INTERMEDIATE
ACCOUNTING
Seventh Canadian Edition
KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK
Prepared by:
Gabriela H. Schneider, CMA
Northern Alberta Institute of Technology
CHAPTER
8
Inventory:
Recognition and Measurement
Learning Objectives
1. Identify major classifications of inventory.
2. Distinguish between perpetual and periodic
inventory systems.
3. Identify the effects of inventory errors on the
financial statements.
4. Identify the items that should be included as
inventory cost.
Learning Objectives
5. Explain the difference between variable costing
and absorption costing in assigning
manufacturing costs to inventory.
6. Distinguish between the physical flow of
inventory and the cost flow assigned to
inventory.
7. Identify possible objectives for inventory
valuation decisions.
Learning Objectives
8. Describe and compare the cost flow
assumptions used in accounting for inventories.
9. Evaluate LIFO as a basis for understanding the
differences among the cost flow methods.
10.Explain the importance of judgement in
selecting an inventory cost flow method.
Inventory: Recognition and
Measurement
Inventory
Classification
and Control
Classification
Management
and control
Basic valuation
issues
Physical Goods
Included in
Inventory
Goods in transit
Consigned goods
Special sales
agreements
Effect of inventory
errors
Costs Included
in Inventory
“Basket”
purchases
Purchase
discounts
Product costs
Period costs
Manufacturing
costs
Variable versus
absorption
costing
Standard costs
Cost Flow
Assumptions
Framework for
analysis
Specific
identification
Average cost
FIFO
LIFO
Evaluation and
Choice
Advantages of
LIFO
Disadvantages
of LIFO
Summary
analysis
Which method
to select?
Consistency
Inventory Classification
• Inventory consists of:
– Assets held for sale in the ordinary course of
business, or
– Goods to be consumed in the production of
finished goods
• A merchandising concern has one inventory
account:
– Merchandise Inventory
• A manufacturing concern will normally have three
inventory accounts:
– Raw materials
– Work in process
– Finished goods
Inventory Cost Flows
Merchandising Operations
Merchandise
Inventory
Purchases
COGS
Cost of goods
sold
$$$
Inventory Cost Flows
Manufacturing Operations
Raw Materials
Work in Process
Inventory
Labour
$$$
Mfg. Overhead
COGM
Finished
Goods
$$$
COGS
COGS
$$$
Inventory Control
• Inventory control is important for:
- Ensuring availability of inventory items
- Preventing excessive accumulation of
inventory items
• The perpetual system maintains a continuous
record of inventory changes
• The periodic system updates inventory
records only periodically
Perpetual System
• Purchases and sales of inventory recorded directly to
Inventory account
• Inventory purchases, freight, purchase returns and
discounts are debited/credited to the Inventory account
• Cost of Goods Sold (COGS) is debited and Inventory is
credited for each sale
• Subsidiary ledger maintained for individual inventory
items
• Periodic inventory counts still required to ensure reliability
• Any differences in counted and recorded quantities are
posted to a separate account – Inventory Over and Short
Periodic System
• Inventory purchases recorded as a debit to Purchases
account
• COGS is a calculation on the Income Statement
• Physical inventory is counted periodically
• Under both periodic and perpetual inventory systems,
physical counts of inventory are conducted at least once a
year
Perpetual and Periodic Systems:
Example
Fesmire Limited reports the following data:
Beginning Inventory :
Purchases: (all credit)
Sales:
(all credit)
Ending Inventory:
100 units at $6
900 units at $6
600 units at $12
400 units at $6
Provide all journal entries under each system.
Perpetual System
Transaction
Purchase
Record Inventory Changes
Inventory
5,400
Accounts Payable
(900 units x $6)
5,400
Sale
Cost of goods sold
Inventory
(600 units x $6)
Record Sales Revenue
Accounts
Receivable
3,600
3,600
Sales
(600 units x $12)
7,200
7,200
Periodic System
Date
Purchase
Record Inventory Changes
Purchases
5,400
Accounts Payable
(900 units x $6)
Sale
Record Sales Revenue
5,400
No entry
Accounts Receiv.
Sales
(600 units x $12)
Year-End
Adjusting
Entry
Cost of goods sold
Inventory (ending)
Purchases
Inventory (beg.)
