1. Accounting Principles
Second Canadian Edition
Weygandt · Kieso · Kimmel · Trenholm
Prepared by: Carole Bowman, Sheridan College
Julia Banks, Cairine Wilson S.S

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:
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. SALES TRANSACTIONS
Only one entry is required to record a sale under a periodic method.
There is no immediate update to the merchandise inventory and cost of goods sold.
There is no cost of goods sold account under the periodic system.
The Cost of Goods Sold is calculated at the end of the period after a physical inventory count is taken.

11. 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.

12. 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.
Under the Perpetual Method, you would have debited the Merchandise Inventory account.

13. 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.
There is NO Purchase Returns and Allowances when using the Perpetual Method for inventory.

14. ACCOUNTING FOR FREIGHT COSTS
When the purchaser directly incurs the freight costs, the account Freight In is debited and Cash is credited.
Under the perpetual method, the freight costs are debited directly to the merchandise inventory account.

15. Calculating Cost of Goods Sold
Cost of Goods Available For Sale
Beginning
Inventory
Cost of Goods Purchased (Purchases – Purchases Returns and Allowances + Freight In) +
Cost of Goods Available For Sale
Ending Inventory
Cost of Goods Sold - =

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

17. Closing Accounts for A Merchandise Company Using the Periodic System
Close Beginning Inventory to Capital
Ending Inventory is Debited and Credited to Capital.
Temporary accounts with credit balances are closed out to capital. (Sales, Purchase Returns and Allowances)
Temporary accounts with debit balances are closed out to capital. (Sales Returns and Allowances, Purchases, Freight-In, Salaries Expense, etc)
Drawings account is closed out to Capital.
The Merchandise Inventory account will not be equal to the ending inventory physical account, so the beginning must be closed out and the ending inventory opened to the Merchandise Inventory account.

18. 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.

19. 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.
Company selects a method and uses it on an ongoing basis to ensure consistent accounting recording practices.
Cost flow assumptions:
1. First-in, first-out (FIFO).
2. Average cost.
3. Last-in, first-out (LIFO).

20. FIFO – First In First Out
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.

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

22. Cost of Goods Available For Sale
FIFO – Calculating Cost of Goods Sold and Ending Inventory During the year 550 units were sold. Calculate the Cost of Goods Sold and the Ending Inventory.
Cost of Goods Available For Sale
Date
Explanation
Units
Unit Cost
Total Cost
1/1
Beginning Inv.
100
$10
$ 1,000
4/15
Purchase
200 11
2,200
8/24
300 12
3,600
11/27
400 13
5,200
TOTAL
1000
$12,000
Cost of Goods Sold
Ending Inventory
Date
Units
Unit Cost
Total Cost
1/1
100
$10
$1,000
11/27
400
$13
$5,200
4/15
200 11
2,200
8/24 50 12
600
250
3,000
Total
$6,200
$5,800

23. 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.

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

25. Average cost method assumes that goods available for sale are homogeneous

26. LIFO – Last-In, First-Out
The LIFO method assumes that the last 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.

27. LIFO method assumes last goods purchased are the first to be sold

28. Cost of Goods Available For Sale
LIFO – Calculating Cost of Goods Sold and Ending Inventory During the year 550 units were sold. Calculate the Cost of Goods Sold and the Ending Inventory.
Cost of Goods Available For Sale
Date
Explanation
Units
Unit Cost
Total Cost
1/1
Beginning Inv.
100
$10
$ 1,000
4/15
Purchase
200 11
2,200
8/24
300 12
3,600
11/27
400 13
5,200
TOTAL
1000
$12,000
Cost of Goods Sold
Ending Inventory
Date
Units
Unit Cost
Total Cost
11/27
400
$13
5,200
1/1
100
$10
$1,000
8/24
150 12
1,800
4/15
200 11
2,200
Total
550
$7,000
450
$5,000

29. Income Statement Effects Periods of Rising Costs
FRASER VALLEY ELECTRONICS
Condensed Income Statement
FIFO
Average Cost
LIFO
Sales
$11,500
$ 11, 500 $
Beginning Inventory
1 000
Purchases
11 000
Cost of Goods Available For Sale
12 000
Ending Inventory
5 800
5 400
5 000
Cost of Goods Sold
6 200
6 600
7 000
Gross Profit
5 300
4 900
4 500
Operating Expenses
2 000
Net Income
(Loss)
$3 300 $
$2 500

30. 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.

