3 INVENTORY BASICSIn 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 transactionPeriodicDelays updating of inventory and cost of goods sold until end of the periodMisstates inventory during the periodThis 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 involves1. taking a physical inventory of goods on hand, and2. 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 SALEFOB Shipping Point FOB Destination PointSellerSellerOwnership passes to buyer here Ownership passes to buyer herePublicCarrierCo.PublicCarrierCo.BuyerBuyer
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) inventoryConsignee Company
10 SALES TRANSACTIONSOnly 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 SaleBeginningInventoryCost of Goods Purchased (Purchases – Purchases Returns and Allowances + Freight In)+Cost of Goods Available For SaleEnding InventoryCost 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 CapitalEnding 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 SaleDateExplanationUnitsUnit CostTotal Cost1/1Beginning Inv.100$10$ 1,0004/15Purchase200112,2008/24300123,60011/27400135,200TOTAL1000$12,000Cost of Goods SoldEnding InventoryDateUnitsUnit CostTotal Cost1/1100$10$1,00011/27400$13$5,2004/15200112,2008/2450126002503,000Total$6,200$5,800
23 AVERAGE COSTThe 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 SaleDateExplanationUnitsUnit CostTotal Cost1/1Beginning Inv.100$10$ 1,0004/15Purchase200112,2008/24300123,60011/27400135,200TOTAL1000$12,000Cost of Goods SoldEnding InventoryDateUnitsUnit CostTotal Cost11/27400$135,2001/1100$10$1,0008/24150121,8004/15200112,200Total550$7,000450$5,000
29 Income Statement Effects Periods of Rising Costs FRASER VALLEY ELECTRONICSCondensed Income StatementFIFOAverage CostLIFOSales$11,500$ 11, 500$Beginning Inventory1 000Purchases11 000Cost of Goods Available For Sale12 000Ending Inventory5 8005 4005 000Cost of Goods Sold6 2006 6007 000Gross Profit5 3004 9004 500Operating Expenses2 000Net 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 TimeFIFOAVERAGELIFOCost of Goods SoldLowestBetween FIFO and LIFOHighestGross/Profit/Net IncomeCash Flow (pretax)SameEnding InventoryThe reverse is true when inventory costs are decreasing over time.
32 BALANCE SHEET EFFECTSFIFO 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 BeginningInventoryCost ofGoodsPurchasedEndingSold_+=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 OverstatedOverstate beginning inventory Overstated UnderstatedUnderstate ending inventory Overstated UnderstatedOverstate ending inventory Understated OverstatedAn error in ending inventory of the current periodwill have a reverse effect on net income of the nextaccounting 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 EquityOverstated 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 statementEstimates 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 saleGross profit marginStep 1Net Sales – Estimated Gross Profit = Estimated Cost of Goods SoldStep 2Cost of Goods Available for Sale – Estimated Cost of Goods Sold = Estimated Cost of Ending Inventory
42 Gross Profit ExampleLalonde Company wishes to prepare an income statement for the month of January. Its records show:net sales = $200,000beginning inventory = $40,000cost of goods purchased = $120,000Previous 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 $ 40,000Cost of Goods Purchased ,000Cost of Goods Available For Sale ,000Less:Estimated Cost of Goods Sold ,000 **Estimated Cost of Ending Inventory $ 20,000 **** Remember: Net Sales – Cost of Goods Sold = Gross ProfitThus: Net Sales – Gross Profit = Cost of Goods SoldRemember: Cost of Goods Available For Sale – Ending Inventory = Cost of Goods SoldThus: 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 costsUsed to estimate the cost of inventoryTo calculate you need:Cost of goods available for saleRetail value of goods available for sale
45 Retail Inventory Method Step 1Step 2Step 3Ending Inventory at RETAILGoods Available For Sale at RETAILNet Sales---=Cost to Retail RatioGoods Available For Sale at RETAILGoods Available For Sale at COST/=Cost to Retail RatioEstimated Cost of Ending InventoryEnding Inventory at Retail=X
46 Retail Inventory Example Given $ At Cost At RetailBeginning Inventory $ $21 500Goods PurchasedGoods available for sale $Net Sales1. Ending Inventory at Retail $2. Cost to retail ratio = / = 75%3. Estimated Cost of ending inventory = x .75 = $
47 Main DisadvantageRetail 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