Chapter 8: Inventory

Inventory

  • Understand inventory from a business perspective.
  • What Types of Companies Have Inventory?
  • Manufacturing, retail, and wholesale often have significant amount of inventories.
  • Some companies produce “just-in-time.”

Inventory Categories

  • Merchandise InventoryUnsold units left on hand for retailers and wholesalers.
  • Manufacturers have 3 accounts:
  • Raw Materials Inventory – Costs for goods/materials on hand byt not yet in production.
  • Work-in-Process – Costs of raw material on which production has started and not complete plus direct labour cost.
  • Finished Goods Inventory – Costs associated with unsold completed goods.

Inventory Planning and Control

  • Management wants to have a wide variety and sufficient quantities on hand, but there may be carrying costs.
  • Monitor to →
  • Minimize carrying costs and meet customer demands.

Information for Decision-Making

  • Existence of various types of inventory owned should be clearly represented, and how it should be measured should be disclosed.
  • Physical inventory increases/decreases, and COGS should be allocated between goods sold or used and those still on hand.
  • Calculate Cost of Goods Available for Sale - Cost of Goods on Hand at the Beginning of the Period + Cost of Goods Acquired or produced during the period = Cost of goods available for sale or use.
  • Calculate COGS - Cost of Goods Available for sale during the period – Cost of goods on hand at the end of the period = Cost of goods sold.

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  • Answers Questions →
  • What physical goods should be included as part of inventory?
  • What costs should be included as part of inventory cost?
  • What cost formula should be used?
  • Has there been an impairment in inventory item value?
  • Define inventory from an accounting perspective.

Recognition

  • Inventories of financial instruments, biological assets and agricultural products, mineral products, and inventories held by producers of agricultural and forest producers and by commodity broker-traders may have special requirements.

Accounting Definition of Inventory

  • Inventories are defined →
  • Held for sale in ordinary course of business;
  • In the process of production for such sale;
  • In the form of materials or supplies to be consumed in the production process or in the rendering of services.
  • An inventory purchase is the opposite of side of a sales transaction and features risks and rewards.
  • Identify which inventory items should be included in ending inventory.

Physical Goods Included in Inventory

  • Acquisitions are typically recorded when goods are received because it may be difficult to identify the exact time when legal title passes.

Goods in Transit

  • Purchased goods that are not yet received – Legal title is determined by shipping terms.
  • F.o.b. shipping point – Legal title passes when seller has delivered the goods to the transporter.
  • Goods in transit shipped this way are recorded as purchases and included in ending inventory.
  • If not, inventories and accounts payable are understated in the statement of financial position, and purchases and ending inventories are understated when calculating COGS for income statement.
  • F.o.b. destination – Legal title passes when goods reach the destination.
  • Cut-off schedule – Ensures that goods received from suppliers year-end are recorded in the appropriate period.
  • Including controlling receipt and shipment of goods, making freight and shipping documents, and ensuring reports on goods received are linked to invoices.
  • Cut-off schedule is completed a few days after period’s end to give time for goods in transit to be received at year end.

Consigned Goods

  • Goods on consignment remain in the consignor’s inventory at purchase price (production cost + handling and shipping cost)
  • Legal title is held by the consignor and revenue goes to them (commission and expenses are incurred)
  • No entry required to adjust inventory for the consignee.

Sales with Buyback Agreements

  • Use inventory to obtain financing without reporting liability or the inventory on the balance sheet.
  • Purchaser agrees to buy inventory and sell it back to the supplier, a “parking transaction.”
  • If risks and rewards of ownership have not been controlled, the inventory remains on seller’s books.

Sales with High Rates of Return

  • Agreements that allow a buyer to return inventory for a full or partial refund.
  • Vendor retains risks and rewards for items expected to be returned.
  • If a reasonable prediction of the returns is established → goods are “sold” and expected sale value is revenue.

