2. INVENTORY CHAPTER 6

3. Agenda Learning goals Vocabulary Quick review Determining inventory quantities Inventory costing Financial statement effects Presentation and Analysis of Inventory Inventory cost flow Assumption in a perpetual inventory system Estimating inventory

4. Learning goals Describe the steps in determining inventory quantities. Calculate ending inventory and cost of gods sold in a periodic inventory system using inventory cost flow assumption Determine the effects of inventory cost flow assumption and inventory errors on the financial statements. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a perpetual inventory system using inventory cost flow assumption Estimate ending inventory using the gross profit and retail inventory methods.

5. Vocabulary Average cost Consigned goods Days sales in inventory First-in, first-out (FIFO) Full disclosure principle Gross profit method Inventory turnover Last-in, first-out (LIFO) Lower cost and market (LCM) Net realizable value Retail inventory method Specific identification Weighted average unit cost

6. Concepts for Review The cost principle and matching principle of accounting The difference between calculating cost of goods sold in perpetual inventory system and in a period inventory system. How to journalize inventory transaction in perpetual and periodic inventory system How to prepare financial statement for a merchandising company

7. Cost and matching principle of accounting- reviewed Cost principle - Requires assets to be recorded at cost matching principle – dictates that expenses be matched with revenues in the period in which those expenses helped to generate revenue.

8. Chapter 10 – Accounting for a Merchandising Business | Accounting 1, 7 th Edition7 Periodic vs. Perpetual Inventory System Periodic Inventory is counted from time to time (periodically) the result is used to calculate Cost of Goods Sold Perpetual Inventory changes are recorded in an account on an ongoing (perpetual) basis A ledger account is used for Cost of Goods Sold

9. Chapter 10 – Accounting for a Merchandising Business | Accounting 1, 7 th Edition8 COGS on the Income Statement From a count From the ledger From addition From a count From subtraction Calculating COGS this way requires a periodic count of inventory (The Periodic System) Purchases is a ledger account for the purchase of inventory Sales — Cost of Goods Sold = Gross Profit (Margin)

10. Chapter 10 – Accounting for a Merchandising Business | Accounting 1, 7 th Edition9 Perpetual Inventory System—Selling Goods Sales have two aspects or portions Example Merchandise that is purchased for $100 is sold for $150, generating a $50 gross profit The reduction of the inventory value is also recorded with each sale The cost of selling merchandise is recorded with each sale.

11. Chapter 10 – Accounting for a Merchandising Business | Accounting 1, 7 th Edition10 Basic Periodic/Perpetual Entries Compared Sale Example Merchandise is sold for $4500, twice the price it cost The cost of the sale and the asset reduction are ignored for now

12. Chapter 10 – Accounting for a Merchandising Business | Accounting 1, 7 th Edition11 Purchase Example Merchandise is bought for $4500 Basic Periodic/Perpetual Entries Compared Transaction details are recorded directly in the Merchandise Inventory account. The Purchases account is eliminated.

13. Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Multiple-Step Income Statement Calculation of Net sales and Gross profit Calculation of Income from operations Calculation of Non-operating activities and Net income

14. Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Single-Step Income Statement All data are classified as either (1) revenues or (2) expenses

15. Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition © 2009 John Wiley & Sons Canada, Ltd. Classified Balance Sheet Merchandise Inventory reported as a current asset following Accounts Receivable

16. 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.

17. 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.

18. 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

19. 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.

20. 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.

21. Example Assume that Hill company has 20,000 units of inventory in its warehouse on December 31. It also has the following goods in transit: (1) sales of 1,500 units shipped December 31, FOB destination, and (2) purchases of 2,500 shipped FOB shipping point by the seller on December 31. How much inventory should they recognize?

22. Example Answer 22,500 because the 1,500 are still under the seller and the 2,500 are also under the seller. Once the 1,500 reach the buyer than they can be subtracted from the inventory. Also as soon as the 2,500 were shipped they became the responsibility of the buyer.

23. 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

24. 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 that each inventory item actually exists, how many, condition…. 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.

