Chapter 6
Inventory Costing and Valuation
Chapter Overview
Presenter: Regula Lewis
Publisher: McGraw-Hill Education, 2022
Context: This chapter addresses the principles of inventory costing and valuation as explored through various accounting methods for merchandise inventory.
Learning Objectives
Identify the components and costs included in merchandise inventory. (LO1)
Calculate cost of goods sold and merchandise inventory using specific identification, moving weighted average, and FIFO-perpetual. (LO2)
Analyze the effects of the costing methods on financial reporting. (LO3)
Calculate the lower of cost and net realizable value of inventory. (LO4)
Analyze the effects of merchandise inventory errors on current and future financial statements-perpetual. (LO5)
Apply both the gross profit and retail inventory methods to estimate inventory. (LO6)
Assess inventory management using both merchandise turnover and days’ sales in inventory. (LO7)
Calculate cost of goods sold and merchandise inventory using FIFO-periodic, weighted average, and specific identification (Appendix 6A). (LO8)
Analyze the effects of inventory errors on current and future financial statements-periodic. (Appendix 6A). (LO9)
LO1: Items in Merchandise Inventory
Definition: Merchandise inventory refers to all goods owned by a company and held for sale.
Items that require special attention:
Goods in Transit: Goods that are being transported but not yet physically received.
Goods on Consignment: Goods given to another party to sell, in which ownership remains with the consignor until sold.
Goods Damaged or Obsolete: Items that cannot be sold due to damage or outdated nature.
LO2: Assigning Costs to Merchandise Inventory
Components of Costs in Merchandise Inventory:
Costs included are expenditures necessary, either directly or indirectly, to bring an item to a saleable condition and location.
Formula:
ext{Cost of Inventory} = ext{Purchase Price} - ext{Discounts} + ext{Additional Costs}
Incidental Costs that Add to Inventory:
Import duties
Transportation-in (freight costs)
Storage
Insurance
Handling costs
Costs associated with aging processes that enhance product value (e.g., wine, cheese).
Physical Count of Merchandise Inventory
Purpose: To confirm the dollar amount of inventory on financial statements and verify the number of units on hand at period end.
Actions Needed:
If the counted inventory is lower than in accounting records, debit Cost of Goods Sold and credit Merchandise Inventory for the value that is missing.
If the count identifies more inventory than records, make the opposite adjustment.
Internal Controls During Physical Inventory Counts:
Use of pre-numbered inventory tickets for each product to reduce counting errors (double counts or omissions).
Assigning Costs to Inventory
Management Decision: Must select a method for determining unit cost that impacts the income statement and balance sheet.
Methods for Costing Inventory:
First-In, First-Out (FIFO): Assumes items are sold in the order acquired.
Process: The earliest purchased units are charged to Cost of Goods Sold; the cost of the latest purchases remains in merchandise inventory.
Example:
Cost of Goods Sold (COGS): 3,535 = 910 + 1,060 + 530 + 1,035
Ending Inventory: 1,265.
Moving Weighted Average (MWA):
Requires calculating average cost per unit at each purchase.
Average cost calculated by dividing the total cost of goods available for sale by the units on hand.
Example:
Reported COGS: 3,568 = 2,000 + 1,568; Ending Inventory: 1,232.
Specific Identification: Suitable for items that can be uniquely identified.
Example Data:
August purchases:
10 LEC bikes at 91 each, 15 bikes at 106 each, 20 bikes at 115 each.
Specific identification directly tracks costs to items sold and remaining inventory.
Comparison of Inventory Methods
Key Insights on Methods:
Total units and costs available for sale remain constant across methods.
Differences arise in the dollar amount assigned to ending inventory and COGS.
Example Summary:
FIFO: COGS 3,535; Ending Inventory 1,265.
Moving Weighted Average: COGS 3,568; Ending Inventory 1,232.
Specific Identification: COGS 3,562; Ending Inventory 1,238.
LO3: Financial Reporting and Inventory
Material Impact: Correct knowledge and utilization of inventory costing methods impact the income statement and balance sheet significantly.
When prices are constant, costing method choice is less impactful.
Rising or falling prices lead to diverse cost amounts assigned based on the selected method.
Ethics and Inventory Management
Significance of Inventory: Next to cash, it is a highly liquid and significant asset class in merchandising businesses.
Potential Risks: Inventory is often targeted by fraud, leading to unauthorized use or resale, and manipulation of inventory pricing.
Consistency Principle: Firms must consistently apply accounting methods to maintain comparability across financial periods.
Advantages and Disadvantages of Cost Flow Assumptions
Method | Advantages | Disadvantages |
|---|---|---|
FIFO | Most current values on the balance sheet. Matches flow of goods for older inventories. | COGS may not reflect current costs, reducing expense-revenue matching accuracy. |
Moving Weighted Average | Smooths purchase price changes over time. | Averaging can lead to inaccurate expense-revenue matching and may be less cost-effective. |
Specific Identification | Provides an exact match of costs to revenues. | Implementation can be costly to maintain, requiring meticulous tracking of individual items. |
LO4: Lower of Cost and Net Realizable Value (LCNRV)
Concept Definition: Inventory reported at the LCNRV if it is lower than its cost.
Guidance Principle: Faithful representation ensures complete, neutral, error-free information, preventing overstatement of assets and profits.
Application: LCNRV is usually applied item by item or, where impractical, in groups of similar items.
Example Calculation Table:
Item
Units
Cost/Unit
Total Cost
NRV/Unit
Total NRV
Roadster
25
750
18,750
790
19,750
Sprint
60
1,100
66,000
1,100
66,000
A1 Series
21
1,800
37,800
1,300
27,300
Trax 4
29
2,200
63,800
2,250
65,250
Total Inventory Figures:
Total Cost: 186,350
Total NRV: 175,850
Required adjustment: 10,500 to reflect LCNRV.
Journal Entry:
Cost of Goods Sold 10,500
Merchandise Inventory 10,500
LO5: Errors in Reporting Inventory
Types of Reporting Errors: Affect COGS, profit, current assets, and equity statements.
Effect Examples:
Understating ending inventory results in overstating COGS and understating profit.
Overstating beginning inventory leads to understated COGS but overstated profit.
Balance Sheet Effects: Changes in inventory directly influence asset valuation and equity presentations.
LO6: Gross Profit Method
Purpose: Estimate ending merchandise inventory applying gross profit ratios to net sales, particularly useful when inventory is lost, stolen, or in case of verification checks.
Example Scenario:
Sales: 31,500; Sales Returns: 1,500; January 1, 2023 Inventory: 12,000; Net Purchases: 20,500; Gross profit ratio: 30%.
LO7: Inventory Turnover and Days’ Sales in Inventory
Significance of Turnover Ratio: Measures liquidity and management's control over inventory.
Days’ Sales in Inventory: Provides insight into how long it may take to convert inventory to cash or receivables.
Importance: This helps assess inventory levels concerning sales demand and associated risks.
Appendix 6A: Detailed Costing Methods
Assigning Costs to Inventory – Periodic System
Explanation of the FIFO method with reported costs for inventory and COGS.
Weighted average costing method detailed in three steps, calculating unit costs based on total purchases and inventory available.
Conclusion
Understanding and accurately applying inventory costing methods is crucial for financial reporting and can lead to meaningful implications for revenue and asset management. The chapter highlights the complexity of inventory management with a practical focus on ethical accounting practices.