Chapter 6 Inventory Costing

Inventory Basics
- A company with too little inventory to meet demand will have dissatisfied
customers and sales personnel
- Company with too much inventory will incur unnecessary costs
- Inventory affects the balance sheet (Merchandise Inventory is a current asset) and
the income statement (COGS)
Determining Inventory Quantities
- (1) Take a physical inventory of goods on hand
- (2) Determining the ownership of goods
- In a perpetual system, the according records continuously and physical count is
taken some time in year
- In periodic, inventory quantities are not maintained on a continuous basis, but are
rather determined at the end of each reporting period by a physical count
- Taking a physical count is necessary for accuracy; involves counting, weighing, or
measuring each kind of inventory on hand
- Companies often count their inventories when the business is closed/slow
- Internal control consists of policies and procedures to improve resources, prevent
and detect errors, safeguards assets, and enhance the accuracy and reliability of
accounting records
- Some internal control procedures are:
1. Counting should be done by employees who do not have custodial or recordkeeping responsibility for the inventory
2. Each counter should establish the authenticity of each inventory item. Example,
does each box contain a television set? Does each storage tank contain gasoline?
3. There should be a second count by another employee or auditor. Counting should
take place in teams of two.
4. Prenumbered inventory tags should be used. All inventory tags should be
accounted for
5. At the end of the count, a designated supervisor should check that all inventory
items are tagged and that no items have more than one tag
- After the physical count is done, the quantity of each kind of inventory is listed on
inventory summary sheets; the listing should be verified by another employee or
auditor
- Unit costs are then applied to the quantities in order to determine the total cost of
the inventory
Determining Ownership of Goods
- We need to be sure that we have not included in the inventory quantities any
goods that do not belong to the company, or forgotten any that do
- Goods in transit goods are considered in transit when they are in the hands of a
public carrier such as a railway, airline, trucking, or shipping company at the
statement date
- (1) FOB shipping point ownership of the goods passes to the buyer when the
public carrier accepts the goods from the seller
- (2) FOB destination ownership of the goods remain with the seller until the goods
reach the buyer

Inventory quantities may be seriously miscounted if goods in transit at the

statement date are ignored; example, a company has 20000 units of inventory on
hand on Dec 31. It has the following goods in transit (1) sales of 1500 units
shipped Dec 31, FOB destination, and (2) purchases of 2500 units shipped FOB
shipping point by the seller on Dec 31. The company has legal rights on the 4000
units
Consigned Goods in some businesses, you must acquire merchandise on consignment
- In a consignment, the holder of the goods (consignee) does not own the goods
- Ownership remains with the shipper of the goods (consignor) until the goods are
actually sold to a customer
- Because consigned goods are not owned by the consignee, they should not be
included in the consignees physical inventory count
- The consignor should include merchandise held by the consignee as part of its
inventory
Other Situations
- (1) Sometimes goods are not physically at the companys warehouse/building
because they have been taken home on approval by a customer
- Goods on approval should be added to the physical inventory count because
they still belong to the seller
- The customer with either return the item or decide to buy it
- (2) In other cases, goods are sold but the seller is holding them for alteration, or
until they are picked up or delivered to the customer
- These goods should not be included in the physical count, as it is the customers
property now
- (3) Damaged or unsaleable goods should not be included in the physical count
and any loss should be recorded
Periodic Inventory System
- Revenues from the sale of merchandise are recorded when the sales are made,
(like perpetual) but no attempt is made on the date of sale to record the COGS
- Instead, a physical inventory count is taken at or near the end of the period
- This count determines the cost of merchandise on hand
- This info and other info is used to determine the COGS during the period
- Under a periodic system, purchases of merchandise are recorded in the Purchase
Expense account, rather than the Merchandise Inventory asset account (in
perpetual)
- Also, one must record Purchase Returns and Allowances and Freight In in separate
accounts; this way accumulated amounts are known for each
Recording Sales of Merchandise (only one entry for periodic)
- Dr: Accounts Receivable/Bank
- Cr: Sales
Sales Returns and Allowances
- Dr: Sales Returns and Allowances
- Cr: Accounts Receivable
-

