INVENTORY COSTING CHAPTER 6

In the balance sheet of merchandising and manufacturing companies, inventory is frequently the most significant current asset. In the income statement, inventory is vital in determining the results of operations for a particular period. Gross profit (net sales - cost of goods sold) is closely watched by management, owners, and other interested parties. INVENTORY BASICS

Perpetual vs. Periodic Inventory Accounting Perpetual – Updates inventory and cost of goods sold after every purchase and sales transaction Periodic – Delays updating of inventory and cost of goods sold until end of the period – Misstates inventory during the period This chapter covers the periodic inventory method.

In order to prepare financial statements, it is necessary to determine the number of units of inventory owned by the company at the statement date, and to value them. The determination of inventory quantities involves 1. taking a physical inventory of goods on hand, and 2. determining the ownership of goods. Taking a physical inventory involves counting, weighing, or measuring each kind of inventory on hand. DETERMINING INVENTORY QUANTITIES

TAKING A PHYSICAL INVENTORY A company, in order to minimize errors in taking the inventory, should adhere to internal control principles by adopting the following procedures: 1. Employees who do not have custodial responsibility for the inventory should do the counting (segregation of duties). 2. Each counter should establish the authenticity of each inventory item (establishment of responsibility).

TAKING A PHYSICAL INVENTORY 3. Another employee should make a second count (independent verification). 4. All inventory tags should be pre-numbered and accounted for (documentation procedures). 5. At the end of the count, a designated supervisor should ascertain that all inventory items are tagged and that no items have more than one tag (independent verification).

Seller Buyer Public Carrier Co. Ownership passes to buyer here Ownership passes to buyer here FOB Shipping Point FOB Destination Point TERMS OF SALE Public Carrier Co. Buyer Seller

Under a consignment arrangement, the holder of the goods (called the consignee) does not own the goods. Ownership remains with the shipper of the goods (consignor) until the goods are actually sold to a customer. Consigned goods should be included in the consignor’s inventory, not the consignee’s inventory. Consignee Company DETERMINING OWNERSHIP OF CONSIGNED GOODS Owned by a consignor; do not count in our (consignee) inventory

SALES TRANSACTIONS Only one entry is required to record a sale under a periodic method.

RECORDING SALES RETURNS AND ALLOWANCES The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a contra revenue account to the Sales account.

PURCHASES OF MERCHANDISE For purchases on account, Purchases is debited and Accounts Payable is credited. For cash purchases, Purchases is debited and Cash is credited.

PURCHASE RETURNS AND ALLOWANCES For purchases returns and allowances that were originally made on account, Accounts Payable is debited and Purchase Returns and Allowances is credited. The Purchase Returns and Allowances account is a contra account.

When the purchaser directly incurs the freight costs, the account Freight In is debited and Cash is credited. ACCOUNTING FOR FREIGHT COSTS

The multi-step income statement under the periodic system requires more detail in the cost of goods sold section, as shown above.

ALLOCATION OF INVENTORIABLE COSTS Beginning Inventory Goods Purchased during the year Cost of Goods Available for Sale Ending Inventory (Balance Sheet) Cost of Goods Sold (Income Statement)

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).

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.

Allocation of the cost of goods available for sale in average cost method is made on the basis of the weighted average unit cost

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

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 YEAR’S 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 + Owner’s 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.