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CHAPTER 6: INVENTORY COSTING INVENTORY BASICS Amount + time required to sell = indicators. E.g.

. economic downturns = initial buildup of inventories (longer to sell). Economic upturns = inventories decrease Balance: too little (dissatisfied customers + sales personnel) vs. too much (unnecessary costs) Balance Sheet: significant current asset (merchandising/manufacturing). Amount + importance vary for companies. Income Statement: cost of goods sold determines operation results. Gross profit = net sales cost of goods sold (watched by management, owners, other parties) DETERMINING INVENTORY QUANTITIES Number of units: 1) physical inventory, 2) ownership of goods TAKING A PHYSICAL INVENTORY Perpetual inventory system: continuous accounting records quantity of merchandise. Physical inventory once a year. Periodic inventory system: inventory quantity at end of reporting periods physical count. Counting, weighing, measuring. More accurate when goods not sold or received during counting = count occurs when business is closed or slow Internal Control: policies + procedures to optimize resources, prevent + detect error, safeguard assets, enhance accuracy + reliability. 1. Counted by employees w/o custodial + recordkeeping responsibility for inventory 2. Authenticity of each inventory item 3. Second count by another employee/auditor, counted by teams of 2 4. Prenumbered inventory tags, each tag accounted for 5. End of count: supervisor checks that all items are tagged + w/ only 1 tag Quantity of each kind of inventory is listed on inventory summary sheets, verified by employee/auditor Unit costs applied to quantities = total cost of inventory. W/o physical count (if inventory is destroyed, or inconvenient interim period) estimating methods DETERMINING OWNERSHIP OF GOODS Goods in Transit: public carrier (railway, airline, trucking, shipping company) at statement date. Belongs to inventory of party w/ legal title. FOB shipping point = owned by buyer. FOB destination = owned by seller Consigned Goods: consignment arrangement: holder of goods (consigner) doesnt own goods. Consigned goods are included in inventory of consignor until they are sold to customer. Other situations: 1) Taken home on approval by customer. Ownership = seller, until customer buys it. 2) Seller holds sold goods for alteration, or until delivery. Ownership = buyer. 3) Damaged or unsaleable goods should be segregated from physical count, any loss recorded.

PERIODIC INVENTORY SYSTEM Revenues from sale of merchandise recorded when sales made Cost of merchandise sold is not determined/recorded until physical inventory at end of period RECORDING SALES OF MERCHANDISE DR Accounts Receivable, CR Sales, To record credit sale per invoice # to Name SALES RETURNS AND ALLOWANCES Dr Sales Returns and Allowances, Cr Accounts Receivable, To record return of inoperable goods from Name

RECORDING PURCHASES OF MERCHANDISE Purchases account: purchases of merchandise: temporary expense account DR Purchases, CR Accounts Payable, To record goods purchased on account, terms n/30 PURCHASE RETURNS AND ALLOWANCES Purchase Returns and Allowances: temporary contra expense account: credit. Purchases less Purchase Returns and Allowances = Net Purchases DR Accounts Payable, CR Purchase Returns and Allowances, To record return of inoperable goods purchased from Highpoint Electronics

FREIGHT COSTS

Freight In (accumulated amounts are known for each): when the purchaser pays for the freight costs. Temporary expense account. Part of cost of goods purchased, added in with Net Purchases Cost Principle: cost of goods purchased includes freight charges to bring goods to purchaser DR Freight In, CR Cash, To record payment of freight, terms FOB shipping point

COMPARISON OF PERPETUAL VS PERIODIC: Purchaser: replace Merchandise Inventory with Purchases, Freight In, and Purchase Returns and Allowances. Seller: no second entry for Cost of Goods Sold COST OF GOODS SOLD 1) Record purchases of merchandise 2) 3) DETERMINING COST OF GOODS PURCHASED Purchases less Purchase Returns and Allowances = Net Purchases Net Purchases + Freight In = Cost of Goods Purchased DETERMINING COST OF GOODS ON HAND Physical Inventory: 1) Count the units on hand for each item of inventory. 2) Apply unit costs to total unit son hand for each item. 3) Total costs for each item, determine total cost of goods on hand Ending Inventory: total cost of goods on hand. (Used Cost of goods sold, recorded as part of closing process) The balance in Merchandise Inventory throughout the period is beginning inventory. End of the year, closing entires eliminate this and records ending inventory. CALCULATING COST OF GOODS SOLD Cost of goods purchased + Beginning Inventory = Cost of goods available for sale Cost of goods available for sale Ending Inventory = Cost of goods sold

4)

INCOME STATEMENT PRESENTATION Adjusted Trial Balance: 2 differences: 1) Merchandise Inventory is beginning inventory, 2) no Cost of Goods Sold account. Cash $ AR $ Merchandise Inventory $ Prepaid Insurance $ Store Equipment $ Accumulated Amortization $ Accounts Payable $ Salaries Payable $ R.A. Lamb, Capital $ R.A. Lamb, Drawing $ Sales $ Sales Returns and Allowances $ Purchases $ Purchase Returns and Allowances $ Freight In $ Salaries Expense $ Rent Expense $ Multiple step income statement:1 difference: detailed Cost of Goods Sold section $ 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 COMPLETING THE ACCOUNTING CYCLE All accounts in the determination of net income are closed