Sales with Delayed Payment Terms

  • Risk of loss due to uncollectible accounts is higher in delayed payment sales, the seller retains legal title until all payments are received.
  • Inventory is considered sold if other revenue recognition criteria are met.

Purchase Commitments

  • Buying inventory in advance – title typically passes at delivery and may be considered work-in-process before that.
  • Ordinary orders → if the buyer/seller can cancel the order, there is no asset/liability or reporting.
  • Non-cancellable purchase contracts – No asset or liability is recognized because it is executory and neither party has performed.
  • Onerous Contract → Unavoidable costs > benefits from receiving, so a loss provision is recognized under IFRS.
  • Contract Entry - Debit Loss on Purchase Contracts and Credit Liability for Onerous Contracts
  • Delivery Entry - Debit Inventory and Liability for Onerous Contracts and credit accounts payable.
  • If the price has recovered, liability for onerous contracts is reduced.
  • A resulting gain (Recovery of Loss) is reported in the period.

Summary of Inventory Recognition Based on Control, Risks, and Reward

Flow of Costs

  • Cost of Goods Manufactured represents product costs of goods completed and transferred to Finished Goods Inventory.
  • Refer to MGT223 notes to trace the flow of raw materials, direct labor, and manufacturing overhead to work in process to finished goods.
  • Finished Goods has the COGM become the COGS which is credited to the merchandise inventory.
  • Identify the effects of inventory errors on the financial statements and adjust for them.

Inventory Errors

  • Incorrectly included/excluded items create errors in the income statement and balance sheet.

Ending Inventory Misstated

  • Omission of items from the ending inventory causes several effects -


Statement of Financial Position

Statement of Income

  • Inventory Understated
  • COGS Overstated
  • Retained Earnings Understated
  • Net Income Understated
  • Working Capital Understated
  • Current ratio Understated
  • Effect carries over to the following year because the beginning inventory is affected (Understated), which causes net income to be affected (overstated).
  • The two errors are counterbalanced/offset.
  • Correcting Entry in Year 1 →
  • Debit Inventory and Credit Cost of Goods Sold
  • Correcting Entry in Year 2 →
  • Debit Inventory and Credit Retained Earnings
  • If the error is discovered after the second year is closed, no entry is required because it is offset.
  • Comparative financial statements for past years are restated and reported at those figures where required.


Purchases and Inventory Misstated

  • Certain goods are not recorded as a purchase and are not counted in ending inventory.

Statement of Financial Position

  • Statement of Income
  • Inventory Understated
  • Purchases Understated
  • Retained Earnings No Effect
  • Ending Inventory Understated
  • Working Capital No Effect
  • COGS No Effect
  • Current ratio Overstated
  • Net Income No Effect
  • Omitting purchase of goods and inventory results in less inventory and AP with understated purchases and ending inventory.
  • Net income is not affected because BOTH purchases and ending inventory are understated.
  • Total working capital doesn’t change, but current ratio is overstated because equal amounts were omitted from inventory and AP.
  • Some possible errors include →
  • Not recording a purchase but counting inventory, not recording a sale even though items are delivered, omitting adjusting entry to update allowance for returns, and failing to adjust inventory to lower of cost and net realizable value.
  • Determine the components of inventory cost

Costs Included in Inventory

  • Inventory cost is made up of all costs of purchase, conversion, and other costs incurred in brining inventories to present location and condition.

Purchase Discounts

  • Suppliers offer cash discounts to purchasers for prompt payment – there are 2 alternate methods to account for purchases and discounts:
  • Gross Method – Purchases and payables recorded at the gross amount of the invoice and purchase discounts later taken are credited to a Purchase Discounts account.
  • Net Method – Records the purchases and payables initially at an amount net of cash discounts. If it is paid within the discount period, cash payment = amount originally set up.
  • If paid after the discount period, record in Purchase Discounts Lost.
  • More theoretically appropriate because it provides a correct reporting of asset cost and liability, and it makes it possible to measure the inefficiency of financial management if discount is not taken.

