INVENTORY VALUATION

CHAPTER 6 INVENTORY VALUATION

Perpetual vs. Periodic • Perpetual • Updates inventory and cost of goods sold after every purchase and sales transaction • Periodic • Delays updating of inventory and cost of goods sold until end of the period • Misstates inventory during the period

The Significance of Inventory • In the balancesheetinventory is frequently the most significant current asset. • In the income statement, inventory is vital in determining the results of operations for a particular period (COGS). • There are two areas of concern with inventory as far as operating income goes: • Revenue recognition (F.O.B. status) • Ending inventory valuation

Ending Inventory Valuation • In order to prepare financial statements, you must determine: • The number of units of inventory owned, and • Value them. • The determination of inventory quantities involves: • Counting goods on hand, and • Determining the ownership of goods.

Items in Merchandise Inventory • Goods in transit – if ownership has been transferred to the owner, included in inventory • Goods on consignment: goods shipped by owner (consignor) to a party (consignee) who sells good for owner. Reported in consignors inventory • Goods damaged or obsolete: not counted in inventory if unsalable, if salable at reduced price, included at their net realizable value (NRV) which is the sales price minus the cost of making the sale.

Costs of Merchandise Inventory • Expenditures necessary, directly or indirectly, in bringing an item to a salable condition and location • Includes invoice price minus discount plus added or incidental costs (shipping, storage, insurance etc.)

Source of Inventory Value Ending Inventory (Balance Sheet) Beginning Inventory Cost of Goods Available for Sale Not Sold Sold Goods Purchased during period Cost of Goods Sold (Income Statement)

Method 1: Specific Identification • 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.

Method 2: 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.

FIFO method assumes earliest goods purchased are the first to be sold

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.

LIFO method assumes latest goods purchased are the first to be sold

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.

Allocation of the cost of goods available for sale in average cost method is made on the basis of the weighted average unit cost

Average cost method assumes that goods available for sale are homogeneous

Homework • Pg 366 - # 7-1, 7-2, 7-3, 7-4, 7-5, 7-6 • Pg 369 # 7-1, 7-2

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.

Why? Balance Sheet Effects FIFOproduces 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).

The Consistency Gap • 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.

Example: Ending Inventory is overstated. Inventory Errors – Income Statement Effects • The ending inventory of one period automatically becomes the beginning inventory of the next period. • An inventory error in this period, affects: • COGS in this period, and thus • Net income in this period, as well as • Ending inventory in this period, and • Beginning inventory next period

Overstated Overstated None Overstated Understated Understated None Understated 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

Lower of Cost or 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 The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation.

Cost of Goods Sold Average Merchandise Inventory Merchandise Turnover = Merchandise Turnover • Used to help analyze short-tem liquidity. • Average inventory = (beginning inventory + ending inventory) / 2 • No simple rule – high rate is preferable as long as inventory is adequate to meet demand.

Day’s Sales in Inventory • Estimate how many days it will take to convert inventory into receivables or cash Ending Inventory Cost of Goods Sold Day’s Sales in inventory = X 365

Do the following Questions: Pg 370 #7-5, 7-6, 7-7, 7-14 Problems 7-1A, 7-4A

INVENTORY VALUATION