INVENTORY VALUATION

CHAPTER 6 INVENTORY VALUATION

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 Perpetual vs. Periodic Inventory (Remember?) This chapter covers the periodic inventory method in mind-numbing detail.

SOURCE OF INVENTORY VALUE:HOW DO YOU ALLOCATE OF INVENTORIABLE COSTS? • This means inventory valuation has two main effects: • Balance Sheet: current assets • Income Statement: Cost of Goods Sold Ending Inventory (Balance Sheet) Beginning Inventory Cost of Goods Available for Sale GAFS Not Sold Sold Goods Purchased during period Cost of Goods Sold (Income Statement) Why?: Because the value of the ending inventory determines how GAFS will be split between Inventory and COGS.

There are three reasons why the valuation of inventory is important: 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: THE SIGNIFICANCE OF INVENTORY A B Beginning Inventory +Net Purchases etc. Net Sales $1,000,000 $1,000,000 =Goods Available COGS 700,000 770,000 +10% -(Ending Inventory) Gross Profit 300,000 230,000 =Cost of Goods Sold Operating Expenses 200,000 200,000 -70% Net Income $100,000 $30,000 • 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.

Seller Seller Buyer Buyer REVENUE RECOGNTION (TERMS OF SALE) F.O.B. F.O.B. Destination Shipping Point Ownership does not pass to the buyer until the… Ownership passes to the buyer at the… …and thus the seller pays for the shipping! As well, you must include these goods in your inventory count if not yet delivered. Public Carrier Co. Public Carrier Co. …and thus the buyer pays for the shipping!

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. ENDING INVENTORY VALUATION DETERMINING INVENTORY QUANTITIES

A company should adhere to internal controlprinciples 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 countershould 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 tagsshould be pre-numbered and accounted for. TAKING THE PHYSICAL INVENTORY

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 1: ACTUAL PHYSICAL FLOW COSTING

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. INVENTORY VALUATION METHOD 2:USE ASSUMED COST FLOW METHODS Achtung !

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 (First In, First Out)

First goods purchased remain in ending inventory. (Seldom coincides with the actual physical flow of inventory). Rarely used in Canada. LIFO (Last In, First Out)

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. AVERAGE COST

VALUATION METHODS: FIFO, Average Cost, LIFO FIFO Prices Time Beginning Inventory Ending Inventory

VALUATION METHODS: Comparison Chart: BS and IS Effects

VALUATION METHODS: FIFO, Average Cost, LIFO FIFO Prices Time Beginning Inventory Ending Inventory

VALUATION METHODS: FIFO, Average Cost, LIFO LIFO Prices Time Beginning Inventory Ending Inventory

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:INCOME STATEMENT 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? In Summary: BALANCE SHEET EFFECTS

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 VALUATION AND THE CONSISTENTCY GAAP

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 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 Example: Ending Inventory isoverstated. INVENTORY ERRORS - INCOME STATEMENT 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 Overstated Overstated None Overstated Understated Understated None Understated ENDING INVENTORY ERROR – BALANCE SHEET EFFECTS

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. VALUING INVENTORY AT THE LOWER OF COST AND MARKET

Date Particulars Debit Credit Dec. 31 ALTERNATIVE LOWER OF COST AND MARKET RESULTS Total Method 2,000 Item by Item Method 9,000 Loss on write down of inventory to LCM 2,000 Inventory 2,000 (Total Method)

Do the following Problems: P6-4A P6-5A P6-6A P6-8A (c & d)

INVENTORY VALUATION