25. Practice questions Self study questions # 1 Questions 1-3 BE 6-1 E6-2

26. Inventory Costing For example assume that throughout the calendar year Fraser Valley Electronic buys a different prices 1,000 Astro Condenser units for resale. Some Astro Condensers cost $10 when they were originally purchased in the previous year. Units purchased in April cost $11, those purchased in August cost $12, and those acquired in November cot $13. Now suppose Fraser Valley Electronics has 450 Astro Condensers remaining in inventory at the end of December. Should these inventory items be assigned a cost of $10, 11, 12 or 13 or some combination of all four?

27. Inventory Costing Methods To determine the cost of goods sold, as well as, the cost of ending invnetory we need to a method of allocating the purchases cost to each item in inventory of each item that has been sold. The methods we will study are: (1) Specific Identification (2) Cost Flow Assumption  FIFO, LIFO and Average Cost

28. 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.

29. INVENTORY VALUATION METHOD 1: ACTUAL PHYSICAL FLOW COSTING For example Fraser Valley Electronic buys identical LCD TVs at cost of $700, $750 and $800. During the year, two are sold at $1,200 each. At December 31, 2014 the company determines that the $750 LCD TV is still on hand. The ending inventory is recorded at $750 and cost of good sold at $1,500 (800+750)

30. INVENTORY VALUATION METHOD 1: ACTUAL PHYSICAL FLOW COSTING Advantages Reports ending inventory at actual cost of matching the cost of goods sold against sales revenue Good to track automobile sales Disadvantages Allows management to manipulate net income ( choose to sell the cheapest cost TV against higher income) Expensive

31. 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.

32. 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.

33. Using FIFO

34. 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.

35. Using LIFO

36. Average Cost Assumes that it is not possible to measure specific physical flow of inventory – Therefore better to use an average price Allocation of cost of goods available for sale is based on weighted average unit cost This is then applied: – to units sold to determine cost of goods sold – to units on hand to determine ending inventory

37. How to calculate Weighted Average Unit Cost? $12,000 / 1000 = $12 Cost of Goods Available for Sale Total Units Available for Sale Weighted Average Unit Cost

38. Using Average Cost = +

39. Practice Questions BE 6-3, 4, E 6-3, 4

40. Financial Statement Effect Inventory affect both the income statement and the balance sheet. Ending inventory appears on the balance sheet COGS is on the income statement Therefore, the choice of which method to use will affect both the assets and net income.

41. Financial Statement Effect In Canada most companies use FIFO or Average Cost but in USA they use LIFO. Some Canadian companies will use LIFO to match the American reporting.

42. Income Statement Effect

43. Balance Sheet Effect FIFO Strength: When prices increase the ending inventory more accurately represented the inventory value (replacement cost) Allows management to make more relevant decisions LIFO Weakness: the ending inventory valuation doesn’t represent the replacement cost and will make for out-of- date valuation and decision making.

44. Summary Effect

45. 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.

46. Inventory Errors Effect of inventory errors on the current year’s income statement: An error in ending inventory of one period will have the reverse effect on net income of the next period

47. Balance Sheet Errors Effect can be determined by using the basic accounting equation: assets = liabilities + owner’s equity

48. 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.

49. 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.

50. 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

51. Practice Questions BE6-5, 6, 7,8 E 6-5, 7, 8

52. Presenting and Analysis of Inventory Suppose you manage a retail store that sells computers, and at the end of the year the value of the computers has dropped almost 25%. Do you think inventory should be stated at COST, in accordance with the cost principle, or at it’s lower MARKET VALUE?

53. 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 method. Market is defined as replacement cost or net realizable value.

54. ALTERNATIVE LOWER OF COST AND MARKET RESULTS

55. If Wacky World uses a periodic inventory system, not entry is needed to adjust the inventory. Wacky would instead use $159,000 as the ending inventory in the calculation of the COGS

56. ALTERNATIVE LOWER OF COST AND MARKET RESULTS If Wacky World uses a perpetual inventory system, the entry to adjust would be DateParticularsDebitCredit Dec. 31 Cost of goods sold 9,000 Merchandise inventory 9,000 To record decline in inventory value from original cost of $168,000 to market value of $159,000

57. Inventory Ratios: Inventory Turnover Ratio = Cost of goods sold ÷ average inventory Measures the number of times, on average, inventory is sold (turned over) during the period. Average inventory is usually average of beginning and ending inventories Days Sales in Inventory = Days in year ÷ inventory turnover ratio The number of days on average that the inventory is on hand before being sold

58. Practice questions P6-4A P6-5A P6-6A P6-7A