WEYGANDT – KIESO - KIMMEL – TRENHOLM – WARREN - NOVAK

ACCOUNTING
PRINCIPLES
VOLUME 1
SEVENTH CANADIAN EDITION

Prepared by Debbie Musil, CPA, FCMA

Kwantlen Polytechnic University
 CHAPTER 6:
INVENTORY COSTING

2
 Inventory Costing

• Determining inventory quantities

– Taking physical inventory
– Determining ownership of goods
• Inventory cost determination methods
– Specific identification
– Cost formulas: FIFO and average
• Financial Statement Effects
– Choice of cost determination method
– Inventory errors
• Presentation and analysis
– Valuing inventory at lower of cost and net realizable
value
– Reporting and analyzing inventory
3
 CHAPTER 6: Inventory Costing
LEARNING OBJECTIVES

1. Describe the steps in determining inventory quantities.

2. Calculate cost of goods sold and ending inventory in a
perpetual inventory system using the specific identification,
FIFO, and weighted average methods of cost determination.
3. Explain the financial statement effects of inventory cost
determination methods.
4. Determine the financial statement effects of inventory errors.
5. Value inventory at the lower of cost or net realizable value.
6. Demonstrate the presentation and analysis of inventory.
7. Calculate ending inventory and cost of goods sold in a
periodic inventory system using FIFO and weighted average
inventory cost formulas (Appendix 6A).
8. Estimate ending inventory using the gross profit and retail
inventory methods (Appendix 6B).

4
 Determining Inventory Quantities

• All companies count their inventory at least once a

year
– Must determine amount and value of inventory to
prepare accurate financial statements
• The determination of inventory quantities involves
– Taking a physical inventory of goods on hand
– Determining the ownership of the goods

5
 Taking a Physical Inventory

• Involves counting, weighing, or measuring each kind of

inventory on hand
• Strong internal controls needed for an accurate inventory
count:
– Count done by employees not normally responsible
for inventory
– Ensure items counted exist by observation
– Second count by another employee
– Ensure all items are counted only once and nothing is
missed (use pre-numbered tags)

6
 Determining Ownership

• Only include inventory owned by company

• Goods in Transit:
– On board a public carrier as at the count date
– Look at FOB point to determine if they should be
included
• Consigned Goods:
– Goods being sold that are owned by others
– Excluded from inventory of consignee (who is selling
on behalf of the owner, the consignor)
– Example: Artist display their paintings at art galleries
for sale. Art Gallary is not the owner.

7
 TERMS OF SALE
FOB Shipping Point FOB Destination Point

Seller Seller

Ownership
passes to
buyer
here
Public Public
Carrier Carrier
Co. Co.
Ownership
passes to
Buyer buyer here
Buyer
 Sales Transaction

General Journal J1
Date Account Title and Explanation Ref Debit Credit
May 4 Accounts Receivable 3,800
Sales 3,800
To record credit sale.

Only one entry is required to record a sale

under a periodic method.

9
Recording Sales Returns & Allowances

General Journal J1
Date Account Title and Explanation Ref Debit Credit
May 8 Sales Returns and Allowances 300
Accounts Receivable 300
To record returned goods.

The normal balance of Sales Returns and

Allowances is a debit. Sales Returns and
Allowances is a contra revenue account to the
Sales account.

10
 Purchase of Merchandise

General Journal J1
Date Account Title and Explanation Ref Debit Credit
May 4 Purchases 3,800
Accounts Payable 3,800
To record goods purchased on
account, terms n/30.

For purchases on account, Purchases is

debited and Accounts Payable is credited. For
cash purchases, Purchases is debited and Cash
is credited.

11
 Purchase Returns & Allowances

General Journal J1
Date Account Title and Explanation Ref Debit Credit
May 8 Accounts Payable 300
Purchase Returns and Allowances 300
To record return of goods

For purchases returns and allowances that were

originally made on account, Accounts Payable is
debited and Purchase Returns and Allowances is
credited. The Purchase Returns and Allowances
account is a contra account.

12
 Purchase Returns & Allowances

General Journal J1
Date Account Title and Explanation Ref Debit Credit
May 4 Freight In 150
Cash 150
To record payment of freight.

When the purchaser directly incurs the

freight costs, the account Freight In is
debited and Cash is credited.

