Tools for Business Decision-Making Fourth Canadian Edition Financial Accounting: Prepared by: Peggy Coady Memorial University of Newfoundland & Catherine Seguin University of Toronto

Reporting and Analyzing Inventory Chapter 6

3 Determining Physical Inventory Whether companies use a periodic or perpetual system, physical inventory must still be counted at the end of the period This will identify inventory shrinkage due to theft, spoilage etc.

Chapter 6 4 Determining Physical Inventory Internal control –Related methods and measures to help a company achieve reliable financial reporting, effective and efficient operations, and compliance with relevant laws and operations –Especially important for inventory (Ch. 6) and cash (Ch. 7)

Chapter 6 5 Determining Physical Inventory To ensure inventory is properly counted companies must have good internal control procedures (e.g. prenumbered tags, counting in teams by employees that do not have responsibility for the record keeping or custody of inventory)

Chapter 6 6 Determining Ownership Goods in transit at the end of the period make determining ownership more difficult Apply the FOB concepts from Chapter 5 –FOB shipping point –FOB destination

Chapter 6 7 Determining Ownership The ownership of consigned goods remains with the owner not the holder of the goods Goods taken home “on approval” by the customer are still owned by the company

Chapter 6 8 Inventory Cost Determination Methods Specific identification Cost formulas –First-in, first-out (FIFO) –Average

Chapter 6 9 Specific Identification Tracks actual physical flow of goods Can only be used when actual costs of each inventory item can be determined; where goods are easily distinguishable (not interchangeable), or for goods produced and segregated for specific projects Used in perpetual inventory system only

Chapter 6 10 Discussion Question What are some examples of companies that might use the specific identification method?

Chapter 6 11 Cost Formulas FIFO or Average Order or flow of costs assumed Can be used in either perpetual or periodic inventory systems

Perpetual vs Periodic Inventory Systems Illustration Chapter 6

13 First-in, First-out (FIFO) Assumes that the first item purchased is the first item sold Inventory is recorded at most recent (current) cost. Cost of goods sold is recorded at the oldest inventory cost

Chapter 6 14 First-in, First-out (FIFO) Ending inventory and cost of goods sold under FIFO is the same for perpetual and periodic inventory systems

Chapter 6 15 Perpetual System Inventory Costing: FIFO Illustration 6-6

Average Under a perpetual inventory system, a new weighted average is calculated after each purchase and used to record cost of goods sold and ending inventory Often called moving average in a perpetual inventory system Chapter 6 16

Chapter 6 17 Average Ending inventory and cost of goods sold under Average is usually different for perpetual and periodic inventory systems

Chapter 6 18 Perpetual System Inventory Costing: Average Illustration 6-8

Chapter 6 19 Discussion Question Why is the average cost formula called a “moving average cost formula” in a perpetual inventory system?

Choice of Cost Determination Method Choose a method that best –Represents physical flow of goods –Reports ending inventory at recent cost Use the same method for inventories of similar nature and usage in company Chapter 6 20

Chapter 6 21 Comparison of Cost Determination Methods Illustration 6-10

Summary of Financial Statement Effects Chapter 6 22 Illustration 6-11

Chapter 6 23 Inventory Errors Errors can occur in accounting for inventory When 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 periods

Chapter 6 24 Effects of Inventory Errors on Current Year’s Statement of Earnings An error in ending inventory of the current period will have a reverse effect on net earnings of the next accounting period.

Chapter 6 25 Ending Inventory Error – Balance Sheet Effect The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation:

Chapter 6 26 When the value of the inventory declines below net realizable value, it is written down to its net realizable value Net realizable value (NRV) is the selling price less any costs necessary to make the goods ready for sale Departure from cost principle Lower of Cost and Net Realizable Value (LCNRV)

Choose LCNRV item by item Allowance method –Debit write down to Cost of Goods Sold; Credit to Allowance to Reduce Inventory to NRV –Allows reversal if NRV increases in certain circumstances Chapter 6 27

Chapter 6 28 Discussion Question Under what circumstances can a write-down in inventory to net realizable value be reversed?

Chapter 6 29 Reporting Inventory In the financial statements or notes the following should be disclosed for inventory: –Total cost of inventory –Cost of goods sold –Method of cost determination –Basis of valuation –Amounts of any write-downs or reversals

Chapter 6 30 Only enough for sales needs Excess inventory costs –Storage costs –Interest costs –Obsolescence How Much Inventory Should a Company Have?

Chapter 6 31 Inventory Turnover = Cost of Goods Sold Average Inventory

Chapter 6 32 Days in Inventory = 365 Days Inventory Turnover

Appendix 6A Reminder: Perpetual vs Periodic Inventory Systems Chapter 6 33 Illustration 6-2

Chapter 6 34 Appendix 6A Periodic Inventory System Illustration 6A-2: FIFO

Chapter 6 35 Appendix 6A Periodic Inventory System Illustration 6A-4: Average

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