3,600
2,400
5,400
600
7,200
7,200
Financial Statement
Presentation
Perpetual
Net Sales
$,$$$
Cost of Goods Sold $$$
Gross Profit
$,$$$
Periodic
Net Sales
Cost of Goods Sold:
Opening Inventory
Add: Net Purchases
Cost of Goods
for Sale $,$$$
Less:
Ending Inventory
Cost of Goods Sold
Gross Profit
$,$$$
$$$
$$$
Available
$$$
$$$
$,$$$
Basic Valuation Issues
• Ending inventory valuation requires answers
to each of the following:
1. Which physical goods should be included as
part of inventory?
2. What costs should be included as part of
inventory cost?
3. What cost flow assumption should be
adopted?
Items to Be Included in
Inventory
•
•
Legal title to goods determines inclusion
The following goods are included in the seller’s
inventory:
1. Goods in transit (if seller has title during
shipment)
2. Goods out on consignment
3. Goods sold under buyback agreements
4. Goods sold with high rates of return that
cannot be estimated
5. Instalment sales (if collectibility cannot be
estimated)
Effect of Inventory Errors
Ending
Inventory
Effect on Income
Statement Items
Effect on Balance
Sheet Items
Understated
COGS
(over) Retained Earnings (under)
Net Income (under) Working Capital (under)
Overstated
COGS
(under) Retained Earnings (over)
Net Income (over)
Working Capital (over)
As an example, consider Brief Exercise 8-10
Brief Exercise 8-10
Given for the year 2005:
COGS
= $1.4 million
Retained Earnings (R/E) = $5.2 million
December 31st inventory errors:
2004: overstated by $110,000
2005: overstated by $45,000
Calculate correct COGS and R/E for December 31, 2005
Brief Exercise 8-10
COGS (as originally stated)
Add: December 31, 2005 overstatement error
Less: December 31, 2004 overstatement error
Corrected COGS
$1,400,000
45,000
1,445,000
110,000
$1,335,000
Retained Earnings (original)
$5,200,000
Less: correction for 2005 inventory
45,000
Retained Earnings (restated)
$5,155,000
Note: 2004 inventory error self-corrected
Costs Included in Inventory
• Costs included in inventory are known as
“inventoriable costs”
• These costs include:
– Product costs (direct materials, direct labour and
manufacturing overhead)
– Purchase (net) costs, and freight-in
• Period costs (selling and administrative) are not
inventoriable costs
• “Basket” purchases total cost allocated to units
based on relative sales value
Inventory Valuation:
Variable costing
• Under variable costing, inventory costs include
only the following manufacturing costs:
– Direct materials used
– Direct labour
– Variable manufacturing overhead
• Fixed manufacturing overhead is treated as a
period cost
• All period costs are ignored
• Variable costing is appropriate for internal
decision-making
Inventory Valuation:
Absorption Costing
• Under absorption costing, inventory costs
include all manufacturing costs as follows:
–
–
–
–
Direct materials used
Direct labour
Variable manufacturing overhead
Fixed manufacturing overhead
• All other costs are period costs and are
ignored
• Both methods are acceptable, but absorption
costing is generally used in Canada
Cost Flow Assumptions
•
•
•
The objective is to most clearly reflect periodic
income
Cost flow assumptions need not be consistent
with physical flow of goods
Objectives of choosing an inventory valuation
method are to:
1. Realistically match expenses against
revenue
2. Report inventory at a realistic amount
3. Minimize income taxes
Cost Flow Assumptions
The cost flow assumptions are:
1.
2.
3.
4.
Specific identification
Average cost
First-in, First-out (FIFO)
Last-in, First-out (LIFO)
Cost Flow Assumptions: Notes
• The ending inventory in units is the same in
all four methods: the cost is different
• The cost of goods sold and the cost of ending
inventory are different
• The cost of purchases is the same in all four
methods
• LIFO results in the smallest reported net
income (with rising prices)
Cost Flow Assumptions: Example
Call-Mart reports the following transactions for March
Date
1
2
15
19
30
Purchases (Sold)
beginning inventory (@$3.80)
1,500 units (@$4.00)
6,000 units (@$4.40)
(4,000 units sold)
2,000 units (@$4.75)
Balance
500
2,000
8,000
4,000
6,000
Determine the cost of goods sold and the cost of ending
inventory, under each cost flow assumption.
