INVENTORY COSTINGINVENTORY COSTING

CHAPTERCHAPTER

66

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 BASICSINVENTORY BASICSINVENTORY BASICSINVENTORY BASICS

Perpetual vs. PeriodicPerpetual vs. PeriodicInventory AccountingInventory AccountingPerpetual vs. PeriodicPerpetual vs. PeriodicInventory AccountingInventory 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 DETERMINING INVENTORY QUANTITIESQUANTITIES

DETERMINING INVENTORY DETERMINING INVENTORY QUANTITIESQUANTITIES

TAKING A PHYSICAL INVENTORYTAKING A PHYSICAL INVENTORYTAKING A PHYSICAL INVENTORYTAKING 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 INVENTORYTAKING A PHYSICAL INVENTORYTAKING A PHYSICAL INVENTORYTAKING 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

PublicCarrier

Co.

Ownership passes to buyer here Ownership passes to buyer here

FOB Shipping Point FOB Destination Point

TERMS OF SALETERMS OF SALETERMS OF SALETERMS OF SALE

PublicCarrier

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 DETERMINING OWNERSHIP OF CONSIGNED GOODSCONSIGNED GOODS

DETERMINING OWNERSHIP OF DETERMINING OWNERSHIP OF CONSIGNED GOODSCONSIGNED GOODS

Owned by a consignor; do not count in our (consignee) inventory

SALES TRANSACTIONSSALES TRANSACTIONSSALES TRANSACTIONSSALES TRANSACTIONS

J1Date Account Title and Explanation Ref Debit CreditMay 4 Accounts Receivable 3,800

Sales 3,800 To record credit sale.

General Journal

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

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

RECORDING SALES RETURNS RECORDING SALES RETURNS AND ALLOWANCESAND ALLOWANCES

RECORDING SALES RETURNS RECORDING SALES RETURNS AND ALLOWANCESAND 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.

The normal balance of Sales Returns and Allowances is a debit. Sales Returns and

Allowances is a contra revenue account to the Sales account.

J1Date Account Title and Explanation Ref Debit CreditMay 8 Sales Returns and Allowances 300

Accounts Receivable 300 To record returned goods.

General Journal

PURCHASES OF PURCHASES OF MERCHANDISEMERCHANDISE

PURCHASES OF PURCHASES OF MERCHANDISEMERCHANDISE

For purchases on account, Purchases is debited and Accounts Payable is credited. For

cash purchases, Purchases is debited and Cash is credited.

For purchases on account, Purchases is debited and Accounts Payable is credited. For

cash purchases, Purchases is debited and Cash is credited.

J1Date Account Title and Explanation Ref Debit CreditMay 4 Purchases 3,800

Accounts Payable 3,800 To record goods purchased on account, terms n/30.

General Journal

J1Date Account Title and Explanation Ref Debit CreditMay 8 Accounts Payable 300

Purchase Returns and Allowances 300 To record return of goods

General Journal

PURCHASE RETURNS AND PURCHASE RETURNS AND ALLOWANCESALLOWANCES

PURCHASE RETURNS AND PURCHASE RETURNS AND ALLOWANCESALLOWANCES

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.

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.

J1Date Account Title and Explanation Ref Debit CreditMay 4 Freight In 150

Cash 150 To record payment of freight.

General Journal

When the purchaser directly incurs the freight costs, the account Freight In is

debited and Cash is credited.

When the purchaser directly incurs the freight costs, the account Freight In is

debited and Cash is credited.

