of a seasonal item, such as snow blowers or beach
umbrellas, at the end of the season.
  Another factor that should be considered when deciding which type of inventory system to
implement relates to the identification of inventory shrinkage. As noted, the use of a
periodic system makes it very challenging to identify shrinkage during the year.
Management has no information about the quantities of inventory on hand until an
inventory count is done. If inventory is missing or identified as damaged during the count, it
is included in the cost of goods sold calculation. The costs of shrinkage can be significant and
management will not necessarily know how much has been lost. Perpetual systems provide
continuous information about the quantity of inventory that should be on hand, which
makes it is easier for management to identify the costs associated with shrinkage.
Management can compare the quantity counted during the annual count with the perpetual
inventory records. Any difference between the inventory record and the physical inventory
is shrinkage.
 Finally, management must assess the costs of purchasing and maintaining the inventory
system. While perpetual systems provide better, more current information about the
quantity and costs of inventory on hand, they do so at a higher cost to the company. A small
business, such as a neighborhood convenience store, may not want to invest in the
necessary technology

Inventory Cost - the sum of a company’s opening inventory and the total inventory purchase costs is
known as cost of goods available for sale (COGAS). This is then allocated between ending inventory
(on the statement of financial position) and cost of goods sold (on the statement of income). This
allocation is done using one of three inventory cost formulas: specific identification (specific ID),
weighted average, and first-in, first-out (FIFO).

The cost of inventory should include:

■
Costs of purchase: The cost of acquiring the inventory.
■
Costs of conversion: Costs directly related to converting raw materials into finished goods (direct
labour and a portion of overhead).
■
Other costs incurred to get inventory to its present location: This may include transportation costs,
handling costs, and import duties.

Administrative overhead and selling and marketing costs are explicitly excluded from the cost of
inventory. Including these costs in inventory values will inflate reported profits

Specific ID - Companies that use specific identification generally have small quantities of high-priced,
unique products in inventory, so the cost and effort required to track the cost of the items is not too
onerous.

Weighted Avg - Under the weighted-average cost formula, a company’s inventory cost is
recalculated every time additional goods are purchased. The weighting is based on the number of
goods purchased relative to the number of goods on hand. When inventory is sold, the weighted-
average cost per unit at that point is used to assign a cost to the products sold

FIFO - When a company uses the first-in, first-out (FIFO) cost formula, the costs of the first units
purchased are assigned to the first units sold and become cost of goods sold.
Deciding factor - if a company’s inventories are not interchangeable (that is, the goods are unique
and each item can be identified), then the company is required to use the specific identification cost
formula. If the goods are interchangeable (that is, they are homogeneous), then management has a
decision to make, as they would have to choose between the weighted-average and the first-in, first-
out cost formulas.

If management has an incentive to maximize earnings (for example, if they have a bonus based on
income), they would be inclined to select FIFO. If management was trying to minimize net income in
order to minimize taxes, then they would be inclined to select the weighted-average method.

Inventory Measurement - LCNRV - lower of cost and net realizable value (NRV).

Net realizable value is equal to the expected selling price of the goods less the estimated costs to
make the sale. If costs greater than selling price, the carrying amount of the inventory must be
reduced. This is known as an inventory writedown, which is treated as an expense (part of cost of
goods sold) in that period. Net realizable value, however, relies on the reasonability of
management’s estimates because the expected selling price and associated selling costs are not
certain until the product is actually sold. This is a situation where management’s bias can impact the
company’s financial results.

Some common internal control procedures for managing inventory include:

• the use of electronic tags on items that sound an alarm when the item leaves the premises without
being purchased (physical controls)

• having different employees responsible for ordering the inventory, checking the inventory when it
is received, and entering inventory information in the accounting system (separation of duties)

• storing valuable goods in locked cabinets or behind counters (physical controls)

• having regular inventory counts conducted (independent verification)

Asset Definition - Provide a future benefit to the entity (measurable!)

-Be controlled by the entity that will obtain the benefits

- Be the result of a transaction/event that has already occurred

Liability Definition - Require some kind of economic sacrifice to settle

- Unavoidable obligation

- Be the result of a past transaction or economic event

Accounting Methods – Under the accrual basis of accounting, transactions are recorded in the period
in which they occur, regardless of when the cash related to these transactions flowed into or out of
the company. Under the cash basis of accounting, transactions are recorded only when the cash is
actually received or paid by the company.

Under the accrual basis of accounting, the recognition of revenues and expenses is not a function of
when the related cash was received or paid. Instead, revenues are recorded when they have been
earned, regardless of whether the related cash was received by the company.
 Revenue Recognition

There are two revenue recognition approaches that are used in determining this: the contract-based
approach (which is also known as the asset-liability approach) and the earnings-based approach.
Companies preparing their financial statements using IFRS must use the contract-based approach,
while companies preparing their financial statements using ASPE must use the earnings-based
approach.

Revenue Recognition under IFRS 5 Step

Step 1 : Identify the contract - A contract exists when all five of the following criteria are met:

• There is a legally enforceable agreement between two or more parties.

