Accounting Principles Second Canadian Edition Weygandt · Kieso · Kimmel · Trenholm Prepared by: Carole Bowman, Sheridan College CHAPTER 6 INVENTORY COSTING INVENTORY BASICS In the balance sheet of merchandising and manufacturing companies, inventory is frequently the most significant current asset. In the income statement, inventory is vital in determining the results of operations for a particular period. Gross profit (net sales - cost of goods sold) is closely watched by management, owners, and other interested parties. Perpetual vs. Periodic Inventory Accounting Perpetual – Updates inventory and cost of goods sold after every purchase and sales transaction Periodic – Delays updating of inventory and cost of goods sold until end of the period – Misstates inventory during the period This chapter covers the periodic inventory method. DETERMINING INVENTORY QUANTITIES In order to prepare financial statements, it is necessary to determine the number of units of inventory owned by the company at the statement date, and to value them. The determination of inventory quantities involves 1. taking a physical inventory of goods on hand, and 2. determining the ownership of goods. Taking a physical inventory involves counting, weighing, or measuring each kind of inventory on hand. TAKING A PHYSICAL INVENTORY A company, in order to minimize errors in taking the inventory, should adhere to internal control principles by adopting the following procedures: 1. Employees who do not have custodial responsibility for the inventory should do the counting (segregation of duties). 2. Each counter should establish the authenticity of each inventory item (establishment of responsibility). TAKING A PHYSICAL INVENTORY 3. Another employee should make a second count (independent verification). 4. All inventory tags should be pre-numbered and accounted for (documentation procedures). 5. At the end of the count, a designated supervisor should ascertain that all inventory items are tagged and that no items have more than one tag (independent verification). TERMS OF SALE FOB Shipping Point FOB Destination Point Seller Seller Ownership passes to buyer here Public Carrier Co. Buyer Ownership passes to buyer here Public Carrier Co. Buyer DETERMINING OWNERSHIP OF CONSIGNED GOODS Under a consignment arrangement, the holder of the goods (called the consignee) does not own the goods. Ownership remains with the shipper of the goods (consignor) until the goods are actually sold to a customer. Consigned goods should be included in the consignor’s inventory, not the consignee’s inventory. Owned by a consignor; do not count in our (consignee) inventory Consignee Company SALES TRANSACTIONS General Journal Date Account Title and Explanation May 4 Accounts Receivable Sales To record credit sale. Ref Debit 3,800 J1 Credit Only one entry is required to record a sale under a periodic method. 3,800 RECORDING SALES RETURNS AND ALLOWANCES General Journal Date Account Title and Explanation May 8 Sales Returns and Allowances Accounts Receivable To record returned goods. Ref Debit 300 J1 Credit 300 The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a contra revenue account to the Sales account. PURCHASES OF MERCHANDISE General Journal Date Account Title and Explanation Ref May 4 Purchases Accounts Payable To record goods purchased on account, terms n/30. Debit 3,800 J1 Credit 3,800 For purchases on account, Purchases is debited and Accounts Payable is credited. For cash purchases, Purchases is debited and Cash is credited. PURCHASE RETURNS AND ALLOWANCES General Journal Date Account Title and Explanation May 8 Accounts Payable Purchase Returns and Allowances To record return of goods Ref Debit 300 J1 Credit For purchases returns and allowances that were originally made on account, Accounts Payable is debited and Purchase Returns and Allowances is credited. The Purchase Returns and Allowances account is a contra account. 300 ACCOUNTING FOR FREIGHT COSTS General Journal Date Account Title and Explanation May 4 Freight In Cash To record payment of freight. Ref Debit 150 When the purchaser directly incurs the freight costs, the account Freight In is debited and Cash is credited. J1 Credit 150 HIGHPOINT ELECTRONICS Income Statement For the Year Ended December 31, 2002 Sales revenue Sales Less: Sales returns and allowances Net sales Cost of goods sold Inventory, January 1 Purchases Less: Purchase returns and allowances Net purchases Add: Freight in Cost of goods purchased Cost of goods available for sale Inventory, December 31 Cost of goods sold Gross profit Operating expenses Salaries expense Rent expense Utilities expense Advertising expense Amortization expense Freight out Insurance expense Total operating expenses Net income $ $ $ $ $ 480,000 20,000 460,000 $ 316,000 144,000 36,000 325,000 17,200 307,800 12,200 320,000 $ 356,000 40,000 $ 45,000 19,000 17,000 16,000 8,000 7,000 2,000 The multi-step income statement under the periodic system requires more detail in the cost of goods sold section, as shown above. $ 114,000 30,000 ALLOCATION OF INVENTORIABLE COSTS Ending Inventory (Balance Sheet) Beginning Inventory Cost of Goods Available for Sale Goods Purchased during the year Cost of Goods Sold (Income Statement) 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 _ Ending Goods Inventory Purchased = Cost of Goods 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 In ven to ry E rro r C o st o f G o o d s S o ld Understate beginning inventory Understated Overstate beginning inventory Overstated Understate ending inventory Overstated Overstate ending inventory Understated N et In co m e Overstated Understated 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 E n d in g In ven to ry E rro r Overstated Understated Assets Overstated Understated L iab ilities None None O w n er’s E q u ity Overstated 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 Cost Television sets Consoles $ Portables Total Video equipment Recorders Movies Total Total inventory $ Market 60,000 45,000 105,000 $ 48,000 15,000 63,000 168,000 45,000 14,000 59,000 $ 166,000 LCM 55,000 52,000 107,000 $ 166,000 The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation. COPYRIGHT Copyright © 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. 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