INVENTORY COSTING CHAPTER 6

Needs to happen at least once a year This is done to verify or correct what you have on paper for your inventory value Actually count, weigh, or measure what you have in inventory Easiest to do when business is closed or sales are very low, so there isnt a lot of activity to cause confusion TAKING PHYSICAL INVENTORY

There are a couple of situations where people get confused about what to include in inventory 1. Goods in Transit 2. Consigned Goods TO COUNT OR NOT TO COUNT

Who do goods belong to when they are in the process of being shipped from the seller to the buyer? The answer is it depends on the terms of the transaction Whoever is paying for the shipping is the owner of the good during shipment FOB shipping point buyer is owner and should count as inventory FOB destination seller is owner and should count as inventory GOODS IN TRANSIT

When a company agrees to sell another companys goods for a fee without taking ownership of the item The holder of the goods (consignee) does not count these items in their inventory The shipper of the goods (consignor) does count them, as they still own the item(s) in question CONSIGNED GOODS

SPECIFIC IDENTIFICATION This is the best method for determining cost Each item is tagged with it`s cost, that follows the item as long as it is in the company With this method you could look at the remaining inventory and know the value This method is expensive and usually automated

INVENTORY COSTING Once the inventory is counted a value needs to be attached to it When all inventory for 1 specific item was purchased for the same price this is easy When inventory costs vary attaching a value becomes more difficult

BE 2, PAGE 317 Mary Anns Hat Shop counted the entire inventory in the store on August 31 and arrived at a total inventory cost of $ The count included $5000 of inventory held on consignment for a local designer; $500 of inventory that was being held for customers who were deciding if they actually wanted to purchase the merchandise; and $750 of inventory that had been sold to customers but was being held for alterations. There were two shipments of inventory received on September 1. The first shipment cost $6000. It had been shipped on August 29, terms FOB destination, and the freight charges were $240. The second shipment cost$3750. It had been shipped on August 28, terms FOB shipping point, and the freight charges were $150. Neither of these shipments were included in the August 31 count. Calculate the correct cost of the inventory on August 31.

ANSWERANSWER

BE6-3, BE6-4, E6-1, E6-2, E6-3 (a,b,c), E6-4 PRACTICEPRACTICE

USING ACTUAL PHYSICAL FLOW COSTING The specific identification method tracks the actual physical flow of the goods. Each item of inventory is marked, tagged, or coded with its specific unit cost. It is most frequently used when the company sells a limited variety of high unit-cost items.

USING ASSUMED COST FLOW METHODS Other cost flow methods are allowed since specific identification is often impractical. These methods assume flows of costs that may be unrelated to the physical flow of goods. Cost flow assumptions: 1. First-in, first-out (FIFO). 2. Average cost. 3.Last-in, first-out (LIFO).

Fraser Valley Electronics Assume that Fraser Valley Electronics has the following information for one of its products, a Z202 Astro Condenser: The company had a total of 1,000 units available for sale during the year. The total cost of the 1,000 units available for sale was $12,000. A physical inventory count at the end of the year determined that 450 units remained on hand. Consequently, it can be calculated that 550 (1, ) units were sold during the year.

FIFOFIFO The FIFO method assumes that the earliest goods purchased are the first to be sold. Often reflects the actual physical flow of merchandise. Under FIFO, the costs of the earliest goods purchased are the first to be recognized as cost of goods sold. The costs of the most recent goods purchased are recognized as the ending inventory.

FIFO method assumes earliest goods purchased are the first to be sold

AVERAGE COST The average cost method assumes that the goods available for sale are homogeneous. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred. The weighted average unit cost is then applied to the units sold to determine the cost of goods sold and to the units on hand to determine the ending inventory.

Average Cost Method

Average cost method assumes that goods available for sale are homogeneous

LIFO The LIFO method assumes that the latest goods purchased are the first to be sold and that the earliest goods purchased remain in ending inventory. Seldom coincides with the actual physical flow of inventory. Under the periodic method, all goods purchased during the year are assumed to be available for the first sale, regardless of date of purchase. Rarely used in Canada.

LIFO method assumes latest goods purchased are the first to be sold

BE6-5, BE6-6, BE6-7, BE6-8, E6-7, E6-8 PRACTICEPRACTICE

INCOME STATEMENT EFFECTS In periods of rising prices, FIFO reports the highest net income, LIFO the lowest and average cost falls in the middle. The reverse is true when prices are falling. When prices are constant, all cost flow methods will yield the same results.

FIFO produces the best balance sheet valuation since the inventory costs are closer to their current, or replacement, costs. BALANCE SHEET EFFECTS

USING INVENTORY COST FLOW METHODS CONSISTENTLY A company needs to use its chosen cost flow method consistently from one accounting period to another. Such consistent application enhances the comparability of financial statements over successive time periods. When a company adopts a different cost flow method, the change and its effects on net income should be disclosed in the financial statements.

Both beginning and ending inventories appear on the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Inventory errors affect the determination of cost of goods sold and net income. INVENTORY ERRORS - INCOME STATEMENT EFFECTS

FORMULA FOR COST OF GOODS SOLD + = Beginning Inventory Cost of Goods Purchased Ending Inventory Cost of Goods Sold _ The effects on cost of goods sold can be determined by entering the incorrect data in the above formula and then substituting the correct data.

EFFECTS OF INVENTORY ERRORS ON CURRENT YEARS INCOME STATEMENT An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period. Understate beginning inventory Understated Overstated Overstate beginning inventory Overstated Understated Understate ending inventory Overstated Understated Overstate ending inventory Understated Overstated

The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation: Assets = Liabilities + Owners Equity ENDING INVENTORY ERROR – BALANCE SHEET EFFECTS Overstated Overstated None Overstated Understated Understated None Understated

When the value of inventory is lower than the cost, the inventory is written down to its market value. This is known as the lower of cost and market (LCM) method. Market is defined as replacement cost or net realizable value. VALUING INVENTORY AT THE LOWER OF COST AND MARKET

ILLUSTRATION 6-20 ALTERNATIVE LOWER OF COST AND MARKET (LCM) RESULTS The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation.

INVENTORY TURNOVER Shows how many time inventory is sold, or turns over in a period The higher the turns the less money is tied up in inventory The higher the inventory turns the better COGS Average Inventory Inventory Turnover

DAYS SALES IN INVENTORY Takes inventory turnover and puts into terms of how long inventory is on hand before it sells Holding inventory costs money The lower the better Days Sales In Inventory Inventory Turnover Days in Year

PRACTICEPRACTICE BE6-9, BE6-10, BE6-11, BE6-15, BE6-16, E6-9, E6-10, E6-11(a) REVIEWREVIEW P6-7A, P6-8A