Chapter 8: Cost-Based Inventories and Cost of Sales

Chapter 8: Cost-Based Inventories and Cost of Sales

Case8-1Love Your Pet, Inc.

8-2Alliance Appliance Ltd.

8-3Terrific Titles Inc.

Suggested Time

Technical Review

TR-1Right to Recovery Asset...... 5

TR-2Inventory Cutoff...... 5

TR-3Cost of Inventory Item...... 5

TR-4Cost of Manufactured Item...... 5

TR-5Inventory Holding Gains/Losses...... 5

TR-6Lower of Cost or NRV...... 15

TR-7Damaged Inventory...... 5

TR-8Onerous Contract...... 5

TR-9Gross Margin Method...... 10

TR-10Retail Inventory Method...... 10

Assignment A8-1Inventory Cost—Items to Include in Inventory...10

A8-2 Inventory Cost—Items to Include in Inventory...10

A8-3Inventory Cost—Items to Include in Inventory...20

A8-4Inventory Discounts and Rebates...... 10

A8-5Inventory Policy Issues...... 20

A8-6Lower of Cost or NRV...... 10

A8-7Lower of Cost or NRV—Income Effects...... 15

A8-8Lower of Cost or NRV—Direct Writedown

versusAllowance Method...... 20

A8-9Lower of Cost or NRV—Allowance Method....20

A8-10Lower of Cost or NRV—Allowance Method (*W)20

A8-11Lower of Cost or NRV—Two Ways to Apply....20

A8-12Lower of Cost or NRV and Foreign Currency....25

A8-13Obsolete Inventory...... 10

A8-14Purchase Commitment...... 10

A8-15Loss on Purchase Commitment...... 10

A8-16Inventory—Error Correction...... 25

A8-17Inventory-Related Errors...... 10

A8-18Inventory Errors...... 10

A8-19Gross Margin Method...... 10

A8-20Gross Margin Method (*W)...... 20

A8-21Retail Inventory Method...... 15

A8-22Retail Inventory Method (*W)...... 30

A8-23Gross Margin and Retail Inventory Methods.....35

A8-24Inventory Concepts—Recording, Adjusting,

Closing, Reporting...... 35

A8-25Statement of Cash Flows...... 20

A8-26ASPE—Accounting Policies...... 30

A8-27Inventory Cost Methods (Appendix) (*W)...... 20

A8-28Inventory Cost Methods (Appendix)...... 40

A8-29Inventory Cost Methods (Appendix)...... 30

A8-30InventoryPolicy Comparison (Appendix)...... 30

*W The solution to this assignment is on the text website, Connect.

This solution is marked WEB.

Cases

Case 8-1 Love Your Pet Inc.

Suggested Solution

Overview

LPI is preparing IFRS-compliant financial statements for the first time, and will be audited for the first time. The company has a line of credit that is limited to 70% of accounts receivable and 50% of inventory, and thus accounts receivable and inventory balances are important. Then company uses its financial statements for tax purposes, and tax minimization might be a reporting objective.

Issues

1. Loyalty program

2. Rebates

3. Manufacturing costs

4. Recall

5. FIFO versus average cost

6. Consignment goods

Analysis and recommendations

1. The free bags should be treated as a separate performance obligation in the sales transaction at the time of the initial sale (IFRS 15). LPI does not account for the free bags until the time of customer redemption. Instead, the fair value of the consideration in respect of the initial sale must be allocated between the award credits and the other components of the sale. LPI will need to apportion the sales revenue on each bag so that 10% of the sales amount is deferred and recorded as unearned revenue until the customer claims the “free” 11th bag. No deferral is required for the 40% of sales that have not been drawn to the program. LPI has been tracking redemptions, so the percentage of bags actually redeemed by the customers who take part in the program should be verifiable.

This is a change in accounting policy, to be accounted for retrospectively (IAS 8).

This change in accounting policy not have any impact on accounts receivable or inventory for purposes of the line of credit calculation, but it will reduce earnings because sales are being deferred.

