CHAPTER
6
Reporting and Analysing
Inventory
Merchandise Inventory
• Owned by the company
• Ready for sale to customers
Manufacturing Inventory
Raw materials
Work in process
Finished goods inventory
Determining Inventory Quantities
• A physical inventory count
– Determines ending inventory
– Enables cost of goods sold to be calculated
Companies that use a perpetual inventory system
must also take a physical inventory to check the
accuracy of “book inventory” against actual
inventory
Taking a Physical Inventory
• Determining inventory quantities by
counting, weighting or measuring each type
of inventory
• Determining ownership of goods, including
goods in transit and consigned goods
Goods in Transit
• Goods on board a truck,
train, ship, or plane at the
end of the period
• Who includes goods in
transit in inventory? The
buyer? The seller?
• Goods in transit are
included in the inventory of
the company with legal title
Ownership
passes to
buyer here
Seller
Illustration 6-1
FOB Shipping Point
Public
Carrier
Co.
FOB Destination Point
Seller
Public
Carrier
Co.
Buyer
Ownership
passes to
buyer here
Buyer
Consigned Goods
• Goods in your store that
you don’t pay for until
they sell
• Company does not take
ownership
Inventory Costing
• After calculating the quantity of units of
inventory, unit costs are applied
• This determines the values for the cost of
goods sold and ending inventory
• This is a complicated process because
inventory is purchased at different times
Inventory Valuation Systems
The following inventory valuation methods are
generally accepted. They can be used in either
a periodic or perpetual inventory system.
• Specific Identification
• Cost Flow Assumptions
– Average cost
– First-in, first-out (FIFO)
– Last-in, first-out (LIFO)
Specific Identification
• Concentrates on the physical tracing of
the particular items sold
• Major limitation is in identifying the
particular item sold
• Used in low-volume, high-priced
industries
– e.g., jewellery stores
Average Cost Flow Assumption
• The average cost of all units in inventory is
calculated each time there is a purchase
– Weighted average cost
• This cost is used to determine cost of goods
sold and inventory
• Major advantage is not having to track the
individual items of inventory
Weighted Average Cost
Cost of
goods
available for
sale ($)
÷
Units
available on
the date of
sale
First-in, First-out (FIFO)
• The assumption is that the first item purchased
is the first item sold
• Inventory is valued at the most current cost
and cost of goods sold is valued at the oldest
inventory cost
• Earnings reported using this cost flow
assumption is higher than any other cost flow
assumption as the oldest costs are used to
determine cost of goods sold
First-in, First-out (FIFO)
Oldest
Costs
Cost of
Goods Sold
Recent
Costs
Ending
Inventory
Last-in, First-out (LIFO)
• The assumption is that the last item
purchased is the first sold
• Inventory is valued at oldest cost and cost of
goods sold is valued at current cost
• This method while allowed under GAAP, is
not permitted for income tax purposes
Last-in, First-out (LIFO)
Recent
Costs
Cost of
Goods Sold
Oldest
Costs
Ending
Inventory
Financial Statement Effects
What are the effects on the balance sheet
and statement of earnings if prices are
assumed to be rising?
Ending
Inventory
Cost of
Goods Sold
Net
Earnings
FIFO
H
L
H
Average
-
-
-
LIFO
L
H
L
Financial Statement Effects
What are the effects on the balance sheet
and statement of earnings if prices are
assumed to be falling?
Ending
Inventory
Cost of
Goods Sold
Net
Earnings
FIFO
L
H
L
Average
-
-
-
LIFO
H
L
H
Financial Statement Effects
What are the effects on the balance sheet and
statement of earnings if prices are assumed to be
stable?
Ending
Inventory
Cost of
Goods Sold
Net
Earnings
FIFO
-
-
-
Average
-
-
-
LIFO
-
-
-
All three cost flow assumptions will give the same results.
Use of Cost Flow Assumptions by
Canadian Companies
FIFO
32%
Other
32%
Average
34%
LIFO
2%
• Each of the cost flow
assumptions are
acceptable in
Canada
• Very few companies
use LIFO as it is not
permitted for income
tax purposes in
Canada
Inventory Errors
• Errors can occur in accounting for
inventory
• When errors occur they affect both
the statement of earnings and the
balance sheet
• An error in ending inventory can
affect the calculation of cost of goods
sold and net earnings in two periods
Lower of Cost and Market (LCM)
• When the value of the inventory declines
below cost, it is written down to its market
value
• Market is defined as net realizable value (or
current replacement cost), not selling price
Lower of Cost and Market (LCM)
• Departure from cost principle
• Follows conservatism concept
• Used only after one of the cost flow assumptions
(specific identification, FIFO, LIFO, or average
cost) is applied
How Much Inventory Should a
Company Have?
– Only enough for
sales needs
– Excess inventory
costs
• Storage costs
• Interest costs
• Obsolescence
Inventory Turnover
Inventory Turnover =
Cost of Goods Sold
Average Inventory
Days in Inventory
Day in Inventory
=
365 days
Inventory Turnover