Chapter Six - I nventory Costing

Chapter Objectives - See Previous Page

Lesson 1. I nventory Basics(Note Overhead)
Taking a physical inventory involves actually counting, weighing or measuring each kind
of inventory on hand.
Companies often count their inventory when the business is at its slowest time of the year.

Read: Accounting in Action Page 264 and 266

Review the difference between perpetual and periodic inventory methods.

I nternal Control Procedures (Note Overhead)
Counting should be done by employees that have no record keeping responsibilities.
Authenticity of each item should be established.
The count should be done by two people.
Pre-numbered inventory tags should be used.
Unit costs are then applied to the items to determine the total cost of the inventory
A supervisor should be sure that inventory items have bee tagged once and once only.

Determining Ownership of the Goods
In general, goods should be included in the inventory of the owner, who has legal title to
them

Examples: FOB Shipping Point - Goods belong to the buyer
FOB Destination Goods belong to the seller
Consignment Goods belong to consignor (Shipper)

Read other situations - Page 267
Complete DO IT on page 267.

Lesson 2: Periodic I nventory System

Read with students page 268 Periodic Inventory System
Note: (Overhead)
Revenue from the sale of merchandise are recorded when sales are made, the same way
as in the perpetual system, but no attempt is made on the date of the sale to record the cost of the
merchandise sold.

Using overheads or giving hand out explain the Recording of Purchases of
Merchandise and The Comparison of Entries

Assign: E6-2 - Page 304
P6-1A - Page 307
Lesson 3: Cost of Goods Sold

Step One Determine the Cost of Goods Purchased
Purchases Purchase Returns and Allowances = Net Purchases
Net Purchases + Freight = Cost of Goods Purchased

Step Two Determine the Cost of Goods Available for Sale
Add the Beginning Inventory to the Cost of Goods Purchased to determine the Cost of
Goods Available for Sale

Step Three Determine the Cost of Goods on Hand
A physical inventory is done to determine the Cost of Goods on Hand, this is called the
Ending I nventory.

Step Four Determine the Cost of Goods Sold
The ending Inventory is deducted from the Cost of Goods Available for Sale to arrive at
the Cost of Goods Sold

Ask students to turn to page 273 and refer to Figure 6.5

Explain to the students that there are two additional closing entries needed in the
periodic system :

A. The beginning Inventory amount debited to the Capital, and Credited to
Merchandise Inventory

B. The ending Inventory amount is debited to Merchandise Inventory and credited
to the Capital. This becomes the beginning inventory the following period.

Students will complete E6-3 (page 304)
E6-5 (page 305)







I nventory Basics
Taking a physical inventory involves actually counting, weighing or measuring each kind
of inventory on hand.
Companies often count their inventory when the business is at its slowest time of the year.

I nternal Control Procedures
Counting should be done by employees that have no record keeping responsibilities.
Authenticity of each item should be established.
The count should be done by two people.
Pre-numbered inventory tags should be used.
Unit costs are then applied to the items to determine the total cost of the inventory
A supervisor should be sure that inventory items have bee tagged once and once only.

Determining Ownership of the Goods

In general, goods should be included in the inventory of the owner, who has legal title to
them:

Examples: FOB Shipping Point - Goods belong to the buyer
FOB Destination Goods belong to the seller
Consignment Goods belong to consignor (Shipper)

Periodic I nventory System
Revenue from the sale of merchandise are recorded when sales are made, the same way
as in the perpetual system, but no attempt is made on the date of the sale to record the cost of the
merchandise sold.


Cost of Goods Sold
Step One Determine the Cost of Goods Purchased
Purchases Purchase Returns and Allowances = Net Purchases
Net Purchases + Freight = Cost of Goods Purchased

Step Two Determine the Cost of Goods Available for Sale
Add the Beginning Inventory to the Cost of Goods Purchased to determine the Cost of
Goods Available for Sale

Step Three Determine the Cost of Goods on Hand


A physical inventory is done to determine the Cost of Goods on Hand, this is called the
Ending I nventory.

Step Four Determine the Cost of Goods Sold
The ending Inventory is deducted from the Cost of Goods
Available for Sale to arrive at the Cost of Goods Sold
Lesson 4: I nventory Costing Under a Periodic I nventory System

1. I nventory Cost Flow Methods
2. Companies that use the periodic inventory system, track the cost of goods purchased.
3. When the cost of the beginning inventory is added, the cost of goods available for sale is
known.
4. This cost must be split between the ending inventory on the balance sheet and the cost of
goods sold on the income statement in accordance with the cost and matching principles.
5. There are a variety of methods available.
6. If the unit costs have not varied each method will yield the same results.
7. If cost have changed, the method chosen to allocate the cost will influence the balance
sheet and income statement amounts.

