Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Prepared by: Debbie Musil Kwantlen Polytechnic University Chapter 6 Inventory Costing

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Inventory Costing Determining inventory quantities Determining inventory quantities Taking physical inventory & determining ownershipTaking physical inventory & determining ownership Inventory costing Inventory costing Specific identification methodSpecific identification method Cost formulas: FIFO and averageCost formulas: FIFO and average Financial Statement Effects Financial Statement Effects Choice of cost determination method and errorsChoice of cost determination method and errors Presentation and analysis Presentation and analysis Valuation, classification and analysisValuation, classification and analysis

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Determining Inventory Quantities All companies must count their inventory at least once a year All companies must count their inventory at least once a year Must determine amount and value of inventory to prepare accurate financial statementsMust determine amount and value of inventory to prepare accurate financial statements The determination of inventory quantities involves The determination of inventory quantities involves Taking a physical inventory of goods on handTaking a physical inventory of goods on hand Determining the ownership of the goodsDetermining the ownership of the goods

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Taking a Physical Inventory Involves counting,weighing, or measuring each kind of inventory on hand Involves counting,weighing, or measuring each kind of inventory on hand Strong internal controls needed for an accurate inventory count: Strong internal controls needed for an accurate inventory count: Count done by employees not normally responsible for inventoryCount done by employees not normally responsible for inventory Ensure items counted exist by observationEnsure items counted exist by observation Second count by another employeeSecond count by another employee Ensure all items are counted and nothing is missed (use pre-numbered tags)Ensure all items are counted and nothing is missed (use pre-numbered tags)

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Determining Ownership Only include inventory owned by company Only include inventory owned by company Goods in Transit: Goods in Transit: On board a public carrier as at the count dateOn board a public carrier as at the count date Look at FOB point to determine if they should be includedLook at FOB point to determine if they should be included Consigned Goods: Consigned Goods: Goods being sold that are owned by othersGoods being sold that are owned by others Excluded from inventory of consignee (who is selling on behalf of the owner, the consignor)Excluded from inventory of consignee (who is selling on behalf of the owner, the consignor)

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Inventory Cost Determination Specific Identification Specific Identification Tracks the actual physical flow of goodsTracks the actual physical flow of goods Each inventory item is marked with its costEach inventory item is marked with its cost Cost Formulas Cost Formulas Specific identification not always allowedSpecific identification not always allowed A cost formula is used instead:A cost formula is used instead: First-in, first-out (FIFO)First-in, first-out (FIFO) AverageAverage Flow of costs may not match physical flowFlow of costs may not match physical flow

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Inventory Costing in a Perpetual Inventory System FIFO: FIFO: FIFO rule is applied at the time of each saleFIFO rule is applied at the time of each sale FIFO (First-in, first-out)FIFO (First-in, first-out) Average: Average: New average cost per unit is calculated after each purchaseNew average cost per unit is calculated after each purchase

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. First-in, First-out (FIFO) Costing: Costing: Costs of earliest goods purchased are first to be recognized as Cost of Goods SoldCosts of earliest goods purchased are first to be recognized as Cost of Goods Sold Costs of most recent goods purchased are recognized as ending inventoryCosts of most recent goods purchased are recognized as ending inventory Often reflects the actual physical flow of merchandise Often reflects the actual physical flow of merchandise

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Perpetual System Inventory Costing: FIFO Ending inventory and cost of goods sold under FIFO is the same for perpetual and periodic systems Ending inventory and cost of goods sold under FIFO is the same for perpetual and periodic systems

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Perpetual System Inventory Costing: Average Assumes that it is not possible to measure specific physical flow of inventory Assumes that it is not possible to measure specific physical flow of inventory Therefore better to use an average priceTherefore better to use an average price Uses a weighted average unit cost Uses a weighted average unit cost Applied when goods are sold: Applied when goods are sold: to units sold to determine cost of goods soldto units sold to determine cost of goods sold to units on hand to determine ending inventoryto units on hand to determine ending inventory

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Perpetual System Inventory Costing: Average (Cont’d) Under a perpetual inventory system, a new weighted average is calculated after each purchase. Under a perpetual inventory system, a new weighted average is calculated after each purchase. This average is then applied to: This average is then applied to: Units sold, to determine cost of goods soldUnits sold, to determine cost of goods sold Remaining units on hand, to determine ending inventoryRemaining units on hand, to determine ending inventory