2. Rebates for inventory must be deducted in determining the cost of purchase (IAS 2). LPI’s current policy is to defer recognition until the subsequent quarter when the amount of the rebate is known and received. Volumes have historically been met and purchases are increasing with sales continuing to grow in recent months. It is very likely that the minimum volumes will continue to be met, so the purchase discount should be recorded based on the estimated rebate expected, resulting in a 10% decrease in inventory and accounts payable at the time of purchase.

Again, this is a change in accounting policy, to be accounted for retrospectively (IAS 8).

The new policy will have the impact of decreasing inventory for purposes of calculating the maximum line of credit available. Earnings will increase, because of the growing volumes; larger discounts are being accrued earlier.

3. LPI has been expensing all manufacturing costs related to production other than direct labour and direct materials. The costs of conversion of inventories include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods (IAS 2).Accordingly, all costs of manufacturing operations should not be expensed during the period, as is presently the case.

Any costs of conversion that are presently expensed need to be allocated to units produced based on the normal capacity of the production facilities. Any units held in ending inventory should have a fixed manufacturing overhead component that is part of the total cost of these units.

This is a change in accounting policy to comply with the GAAP requirement for absorption costing and must be applied retrospectively.

If production is higher than sales in a given year this method, this will result in a higher amount in ending inventory for purposes of calculating the line of credit, as compared to expensing all costs during the period other than direct labour and direct materials.

4. The recall of the dry dog food brings two issues into question. The first issue is one of inventory valuation. LPI has chosen to remove all products from the supplier from its shelves due to health concerns, rendering them unsaleable, and therefore having no net realizable value. Given that the supplier has gone out of business, it is unlikely that there is any avenue for LPI to recover costs on this product. The carrying amount of these products must be removed from inventory completely and recorded as a loss in the current period; this is an impairment (IAS 2). If there is any subsequent reversal of any write-down of the inventory because amounts become recoverable, this is recognized in the reversal year. It seems unlikely there will be a reversal in this situation.

The impairment will result in lower inventory in the current period for purposes of calculating the available line of credit amount. Earnings will also decrease.

The second issue is the potential for contingent liabilities arising if customers file suit against LPI in their role as a distributor for the contaminated food. The batches held by LPI included some that were suspected of contamination. Presently, no action has been launched against LPI and there are no Canadian incidents. Lacking a loss incident, no accrual or note disclosure is required in the financial statements. This may be an issue for consideration in future periods.

5. This is a voluntary change in accounting policy, from FIFO to average cost. A voluntary change in accounting policy should be made if it results in information that is more relevant and reliable to the users of the financial statements (IAS 8). In this instance, a change from FIFO to the average cost method would arguably make LPI’s statements more comparable to competitors in the industry, making financial statements more relevant to users.

Once more, this is a change in accounting policy, to be accounted for retrospectively (IAS 8).

Given that prices are rising, a switch to average cost would result in higher cost of goods sold expense and lower ending inventory as compared to FIFO where the newer, higher costs would be averaged in cost of goods sold and not deferred in ending inventory. This would lower the gross margin in the current period and decrease the current ratio, decreasing the maximum borrowing amount based on the line of credit agreement. Earnings would decrease.

6. LPI does not pay for the rabbit food product until it is sold, giving Carly 80% of the retail price at that time. The inventory held at LPI locations has not actually been purchased, and therefore is not an asset to be recorded by LPI. This is consignment inventory and should not be recorded in LPI’s records. As an agent, the company will record only their sales commission as revenue, not the amount charged to the customer in-store. Because the rabbit food is not recorded as inventory, it will not be included for purposes of calculating the maximum line of credit available.

Conclusion

Many of the issues above affect income and inventory. If tax minimization is important, the overall impact will have cash flow implications, increasing or decreasing the tax paid. Inventory is significant with respect to the operating line of credit.

The company’s cash flow requirements over the coming year should be determined, using a cash budget. If the line of credit is close to its limits, the bank should be consulted in advance.