$ $

To close the Merchandise Inventory account (updates inventory account, new amount is beginning inventory for new period) : 1) Merchandise Inventory credited to owners capital = 0. 2) Merchandise Inventory debited and Capital credited for ending inventory. 1) DR Name, CR Merchandise Inventory. 2) DR Merchandise Inventory, CR Name Closing Process: 1) Temporary credit accounts (Sales, Purchase Returns + Allowances, also Merchandise Inventory) debited to capital. 2) Temporary debit accounts (sales Returns and Allowances, Purchases, etc, etc, also Merchandise Inventory) credited to capital. 3) Drawings account credited to capital.

INVENTORY COSTING UNDER A PERIODIC INVENTORY SYSTEM Applying unit costs to quantities for ending inventory allocate different purchase costs to each item in inventory + sold Determination + allocation of cost of items from cost of goods available for sale (BI + cost of goods Purchased) EI and Cost of goods Sold: aided by cost principle (cost is basis of inventory accounting, includes expenditures in process) + matching principle (matching appropriate costs with sales revenue of inventory) Perpetual system: allocation w/ each sale. Periodic: end of period Some use periodic inventory system for quantities (point-of-sale computer systems, but these dont maintain for costs cant identify purchase date + cost of item), Periodic for costs. USING ACTUAL PHYSICAL FLOW COSTING SPECIFIC IDENTIFICATION Tracks actual physical flow each item marked, tagged, coded with specific unit cost. Ending inventory is specifically costed for total cost Companies w/ limited number of identifiable high-unit-cost items (automobile dealerships, furniture stores) Pros: Ideal: 1) Actual cost of ending inventory, 2) actual cost of goods sold matches sales revenue Cons: manipulation of net income. Maximize (sell item with lowest cost), minimize (sell item with highest cost) Reality: identity of goods at specific cost is lost between purchase and sale. USING ASSUMED COST FLOW METHODS FIFO, AVERAGE COST, LIFO Assumed cost flow methods / cost flow assumptions FIRST IN, FIRST OUT (FIFO) Earliest goods purchased are first sold cost of earliest goods are first recognized as cost of goods sold. Periodic inventory system: allocation at end of period, assuming entire pool of costs is available at the time Ending Inventory: unit cost of most recent purchase + working back until all are costed. Or Cost of good available for sale Less Cost of goods sold. Pros: often matches actual physical flow, good business practice to sell oldest units first AVERAGE COST Assumes goods are identical + nondistinguishable. Allocation is on basis of weighted average cost Cost of Goods Available for Sale / Total Units Available for Sale = Weighted Average Unit Cost Cost is applied to Ending Inventory + goods sold LAST IN, FIRST OUT (LIFO) Latest goods purchased are first sold cost of last goods are first recognized as cost of goods sold Periodic inventory system: all goods purchased in period are assumed available for first sale Ending Inventory: unit cost of oldest goods available for sale + working forward until all are costed Cons: doesnt coincide with actual physical flow (except for goods in piles), not allowed in Canada

FINANCIAL STATEMENT EFFECTS OF COST FLOW METHODS Many different kinds are used. A company may use more than 1 at the same time. Factors when adopting a cost flow method: INCOME STATEMENT EFFECTS Depending on different cost flow methods, the ending inventory + cost of goods sold + net income are different Rising Prices: FIFO = higher income, expenses w/ revenues are lower unit costs of first units purchased. ADV: favorable to external users. Higher bonuses for management. Falling Prices: reversed. Stable: same. LIFO = best income statement valuation: ADV: Matches current costs w/ current revenues. (cost of goods sold = cost of goods most recently acquired). DIS: can be manipulated (timing of purchases), not allowed in Canada BALANCE SHEET EFFECTS

FIFO: best balance sheet valuation: ADV: Rising Prices: costs ending inventory will approximate current/ replacement cost, higher inventory. (management wants to replace inventory once sold, so this is relevant) LIFO: DIS: Rising Prices: costs ending inventory are understated (terms of current costs) Cash flow: revenues and purchases are not affected, only allocation between E.I. and C.o.G.S. (no cash involved) Over life cycle of business/product: all 3 give same results. (E.I. and C.o.G.S. vary over period)

SUMMARY OF EFFECTS (rising prices) FIFO C.o.G.S. Lowest Gross Profit/Net Income Highest Cash flow (pretax) Same Ending Inventory Highest

AVERAGE In Between In Between Same In between

LIFO Highest Lowest Same Lowest

SELECTION OF COST FLOW METHOD Objective: to provide information useful to decision-makers Choice among acceptable methods is allowed to accommodate different circumstances of company + industry (not to manipulate financial position) CICA: where method is important factor for income suitable to determine costs with method that results in charging against operations costs which most fairly match the sales revenue for the period. USING INVENTORY COST FLOW METHODS CONSISTENTLY Consistent use from 1 period to the next, to compare over time periods (net income) Change is allowed, but change + effects on net income should be disclosed in statement: Full disclosure principle: requires all relevant information to be disclosed.

