Reporting and Analysing Inventory CHAPTER 6

Merchandise Inventory Owned by the company Ready for sale to customers

Manufacturing Inventory Finished goods inventory Work in process Raw materials

A physical inventory countA physical inventory count –Determines ending inventory –Enables cost of goods sold to be calculated Companies that use a perpetual inventory system must also take a physical inventory to check the accuracy of “book inventory” against actual inventory Determining Inventory Quantities

Taking a Physical Inventory Determining inventory quantities by counting, weighting or measuring each type of inventoryDetermining inventory quantities by counting, weighting or measuring each type of inventory Determining ownership of goods, including goods in transit and consigned goodsDetermining ownership of goods, including goods in transit and consigned goods

Goods in Transit Goods on board a truck, train, ship, or plane at the end of the periodGoods on board a truck, train, ship, or plane at the end of the period Who includes goods in transit in inventory? The buyer? The seller?Who includes goods in transit in inventory? The buyer? The seller? Goods in transit are included in the inventory of the company with legal titleGoods in transit are included in the inventory of the company with legal title

Ownership passes to buyer here Ownership passes to buyer here Public Carrier Co. Public Carrier Co. Seller Buyer FOB Shipping Point FOB Destination Point Illustration 6-1

Consigned Goods Goods in your store that you don’t pay for until they sellGoods in your store that you don’t pay for until they sell Company does not take ownershipCompany does not take ownership

Inventory Costing After calculating the quantity of units of inventory, unit costs are appliedAfter calculating the quantity of units of inventory, unit costs are applied This determines the values for the cost of goods sold and ending inventoryThis determines the values for the cost of goods sold and ending inventory This is a complicated process because inventory is purchased at different timesThis is a complicated process because inventory is purchased at different times

Inventory Valuation Systems The following inventory valuation methods are generally accepted. They can be used in either a periodic or perpetual inventory system. Specific IdentificationSpecific Identification Cost Flow AssumptionsCost Flow Assumptions –Average cost –First-in, first-out (FIFO) –Last-in, first-out (LIFO)

Specific Identification Concentrates on the physical tracing of the particular items soldConcentrates on the physical tracing of the particular items sold Major limitation is in identifying the particular item soldMajor limitation is in identifying the particular item sold Used in low-volume, high-priced industriesUsed in low-volume, high-priced industries –e.g., jewellery stores

Average Cost Flow Assumption The average cost of all units in inventory is calculated each time there is a purchaseThe average cost of all units in inventory is calculated each time there is a purchase –Weighted average cost This cost is used to determine cost of goods sold and inventoryThis cost is used to determine cost of goods sold and inventory Major advantage is not having to track the individual items of inventoryMajor advantage is not having to track the individual items of inventory

Weighted Average Cost Cost of goods available for sale ($) Units available on the date of sale ÷

First-in, First-out (FIFO) The assumption is that the first item purchased is the first item soldThe assumption is that the first item purchased is the first item sold Inventory is valued at the most current cost and cost of goods sold is valued at the oldest inventory costInventory is valued at the most current cost and cost of goods sold is valued at the oldest inventory cost Earnings reported using this cost flow assumption is higher than any other cost flow assumption as the oldest costs are used to determine cost of goods soldEarnings reported using this cost flow assumption is higher than any other cost flow assumption as the oldest costs are used to determine cost of goods sold

First-in, First-out (FIFO) Cost of Goods Sold Ending Inventory Oldest Costs Recent Costs

Last-in, First-out (LIFO) The assumption is that the last item purchased is the first soldThe assumption is that the last item purchased is the first sold Inventory is valued at oldest cost and cost of goods sold is valued at current costInventory is valued at oldest cost and cost of goods sold is valued at current cost This method while allowed under GAAP, is not permitted for income tax purposesThis method while allowed under GAAP, is not permitted for income tax purposes

Last-in, First-out (LIFO) Cost of Goods Sold Ending Inventory Recent Costs Oldest Costs

Financial Statement Effects FIFO Average LIFO Ending Inventory Cost of Goods Sold Net Earnings What are the effects on the balance sheet and statement of earnings if prices are assumed to be rising?HLH--- LHL

Financial Statement Effects FIFO Average LIFO Ending Inventory Cost of Goods Sold Net Earnings What are the effects on the balance sheet and statement of earnings if prices are assumed to be falling?LHL--- HLH

Financial Statement Effects FIFO Average LIFO Ending Inventory Cost of Goods Sold Net Earnings What are the effects on the balance sheet and statement of earnings if prices are assumed to be stable? All three cost flow assumptions will give the same results.

Use of Cost Flow Assumptions by Canadian Companies Each of the cost flow assumptions are acceptable in Canada Very few companies use LIFO as it is not permitted for income tax purposes in Canada

Inventory Errors Errors can occur in accounting for inventoryErrors can occur in accounting for inventory When errors occur they affect both the statement of earnings and the balance sheetWhen errors occur they affect both the statement of earnings and the balance sheet An error in ending inventory can affect the calculation of cost of goods sold and net earnings in two periodsAn error in ending inventory can affect the calculation of cost of goods sold and net earnings in two periods

Lower of Cost and Market (LCM) When the value of the inventory declines below cost, it is written down to its market valueWhen the value of the inventory declines below cost, it is written down to its market value Market is defined as net realizable value (or current replacement cost), not selling priceMarket is defined as net realizable value (or current replacement cost), not selling price

Lower of Cost and Market (LCM) Departure from cost principleDeparture from cost principle Follows conservatism conceptFollows conservatism concept Used only after one of the cost flow assumptions (specific identification, FIFO, LIFO, or average cost) is appliedUsed only after one of the cost flow assumptions (specific identification, FIFO, LIFO, or average cost) is applied

How Much Inventory Should a Company Have? –Only enough for sales needs –Excess inventory costs Storage costs Interest costs Obsolescence

Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory

Days in Inventory Day in Inventory = 365 days Inventory Turnover