Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Prepared by: Debbie Musil Kwantlen University College Chapter 6 Inventory Costing

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Determining Inventory Quantities All companies must count their inventory at least once a year All companies must count their inventory at least once a year The determination of inventory quantities involves The determination of inventory quantities involves Taking a physical inventory of goods on handTaking a physical inventory of goods on hand Determining the ownership of the goodsDetermining the ownership of the goods On board a public carrier as at the count dateOn board a public carrier as at the count date Look at FOB point to determine if they should be includedLook at FOB point to determine if they should be included

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Inventory Costing Specific Identification Specific Identification Tracks the actual physical flow of goodsTracks the actual physical flow of goods Each inventory item is marked with its costEach inventory item is marked with its cost Cost Flow Assumptions Cost Flow Assumptions Specific identification not always practicalSpecific identification not always practical A cost flow assumption is used instead:A cost flow assumption is used instead: First-in, first-out (FIFO)First-in, first-out (FIFO) Average costAverage cost Last-in, first-out (LIFO)Last-in, first-out (LIFO) Flow of costs may not match physical flowFlow of costs may not match physical flow

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. First-in, First-out (FIFO) Earliest goods purchased are assumed the first sold Earliest goods purchased are assumed the first sold Often reflects the actual physical flow of merchandise Often reflects the actual physical flow of merchandise Costing: Costing: Costs of earliest goods purchased are first to be recognized as Cost of Goods SoldCosts of earliest goods purchased are first to be recognized as Cost of Goods Sold Costs of most recent goods purchased are recognized as ending inventoryCosts of most recent goods purchased are recognized as ending inventory

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Using FIFO

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Average Cost Assumes that it is not possible to measure specific physical flow of inventory Assumes that it is not possible to measure specific physical flow of inventory Therefore better to use an average priceTherefore better to use an average price Allocation of cost of goods available for sale is based on weighted average unit cost Allocation of cost of goods available for sale is based on weighted average unit cost This is then applied: This is then applied: to units sold to determine cost of goods soldto units sold to determine cost of goods sold to units on hand to determine ending inventoryto units on hand to determine ending inventory

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Using Average Cost = +

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Last-in, First-out (LIFO) Latest goods purchased assumed to be first sold Latest goods purchased assumed to be first sold Seldom coincides with actual physical flow of inventory Seldom coincides with actual physical flow of inventory Costing: Costing: Costs of earliest goods purchased remain in ending inventoryCosts of earliest goods purchased remain in ending inventory Costs of most recent goods purchased are first to be recognized as Cost of Goods SoldCosts of most recent goods purchased are first to be recognized as Cost of Goods Sold Recent changes prohibit its use in Canada Recent changes prohibit its use in Canada

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Using LIFO

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Inventory Errors Effect of inventory errors on the current year’s income statement: Effect of inventory errors on the current year’s income statement: An error in ending inventory of one period will have the reverse effect on net income of the next period An error in ending inventory of one period will have the reverse effect on net income of the next period

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Balance Sheet Errors Effect can be determined by using the basic accounting equation: Effect can be determined by using the basic accounting equation: assets = liabilities + owner’s equity

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Inventory Valuation Lower of cost or market – when the value of inventory is lower than cost, it is written down to that lower value Lower of cost or market – when the value of inventory is lower than cost, it is written down to that lower value Market is defined as net realizable value Market is defined as net realizable value Selling price less any costs to make the goods ready for saleSelling price less any costs to make the goods ready for sale Assessed on an item-by-item basis Assessed on an item-by-item basis

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Inventory Ratios: Inventory Turnover Ratio = Cost of goods sold ÷ average inventory The number of times inventory “turns over” during a given period The number of times inventory “turns over” during a given period Average inventory is usually average of beginning and ending inventories Average inventory is usually average of beginning and ending inventories Days Sales in Inventory = Days in year ÷ inventory turnover ratio The number of days on average that the inventory is on hand before being sold The number of days on average that the inventory is on hand before being sold

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Inventory Costing in a Perpetual Inventory System FIFO: FIFO: FIFO rule is applied at the time of each sale*FIFO rule is applied at the time of each sale* Uses the oldest goods on hand before each sale in the FIFO calculationUses the oldest goods on hand before each sale in the FIFO calculation Weighted average: Weighted average: New average is calculated after each purchase*New average is calculated after each purchase* Usually referred to as moving weighted averageUsually referred to as moving weighted average LIFO: LIFO: LIFO rule is applied at the time of each sale*LIFO rule is applied at the time of each sale* Use the most recent purchases before each sale in the LIFO calculationUse the most recent purchases before each sale in the LIFO calculation *Instead of at the end of the accounting period

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Perpetual System Inventory Costing: FIFO Ending inventory and cost of goods sold under FIFO is the same for perpetual and periodic systems Ending inventory and cost of goods sold under FIFO is the same for perpetual and periodic systems

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Perpetual System Inventory Costing: Average Cost Under a perpetual inventory system, a new weighted average is calculated after each purchase. Under a perpetual inventory system, a new weighted average is calculated after each purchase. This average is then applied to: This average is then applied to: Units sold, to determine cost of goods soldUnits sold, to determine cost of goods sold Remaining units on hand, to determine ending inventoryRemaining units on hand, to determine ending inventory

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Perpetual System Inventory Costing: LIFO Latest units purchased before each sale are allocated to cost of goods sold (versus periodic: latest units bought during the period) Latest units purchased before each sale are allocated to cost of goods sold (versus periodic: latest units bought during the period)

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Estimating Inventories Not always possible or practical to count inventory – must be estimated Not always possible or practical to count inventory – must be estimated Two estimating methods are availableTwo estimating methods are available Gross profit method Gross profit = net sales x gross profit marginGross profit = net sales x gross profit margin Cost of goods sold = net sales less estimated gross profitCost of goods sold = net sales less estimated gross profit Estimated ending inventory = goods available for sale less cost estimated cost of goods soldEstimated ending inventory = goods available for sale less cost estimated cost of goods sold

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Estimating Inventories 2 Retail inventory method Cost-to-retail ratio: goods available for sale at cost / goods available for sale at retailCost-to-retail ratio: goods available for sale at cost / goods available for sale at retail Goods available for sale at retail less net sales = ending inventory at retailGoods available for sale at retail less net sales = ending inventory at retail Ending inventory at retail x cost-to-retail ratio = estimated cost of ending inventoryEnding inventory at retail x cost-to-retail ratio = estimated cost of ending inventory

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