c8 Act IN BF.P

Learning Objectives

• Determine the value of merchandise inventory under the perpetual inventory system

  • Specific Identification Method

  • First-In, First-Out (FIFO) Method

  • Weighted-Average Cost Method

• The Effect of Different Valuation Methods: Perpetual

• Determining the Actual Quantity of Inventory

  • Physical Inventory Count

• Describe ethics relating to inventory

• Explain the impact of inventory errors

• Apply the lower of cost and net realizable value (LCNRV) rule to value merchandise inventory

• Determine the value of merchandise inventory under the periodic inventory system

  • Specific Identification Method

  • First-In, First-Out (FIFO) Method

  • Weighted-Average Cost Method

  • The Effect of Different Valuation Methods: Periodic

Importance of Inventory Valuation

• Inventory valuation is crucial as it impacts financial reporting.

  • Affects the income statement through COGS, gross profit, and net income.

  • Influences the balance sheet through current assets and owner's equity.

  • Affects decisions by internal management (e.g., product lines based on reported gross profit) and external users (e.g., banks' lending decisions).

• The consistency of the method is key for accurately reflecting financial health.

Inventory Valuation Methods

1. Specific Identification Method

• Used for unique items (e.g., cars, jewelry).

• Tracks the cost of each specific item sold and remaining in inventory.

• Costly and impractical for homogeneous goods.

2. First-In, First-Out (FIFO)

• Assumes the first items received are the first sold.

• Used for perishable goods (e.g., dairy)

• In times of rising costs, FIFO results in higher ending inventory values.

3. Weighted-Average Cost Method

• Calculates an average cost for all identical items sold.

• Simplifies tracking when items are indistinguishable.

• Good for uniform materials like oil or plastics.

• Averages out fluctuations in inventory costs.

Choosing an Inventory Valuation Method

• Accountants must choose a consistent method, which can only be changed with justified reasoning.

• Manipulating inventory valuation can lead to ethical issues and inaccuracies in financial reporting.

Determining Actual Quantity of Inventory

• Accurate recording of incoming and outgoing inventory is critical.

• Reliability of inventory counts can be ensured through systematic physical counts, especially under periodic systems.

• Modern technology can simplify the process of tracking inventory movements.

Physical Inventory Count Steps

1. Designate personnel for counting and verification.

2. Use pre-numbered sheets to record counts.

3. Compare physical counts to recorded values and investigate discrepancies.

Ethics in Inventory Valuation

• Management can manipulate inventory reported on financial statements.

• Accurate tracking and assessment are needed to avoid unethical practices.

• Internal controls and proper audits are essential for maintaining integrity in inventory management.

Impact of Inventory Errors

• Errors in valuing inventory directly affect COGS and consequently gross profit.

  • Overstating inventory leads to understated COGS and overstated profit.

  • Understating inventory leads to overstated COGS and understated profit.

• Self-Correcting Nature of Inventory Errors:

  • Errors roll over into the next period, changing balance sheet and income figures.

Lower of Cost and Net Realizable Value (LCNRV) Rule

• Inventory must be reported at the lower of its cost or the NRV.

• Focus ensures conservative reporting of asset values.

Inventory Valuation under Periodic Inventory System

1. Gross Profit Method

• Uses historical gross margin percentages to estimate ending inventory values.

2. Retail Method

• Compares total costs to total retail price to estimate a cost for ending inventory.

Summary of Inventory Valuation Methods

• Each method of inventory valuation can produce vastly different financial results and affects how both internal and external stakeholders view the business's financial health.

Key Terms and Definitions:

• Merchandise Inventory: The goods that a company sells to customers.

• Perpetual Inventory System: A method of tracking inventory that updates records continuously as sales and purchases occur.

• Specific Identification Method: This tracks the cost of each unique item sold and still in stock, but it's not practical for similar items.

• First-In, First-Out (FIFO) Method: A way of valuing inventory assuming the first items purchased are the first to be sold, which helps with perishable goods.

• Weighted-Average Cost Method: Averages the costs of identical items to determine their value, making inventory tracking easier.

• Physical Inventory Count: A process of physically counting all items in inventory to ensure accurate records.

• Lower of Cost and Net Realizable Value (LCNRV) Rule: This accounting rule states that inventory should be valued at the lower price between its acquisition cost and what it can be sold for.

• Gross Profit Method: An estimation technique relying on historical data to determine the value of ending inventory based on gross margin percentages.

• Retail Method: Estimates inventory costs by comparing total costs with total retail prices.

• Inventory Turnover Ratio: A measure of how many times inventory is sold or used in a specific period, indicating efficiency in inventory management.

• Inventory Valuation Methods: Various methods used to determine the value of inventory for financial reporting.

• Specific Identification Method: Tracks the cost of each unique item sold and remaining in inventory, but is impractical for similar items.

• First-In, First-Out (FIFO) Method: Assumes the first items received are the first sold; helpful for perishable goods.

• Weighted-Average Cost Method: Calculates the average cost for all identical items sold, making inventory tracking simpler.

• Consigned Inventory: Inventory that is held by one party (the consignee) for sale, but is still owned by another party (the consignor).

• Consignor (the owner of merchandise): The person or entity that sends goods to the consignee for sale.

• Consignee (the selling agent): The person or entity that receives goods from the consignor for sale.

• Net Realizable Value (NRV): The estimated selling price of inventory minus any costs to sell or complete it.

• Lower of Cost and Net Realizable Value (LCNRV): A rule stating inventory should be reported at the lower value between its cost and its NRV.

• Specification Identification Method (Periodic): A method to identify specific items in inventory used under a periodic system.

• First-In, First-Out (FIFO) Method (Periodic): FIFO applied in a periodic inventory system.

• Weighted-Average Cost Method (Periodic): Average cost calculation for identical items sold under a periodic inventory system.

• Gross Profit Method: Estimates ending inventory based on historical gross margin percentages.