Accounting Principles Second Canadian Edition Weygandt · Kieso · Kimmel · Trenholm Prepared by: Carole Bowman, Sheridan College CHAPTER 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 taking a physical inventory of goods on hand, and 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: Employees who not have custodial responsibility for the inventory should the counting (segregation of duties) Each counter should establish the authenticity of each inventory item (establishment of responsibility) TAKING A PHYSICAL INVENTORY Another employee should make a second count (independent verification) All inventory tags should be pre-numbered and accounted for (documentation procedures) 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 Seller FOB Destination Point Seller Ownership passes to buyer here Public Carrier Co Buyer Public Ownership Carrier passes to Co buyer here 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; not count in our (consignee) inventory Consignee Company SALES TRANSACTIONS General Journal Date Account Title and Explanation May 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 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 Understate beginning inventory Understated Overstate beginning inventory Overstated Understate ending inventory Overstated Overstate ending inventory Understated 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 Overstated Understated Overstated Understated None None 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 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 .. .CHAPTER INVENTORY COSTING INVENTORY BASICS In the balance sheet of merchandising and manufacturing... 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... 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