Unit 1.6

Inventory Costing

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 Basics

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

Mis-states inventory during the period

This chapter covers the periodic inventory method.

Perpetual vs Periodic Costing

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 Quantities

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 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).

Taking Physical Inventory - continued

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, 2008

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.

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. A deluxe sports car dealership for instance

Using Actual Physical Flow

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).

Using Assumed Cost Flow Methods

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.

First In, First Out

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

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.

Average Cost Method

Average cost method assumes that goods available for sale are homogeneous

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.

Last In, First Out

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

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.

Important Income Statement Effects

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

Balance Sheet Effects

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.

Using Inventory Valuation Methods Consistently

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 – Effects on the Income Statement

Cost of Inventory Error Goods Sold Net Income

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

Effects of Inventory Errors on Current Year’s Income Statement

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 Assets Liabilities Owner’s Equity

Overstated Overstated None Overstated Understated Understated None Understated

Effects of Inventory Errors on Current Year’s Balance Sheet

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 Lower of Cost or Market

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.

Valuing Inventory at the Lower of Cost or Market - continued