These two sales entries are exactly the same as the perpetual system, with one
exception. The periodic system does not include the second journal entry that
records the COGS and MI
COGS are determined by calculation at the end of the period

Recording Purchases of Merchandise

- Dr: Purchases (temporary expense account reported on the income statement;
normal debit balance)
- Cr: Accounts Payable
Purchase Returns and Allowances
- Dr: Accounts Payable
- Cr: Purchase Returns and Allowances (contra account; normal balance is a credit;
P-PRAA=NP)
Freight Costs
- When the purchases pays for freight costs
- Dr: Freight In (temporary expense account, normal debit balance
- Cr: Bank
- *Just as freight was a part of the cost of merchandise inventory in perpetual,
freight in is part of the COGS in a periodic system (in accordance to the cost
principle)
- Freight in is added to net purchases to determine COGS
Comparison of entries in Perpetual and Periodic

Cost of Goods Sold

- In a periodic system, temporary accounts are used to accumulate the increases
and decreases in purchases and sales throughout the period
- Change in inventory is not recorded daily, thus is not known, neither is the COGS
- To determine COGS, there are 3 steps (1) Record purchase of merchandise (2)
Determine the COGS purchased (3) Determine the COGS on hand at the beginning
and end of the accounting period)
Determining Cost of Goods Purchased

We use three accounts earlier to record the purchase of inventory in a periodic

system
(1) Purchase of merchandise (Purchases); Debit balance; Increases COGS
(2) Purchase Returns granted by seller (Purchase Returns); Credit balance;
Decreases COGS
(3) Freight charges paid by purchaser (Freight in); Debit balance; Increases COGS

The procedure to determine Cost of Goods purchased is:

(1)Purchases Purchase Returns and Allowances (Credit balance) = Net Purchases
(2)Freight in + Net Purchases = Cost of Goods Purchased
Determining Cost of Goods on Hand
- Must take a physical inventory
- (1) Count the units on hand for each item of inventory
- (2) Apply unit costs to the total units on hand for each item of inventory
- (3) Total the costs for each item of inventory, to determine the total cost of goods
on hand
- The total cost of goods on hand is the ending inventory
- This ending inventory amount will be used to calculate the COGS and will be
recorded as part of the closing process in the MI account
- Closing entries are made to eliminate beginning inventory and to record ending
inventory in MI account
Cost of Goods Sold two steps
- (1) Add the cost of goods purchased to the cost of goods on hand at the beginning
of the period (beginning inventory). The result is the Cost of goods Available for
Sale (BI+ P +F-in = COGAFS)
- (2) Subtract the cost of goods on hand at the end of the period (ending inventory)
from the cost of goods available for sale. The result is COGS. (COGAFS EI =
COGS)
Income Statement
- Two exceptions from perpetual: (1) the MI account is the beginning inventory
amount; not yet updated
- (2) There is no COGS account, rather Purchases, Purchase Returns, and Freight in
are new accounts
Completing the Accounting Cycle
- After financial Statement, closing entries and post-closing trial balance complete
the accounting cycle
- For merchandising company, all accounts that affect net income are closed into the
owners capital, whether you are using periodic or perpetual
- Data to prepare closing entries can be taken form the income statement and
balance sheet
- The closing entries are the same as the previously learned, with one exception: the
treatment of MI. In the adjusted trial balance, the balance reported for inventory is
its beginning balance, not the ending balance reported in a perpetual inventory
system
- During the period, no entries are made to the MI account since the temporary
Purchases account is used. The BI remains in the account unchanged all year. At
year end, entries must be made to eliminate the BI, and to record the new EI
Two journal entries are required to close the MI in a periodic system