Specific Identification
• Items sold and purchased are individually
identified as to cost
• Works best with items that are unique, high cost,
with small numbers held as inventory
• Advantage:
– Matches actual costs with revenue
• Disadvantages:
– May be costly to implement and maintain
– May lead to income manipulation
Weighted-Average Method
Date
March 1
March 2
March 15
March 30
Purchases
500 units
1,500 units
6,000 units
2,000 units
Unit Cost
$3.80
$4.00
$4.40
$4.75
10,000 units
Purchase Cost
$ 1,900
$ 6,000
$26,400
$ 9,500
$43,800
Unit Cost = $43,800  10,000 = $4.38
Cost of goods available
$43,800
Cost of goods sold
4,000 X $4.38 = 17,520
Ending inventory
6,000 X $4.38 = $26,280
Moving Average Method
Date
Purchases
Unit Cost
Purchase Cost On Hand
March 1
500 units
$3.80
$ 1,900
$ 1,900
March 2
1,500 units
$4.00
$ 6,000
7,900
March 15
6,000 units
$4.40
$26,400
34,300
New Unit Cost calculated – to use as Cost of Goods Sold
$34,300/8,000 units = $4.2875
March 19
(4,000) units sold
17,150
March 30
2,000 units
$4.75
$ 9,500
26,650
New Unit Cost calculated—to use as COGS for next sale and for inventory
$26,650/6,000 units = $4.4417
Cost of goods available
$43,800
Cost of goods sold
4,000 X $4.2875 = 17,150
Ending inventory
6,000 X $4.4417 = $26,650
Average Cost Method
• Average unit cost calculated (and used for COGS)
with each new purchase with moving average
• Seen as a compromise between LIFO and FIFO
• Advantages:
– Easy to apply, objective, not as subject to
income manipulation
– Provides income tax minimization during rising
prices
• Disadvantage:
– Recent costs reflected in COGS, older costs
reflected in Inventory
First-In, First-Out Method
Date
March 1
March 2
March 15
March 30
Purchases
500 units
1,500 units
6,000 units
2,000 units
Ending inventory
Cost of goods available
Cost of goods sold
Unit Cost
$3.80
$4.00
$4.40
$4.75
6,000 units
2,000 @ $4.75 =
4,000 @ $4.40 =
Purchase Cost
$ 1,900
$ 6,000
$26,400
$ 9,500
$ 9,500
17,600
$27,100
$43,800
$43,800 - $27,100 = $16,700
First-In, First-Out Method
Advantages:
• Attempts to approximate physical flow of goods
• Ending inventory close to current cost
Disadvantages:
• Current costs not matched to current revenues
– Oldest cost of goods are used with current sale
price
• In times of rapidly increasing prices, leads to gross
profit and net income distortions
Last-In, First-Out Method
Date
March 1
March 2
March 15
March 30
Purchases
500 units
1,500 units
6,000 units
2,000 units
Ending inventory
Cost of goods available
Unit Cost
$3.80
$4.00
$4.40
$4.75
6,000 units
500 @ $3.80 =
1,500 @ $4.00 =
4,000 @ $4.40 =
Purchase Cost
$ 1,900
$ 6,000
$26,400
$ 9,500
$ 1,900
6,000
17,600
$25,500
$43,800
Cost of goods sold
$43,800 – $25,500 = $18,300
2,000 @ $4.40 =
2,000 @ $4.75 =
$ 8,800
9,500
$18,300
Advantages of LIFO Method
• Matches more recent costs with current
revenues
• Under LIFO, the need to write down inventory
to market is minimized
Disadvantages of LIFO Method
• Results in lowest net income and hence reduced
earnings
• Ending inventory is understated
• Does not approximate physical flow of goods
except in special situations
• LIFO liquidation may result in income that is not
appropriate
• May cause poor buying habits (layer liquidation)
• Not accepted by CCRA for tax purposes
• Current (replacement) cost measurement lost
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