INVENTORY ERRORS Reasons: counting/pricing inventory incorrectly, improper recognition of transfer of legal title for G.I.Transit INCOME STATEMENT EFFECTS (cost of goods sold and net income) Dollar effects: enter incorrect data in the formula, and substitute correct data 1) Beginning Inventory + C.o.G.Purchased = C.o.G.Available for Sale E.I. = C.o.G.Sold 2) Sales C.o.G.Sold = Gross Profit/Net Income C.o.G. = B.I. + C.o.G. = C.o.G. - Ending = C.o.G. Sales Gross Purchased Available Inventory Sold Sold Profit/ N.I. U + NE =U - NE =U NE -U =O U Beginning Inventory O + NE =O - NE =O NE -O =U O Beginning Inventory +U =U - NE =U NE -U =O U C.o.G. NE Purchased +O =O - NE =O NE -O =U O C.o.G. NE Purchased NE + NE = NE -U =O NE -O =U U E.I. NE + NE = NE -O =U NE -U =O O. E.I. Since E.I. of one period becomes B.I. of next, an error in E.I. of one period will have reverse effects on N.I. of next period Errors offset one another, but distortion impacts financial analysis and management decisions BALANCE SHEET EFFECTS (ending inventory + owners capital) Assets + Liabilities + Owners Equity Errors in B.I. have no impact on the balance sheet if E.I. is calculated correctly, but wrong N.I. is part of Owners Equity (same effect). Owners Equity after 2 periods will be correct, because N.I. is self correcting STATEMENT VALUATION AND PRESENTATION VALUING INVENTORY AT THE LOWER OF COST AND MARKET (LCM) Lower of cost and market (LCM): when value of inventory is lower than cost, inventory is written down to market value. (e.g. values fall due to changes in tech/ style). Applied after a costing method determines cost

Conservatism: choosing alternate method that is least likely to overstate assets + net income market: not specifically defined, may include replacement cost or net realizable value (majority of Canadian companies). Merchandising company: NRV: selling price less any costs required to make goods ready for sale LCM can be for individual items or categories or total inventory (common practice: least conservative but yields conservative results + allows increases in value to offset decreases in part or in full. Also for income tax purposes) Total Inventory: DR Loss Due to Decline in Net Realizable Value of Inventory $$, CR Merchandise Inventory $$. To record decline in inventory value, from original cost of $168,000 to current NRV of $166,000. Loss = Other Expenses (Income Statement). LCM is applied consistently.

APPENDIX 6-B: ESTIMATING INVENTORIES When? 1) management (periodic inventory system) may want monthly/quarterly statements. 2) casualty (fire or flood) 1) 2) GROSS PROFIT METHOD Estimates cost of ending inventory by applying gross profit rate to net sales (e.g. for interim statements in periodic inventory system) Step 1: Net Sales $$, Less: Estimated gross profit (% x Net Sales) $$ = Estimated cost of goods sold $$. Step 2: Beginning Inventory $$ + Cost of goods purchased $$ = Cost of goods available for sale $$, Less: Estimated cost of goods sold $$ = Estimated cost of ending inventory $$ Assumption: gross profit margin is constant (may actually change due to change in merchandising policies + market conditions, margin should be adjusted for current operating conditions). Sometimes more accurate to apply on department or product-line basis. Not for end of year statements. Can be used to test reasonableness of ending inventory amount.

RETAIL INVENTORY METHOD Retail stores: thousands of types of merch at low unit costs (applying unit costs difficult + time consuming) Relationship between cost + sales price is established, percentage applied to E.I. at retail prices Step 1: Goods Available for Sale at Retail Net Sales = Ending Inventory at Retail Step 2: Goods Available for Sale at Cost / Goods Available for Sale at Retail = Cost to Retail Ratio Step 3: Ending Inventory at Retail x Cost to Retail Ratio = Estimated Cost of Ending Inventory At Cost At Retail Beginning Inventory $14,000 $21,500 Goods Purchased 61,000 78,500 Goods Available for Sale $75,000 100,000 Net Sales 70,000 1) Ending inventory at retail 30,000 2) Cost to retail ratio = (75000 / 100,000) = 75% 3) Estimated cost of ending inventory = $30,000 x 75% 22,500 Facilitates physical inventory. Goods on hand can be valued @ prices marked on merchandise, cost to retail ratio applied to goods on hand @ retail to determine Ending Inventory at Cost CON: averaging technique = incorrect inventory valuation if E.I. mix is not similar to goods available for sale. Minimized problem by applying to department/ product line basis.