1. Prepared by: Keri Norrie, Camosun College
ACCOUNTING PRINCIPLES
Third Canadian Edition
Prepared by: Keri Norrie, Camosun College

2. CHAPTER 6
INVENTORY COSTING

3. INVENTORY BASICS
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.

4. PERPETUAL VS. PERIODIC INVENTORY ACCOUNTING
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.

5. DETERMINING INVENTORY QUANTITIES
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.

6. 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).

7. 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).

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

9. DETERMINING OWNERSHIP OF CONSIGNED GOODS
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.
Owned by a consignor; do not count in our (consignee) inventory
Consignee Company

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

11. 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.

12. USING COST FLOW ASSUMPTIONS
Other cost flow assumptions are allowed since specific identification is often impractical.
These assume flows of costs 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).

13. FIFO
The FIFO cost flow assumption 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.

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

15. AVERAGE COST
The average cost flow assumption 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.

16. Allocation of the cost of goods available for sale in average cost flow assumption is made on the basis of the weighted average unit cost

17. Average cost flow assumption assumes that goods available for sale are homogeneous

18. LIFO
The LIFO cost flow assumption 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.

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

20. 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.

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

22. USING INVENTORY COST FLOW ASSUMPTIONS CONSISTENTLY
A company needs to use its chosen cost flow assumption 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 assumption, the change and its effects on net income should be disclosed in the financial statements.

23. INVENTORY ERRORS – INCOME STATEMENT EFFECTS
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.

24. 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.

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

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

27. VALUING INVENTORY AT THE LOWER OF COST AND MARKET
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.

28. ALTERNATIVE LOWER OF COST AND MARKET (LCM) RESULTS1 4 , T o t a l 6 3 5 9 i n v e r y 8 $ C o s t M a r k e L T l v i n 6 , $ 5 P b 4 2 1 7 V d q u p m R c 8
The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation.

29. USING THE INFORMATION IN THE FINANCIAL STATEMENTS
Inventory is particularly important because:
It is a large current asset on the balance sheet
It becomes a large expense on the income statement
It is vulnerable to theft or misuse

30. USING THE INFORMATION IN THE FINANCIAL STATEMENTS
A balancing act is needed to ensure that a sufficient, but not excessive, quantity of inventory is on hand.
Two ratios help evaluate the management of inventory:
Inventory turnover
Days sales in inventory

31. INVENTORY TURNOVER
Inventory turnover =
Cost of goods sold
Average inventory

32. DAYS SALES IN INVENTORY
Inventory turnover

33. COPYRIGHT
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