MI inventory is not actually closed, rather updated form BI TO EI

To summarize: (!) MI is credit for its BI and debited to Owners Capital
(2) The MI is debited for its EI and credited to Owners Capital
(3) Temporary accounts with credit balances (Sales, Purchase Returns) are debited
are debited for their individual account balance and total credit to the owners
capital account
(4) Temporary accounts with debit balances (Sales Returns, Purchases, Purchase
Returns, Freight in, Operating expenses) are credit and total debited to owners
capital
(5) Drawings is credited and its balance is debited to capital
In the post-closing trial balance, the current asset account MIs balance after
closing equal ending inventory This amount is the BI for the new period

Inventory Costing Under a Periodic Inventory System

- When all inventory items are purchased at the same unit cost, it is simple to apply
unit costs to the quantities on hand during the physical inventory
- When items are purchased at different costs during the period, it is difficult to
decide which particular item at which unit cost remains in inventory and which unit
cost has been sold
- The cost of items must be allocated in a consistent and rational way (1) following
the cost principle, cost is the primary basis of accounting for inventories. This
includes all expenditures needed to acquire goods and to make them ready for sale
(2) Following the matching principle, in accounting for inventories, the major
objective is the matching of appropriate costs with sales revenue
- Under a perpetual method, this allocation is made as each item is sold
- Under periodic, the allocation is made at the end of the period
- Companies may use the perpetual inventory of inventories on hand, so reorders
are made automatically when inventories fall to a certain level
- Periodic inventory costing methods include specific identification, FIFO, Average
cost, and LIFO
Using Actual Physical Flow Costing Specific Identification
- This method tracks the actual physical flow of the goods
- Each item of inventory is marked, tagged, or coded with its specific unit cost
- This method is possible when a company sells a limited number of high-unit-cost
items that can be clearly identified from purchase through to sale (automobiles,
furniture stores etc)
- Ideal method of allocating cost of goods available for sale; reports EI at actual cost
and matches the actual cost of goods sold against sales revenue
- May let management to manipulate net income
- Method is impractical for bigger businesses
Using Assumed Cost Flow Methods FIFO, Average Cost, and LIFO
- Assumed flows of costs that may be unrelated to the physical flow of goods thus
called assumed cost flow methods
First-In, First-Out (FIFO)
- Assumes that the earliest goods purchased are the first to be sold; often matches
the actual physical flow
- The cost of the earliest goods purchased is the first to be recognized as the COGS;
does not mean that oldest units are really sold first, it just means that their cost is
recognized first

In periodic system, we ignore the timing of the dates of each sale; we make the
allocation at the end of a period ad assume that the entire pool of costs is available
for allocation at that time

Ending inventory = COGAFS COGS as well; Can use this method to check
accuracy

Average Cost Method

- Assumes that the goods available for sale are identical; the allocation of the
COGAFS is on the basis of the weighted average unit cost. The formula to calculus
weighted average unit cost = COGAFS/Total Units Available for sale

Last-In, First-out (LIFO)

- Assumes that the latest goods purchased are the first to be sold; LIFO rarely
coincides with the actual physical flow (only for goods in piles or products in bins at
stores like Bulk Barn)

Under a periodic system, all goods purchased during the period are assumed to be
available for the first sale, regardless of the date of purchase.
In LIFO, the cost of the last goods in is the first to be assignment to COGS

Financial Statement Effects of Cost Flow Methods

- All four cost flow methods are acceptable, though very few use LIFO in Canada
- Companies may use more than one cost flow method at the same time
- The reasons companies adopt different methods are usually due to (1) Income
Statement effect (2) Balance Sheet effects
Income Statement effects

The COGAFS is same for all, but EI and COGS are different
In a period of rising prices, FIFO produces a higher income and LIFO the lowest
To management, higher net income is an advantage; causes external users to view
the company more favorably
If prices are falling, LIFO will produce higher income
If prices are stable, all three methods will report the same results
LIFO provides the best income statement valuation. It matches current costs
with current revenues

Balance Sheet Effects

- FIFO produces the best balance sheet valuation
- In rising prices, LIFO understates inventory in terms of current costs
- Revenue and purchases are not affected by any method (cash flow remain same
with all)
- Overtime, all three cost flow methods will give exactly the same results over the
life cycle of the business or product
Summary of Effects
ADD PICTURE