A. Specific I dentification Method
The specific identification method tracks the actual physical flow of the goods.
It is primarily used when the inventory consists of a relatively small number of uniquely
identifiable, high priced items, like the inventory of a car dealership.
Specific identification is not appropriate for high volume, low cost inventory.

B. First-I n, First-Out
(FI FO)
B. The FIFO method assumes that the earliest goods acquired are the first ones sold.
C. The allocation of cost is done ate the end of the period, one the physical inventory count
has been done.
D. The cost of the ending inventory is obtained by taking the unit cost of the most recent
purchase and working backward until all the inventory have been costed.
E. If the order of selling is first-in, first-out, then what remains in inventory are the latest
units purchased (Last-In, Still-Here)

Students will now refer to page 278 Figure 6-9
Assign: E6-6 (Page 305)

0. Average Cost
1. Under this method, a weighted average unit cost is calculated.
2. Cost of goods available for sale divided by Total units available for sale = Weighted
average costs per unit
3. This inventory cost is applied to the units still on hand to determine the cost of the ending

inventory, and to the units sold to determine the cost of goods sold.

Students will now refer to page 280 Figure 6-11
Assign: E6-7 (Page 305)





D. Last-I n, First-Out (LI FO)

The LIFO Method assumes that the latest good acquired are the first ones sold.
The allocation of cost is done at the end of the period, once the physical inventory count
has been done.
The cost of the ending inventory is obtained by taking the unit cost of the oldest goods
available for sale and working forward until all the inventory have been costed.
As a result, the first costs assigned to the ending inventory are the costs of the beginning
inventory (First-In, First-Here)

Assign: E6-7 (Page 305)


Lesson Five - Effects of Cost Flow Methods

1. With students read page 281 to the top of page 282.


2. I ncome Statement Effects




LI FO provides the best income statement valuation, since it matches current costs with current
revenues. However, it is not often used in Canada because it is not allowed by Revenue and
Customs Canada for tax purposes.
PRI CES AVERAGI NG
EFFECTS
FI FO EFFECTS LI FO EFFECTS
STABLE Identical Results Identical Results Identical Results
RI SI NG Between Lowest Highest
FALLI NG Between Highest Lowest
Balance Sheet Effects














LI FO provides the best income statement valuation, since it matches current costs with current
revenues. However, it is not often used in Canada because it is not allowed by Revenue and
Customs Canada for tax purposes.
Cash Flow Effects
The cash flow is the same under each method. The inventory cost flow method only allocates the
cost of goods available for sale between the cost of goods sold and the ending inventory. It does
not impact the cash received from sales, or paid for purchases.
3. Read with students 285 to 287 - Inventory Errors -
Explain to students that there can be many different combinations of errors in inventory.
See Figure 6-17
Using this table and a copy of an income statement students can see the effects of
understatements and overstatements in the income statement.
See Figure 6-19
Effects of inventory errors on a balance.
Lower of Cost and Market
Market Value - Estimated amount for which an asset can be sold
PRI CES AVERAGI NG
EFFECTS
FI FO EFFECTS LI FO EFFECTS
STABLE Identical Results Identical Results Identical Results
RI SI NG Between Merchandise Inventory
will be highest.
Merchandise Inventory
will be lowest.
FALLI NG Between Merchandise Inventory
will be highest.
Merchandise Inventory
will be lowest
Balance Sheet Effects


When the market value of the inventory falls below its cost, the Inventory is written down
to the market value in the period during which the decline occurred. Thus the inventory is shown
on the balance sheet at the lower of cost and market.
LCM is commonly applied to the total inventory , not to individual items.

The Journal Entry:
Loss to Decline In Net Realizable Value of Inventory (IS) Debit
Merchandise Inventory (BS) Credit









I ncome Statement Effects



LI FO provides the best income statement valuation, since it matches current costs with current
revenues. However, it is not often used in Canada because it is not allowed by Revenue and
Customs Canada for tax purposes.

PRI CES AVERAGI NG
EFFECTS
FI FO EFFECTS LI FO EFFECTS
STABLE Identical Results Identical Results Identical Results
RI SI NG Between Merchandise Inventory
will be highest.
Merchandise Inventory
will be lowest.
FALLI NG Between Merchandise Inventory
will be highest.
Merchandise Inventory
will be lowest
PRI CES AVERAGI NG
EFFECTS
FI FO EFFECTS LI FO EFFECTS
STABLE Identical Results Identical Results Identical Results
RI SI NG Between Lowest Highest
FALLI NG Between Highest Lowest

LI FO provides the best income statement valuation, since it matches current costs with current
revenues. However, it is not often used in Canada because it is not allowed by Revenue and
Customs Canada for tax purposes.


Cash Flow Effects


The cash flow is the same under each method. The inventory cost flow method only allocates the
cost of goods available for sale between the cost of goods sold and the ending inventory. It does
not impact the cash received from sales, or paid for purchases.