1. CHAPTER 1 Prepared By: Debbie Musil Kwantlen Polytechnic University Tools for Business Decision- Making Fifth Canadian Edition Financial Accounting 6 Copyright John Wiley & Sons Canada, Ltd. 1

2. CHAPTER 1 Reporting and Analyzing Inventory Study Objectives 1.Describe the steps in determining inventory quantities. 2.Apply the methods of cost determination – specific identification, FIFO, and average – under a perpetual inventory system. 3.Explain the financial statement effects of the inventory cost determination methods. 4.Identify the effects of inventory errors on the financial statements. 5.Demonstrate the presentation and analysis of inventory. 6.Apply the inventory cost formulas – FIFO and average – under a periodic inventory system (Appendix 6A). 6 Copyright John Wiley & Sons Canada, Ltd. 2 6

3. CHAPTER 1 Determining Inventory Quantities Whether companies use a periodic or perpetual system, physical inventory must still be counted at the end of the period: – To check the accuracy of the perpetual inventory records – To determine the amount of inventory lost to shrinkage or theft Copyright John Wiley & Sons Canada, Ltd. 3 6

4. CHAPTER 1 Taking Inventory To ensure inventory is properly counted, companies must have a good system of internal control: – Employees who perform the count should not have responsibility for custody or record- keeping – Counter establishes validity of item – Second count by another employee or auditor – Pre-numbered tags 6

5. CHAPTER 1 Need to consider ownership of goods when taking inventory Goods in transit at the end of the period make the determination of ownership more complicated: – Determine who has legal title to goods in transit – Include in inventory if company has legal title Determining Ownership 6

6. CHAPTER 1 Apply freight/shipping concepts from Chapter 5: – FOB shipping point versus FOB destination Ownership of consigned goods remains with the owner (the consignor), not the holder of the goods (the consignee) Goods taken home “on approval” by a customer are still owned by the company Determining Ownership (continued) 6

7. CHAPTER 1 6 Inventory Cost Determination Methods Once inventory quantities are counted, must apply unit costs to determine total cost of inventory Units of the same inventory can be purchased at different prices Which costs should be used?

8. CHAPTER 1 6 Specific Identification Tracks physical flow of goods Used in perpetual system only Can only be used where – Actual costs of each item can be determined – Goods are easily distinguishable – Or for goods produced and segregated for specific projects

9. CHAPTER 1 Discussion Question What are some examples of companies and their products that might use the specific identification method? 6 Copyright John Wiley & Sons Canada, Ltd. 9

10. CHAPTER 1 6 Cost Formulas Cost formulas assume a flow of costs that may not be the same as the actual flow of goods FIFO (First-in, first-out) – Cost of first item purchased is cost of first item sold Average – Cost is determined using a moving (weighted) average of the cost of the items purchased Cost Formulas

11. CHAPTER 1 First-in, First-out (FIFO) Merchandise inventory is recorded at most recent (current) cost in the current assets section of statement of financial position Cost of goods sold is recorded as an expense at oldest inventory cost on income statement 6

12. CHAPTER 1 First-in, First-out (FIFO) (continued) Ending inventory and cost of goods sold under FIFO are the same for periodic and perpetual inventory systems 6

13. CHAPTER 1 Copyright John Wiley & Sons Canada, Ltd. 13 6 Perpetual System Inventory Costing - FIFO Illustration 6-4

14. CHAPTER 1 Average 6 Used when physical flow of inventory cannot be measured Under a perpetual inventory system, a new weighted (called moving) average is calculated after each purchase – Used to record cost of goods sold and ending inventory

15. CHAPTER 1 Perpetual System Inventory Costing - Average Copyright John Wiley & Sons Canada, Ltd. 15 6 Illustration 6-6

16. CHAPTER 1 Discussion Question Why is the average cost formula called a “moving” average cost formula in a perpetual inventory system? 6 Copyright John Wiley & Sons Canada, Ltd. 16

17. CHAPTER 1 Choice of Cost Determination Method Choose a method that best – Represents physical flow of goods, – Reports ending inventory at recent cost, and Use the same method for inventories of similar nature and usage 6

18. CHAPTER 1 Advantages of Cost Determination Methods Copyright John Wiley & Sons Canada, Ltd. 18 6 Illustration 6-8

19. CHAPTER 1 Summary of Financial Statements Effects Copyright John Wiley & Sons Canada, Ltd. 19 6 Illustration 6-9

20. CHAPTER 1 Errors can occur in accounting for inventory – Incorrect counting or costing – Transfer of title not recognized Errors affect both – Statement of financial position – through merchandise inventory – Income statement – through cost of goods sold Inventory Errors 6

21. CHAPTER 1 Effects of Inventory Errors on Income Statement Copyright John Wiley & Sons Canada, Ltd. 21 6 Illustration 6-10

22. CHAPTER 1 Effects of Inventory Errors on Statement of Financial Position Copyright John Wiley & Sons Canada, Ltd. 22 6 Illustration 6-12

23. CHAPTER 1 An error in ending inventory of the current period will have a reverse effect on profit in the next accounting period An error in ending inventory affects retained earnings of the same period – But not the next period, as the error reverses Summary of Effects of Errors 6

24. CHAPTER 1 When the net realizable (fair) value is less than cost, the value is written down – The lower of cost and net realizable value (LCNRV) rule Net realizable value is selling price less any costs to make ready for sale Valuing Inventory at the Lower of Cost and Net Realizable Value 6

25. CHAPTER 1 Apply rule to individual inventory items Reduce inventory by crediting it for the amount of write-down, debit is to cost of goods sold Reverse write-down if value subsequently recovers – When conditions that caused the write-down have changed LCNRV Rule - Application 6

26. CHAPTER 1 Discussion Question Under what circumstances can a write-down in inventory to net realizable value be reversed? 6 Copyright John Wiley & Sons Canada, Ltd. 26

27. CHAPTER 1 No significant differences between IFRS and ASPE In the statement of financial position: – At the lower of cost and NRV In the notes to the statements – Total amount of inventory – Cost of goods sold – Cost determination method – Basis of valuation – Amount of write-downs or reversals Reporting Inventory 6

28. CHAPTER 1 How much inventory should a company have? Two ratios to help manage: – Inventory turnover ratio – measures the number of times inventory is sold in a period – Days in inventory ratio – converts inventory turnover ratio into number of days inventory is held Inventory Turnover 6

29. CHAPTER 1 Inventory Ratios In general, the higher the inventory turnover and the lower the days in inventory ratios, the better 6 Copyright John Wiley & Sons Canada, Ltd. 29 Inventory Turnover= Cost of goods sold Average inventory Days in Inventory= 365 days Inventory turnover

30. CHAPTER 1 Both inventory cost formulas (FIFO and average) can also be used in periodic systems Allocation is made at the end of the period Appendix 6A – Periodic Inventory Systems 6

31. CHAPTER 1 Appendix 6A – Periodic System Under FIFO Copyright John Wiley & Sons Canada, Ltd. 31 6 Illustration 6A-2

32. CHAPTER 1 Appendix 6A – Periodic System Under Average Copyright John Wiley & Sons Canada, Ltd. 32 6 Illustration 6A-4

33. CHAPTER 1 Comparing IFRS and ASPE Copyright John Wiley & Sons Canada, Ltd. 33 6

34. CHAPTER 1 Copyright Notice Copyright © 2012 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright John Wiley & Sons Canada, Ltd. 34 6