ACCOUNTING FOR FREIGHT COSTSACCOUNTING FOR FREIGHT COSTSACCOUNTING FOR FREIGHT COSTSACCOUNTING FOR FREIGHT COSTS

Sales revenueSales 480,000$ Less: Sales returns and allowances 20,000

Net sales 460,000$ Cost of goods sold

Inventory, January 1 36,000$ Purchases 325,000$ Less: Purchase returns and allowances 17,200 Net purchases 307,800$ Add: Freight in 12,200 Cost of goods purchased 320,000 Cost of goods available for sale 356,000$ Inventory, December 31 40,000

Cost of goods sold 316,000 Gross profit 144,000$ Operating expenses

Salaries expense 45,000$ Rent expense 19,000 Utilities expense 17,000 Advertising expense 16,000 Amortization expense 8,000 Freight out 7,000 Insurance expense 2,000

Total operating expenses 114,000 Net income 30,000$

For the Year Ended December 31, 2002

HIGHPOINT ELECTRONICSIncome Statement

The multi-step income statement under the periodic system requires more detail in the cost

of goods sold section, as shown above.

ALLOCATION OF ALLOCATION OF INVENTORIABLE COSTSINVENTORIABLE COSTS

ALLOCATION OF ALLOCATION OF INVENTORIABLE COSTSINVENTORIABLE 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 USING ACTUAL PHYSICAL FLOW COSTINGFLOW COSTING

USING ACTUAL PHYSICAL USING ACTUAL PHYSICAL FLOW COSTINGFLOW 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 USING ASSUMED COST FLOW METHODSFLOW METHODS

USING ASSUMED COST USING ASSUMED COST FLOW METHODSFLOW 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).

FIFOFIFOFIFOFIFO

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 COSTAVERAGE COSTAVERAGE COSTAVERAGE 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

LIFOLIFO

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 EFFECTSINCOME STATEMENT EFFECTSINCOME STATEMENT EFFECTSINCOME 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 EFFECTSBALANCE SHEET EFFECTSBALANCE SHEET EFFECTSBALANCE SHEET EFFECTS

USING INVENTORY COST FLOW USING INVENTORY COST FLOW METHODS CONSISTENTLYMETHODS CONSISTENTLY

USING INVENTORY COST FLOW USING INVENTORY COST FLOW METHODS CONSISTENTLYMETHODS 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 - INVENTORY ERRORS - INCOME STATEMENT EFFECTSINCOME STATEMENT EFFECTS

INVENTORY ERRORS - INVENTORY ERRORS - INCOME STATEMENT EFFECTSINCOME STATEMENT EFFECTS

FORMULA FOR FORMULA FOR COST OF GOODS SOLDCOST OF GOODS SOLD

FORMULA FOR FORMULA FOR COST OF GOODS SOLDCOST OF GOODS SOLD

+ =BeginningInventory

Cost of Goods

Purchased

EndingInventory

Cost of GoodsSold

_

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.

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 EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S ERRORS ON CURRENT YEAR’S

INCOME STATEMENT INCOME STATEMENT

EFFECTS OF INVENTORY EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S ERRORS ON CURRENT YEAR’S

INCOME STATEMENT INCOME STATEMENT

An error in ending inventory of the current periodwill have a reverse effect on net income of the next

accounting period.

An error in ending inventory of the current periodwill 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 – ENDING INVENTORY ERROR – BALANCE SHEET EFFECTSBALANCE SHEET EFFECTS

ENDING INVENTORY ERROR – ENDING INVENTORY ERROR – BALANCE SHEET EFFECTSBALANCE 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 VALUING INVENTORY AT THE LOWER OF COST AND MARKETLOWER OF COST AND MARKETVALUING INVENTORY AT THE VALUING INVENTORY AT THE

LOWER OF COST AND MARKETLOWER OF COST AND MARKET

ILLUSTRATION ILLUSTRATION 6-206-20 ALTERNATIVE LOWER OF COST ALTERNATIVE LOWER OF COST AND MARKET (LCM) RESULTSAND MARKET (LCM) RESULTS

Cost Market LCMTelevision setsConsoles 60,000$ 55,000$ Portables 45,000 52,000 Total 105,000 107,000 Video equipmentRecorders 48,000 45,000 Movies 15,000 14,000 Total 63,000 59,000 Total inventory 168,000$ 166,000$ $ 166,000

The common practice is to use total inventory rather than individual items or major

categories in determining the LCM valuation.