CHAPTER
6
INVENTORY VALUATION
Perpetual vs. Periodic Inventory
(Remember?)
Perpetual
– Updates inventory and cost of goods sold
after every purchase and sales transaction
This chapter covers the periodic inventory method
 Periodic
in mind-numbing detail.
– Delays updating of inventory and cost of
goods sold until end of the period
– Misstates inventory during the period

SOURCE OF INVENTORY VALUE:
HOW DO YOU ALLOCATE OF INVENTORIABLE COSTS?
This means inventory valuation has
two main effects:
Beginning
Inventory
1.Balance Sheet: current assets
2.Income Statement: Cost of Goods
Sold
Cost of Goods
Available for Sale
GAFS
Goods
Purchased
during period
Why?:
Because the value of the ending
inventory determines how GAFS will
be split between Inventory and
COGS.
Ending
Inventory
(Balance Sheet)
Not Sold
Sold
Cost of Goods
Sold (Income
Statement)
THE SIGNIFICANCE OF
INVENTORY
There are three reasons why the valuation of
inventory is important:

1.
2.
3.
Inventory is often the largest asset on a business’s
balance sheet
COGS is usually the most significant expense on the
income statement.
Due to the nature of a business’s cost structure (i.e. a
small change in ending inventory = a big change in
final Net Income).
THE SIGNIFICANCE OF
INVENTORY
Cost structure of a typical business:

Beginning Inventory
+Net Purchases etc.
Net Sales
=Goods Available
-(Ending Inventory)
=Cost of Goods Sold
$1,000,000
$1,000,000
COGS
700,000
770,000
Gross Profit
300,000
230,000
Operating Expenses
200,000
200,000
$100,000
$30,000
Net Income


So a small error in inventory, can have a big effect on
Net Income
NOTE: Ending inventory and Net Income move in the
same direction.
REVENUE RECOGNTION
F.O.B.
(TERMS OF SALE)
Destination
Shipping Point
Seller
Public
Carrier
Co.
Buyer
F.O.B.
Ownership
does not pass
to the buyer
until the…
Ownership
passes to the
buyer at the…
…and thus the
seller pays for
the shipping!
…and thus the
buyer pays for
the shipping!
As well, you
must include
these goods in
your inventory
count if not yet
delivered.
Seller
Public
Carrier
Co.
Buyer
ENDING INVENTORY
VALUATION
DETERMINING INVENTORY QUANTITIES

In order to prepare financial statements, you must
determine:
1.
2.

The number of units of inventory owned, and
Value them.
The determination of inventory quantities involves:
1.
2.
Counting goods on hand, and
Determining the ownership of goods.
TAKING THE PHYSICAL INVENTORY
A company should adhere to internal control
principles in order to minimize errors and
fraud in inventory counts:
1. Segregation of duties Employees who do not have
custodial responsibility for the inventory should do the counting.
2. Establishment of responsibility Each counter
should establish authenticity of each inventory item.
3. Independent verification Another employee should
make a second count. At the end of the count, a supervisor should
ascertain that all inventory items are tagged and that no items have more
than one tag.
4. Documentation procedures All inventory tags should
be pre-numbered and accounted for.
INVENTORY VALUATION
METHOD 1: 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.
INVENTORY VALUATION
METHOD 2:USE 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 actual physical
flow of goods.
Cost flow assumptions:
1. First-in, first-out (FIFO).
2. Last-in, first-out (LIFO).
3. Average Cost.
FIFO (First In, First Out)

The FIFO method assumes that the earliest
goods purchased are the first to be sold.
–


(This often reflects the actual physical flow of
merchandise).
Under FIFO, the first goods purchased in
the period are assumed to be the first sold
The ending inventory consists of the most
recently purchased.
LIFO (Last In, First Out)