• It has been approved and the parties are committed to their obligations.

• Each party’s rights to receive goods or services or payment for those goods and services can be
identified.

• The contract has commercial substance, meaning that the risk, timing, or amount of the company’s
future cash flows is expected to change as a result of the contract.

• Collection is considered probable.

Step 2: Identify the performance obligations - Performance obligations relate to distinct goods or
services. Goods or services are considered to be distinct if both of the following criteria are met:

• The customer can benefit from the good or service (by using, consuming, or selling it) on its own or
with other resources it possesses or can obtain from a third party.

• The promise to transfer the goods or services is separate from other promised goods or services in
the contract. That is, these goods or services are being purchased as separate items under the
contract, rather than forming part of a larger good or service.

Step 3: Determine the transaction price. The transaction price is the amount of consideration the
company expects to receive in exchange for providing the goods or services. The transaction price
must reflect any variable consideration. Variable consideration can result if there are discounts,
refunds, rebates, price concessions, incentives, performance bonuses, penalties, and so on. The
transaction price must include any expected noncash consideration and is reduced by any
consideration that will be paid to the customer in relation to discounts, volume rebates, or coupons.

Step 4 - Allocate the transaction price to performance obligations. If, in Step 2, only a single
performance obligation was identified, then this step is not required. However, if multiple
performance obligations were identified, then a portion of the transaction price determined in Step
3 must be allocated to each of them. The transaction price is allocated on the basis of the stand-
alone selling price of each performance obligation.

Step 5: Recognize revenue when each performance obligation is satisfied. As each performance
obligation is satisfied, the company recognizes revenue equal to the portion of the transaction price
that has been allocated to it in Step 4. Performance obligations are satisfied when control of the
goods or services are transferred to the customer. Control is transferred if the customer has the
ability to direct the use of the asset and obtain substantially all of the remaining benefits from it
through its use, consumption, sale, and so on. It is possible that control is transferred at a point in
time or over time. If control is transferred over time, then the company must identify an appropriate
basis upon which the extent of transfer can be measured each period.

Special Cases:

Right of Returns - If a company makes sales with a right of return, management must estimate the
extent of expected returns because they affect the estimated transaction price (Step 3 of the five-
step model). The amount of expected returns is another form of variable consideration. A refund
liability is established for the amount of expected returns because management expects the
company will have to return (as a refund or credit) this portion of the consideration received from
the customer.

Warranty - A service warranty is considered to be a separate performance obligation (Step 2 of the

five-step model) and, as such, a portion of the transaction price must be allocated to it. Assurance
warranties are not considered to be separate performance obligations, so there is no need to
allocate the transaction price.

Consignment - In terms of recognizing revenue when there is a consignment arrangement, the

consignor would not recognize any revenue when they transfer goods to the consignee (because
they retain control of them). At the time the goods are sold, both the consignor and the consignee
would recognize revenue. The consignor’s transaction price (Step 3 of the five-step model) would be
the net amount (the selling price less consignee’s commission), while the consignee’s transaction
price (Step 3 of the five-step model) would be the amount of the commission

Third Party Sales- The answer to this question depends on whether the company’s performance
obligation is to provide the goods or services (in which case it is considered to be a principal) or to
arrange for a third party to provide the goods or services (in which case it is considered to be an
agent). If the company is considered to be a principal, then the transaction price (Step 3 of the five
step model) would be the gross amount. If the company is considered to be an agent, then the
transaction price (Step 3 of the five-step model) would be the net amount.

Bill and Hold - • Reason should be substantive • Goods separately identified as belonging to the
buyer. • Goods ready for delivery to the buyer • goods not transferred to another customer or for
other uses

Revenue under ASPE:

Sale of Goods Revenue from the sale of goods can be recognized when all of the following criteria
are met:

1. The risks and rewards of ownership have been transferred to the customer.

2. The seller has no continuing involvement or control over the goods.

3. The amount of consideration to be received can be measured with reasonable assurance.

4. Collection is reasonably assured

Provision of Services - Revenue from the provision of services can be recognized when all of the
following criteria are met:

1. The service has been performed.

2. The amount of consideration to be received can be measured with reasonable assurance.

3. Collection is reasonably assured.

Cash flow Statement

Interest and Dividends Under IFRS –

Interest and dividends received can be classified as cash from operations or cash from investing
activities

Interest and dividends paid can be classified as cash from operations or cash used for financing
activities

The key elements of an effective internal control system include:

1. Segregation of duties
2. Security procedures
3. Regular bank reconciliations

Allowance method of accounting for bad debts

Writing off a specific receivable - Companies establish policies for when accounts are to be written
off. A write off is what occurs when a specific customer’s account receivable is removed from a
company’s books when the account is deemed uncollectible. Some companies’ write off policies may
use timelines, such as writing off an account once it is more than 180 days overdue. Other
companies may wait for specific indications, such as being notified of a customer’s bankruptcy,
before writing off an account. Note that this entry has no effect on the statement of income, nor
does it change the carrying amount of receivables, because it has off setting effects on the two
accounts making up this amount.