  • Gross Method → purchase discounts are deducted from purchases in determining cost of goods sold.
  • Net Method → purchase discounts not taken are a financial expense reported under Other Expenses.

Vendor Rebates

  • Cash rebates a reduction of the purchase cost of inventory per unit purchased after a certain amount is purchased.
  • General Rebates:
  • Discretionary on the part of the supplier → no rebate is recognized until paid or obligated.
  • Probable and reasonably estimated – recognize the rebate as a reduction in the cost of purchases for the period. Allocate AR between goods remaining in inventory and goods sold.
  • Amount of the receivable recognized is based on the proportion of the total rebate expected relative to transactions to date.

  • Calculation → (Total number of units in a year x rebate) x current units purchased/total units in a year
  • Or current units purchased x rebate.


Product Costs

  • Product costs attach to inventory and are recorded in the inventory accounts.
  • Connected with bringing goods to the buyer’s place of business and converting them to a salable condition.
  • Includes Freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs.
  • IFRS → Includes eventual decommissioning or restoration costs “asset retirement”
  • ASPE → Add the costs to related property, plant, equipment.
  • Taxes → Taxes that cannot be recovered are a cost of inventory (i.e. provincial sales tax on resale/manufacturing goods).
  • Taxes that can be recovered are not included as inventory’s cost. (i.e. HST)
  • Conversion Costs – Includes direct labor and an allocation of the fixed and variable production overhead costs incurred in processing direct materials into finished goods.
  • Based on normal production capacity – If production levels are very high, fixed costs are spread out over larger number of units produced.


Borrowing Costs

  • Interest costs to finance activities to help prepare inventories for sale.
  • IFRS → interest costs are product costs if they are incurred for inventory items that take more time to complete.
  • If financing relates to large quantity manufactured inventory, companies may choose to capitalize them or not.
  • ASPE → If interest is capitalized, disclose the amount and the policy.

Standard Costs

  • Standard Cost System – Predetermines the unit costs for material, labor, and MOH.
  • Based on costs incurred per unit of finished goods at normal levels of efficiency/capacity.
  • If actual costs do not equal standard costs, differences are recorded in variance accounts.
  • Acceptable only if results approximate actual costs.
  • Unallocated MOH is expensed as it is incurred.

Cost of Service Providers’ Work in Process

  • Service companies accumulate significant work-in-process inventories as well – and are measured at production costs.
  • Typically direct labor from service personnel and MOH.

Costs Excluded from Inventory

  • Costs closely related to acquiring and converting a product but not considered as a product cost.
  • i.e. storage costs
  • Selling expenses, general and administrative expenses are not considered directly related to the acquisition or conversion of goods – they are period costs.

“Basket” Purchases and Joint Product Costs

  • A group of units with different characteristics is purchased at a single lump-sum price in a basket purchase.
  • Relative Sales Value Method - Allocate the total cost amount the various units based on their relative sales value.
  • Used to allocate a joint cost.

Distinguish between perpetual and periodic inventory systems and account for them.

Inventory Accounting Systems

Perpetual System

  • Perpetual Inventory System continuously tracks changes in the Inventory account.
  • Cost of all purchases and cost of items sold are recorded directly in the Inventory account as purchases/sales occur.
  • Accounting Features
  • Purchases of merchandise for resale or raw materials for production are debited to Inventory rather than Purchases.
  • Freight-in is debited and purchase returns and allowances and purchase discounts are credited to Inventory instead of being accounted for in separate accounts.
  • The Cost of items sold is recognized at the time of sale by debiting Cost of Goods Sold and crediting Inventory.
  • Inventory is a control account supported by a subsidiary ledger of individual inventory records.
  • Subsidiary records show the quantity and cost of each type of inventory on hand.
  • Provides a continuous record of balances in Inventory account and COGS account.


