Accounting Principles

Second Canadian Edition

Weygandt Kieso Kimmel Trenholm

Prepared by: Carole Bowman, Sheridan College

CHAPTER

6
INVENTORY COSTING

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.

Perpetual vs. Periodic Inventory 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.

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.


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).

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).

TERMS OF SALE
FOB Shipping Point FOB Destination Point

Seller

Seller

Ownership passes to buyer here

Public Carrier Co.

Ownership passes to buyer here

Public Carrier Co.

Buyer

Buyer

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 consignors inventory, not the consignees inventory.
Owned by a consignor; do not count in our (consignee) inventory
Consignee Company

SALES TRANSACTIONS

General Journal Date Account Title and Explanation May 4 Accounts Receivable Sales To record credit sale.

Ref

Debit 3,800

J1 Credit 3,800

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

RECORDING SALES RETURNS AND ALLOWANCES

General Journal Date Account Title and Explanation May 8 Sales Returns and Allowances Accounts Receivable To record returned goods. Ref Debit 300 J1 Credit 300

The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a contra revenue account to the Sales account.

PURCHASES OF MERCHANDISE
General Journal Date Account Title and Explanation Ref May 4 Purchases Accounts Payable To record goods purchased on account, terms n/30. J1 Credit 3,800

Debit 3,800

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

PURCHASE RETURNS AND ALLOWANCES

General Journal Date Account Title and Explanation May 8 Accounts Payable Purchase Returns and Allowances To record return of goods J1 Credit 300

Ref

Debit 300

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.

ACCOUNTING FOR FREIGHT COSTS

General Journal Date Account Title and Explanation May 4 Freight In Cash To record payment of freight. J1 Credit 150

Ref

Debit 150

When the purchaser directly incurs the freight costs, the account Freight In is debited and Cash is credited.

HIGHPOINT ELECTRONICS Income Statement For the Year Ended December 31, 2002 Sales revenue Sales Less: Sales returns and allowances Net sales Cost of goods sold Inventory, January 1 Purchases Less: Purchase returns and allowances Net purchases Add: Freight in Cost of goods purchased Cost of goods available for sale Inventory, December 31 Cost of goods sold Gross profit Operating expenses Salaries expense Rent expense Utilities expense Advertising expense Amortization expense Freight out Insurance expense Total operating expenses Net income $ $ $ $ $ 325,000 17,200 307,800 12,200 $ 320,000 356,000 40,000 $ $ 45,000 19,000 17,000 16,000 8,000 7,000 2,000 316,000 144,000 36,000 480,000 20,000 460,000

The multi-step income statement under the periodic system requires more detail in the cost of goods sold section, as shown above.
$ 114,000 30,000

ALLOCATION OF INVENTORIABLE COSTS

Ending Inventory (Balance Sheet) Cost of Goods Available for Sale Goods Purchased during the year Cost of Goods Sold (Income Statement)

Beginning Inventory

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.

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. Cost flow assumptions: 1. First-in, first-out (FIFO). 2. Average cost. 3. Last-in, first-out (LIFO).

FIFO


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 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

LIFO


 

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 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.

BALANCE SHEET EFFECTS

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

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.

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.

FORMULA FOR COST OF GOODS SOLD

Beginning Inventory

Cost of _ Ending Goods Inventory Purchased

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.

EFFECTS OF INVENTORY ERRORS ON CURRENT YEARS INCOME STATEMENT

Inventory Error Cost of Goods Sold Net Income
Overstated Understated Understated Overstated

Understate beginning inventory Understated Overstate beginning inventory Overstated Understate ending inventory Overstated Overstate ending inventory Understated

An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.

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 + Owners Equity
Ending Inventory Error Assets Liabilities Owners Equity

Overstated Understated

Overstated Understated

None None

Overstated Understated

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.

ILLUSTRATION 6-20

ALTERNATIVE LOWER OF COST AND MARKET (LCM) RESULTS

Cost Television sets Consoles $ Portables Total Video equipment Recorders Movies Total Total inventory $ 60,000 45,000 105,000 48,000 15,000 63,000 168,000 $ Market 55,000 52,000 107,000 LCM

45,000 14,000 59,000 $ 166,000

$ 166,000

The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation.

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.