CHAPTER 6 INVENTORY COSTING

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 Goods Purchased Ending 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 YEAR’S INCOME STATEMENT Understate beginning inventory Understated Overstated Overstate beginning inventory Overstated Understated Understate ending inventory Overstated Understated Overstate ending inventory Understated Overstated 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 + Owner’s Equity Overstated Overstated None Overstated Understated Understated None 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 The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation.