2. INVENTORY VALUATION CHAPTER 6

3. Perpetual vs. Periodic Inventory (Remember?) 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 mind-numbing detail.

4. SOURCE OF INVENTORY VALUE: HOW DO YOU ALLOCATE OF INVENTORIABLE COSTS? Beginning Inventory Goods Purchased during period Cost of Goods Available for Sale GAFS Ending Inventory (Balance Sheet) Cost of Goods Sold (Income Statement) Not Sold Sold This means inventory valuation has two main effects: 1.Balance Sheet: current assets 2.Income Statement: Cost of Goods Sold Why?: Because the value of the ending inventory determines how GAFS will be split between Inventory and COGS.

5. There are three reasons why the valuation of inventory is important: 1. Inventory is often the largest asset on a business’s balance sheet 2. COGS is usually the most significant expense on the income statement. 3. Due to the nature of a business’s cost structure (i.e. a small change in ending inventory = a big change in final Net Income). THE SIGNIFICANCE OF INVENTORY

6. Cost structure of a typical business: THE SIGNIFICANCE OF INVENTORY Net Sales COGS Gross Profit Operating Expenses Net Income $1,000,000 700,000 770,000 300,000 230,000 200,000 $100,000 $30,000 +Net Purchases etc. Beginning Inventory =Goods Available -(Ending Inventory) =Cost of Goods Sold So a small error in inventory, can have a big effect on Net Income NOTE: Ending inventory and Net Income move in the same direction.

7. Seller Buyer Public Carrier Co. REVENUE RECOGNTION (TERMS OF SALE) REVENUE RECOGNTION (TERMS OF SALE) Public Carrier Co. Buyer Seller Ownership passes to the buyer at the… F.O.B. Shipping Point Destination Ownership does not pass to the buyer until the… …and thus the buyer pays for the shipping! …and thus the seller pays for the shipping! As well, you must include these goods in your inventory count if not yet delivered.

8. In order to prepare financial statements, you must determine: 1. The number of units of inventory owned, and 2. Value them. The determination of inventory quantities involves: 1. Counting goods on hand, and 2. Determining the ownership of goods. ENDING INVENTORY VALUATION DETERMINING INVENTORY QUANTITIES ENDING INVENTORY VALUATION DETERMINING INVENTORY QUANTITIES

9. TAKING THE PHYSICAL INVENTORY A company should adhere to internal control principles in order to minimize errors and fraud in inventory counts: 1. Segregation of duties Employees who do not have custodial responsibility for the inventory should do the counting. 2. Establishment of responsibility Each counter should establish authenticity of each inventory item. 3. Independent verification Another employee should make a second count. At the end of the count, a supervisor should ascertain that all inventory items are tagged and that no items have more than one tag. 4. Documentation procedures All inventory tags should be pre-numbered and accounted for.

10. INVENTORY VALUATION METHOD 1: ACTUAL PHYSICAL FLOW COSTING INVENTORY VALUATION METHOD 1: 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.

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

12. FIFO (First In, First Out) The FIFO method assumes that the earliest goods purchased are the first to be sold. – (This often reflects the actual physical flow of merchandise). Under FIFO, the first goods purchased in the period are assumed to be the first sold The ending inventory consists of the most recently purchased.

13. LIFO (Last In, First Out) First goods purchased remain in ending inventory. – (Seldom coincides with the actual physical flow of inventory). Rarely used in Canada.

14. 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.

15. Ending Inventory VALUATION METHODS: FIFO, Average Cost, LIFO VALUATION METHODS: FIFO, Average Cost, LIFO Time Prices Beginning Inventory

16. VALUATION METHODS: Comparison Chart: BS and IS Effects VALUATION METHODS: Comparison Chart: BS and IS Effects

17. Ending Inventory VALUATION METHODS: FIFO, Average Cost, LIFO VALUATION METHODS: FIFO, Average Cost, LIFO Time Prices Beginning Inventory

18. VALUATION METHODS: Comparison Chart: BS and IS Effects VALUATION METHODS: Comparison Chart: BS and IS Effects

19. Ending Inventory VALUATION METHODS: FIFO, Average Cost, LIFO VALUATION METHODS: FIFO, Average Cost, LIFO Time Prices Beginning Inventory

20. VALUATION METHODS: Comparison Chart: BS and IS Effects VALUATION METHODS: Comparison Chart: BS and IS Effects

21. Ending Inventory VALUATION METHODS: FIFO, Average Cost, LIFO VALUATION METHODS: FIFO, Average Cost, LIFO Time Prices Beginning Inventory

22. VALUATION METHODS: Comparison Chart: BS and IS Effects VALUATION METHODS: Comparison Chart: BS and IS Effects

23. VALUATION METHODS: Comparison Chart: BS and IS Effects VALUATION METHODS: Comparison Chart: BS and IS Effects

24. VALUATION METHODS: Comparison Chart: BS and IS Effects VALUATION METHODS: Comparison Chart: BS and IS Effects

25. In Summary: 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.

26. FIFO produces the best balance sheet valuation. This is because the inventory costs are closer to their current, or replacement, costs (since what’s left is the most recently purchased). In Summary: BALANCE SHEET EFFECTS In Summary: BALANCE SHEET EFFECTS Why?

27. INVENTORY VALUATION AND THE CONSISTENTCY GAAP 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 fiscal 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.

28. Both beginning and ending inventories appear on the income statement for the periodic method. The ending inventory of one period automatically becomes the beginning inventory of the next period. An inventory error in this period, affects: – COGS in this period, and thus – Net income in this period, as well as – Ending inventory in this period, and – Beginning inventory next period INVENTORY ERRORS - INCOME STATEMENT EFFECTS Example: Ending Inventory is overstated.

29. 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

30. 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 method. Market is defined as replacement cost or net realizable value. VALUING INVENTORY AT THE LOWER OF COST AND MARKET

31. ALTERNATIVE LOWER OF COST AND MARKET RESULTS Total Method 2,000 Item by Item Method 9,000 DateParticularsDebitCredit Dec. 31 Loss on write down of inventory to LCM 2,000 Inventory 2,000 (Total Method)

32. Do the following Problems: P6-4A P6-5A P6-6A P6-8A (c & d)