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Financial Statement Effects Income statement effect: Income statement effect: When prices rising, FIFO produces higher incomeWhen prices rising, FIFO produces higher income When prices falling, opposite is trueWhen prices falling, opposite is true Balance sheet effect: Balance sheet effect: FIFO provides the most accurate valuation of inventoryFIFO provides the most accurate valuation of inventory More closely approximates replacement costMore closely approximates replacement cost Cost formula should be used consistently Cost formula should be used consistently Enhances comparability of statements over timeEnhances comparability of statements over time Use the method best corresponds with actual physical flowUse the method best corresponds with actual physical flow

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Inventory Errors Errors in inventory affect both income statement and balance sheet Errors in inventory affect both income statement and balance sheet Through the calculation of cost of goods soldThrough the calculation of cost of goods sold Ending inventory of one period becomes beginning inventory of the next period Ending inventory of one period becomes beginning inventory of the next period Errors in ending inventory carry over to the following periodErrors in ending inventory carry over to the following period

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Inventory Errors Effect of inventory errors on the current year’s income statement: 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 profit of the next period An error in ending inventory of one period will have the reverse effect on profit of the next period

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Balance Sheet Errors Effect can be determined by using the basic accounting equation: Effect can be determined by using the basic accounting equation: assets = liabilities + owner’s equity

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Inventory Valuation Lower of cost and net realizable value Lower of cost and net realizable value when the value of inventory is lower than cost, it is written down to that lower valuewhen the value of inventory is lower than cost, it is written down to that lower value Net realizable value: selling price less any costs to make the goods ready for saleNet realizable value: selling price less any costs to make the goods ready for sale Assessed on an item-by-item basis Assessed on an item-by-item basis Reversed if net realizable value increases before goods are sold Reversed if net realizable value increases before goods are sold

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Classifying and Reporting Inventory Depends on whether company is a merchandiser or manufacturer Depends on whether company is a merchandiser or manufacturer Merchandiser buys its inventory – only one classification usedMerchandiser buys its inventory – only one classification used Manufacturer produces its inventory – classified into raw materials, work in process and finished goodManufacturer produces its inventory – classified into raw materials, work in process and finished good Typically recorded as a current asset, but can be non-current if not sold in one year Typically recorded as a current asset, but can be non-current if not sold in one year

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Analysis of Inventory Must balance competing objectives: Must balance competing objectives: Excessive levels of inventory leads to high carrying costsExcessive levels of inventory leads to high carrying costs Too little inventory may result in lost salesToo little inventory may result in lost sales Ratios help determine whether a company has too much or too little inventory: Ratios help determine whether a company has too much or too little inventory: Inventory turnover ratioInventory turnover ratio Days sales in inventoryDays sales in inventory

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Inventory Turnover = Cost of Goods Sold ÷ Average Inventory The number of times inventory “turns over” during a given period The number of times inventory “turns over” during a given period Average inventory is usually average of beginning and ending inventories Average inventory is usually average of beginning and ending inventories

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Days Sales in Inventory = Days in Year ÷ Inventory Turnover The number of days on average that the inventory is on hand before being sold The number of days on average that the inventory is on hand before being sold

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Appendix 6A: Inventory Cost Formulas in Periodic Systems: FIFO

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Inventory Cost Formulas in Periodic Systems: Average = x

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Appendix 6B: Estimating Inventories Not always possible or practical to count inventory – must be estimated Not always possible or practical to count inventory – must be estimated Two estimating methods are availableTwo estimating methods are available Gross profit method Estimated gross profit = net sales × gross profit marginEstimated gross profit = net sales × gross profit margin Estimated cost of goods sold = net sales − estimated gross profitEstimated cost of goods sold = net sales − estimated gross profit Estimated ending inventory = goods available for sale − cost estimated cost of goods soldEstimated ending inventory = goods available for sale − cost estimated cost of goods sold

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Fifth Canadian Edition © 2010 John Wiley & Sons Canada, Ltd. Appendix 6B: Estimating Inventories 2 Retail inventory method uses the cost-to-retail ratio applied to ending inventory at retail to determine the estimated cost of the inventory Retail inventory method uses the cost-to-retail ratio applied to ending inventory at retail to determine the estimated cost of the inventory Calculation: Calculation: Ending inventory at retail = goods available for sale at retail − net salesEnding inventory at retail = goods available for sale at retail − net sales Cost-to-retail ratio = goods available for sale at cost ÷ goods available for sale at retailCost-to-retail ratio = goods available for sale at cost ÷ goods available for sale at retail Estimated cost of ending inventory = ending inventory at retail × cost-to-retail ratioEstimated cost of ending inventory = ending inventory at retail × cost-to-retail ratio

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