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.
Determination of inventory quantities involves:
1. taking a physical inventory of goods on hand
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 at the sellers
shipping dock
(shipping point)

Public
Carrier
Co.

Buyer

Ownership passes
to buyer at the
buyers receiving
dock (destination)

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
consignors inventory, not the consignees
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 YEARS
INCOME STATEMENT
Inventory Error
Understate beginning inventory
Overstate beginning inventory
Understate ending inventory
Overstate ending inventory

Cost of
Goods Sold

Net Income

Understated
Overstated
Overstated
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 + Owners Equity

Ending Inventory
Error

Overstated
Understated

Assets

Overstated
Understated

Liabilities

None
None

Owners Equity

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.