31. The reverse is true when inventory costs are decreasing over time.
Summary of Effects When Inventory Costs are Rising Over Time
FIFO
AVERAGE
LIFO
Cost of Goods Sold
Lowest
Between FIFO and LIFO
Highest
Gross/Profit/Net Income
Cash Flow (pretax)
Same
Ending Inventory
The reverse is true when inventory costs are decreasing over time.

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

33. 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.

34. 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.

35. FORMULA FOR COST OF GOODS SOLD
Beginning
Inventory
Cost of
Goods
Purchased
Ending
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.

36. 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.

37. 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

38. 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.

39. 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.

40. Gross Profit Method of Determining Ending Inventory
Commonly used to prepare interim (e.g. monthly) financial statements in a periodic inventory system.
Not used in preparing a company’s financial statement
Estimates the cost of ending inventory by applying a gross profit rate to net sales.

41. Gross Profit Method You need: Net sales
Cost of goods available for sale
Gross profit margin
Step 1
Net Sales – Estimated Gross Profit = Estimated Cost of Goods Sold
Step 2
Cost of Goods Available for Sale – Estimated Cost of Goods Sold = Estimated Cost of Ending Inventory

42. Gross Profit Example
Lalonde Company wishes to prepare an income statement for the month of January. Its records show:
net sales = $200,000
beginning inventory = $40,000
cost of goods purchased = $120,000
Previous year had a 30% gross profit margin and expects to earn the same this year.
Calculate the Estimated Cost of Ending Inventory

43. Gross Profit Method Step 1: Net Sales $200,000
Less: Estimated Gross Profit (30% of $200,000) ,000 **
Estimated Cost of Goods Sold $140,000 **
Step 2:
Beginning Inventory $ 40,000
Cost of Goods Purchased ,000
Cost of Goods Available For Sale ,000
Less:Estimated Cost of Goods Sold ,000 **
Estimated Cost of Ending Inventory $ 20,000 **
** Remember: Net Sales – Cost of Goods Sold = Gross Profit
Thus: Net Sales – Gross Profit = Cost of Goods Sold
Remember: Cost of Goods Available For Sale – Ending Inventory = Cost of Goods Sold
Thus: Cost of Goods Available For Sale – Cost of Goods Sold = Ending Inventory

44. Retail Inventory Method
For retail stores which have thousands of types of merchandise at low unit costs
Used to estimate the cost of inventory
To calculate you need:
Cost of goods available for sale
Retail value of goods available for sale

45. Retail Inventory Method
Step 1
Step 2
Step 3
Ending Inventory at RETAIL
Goods Available For Sale at RETAIL
Net Sales
--- =
Cost to Retail Ratio
Goods Available For Sale at RETAIL
Goods Available For Sale at COST / =
Cost to Retail Ratio
Estimated Cost of Ending Inventory
Ending Inventory at Retail = X

46. Retail Inventory Example
Given $ At Cost At Retail
Beginning Inventory $ $21 500
Goods Purchased
Goods available for sale $
Net Sales
1. Ending Inventory at Retail $
2. Cost to retail ratio = / = 75%
3. Estimated Cost of ending inventory = x .75 = $

47. Main Disadvantage
Retail Inventory Method is an averaging technique. You are basing your ending inventory value on the cost to retail ratio of all goods available.
Becomes an issue if what is left in inventory is not representative of the mix of all goods that were available for sale

48. COPYRIGHT
Copyright © 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.