Selection of Cost flow Method and Consistency

- Choices of cost flow method can lead to different financial statement effects,
depending on the direction of prices
- Choice of method is given to accommodate differences in the circumstances of the
company and industry
- Cannot select the method that is useful to us and change it every period
- Consistency is important in order to compare
- Change in inventory costing method is disclosed in financial statements (full
disclosure principle)
Inventory Errors
- Errors may occur in taking or costing inventories caused by counting or pricing
inventory incorrectly
- Errors affect both the income statement and balance sheet
- On the Income statement, it would affect the COGS and Net income, and on the
balance sheet, ending inventory and owners capital
- If BI is understated, COGS are understated, and Income is overstated
- If Purchases are understated, COGS will be understated, and income will be
understated
- If EI is understated, COGS are overstated, and income is understated
- An error in ending inventory of the current period will have a reverse effect on net
income in the next period
- The combined net income for two years us correct because the errors cancel out
- On the balance sheet, understated ending inventory will hce understated assets,
and understated owners equity
Statement Valuation and Presentation
Valuing Inventory at the Lower of Cost and Market (LCM)
- When the value of inventory is lower than its cost, the inventory is written down to
tis market value (done by LCM when decline occurs)
- LCM follows conservatism when choosing among alternatives, the best choice is
the method that is least likely to overstate assets and net income
Inventory Cost Flow Methods in Perpetual Inventory Systems

(1)FIFO
- The cost of the earliest goods on hand prior to each sale is charged to COGS

The COGS Sold on September 10 consist of all the units on hand on Jan 1, all units
purchased on April 15, and 250 (number needed to equal 550 sold) of the units
purchased on August 24

The ending inventory is $5800 and COGS is $6200

The results under FIFO in a perpetual system are the same as in a periodic system

(2) Average Cost

- Called moving average cost method in perpetual
- Weighted average unit cost: Calculated by dividing COGAFS/Total Units
- The difference is that under this method a new average is calculated after each
purchase

(2)LIFO
- The cost of the most recent purchase prior to sale is allocated to the units sold
- The use of LIFO in perpetual will usually produce cost allocations different from
using LIFO in a periodic system
- In a perpetual system, the latest units purchased before each sale are allocated
to COGS. In periodic, the latest units bought during the period are allocated to
COGS
- When a purchase is made after the last sale, the LIFO periodic system will apply
this purchase to the previous sale.
- If we compare the COGS and EI figures for each of these perpetual cost flow
assumptions we find the same proportionate outcomes that we saw with periodic
cost flow assumptions
- Example, when prices are rising, FIFO will always yield the highest EI and LIFO the
lowest. LIFO will result in higher COGS (low net income). If prices are falling, the
reverse will happen
Estimating Inventories

If inventory was destroyed by fire, a company cannot do a physical count of its

inventory
- Two methods: (1) Gross Profit method (2) Retail inventory method
Gross profit Method
- Estimates the cost of EI by applying a gross profit rate to net sales
- Step (1) Net Sales Estimated Gross Profit = Estimated COGS
- Step (2) COGAFS Estimated COGS = Estimated Cost of Ending Inventory
- This method is based on the assumption that the gross profit margin will remain
constant, but this is not usually true
- The gross profit method should not be used in preparing a companys financial
statement at the end of the year, but rather made from physical inventory counts
Retail Inventory Method
- The application of unit costs to inventory quantities is time consuming when a
company has thousands of types of merchandises
- An alternative is to use the Retail Inventory method to estimate the cost of
inventory
- (1) Goods Available for Sale at Retail Net Sales = Ending Inventory at Retail
- (2) Goods Available for Sale at Cost/ Goods Available for Sale at Retail = Cost to
Retail Ratio
- (3) Ending inventory at retail x Cost to Retail Ratio = Estimated Cost of Ending
Inventory
- This method also facilitated taking a physical inventory at the end of the year
- The major disadvantage of the retail method is that it is an averaging technique. It
may produce an incorrect inventory valuation if the mix of the ending inventory is
not representative of the mix in the Goods Available for sale.