Periodic System

  • Periodic Inventory System – Quantity of inventory on hand is determined periodically.
  • Acquisition of inventory is recorded by a debit to Purchases Account.
  • Total in Purchases at end of period is added to Cost of Inventory on hand next period.
  • Cost of ending inventory is subtracted from the cost of goods available to calculate COGS.
  • COGS is a residual amount that depends on calculating the cost of ending inventory. (Physically counting and costing it)

Comparing Perpetual and Periodic Systems

  • Perpetual inventory continues to transfer in and out of the inventory account, with sales debiting the COGS and end of period entries requiring no entry.
  • If there is a difference between perpetual inventory record and physical count, we use the separate entry to adjust it. “Inventory Over and Short.”
  • Due to shrinkage, breakage, shop-lifting, etc. and reported as “Loss on Inventory” on other revenues/gains or other expenses/losses (income statement)

  • Periodic Inventory transfers the amount using Purchases, and Purchase Returns accounts, and requires an end of period entry to take everything out of purchases, and reallocate to Returns, Inventory, and COGS.
  • No separate account for Over and Short because there is no up-to date inventory account to compare.

Supplementary System → Quantities Only

  • Quantities only system – Logs detailed inventory records of increases/decreases in quantities only rather than dollar amounts.
  • The record is not part of double-entry, so periodic system is still required in main accounts.
  • Companies typically take a physical inventory once a year – Dangers of loss and error are always present, so the company requires periodic verification of inventory records by counts compared with the detailed records.
  • Correct the records so that they agree.

Objective 7 → Identify and apply GAAP cost formula options and indicate when each cost formula is appropriate.

Cost Formulas

  • Cost formulas assign inventory costs incurred during the accounting period to inventory still on hand at the end of the period (ending inventory) and to inventory sold during the period (COGS).

Specific Identification

  • Each item that is sold and each item in inventory needs to be identified.
  • Costs of specific items sold is in COGS and costs of specific items on hand is in ending inventory.
  • Effective for goods not ordinarily interchangeable and for goods/services produced and separated for specific projects.
  • This is so that the benefit is achieved and to prevent management from manipulating net income.
  • Most used in situations of relatively small number of items that are costly and distinguishable.

  • If used more generally, managers can sell more expensive products to boost net income and allocating costs can become arbitrary.
  • It is difficult to related shipping charges, storage costs, discounts, and other blanket costs to a specific inventory item.

Weighted Average Cost

  • Takes into account that volume of goods acquired at each price is different.
  • Beginning inventory units and cost are included in calculating the average cost per unit.

Calculation Weighted average cost per unit = total cost / number of units.

  • Moving-average Cost Formula – Used with perpetual inventory records kept in both units and dollars.
  • A new average unit cost is calculated each time a purchase is made because COGS at the updated average cost has to be recognized.
  • Calculation Cost of units available / Units available.
  • (Balance in price + (purchased units x the price bought at)) / (balance in units + purchased units)

  • Reasonable to cost items based on an average price – and is simple to apply, is objective, and not very open to income manipulation.

First-In, First-Out (FIFO)

  • Assigns costs based on the assumption that goods are used in the order in which they are purchased.
  • “First items purchased” are the first ones “used” or “sold.” Inventory remaining comes from recent purchases.
  • Periodic Inventory – Ending inventory cost for all units remaining is calculated by taking the cost of the most recent purchase and working back until all units in the ending inventory are accounted for.

  • Perpetual Inventory – With quantities and dollars, a cost figure is attached to each withdrawal from inventory – keep track of the cost of the inventory that moves in and out of the company.

  • In both FIFO, COGS and ending inventory are the same.
  • Objective → roughly follow the actual physical flow of goods, and it does not permit manipulation of income.
  • Ending inventory is close its current cost as well.
  • Disadvantage - current costs are not matched against current revenues on the income statement. Gross profit and net income may be distorted because oldest costs are charged.