Allowance Method –

% of Credit Sales - This method uses sales on account as the basis for the estimate. It is also known
as the statement of income method because it is based on information from the statement of
income.

% of Receivables – This method uses an aging of the various receivables as the basis for the estimate.
It is also known as the statement of financial position method because it is based on information
from the statement of financial position.

So, for there to be an overall debit balance in this account, a company would have had to write off
more accounts than it had previously allowed for. In other words, write offs exceeded the amount of
the allowance that had been established for doubtful accounts. If this was the case, then we know
two things about the prior year’s financial statements:

1. The bad debts expense for that year was understated (an insufficient allowance was established)
and, therefore, net income was overstated.
2. The carrying amount of accounts receivable on the statement of financial position was overstated
because an insufficient allowance was established.

ASPE does not specifically require that accounts receivable be discounted since it is normally a
current assets account. Nevertheless, it would make sense to consider the time value of money,
since the accounts receivable involves a lengthy collection period.

PPE Cost under IFRS/ASPE - When PP&E is acquired, the company must decide which costs
associated with the purchase of the asset should be capitalized (that is, included as a part of the
asset’s cost). The general guideline is that all of the costs necessary to acquire the asset and ready it
for use should be capitalized. Any cost incurred that is not capitalized as part of the asset cost would
be expensed in the period it is incurred.

“Cost” Includes

• purchase price (less any discounts or rebates)

• non-refundable taxes and import duties on the purchase price

• legal costs associated with the purchase

• shipping or transportation costs

• site preparation, installation, and set-up costs

In determining whether these costs should be capitalized (that is, added to the cost of the asset) or
expensed as period costs, management must consider whether or not these assets create a future
economic benefit. In other words, will these costs extend the useful life of the asset (beyond the
original estimate), will they reduce the asset’s operating costs, or will they improve the asset’s
output either in terms of quantity or quality? If the answer to any of these questions is “yes,” then a
future economic benefit (an asset) has been created and the costs are capitalized. If no future
economic benefit has been created, then these are period costs and should be expensed.

Subsequent Recognition

Under ASPE – If we incur eg repair costs after the initial procurement, we should ask better or
repair? If it increases the efficiency/useful life/effectiveness, then it is for better and hence
capitalised.

Under IFRS - If we incur eg repair costs after the initial procurement, we should ask is it a day-to-day
maintenance or a major overhaul? If it is a major overhaul, then it is capitalised.

IFRS provides an option of valuing certain capital assets at fair value if

 PPE if fair value can be measured reliably

 Intangible if an active market exists

ASPE does not allow capital assets to be measured at fair value.

Under IFRS, there are two models that can be considered when determining the amount at which
PP&E will be reflected on the statement of financial position. These are the cost model and the
revaluation model. Only the cost model is allowed under ASPE.
Under the cost model, PP&E assets are presented on the statement of financial position at their
carrying amount (also known as net book value), which is their cost less their accumulated
depreciation and accumulated impairment losses.

Under the revaluation model, PP&E assets are carried at their fair value (as determined at points of
time known as the revaluation dates) less any subsequent accumulated depreciation and any
subsequent impairment losses.

Basket Purchase - The purchase price is allocated using the asset’s relative fair value at the time of
purchase, which can be determined in a number of ways. The most common way would be to have
an appraisal completed that will provide the relative fair values of each asset. It is very common for
the total purchase price and the total appraised value to differ. It is important to remember that the
company must record the purchase for what it paid, not what the appraised values are.

Depreciation expense should be recorded for each PP&E asset that a company holds for use in its
operations. This is the case even if the asset was idle during the period. There are a few exceptions
to this. The first exception would be if the asset is already fully depreciated (its carrying amount is
equal to its expected residual value). The second exception would be if the company uses the units-
of-production method to depreciate the asset and the asset was idle during the period. In this case,
because there would have been no production, there would be no depreciation expense to record. A
third exception is when a PP&E asset is no longer being used in the business and management has
determined that it will be sold. At this point the asset is considered to be “held for sale” and
depreciation is no longer recorded for the asset because the future benefits it embodies are no
longer being consumed through its use.

Impairment ASPE – NBV compared to Cf’s, when NBV>Cf’s, we compared NBV with FV.

NBV = Cost – amortisation

When, NBV<Cf’s, we do nothing

Impairment IFRS – In case, Recoverable Amount is less than Net Book Value then the equipment
needs to be written down to recoverable amount.

Recoverable amount is Higher of Fair Value of assets less cost to sell and value in use of assets (sum
of discounted cash flows) Recoverable amount = Higher of discounted CF and FV

Under ASPE, depreciation is based on asset class, whereas in IFRS, depreciation is based on
components.

Intangible Asset Criteria

Was purchased so it is a history transaction

Has measurable future benefit as it allows the brand to be protected and recognized

Control of these benefits are owned by BI, so BI will attain these future benefits
And is separately identifiable as it was purchased, and will be able to be sold