First goods purchased remain in ending
inventory.
–

(Seldom coincides with the actual physical flow
of inventory).
Rarely used in Canada.
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.
VALUATION METHODS:
FIFO, Average Cost, LIFO
Prices
Time
Beginning
Inventory
Ending Inventory
VALUATION METHODS:
Comparison Chart: BS and IS Effects
Method
FIFO
Average
Cost
LIFO
Rising Prices
Highest Ending Inventory
Highest Net Income
Falling Prices
Constant
Prices
VALUATION METHODS:
FIFO, Average Cost, LIFO
Prices
Time
Beginning
Inventory
Ending Inventory
VALUATION METHODS:
Comparison Chart: BS and IS Effects
Method
FIFO
Average
Cost
LIFO
Rising Prices
Highest Ending Inventory
Highest Net Income
Falling Prices
Lowest Ending Inventory
Lowest Net Income
Constant
Prices
VALUATION METHODS:
FIFO, Average Cost, LIFO
Prices
Time
Beginning
Inventory
Ending Inventory
VALUATION METHODS:
Comparison Chart: BS and IS Effects
Method
FIFO
Rising Prices
Highest Ending Inventory
Highest Net Income
Average
Cost
LIFO
Lowest Ending Inventory
Lowest Net Income
Falling Prices
Lowest Ending Inventory
Lowest Net Income
Constant
Prices
VALUATION METHODS:
FIFO, Average Cost, LIFO
Prices
Time
Beginning
Inventory
Ending Inventory
VALUATION METHODS:
Comparison Chart: BS and IS Effects
Method
FIFO
Rising Prices
Falling Prices
Highest Ending Inventory
Highest Net Income
Lowest Ending Inventory
Lowest Net Income
Lowest Ending Inventory
Lowest Net Income
Highest Ending Inventory
Highest Net Income
Average
Cost
LIFO
Constant
Prices
VALUATION METHODS:
Comparison Chart: BS and IS Effects
Method
Rising Prices
Falling Prices
FIFO
Highest Ending Inventory
Highest Net Income
Lowest Ending Inventory
Lowest Net Income
Average
Cost
In between FIFO and
LIFO
In between FIFO and
LIFO
LIFO
Lowest Ending Inventory
Lowest Net Income
Highest Ending Inventory
Highest Net Income
Constant
Prices
VALUATION METHODS:
Comparison Chart: BS and IS Effects
Method
Rising Prices
Falling Prices
FIFO
Highest Ending Inventory
Highest Net Income
Lowest Ending Inventory
Lowest Net Income
Average
Cost
In between FIFO and
LIFO
In between FIFO and
LIFO
LIFO
Lowest Ending Inventory
Lowest Net Income
Highest Ending Inventory
Highest Net Income
Constant
Prices
All methods
will return
the same
result
In Summary:
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.
In Summary:
BALANCE SHEET EFFECTS
FIFO produces the best balance sheet valuation.
This is because the inventory costs are closer to their
current, or replacement, costs (since what’s left is the
most recently purchased).
Why?
INVENTORY VALUATION AND THE
CONSISTENTCY GAAP



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 fiscal 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 for the periodic method.
The ending inventory of one period automatically
becomes the beginning inventory of the next period.
An
inventory
in this
period, affects:
Example:
Endingerror
Inventory
is overstated.
–
–
–
–
COGS in this period, and thus
Net income in this period, as well as
Ending inventory in this period, and
Beginning inventory next 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
Ending Inventory
Error
Overstated
Understated
Assets
Overstated
Understated
Liabilities
None
None
Owner’s 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 method.
Market is defined as replacement cost or
net realizable value.
ALTERNATIVE LOWER OF COST
AND MARKET RESULTS
Date
Dec. 31
Total Method
Item by Item Method
2,000
9,000
Particulars
Loss on write down of inventory to LCM
Inventory
(Total Method)
Debit
Credit
2,000
2,000
Do the following Problems:
P6-4A
P6-5A
P6-6A
P6-8A (c & d)