Choice of Cost Formula

  • Objectives
  • Approach should correspond to the physical flow of goods.
  • Inventory costs should be representative of recent cost.
  • The same method should be used for all inventory assets with similar economic characteristics for the entity.
  • Consider income taxes – An average cost formula results in recent costs reflected more in COGS so there may be tax advantages.
  • Should be consistent.

Last-In, First-Out (LIFO) – the legacy

  • Assigns cost based on assumption that the cost of the most recent purchase is the first cost to be charged to COGS.
  • No longer permitted under ASPE/IFRS:
  • Doesn’t represent actual flow of costs.
  • Balance sheet isn’t a fair representation of recent cost of inventories on hand.
  • Distorts reported income → old inventory costs may be expensed due to a reduction in base inventory.

Objective 8 → Explain why inventory is measured at the lower of cost and net realizable value and apply the lower of cost and net realizable standard.

Lower of Cost and Net Realizable Value

Rationale for Lower of Cost and Net Realizable Value (LC&NRV)

  • Decide whether cost is appropriate for recording inventory on the balance sheet.
  • Cost is not appropriate if the asset’s value is less than its carrying amount.
  • That is why inventories are measured at LC&NRV.
  • Justification
  • Readers presume current assets can be converted into at least as much cash as the amount reported.
  • A loss of utility should be deducted from revenues in the period of loss, not the period where it is sold.
  • Net Realizable Value – The estimated selling price less the estimated costs to complete and sell the goods – a.k.a. the new definition of “market.”

What is Net Realizable Value

  • NRV is an estimate that changes over time for several reasons:
  • Inventories deteriorate.
  • Selling prices fluctuate.
  • Substitute products appear.
  • Input costs to sell, liquidate, or dispose of the product vary with conditions and markets the inventory is sold into.
  • Estimates are based on the best evidence available and shortly after the balance sheet data.
  • A new assessment is required at each new balance sheet or if economic circumstances change causing the estimate to change.

Application of LC&NRV

  • Standard: Inventory is valued at cost unless NRV is lower than cost, in which case inventory is valued at NRV.
  • Steps →
  • Determine the cost.
  • Calculate the NRV.
  • Compare the two.
  • Use the lower value to measure inventory for balance sheet.
  • Analysis is usually applied only to losses in value that occur in the normal course of business.
  • If amount is significant, carry out goods in separate inventory accounts.
  • Typically comparison is applied on an item-by-item basis.
  • Grouping is appropriate for inventory items related in end use, produced/marketed in the same geographical area, and for items that cannot be evaluated separately from other items in a product line.
  • Item-by-item approach is the more conservative method → net realizable values above cost are not included in calculation.
  • Different totals may arise from applying the rule to subtotals as individual realizable values lower than cost are offset against ones higher than cost.

Recording the LC&NRV

  • There are 2 different methods for recording inventory at lower market amount:
  • Direct Method – Records NRV of inventory directly in the Inventory Account if amount < cost.
  • All loss is buried in COGS, so no loss is reported separately in the income statement.
  • Indirect Method (Allowance Method) – recognize a loss account (contra-asset to Inventory) in the income statement to record the write-off.
  • Periodic - transfer beginning inventory and record ending inventory.

  • Perpetual - Reduce inventory from cost to NRV.

  • Identifying the loss due to decline in NRV separately allows it to clearly disclose the loss resulting in market decline.
  • The allowance account should be retained if the inventory is still on hand but closed if it is sold.
  • Some accountants leave it on the books and adjust it for new LC&NRV.
  • Changing prices cause the allowance to incur losses or gains. (It should not have a debit balance because recovering loss cannot exceed original cost)

Evaluation of LC&NRV

  • Recognizing NRV only when they are lower than cost causes distortions of income.
  • Accounting values reported are not neutral and unbiased measures of income/net assets.
  • Companies may over/underestimate realizable values for desired results.
  • Many financial statement users appreciate LC&NRV because inventory and income are not overstated.