Case 8-2Alliance Appliance Ltd.

Overview

This case is designed to highlight the differences in financial reporting under IFRS as compared to ASPE. The student must adopt an advisory role and prepare a report to the CFO concerning ten specific issues. The issues mostly are general presentation issues, but a few also include more specific treatments, such as held-for-sale properties, inventory valuation, and an onerous contract.

Sample response

To: Chief Financial Officer, Alliance Appliance Ltd.

From: Maxwell Davies, Henry & Higgins

Date: 04 April 20X7

I have reviewed the reporting issues that you raised concerning a potential switch from ASPE to IFRS. I am happy to provide my advice, enumerated in the points that follow:

1. IFRS does not require specific financial statement titles; the titles you presently use are quite acceptable, with one exception. The exception is that instead of “Statement of Retained Earnings”, AAL would need to provide a “statement of changes in shareholders’ equity”. “Retained earnings” would be just one column within this statement.
2. On the income statement, expenses would need to be organized either by function within AAL or by nature (that is, by type of expense). For example, a functional classification could be by ‘assembly’ and by ‘distribution’. A classification by type of expense would, in contrast, be items such as employee expense (that is, wages, salaries, and benefits) and by depreciation expense. Consistent classification is necessary.
3. There will be no change in reporting preferred dividends under IFRS. Retained earnings will be one column in the statement of changes in shareholders’ equity, and dividends paid will continue to be a component displayed in that column.
4. The warranty is a separate performance obligation. Revenue must be allocated to this in the initial sale, and recognized over the warranty period.
5. Gains and losses from foreign currency transactions would continue to be shown on the income statement under IFRS, unless they are hedged, in which case they may pass through Other Comprehensive Income, which is a category of shareholders’ equity and be shown in the statement of changes in shareholders’ equity rather than on the income statement.
6. The Japanese contract would qualify as an “onerous contract” under IFRS; the amount by which the contract price is greater than the fair value would be recognized as a loss at the SFP date. ASPE doesn’t use that particular terminology, but the potential loss would also be recorded under ASPE.
7. Under both ASPE and IFRS, inventory written down can be written back up if fair value recovers, but no higher than their originally recorded cost.No adjustment or change in practice would be required.
8. Under ASPE, the asset exchange can be valued at either the value of the consideration or the value of the asset acquired, whichever is the more reliable measure. In contrast, IFRS requires that the value of the consideration be used, regardless of which measure is more reliable. The carrying value of the acquired lot will need to restated to the value of the Ottawa property, if and when AAL switches to IFRS.
9. The cumulative currency translation difference is treated essentially the same under ASPE and IFRS—a separate component of shareholder’s equity. The only difference is that under IFRS, the cumulative amount is shown on the statement of changes in shareholders’ equity as one component of other comprehensive income.
10. The building has been written down prematurely. It shouldcontinue to be reported at its depreciated cost (and depreciation should continue) until it has been abandoned. Once it is abandoned in 20X7, depreciation can cease and the asset should be written down to its recoverable value. Under IFRS, however, it cannot be reclassified as a held-for-sale asset unless it is likely to be sold within the next year. If no process for sale has begun, then the asset cannot be reclassified but must remain in the buildings account as an idle asset.

I hope my responses will help you in AAL’s potential shift to IFRS. Please do not hesitate to contact me if you’d like more information.

Best wishes,

Maxwell Davies, staff auditor

Henry & Higgins

© 2017 McGraw-Hill Education. All rights reserved

Solutions Manual to accompany Intermediate Accounting, Volume 1, 7th edition8-1

Case 8-3 Terrific Titles Inc.

Overview

The issues are:

• Inventory valuation
• Revenue recognition
• Expense recognition
• Intangible assets and deferred charges

If TTI acquires TLC, TLC will need to change its policies to conform with IFRS since TLC will be consolidated into TTI’s results, and therefore must follow IFRS.

