Reporting and Analysing Inventory

CHAPTER

6

Merchandise InventoryMerchandise Inventory

• Owned by the companyOwned by the company• Ready for sale to customersReady for sale to customers

Manufacturing InventoryManufacturing Inventory

Finished goods inventoryFinished goods inventoryWork in processWork in process

Raw materialsRaw materials

• A physical inventory countA physical inventory count– Determines ending inventoryDetermines ending inventory

– Enables cost of goods sold to be calculatedEnables cost of goods sold to be calculated

Companies that use a perpetual inventory system Companies that use a perpetual inventory system must also take a physical inventory to check the must also take a physical inventory to check the accuracy of “book inventory” against actual accuracy of “book inventory” against actual inventoryinventory

Determining Inventory QuantitiesDetermining Inventory Quantities

Taking a Physical InventoryTaking a Physical Inventory

• Determining inventory quantities by Determining inventory quantities by counting, weighting or measuring each type counting, weighting or measuring each type of inventoryof inventory

• Determining ownership of goods, including Determining ownership of goods, including goods in transitgoods in transit and and consigned goodsconsigned goods

Goods in TransitGoods in Transit

• Goods on board a truck, Goods on board a truck, train, ship, or plane at the train, ship, or plane at the end of the periodend of the period

• Who includes goods in Who includes goods in transit in inventory? The transit in inventory? The buyer? The seller?buyer? The seller?

• Goods in transit are Goods in transit are included in the inventory of included in the inventory of the company with legal titlethe company with legal title

Ownership passes to

buyer here

Ownership passes to

buyer here

PublicCarrierCo.

PublicCarrierCo.

Seller

Seller

Buyer

Buyer

FOB Shipping Point

FOB Destination Point

Illustration 6-1

Consigned GoodsConsigned Goods

• Goods in your store that Goods in your store that you don’t pay for until you don’t pay for until they sellthey sell

• Company does not take Company does not take ownershipownership

Inventory CostingInventory Costing

• After calculating the quantity of units of After calculating the quantity of units of inventory, unit costs are appliedinventory, unit costs are applied

• This determines the values for the cost of This determines the values for the cost of goods sold and ending inventorygoods sold and ending inventory

• This is a complicated process because This is a complicated process because inventory is purchased at different timesinventory is purchased at different times

Inventory Valuation SystemsInventory Valuation Systems

The following inventory valuation methods are The following inventory valuation methods are generally accepted. They can be used in either generally accepted. They can be used in either a periodic or perpetual inventory system.a periodic or perpetual inventory system.

• Specific IdentificationSpecific Identification• Cost Flow AssumptionsCost Flow Assumptions

– Average costAverage cost– First-in, first-out (FIFO)First-in, first-out (FIFO)– Last-in, first-out (LIFO)Last-in, first-out (LIFO)

Specific IdentificationSpecific Identification

• Concentrates on the physical tracing of Concentrates on the physical tracing of the particular items sold the particular items sold

• Major limitation is in identifying the Major limitation is in identifying the particular item soldparticular item sold

• Used in low-volume, high-priced Used in low-volume, high-priced industriesindustries– e.g., jewellery storese.g., jewellery stores

Average Cost Flow AssumptionAverage Cost Flow Assumption

• The average cost of all units in inventory is The average cost of all units in inventory is calculated each time there is a purchasecalculated each time there is a purchase– Weighted average costWeighted average cost

• This cost is used to determine cost of goods This cost is used to determine cost of goods sold and inventorysold and inventory

• Major advantage is not having to track the Major advantage is not having to track the individual items of inventoryindividual items of inventory

Weighted Average CostWeighted Average Cost

Cost of goods

available for sale ($)

Units available on the date of

sale

÷

First-in, First-out (FIFO)First-in, First-out (FIFO)

• The assumption is that the first item purchased The assumption is that the first item purchased is the first item soldis the first item sold

• Inventory is valued at the most current cost Inventory is valued at the most current cost and cost of goods sold is valued at the oldest and cost of goods sold is valued at the oldest inventory costinventory cost

• Earnings reported using this cost flow Earnings reported using this cost flow assumption is higher than any other cost flow assumption is higher than any other cost flow assumption as the oldest costs are used to assumption as the oldest costs are used to determine cost of goods solddetermine cost of goods sold