Objective 9 → Identify inventories that are or may be valued at amounts other than the lower of cost and net realizable value.

Exceptions to Lower of Cost and Net Realizable Value Model

Inventories Measured at Net Realizable Value

  • Criteria →
  • The sale is assured or there is an active market for the product/minimal risk of failure to sell.
  • Costs of disposal can be estimated.
  • May be used for certain industries (i.e. agricultural produce, forest producers) or when cost figures are too difficult to obtain.

Inventories Measured at Fair Value Less Costs to Sell

Inventories of Commodity Broker-Traders and Similar Entities

  • These business models measure at fair value less costs to sell.
  • i.e. grain and livestock futures contracts.
  • Recognized in the net income in the period of the change and assigned an asset level 1-3 depending on the level of inputs to measure fair value.

Biological Assets and Agricultural Produce at Point of Harvest

  • Refer to Illustration 8-26 on Page 465 for IFRS’ list of biological assets and agricultural produce.
  • ASPE Inventories of biological assets and products of biological assets at point of harvest are excluded from measurement requirements of ASPE if they are accounted for at NRV and in accordance with industry practices.
  • Inventories must follow expense recognition and disclosure.
  • IFRS Accounting for biological assets and agricultural produce at point of harvest is under IAS 41. They don’t fall under IAS 2 for measurement.

Objective 10 → Apply the gross profit method of estimating inventory.


Estimating Inventory

The Need for Estimates

  • Estimation methods are used to approximate physical inventory at hand to verify the accuracy of perpetual inventory amounts or arrive at an inventory amount.

Applying the Gross Profit Method

  • Three Premises
  • Cost of Goods Available for sale = the beginning inventory + purchases.
  • Goods not included in COGS is on hand in ending inventory.
  • When an estimate of COGS is deducted from cost of goods available for sale, the result is an estimate of ending inventory.
  • Calculation: Gross Profit = Percentage x Sales at Selling Price.
  • To find estimated inventory, (beginning inventory + purchases) – sales at cost.

  • COGS percentage is the complement of the gross profit percentage.
  • Estimated Cost of Goods sold percent + gross profit percent = 100%


Gross Profit Percentage vs. Markup on Cost

  • Gross Profit Percentage is typically used – the gross profit as a percentage of the selling price.
  • Most goods are stated on a retail basis.
  • A profit quoted on selling price < one based on cost, and the lower rate gives a favourable impression to the consumer.
  • Gross profit based on selling price cannot exceed 100%.
  • Calculation: Gross Profit Percentage = Gross Profit / Selling Price.
  • Percentage of Markup on Cost = Gross Profit / Cost
  • Selling Price = Cost + Gross Profit.

Using the Results

  • Disadvantages →
  • Gross profit provides an estimate only.
  • Gross profit method uses past percentages in determining the markup. A current rate is more appropriate.
  • It may be inappropriate to apply a single gross profit rate.
  • The gross profit method is an estimate, so it is not normally accepted for financial reporting purposes – it is an additional verification of inventory.
  • i.e. interim reporting and insurance purposes.

Objective 11 → Identify how inventory should be presented and the type of inventory disclosures required by IFRS and ASPE.

Presentation and Disclosure of inventories

  • Inventories are a significant asset for a manufacturing and merchandising company and of many service enterprises.
  • They must disclose additional info:
  • Choice of accounting policy adopted to measure inventory.
  • Carrying amount of the inventory in total and by classification (i.e. supplies, material, work in process, finished goods.)
  • Amount of inventories recognized as an expense in the period, including unabsorbed and abnormal amounts of overhead.
  • Carrying amount of inventory pledged as collateral for liabilities.
  • IFRS → requires additional disclosures including considerable info such as carrying amount of inventory carried at fair value less costs to sell and details about inventory writedowns/reversal of writedowns.