There is some conflict between the accounting policies that TLC will have to adopt in the future and TTI’s immediate objective to establish a bid price based on earnings projections. A bid price would be based on TTI’s evaluation of (1) earnings potential and (2) volatility of earnings and/or cash flows. High earnings is good, but volatility is bad—the risk vs. return trade-off.

Sample response

Dear Ms. O’Malley:

I am pleased to report my findings concerning TLC’s accounting policies and practices. I believe that it will be necessary to make some adjustments to TLC’s reported numbers for 20X3 as well as take some additional factors into account when we project the company’s earnings into the future in order to establish a bid price.

One overriding consideration is that TLC, as a private company, seems to use a combination of Canadian accounting standards for private enterprises and some eclectic accounting policies that appear to be rather unorthodox. In effect, TLC uses a disclosed basis of accounting.If we acquire TLC, the company will need to change its accounting policies to conform with IFRS, since we use IFRS and we will need to consolidate TLC.

My discussion of the major issues is as follows:

a.Inventory valuation. TLC develops and produces its own books. All of the cost of development, production, and printing are included in inventory and allocated over the number of copies in each edition’s initial press run. The result is that the first print run has a huge unit cost while succeeding press runs (if any) bear only the cost of that particular print run. As a result, cost of goods sold will be very high for the initial run, quite likely yielding a negative gross margin for that initial run, even for a very successful book. For performance evaluation and for earnings prediction, these numbers are apt to be very misleading. As well, loading all of these costs into the inventoriable cost will usually result in an inventory value that is significantly higher than net realizable value. Therefore, the development costs should be removed from inventory and accounted for separately.

b.Development and production costs. We have a dichotomy in this regard. For financial reporting purposes, TLC will have to change their accounting policy for development costs to accord with IFRS, once we acquire them. One option is to expense development costs when they are incurred—even for historically successful books.An edition’s success may not be predictable with assurance, because new competitors enter the market regularly.

On the other hand, spreading the development and production costs over the 3-year life span of the book will assist with our prediction of future earnings (on which we base the bid price) as well as ongoing evaluation of TLC’s management. However, it is questionable as to whether these costs can properly be considered as an intangible asset, and thereby capitalized and amortized. IFRS discourages treating expenditures for new products as intangible assets (IAS 38, paragraph 69). Every new edition is, in effect, a new product, and therefore I recommend that TLC’s policy for these costs should be to expense them when incurred.

For our analytical purposes in developing a bid price, however, I suggest that we remove development and pre-production costs from inventories in recent prior years and amortize them over 3-year periods so we can discern the underlying earnings. Then we can look at the cash flow volatility over the years to measure the risk potential of the erratic production levels.

c.Revenue recognition. TLC recognizes revenue when books are shipped. However, there is a 6-month official return policy that is unofficially stretched for college and university bookstores, which account for 90% of total sales. The return rate seems to be difficult to predict. If it is not feasible to make a reliable estimate of the return rate, either overall or book-by-book, revenue recognition probably should be deferred until the 6-month “official” return period has ended. This will create a right to recovery asset on the books, for the books that can be returned,

d.Supporting material for instructors. The cost of providing free supporting materials for instructors can be considerable. They have no inventory value in the usual sense because their net realizable value is zero (even though students would love to get their hands on solutions manuals). The significant cost of these items suggests that instead of inventorying the costs, TLC should instead defer some of the revenue and treat each book’s sale as really having multiple performance obligations: (1) a book delivered to the students when they buy them, and (2) supporting material prepared and made available for instructors. While there is no measurable value for the second deliverable, an allocation of revenue could be based on the relative costs of the two deliverables.

e.Inventory valuation of returned books. TLC restores returned books to inventory at the unit cost they originally bore. This has two problems: (1) the original assigned cost is too high, as discussed above, and (2) if large quantities of a book are returned, it probably indicates that the book is unsuccessful and therefore that its net realizable value is much lower than the original unit cost. We will need to determine how much of the current inventory is comprised of returned books, and probably write off those books for our estimation process.