First-in, First-out (FIFO)First-in, First-out (FIFO)

Cost of Goods Sold

Cost of Goods Sold

Ending InventoryEnding

Inventory

Oldest Costs

Oldest Costs

Recent Costs

Recent Costs

Last-in, First-out (LIFO)Last-in, First-out (LIFO)

• The assumption is that the last item The assumption is that the last item purchased is the first soldpurchased is the first sold

• Inventory is valued at oldest cost and cost of Inventory is valued at oldest cost and cost of goods sold is valued at current costgoods sold is valued at current cost

• This method while allowed under GAAP, is This method while allowed under GAAP, is not permitted for income tax purposesnot permitted for income tax purposes

Last-in, First-out (LIFO)Last-in, First-out (LIFO)

Cost of Goods Sold

Cost of Goods Sold

Ending InventoryEnding

Inventory

Recent Costs

Recent Costs

Oldest Costs

Oldest Costs

Financial Statement EffectsFinancial Statement Effects

FIFOFIFO

AverageAverage

LIFOLIFO

Ending Ending InventoryInventory

Cost of Cost of Goods SoldGoods Sold

Net Net EarningsEarnings

What are the effects on the balance sheet and statement of earnings if prices are assumed to be rising?

HH LL HH

-- -- --

LL HH LL

Financial Statement EffectsFinancial Statement Effects

FIFOFIFO

AverageAverage

LIFOLIFO

Ending Ending InventoryInventory

Cost of Cost of Goods SoldGoods Sold

Net Net EarningsEarnings

What are the effects on the balance sheet and statement of earnings if prices are assumed to be falling?

LL HH LL

-- -- --

HH LL HH

Financial Statement EffectsFinancial Statement Effects

FIFOFIFO

AverageAverage

LIFOLIFO

Ending Ending InventoryInventory

Cost of Cost of Goods SoldGoods Sold

Net Net EarningsEarnings

What are the effects on the balance sheet and What are the effects on the balance sheet and statement of earnings if prices are assumed to be statement of earnings if prices are assumed to be stable?stable?

-- -- --

-- -- --

-- -- --

All three cost flow assumptions will give the same results.All three cost flow assumptions will give the same results.

Use of Cost Flow Assumptions by Use of Cost Flow Assumptions by Canadian CompaniesCanadian Companies

FIFO32%

LIFO2%Average

34%

Other32%

• Each of the cost flow Each of the cost flow assumptions are assumptions are acceptable in acceptable in CanadaCanada

• Very few companies Very few companies use LIFO as it is not use LIFO as it is not permitted for income permitted for income tax purposes in tax purposes in CanadaCanada

Inventory ErrorsInventory Errors

• Errors can occur in accounting for Errors can occur in accounting for inventoryinventory

• When errors occur they affect both When errors occur they affect both the statement of earnings and the the statement of earnings and the balance sheetbalance sheet

• An error in ending inventory can An error in ending inventory can affect the calculation of cost of goods affect the calculation of cost of goods sold and net earnings in two periodssold and net earnings in two periods

Lower of Cost and Market (LCM)Lower of Cost and Market (LCM)

• When the value of the inventory declines When the value of the inventory declines below cost, it is written down to its market below cost, it is written down to its market valuevalue

• Market is defined as Market is defined as net realizable valuenet realizable value (or (or current replacement cost), not selling pricecurrent replacement cost), not selling price

Lower of Cost and Market (LCM)Lower of Cost and Market (LCM)

• Departure from cost principleDeparture from cost principle

• Follows Follows conservatismconservatism concept concept

• Used only after one of the cost flow assumptions Used only after one of the cost flow assumptions (specific identification, FIFO, LIFO, or average (specific identification, FIFO, LIFO, or average cost) is appliedcost) is applied

How Much Inventory Should a How Much Inventory Should a Company Have?Company Have?

– Only enough for Only enough for sales needssales needs

– Excess inventory Excess inventory costscosts• Storage costsStorage costs

• Interest costsInterest costs

• ObsolescenceObsolescence

Inventory TurnoverInventory Turnover

Inventory Turnover =Inventory Turnover = Cost of Goods SoldCost of Goods Sold

Average InventoryAverage Inventory

Days in InventoryDays in Inventory

Day in Inventory =Day in Inventory = 365 days365 days

Inventory TurnoverInventory Turnover