Image result for mann co keyObjective 12 → Explain how inventory analysis provides useful information and apply ratio analysis to inventory.

Analysis

  • Use financial ratios to evaluate the inventory levels.
  • Inventory Turnover Ratio – Measures number of times on average that inventory is sold during the period.
  • Helps to measure the liquidity of the investment in inventory. (Faster turnover = faster cash inflows)
  • Calculation: Cost of Goods Sold / Average Inventory.

  • Average Days to Sell Average age of the inventory on hand or the number of days to sell inventory after it is acquired.
  • Calculation: 365 / Inventory Turnover

Objective 13 → Identify differences in accounting between IFRS and ASPE, and what changes are expected in the near future.

  • There are few differences in recognition and measurement standards for most inventories.
  • Significant differences: separate international standard (IAS 41) covering biological assets and agricultural produce at the point of harvest and these assets are not specifically covered by ASPE.
  • See Illustration 8-34 on Page 447.
  • No major changes expected in the near future.

Objective 14 (Appendix 8A) → Apply the retail method of estimating inventory

  • Retailers use this identification to value their inventories if individual inventory units are significant.
  • Retail Inventory Method – Retail prices x Cost-to-retail ratio.
  • Requires certain info:
  • Total cost and retail value of goods purchased.
  • Total cost and retail value of goods available for sale.
  • Sales for the period.
  • Sales for the period are deducted from retail value of goods available for sale to get an estimate of ending inventory at retail (Selling prices).
  • Cost-to-retail Ratio = Total goods available for sale at cost / total goods available for sale at retail.
  • Inventory balance can be approximated without a physical count, useful for interim reports or for estimating losses from casualty.
  • Image result for winners price tagIt also functions as a control device to explain deviations from a physical count and speeds up the physical inventory count.

Retail Method Terminology

  • Markup – Increase in price above the original sales price.
  • Markup cancellations – Decreases in merchandise prices that had been marked up above retail price.
  • Net Markups – markups – markup cancellations.
  • Markdowns – Reductions in price below the original selling price. (common for decline in general price levels, special sales, damage, overstock, competition)
  • Markdown Cancellations – Markdowns are offset by increases in prices of goods that have been marked down.
  • Net Markdowns – markdowns – markdown cancellations.

Retail Inventory Method with Markups and Markdowns – Conventional Method

  • Conventional Method - Uses the cost-to-retail ratio that includes net markups but excludes net markdowns.
  • To approximate lower of cost and market, net markdowns are considered a current loss and not included in calculation.
  • Denominator is larger, and the ratio is lower.

  • Many possible cost-to-retail ratios can be → different inventory cost formula and valuation methods result in different ratio.

  • For FIFO, estimated ending inventory comes from purchases – so opening inventory at cost and retail is excluded in determining the ratio.
  • According to CPA Canada Handbook, in determining cost, markdowns are included – a separate adjustment must be made to obtain LR&NRV.


Special Items

  • Freight Costs – Part of purchase cost.
  • Purchase Returns – Reduction of cost price and retail price.
  • Purchase allowances – Reduction of purchase cost. (Unless normal selling prices are adjusted)
  • Purchase Discounts – Reduction of the purchase cost.
  • Sales return and allowances is an adjustment to gross sales.
  • Sales discounts to customers are not recognized when sales are recorded gross.
  • Transfers in from another department are reported the same way as purchases.
  • Normal Shortages are deducted in the retail column being no longer available for sale.
  • Abnormal Shortages – Deducted from both cost and retail columns before calculation of ratio, it’s reported as a special inventory amount or a loss.
  • Employee Discounts Deduct from the retail column.

Evaluation of Retail Inventory Method

  • It has an averaging effect for varying rates of gross profit.
  • Reasons for use →
  • Permits calculation of net income without physical inventory count.
  • It’s a control measure in determining inventory shortages.
  • Controls quantities of merchandise on hand.
  • It is a source of info for insurance and tax purposes.


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