13
 CHAPTER 6: Inventory Costing
LEARNING OBJECTIVES

1. Describe the steps in determining inventory quantities.

2. Calculate cost of goods sold and ending inventory in a
perpetual inventory system using the specific identification,
FIFO, and weighted average methods of cost determination.
3. Explain the financial statement effects of inventory cost
determination methods.
4. Determine the financial statement effects of inventory errors.
5. Value inventory at the lower of cost or net realizable value.
6. Demonstrate the presentation and analysis of inventory.
7. Calculate ending inventory and cost of goods sold in a
periodic inventory system using FIFO and weighted average
inventory cost formulas (Appendix 6A).
8. Estimate ending inventory using the gross profit and retail
inventory methods (Appendix 6B).

14
 Inventory Cost Determination

• Specific Identification
– Tracks the actual physical flow of goods
– Each inventory item is marked with its cost
– Used where goods are not ordinarily interchangeable
– Eg. Cars
• Cost Formulas
– Specific identification not always suitable
– A cost formula is used instead:
• First-in, first-out (FIFO)
• Weighted Average
• Last-in, First-out (LIFO)
– Flow of costs may not match physical flow

15
 Inventory Costing in a Perpetual
Inventory System

• FIFO:
– FIFO rule is applied at the time of each sale
– FIFO (First-in, first-out)
• Weighted Average:
– New average cost per unit is calculated after each
purchase
• LIFO:
– Goods that are purchased the most recently are
first ones to be sold

16
 Perpetual Inventory System -
First-in, First-out (FIFO)

• FIFO assumes oldest goods are sold first

• Costing:
– Costs of earliest goods purchased are first to be
recognized as Cost of Goods Sold
– Costs of most recent goods purchased are
recognized as ending inventory
• Often reflects the actual physical flow of
merchandise
• Given the chart on the next slide, a physical
inventory was counted at the end of the year
determined 450 units remained on hand

17
 Using FIFO
COST OF GOODS AVAILABLE FOR SALE
Date Explanation Units Unit Cost Total Cost
J an-01 Beginning inventory 100 10 $ 1,000
Apr-15 Purchase 200 11 2,200
Aug-24 Purchase 300 12 3,600
Nov-27 Purchase 400 13 5,200
Total 1,000 $ 12,000

Step 1: Ending Inventory Step 2: Cost of Goods Sold

Date Units Unit Cost Total Cost

Nov-27 400 $ 13 $5,200 Cost of goods available for sale $ 12,000
Aug-24 50 12 600 Less: Ending inventory 5,800
Total 450 $5,800 Cost of goods sold $ 6,200

Alternate Calculation of Cost of Goods Sold

Date Units Unit Cost Cost of Goods Sold
J an. 1 100 $10 $1,000
Apr. 15 200 11 2,200
Aug. 24 250 12 3,000
Total 550 $6,200
Perpetual System Inventory Costing – FIFO
(Cont’d)
• Ending inventory and cost of goods sold under FIFO is
the same for perpetual and periodic systems

19
Perpetual Inventory System - Weighted
Average
• Assumes that it is not possible to measure
specific physical flow of inventory
– So we use a weighted average unit cost
• Applied when goods are sold:
– to units sold to determine cost of goods
sold
– to units on hand to determine ending
inventory

20
 Average Cost

COST
COSTOF
OFGOODS
GOODSAVAILABLE
AVAILABLEFOR
FORSALE
SALE
Date
Date Explanation
Explanation Units
Units Unit
UnitCost
Cost Total
TotalCost
Cost
J Jan-01
an-01 Beginning
Beginninginventory
inventory 100
100 10
10 $$ 1,000
1,000
Apr-15
Apr-15 Purchase
Purchase 200
200 11
11 2,200
2,200
Aug-24
Aug-24 Purchase
Purchase 300
300 12
12 3,600
3,600
Nov-27
Nov-27 Purchase
Purchase 400
400 13
13 5,200
5,200
Total
Total 1,000
1,000 $$12,000
12,000

Step
Step1:1:Ending
EndingInventory
Inventory Step
Step2:2:Cost
CostofofGoods
GoodsSold
Sold

Calculate
Calculateunit
unitcost:
cost:$12,000
$12,000÷÷1,000
1,000==$12 Cost
$12 Costofofgoods
goodsavailable
availablefor
forsale
sale $$12,000
12,000
Units
Units Unit Cost
Unit Cost = Total
TotalCost
Cost Less: Ending inventory
Less: Ending inventory 5,400
5,400
+
450
450 $12
$12 $ 5,400
$5,400 Cost of goods sold
Cost of goods sold $ 6,600
$ 6,600
 Perpetual System Inventory Costing –
Weighted Average (Cont’d)

• Under a perpetual inventory system, a new weighted

average is calculated after each purchase.
• This average is then applied to:
– Units sold, to determine cost of goods sold
– Remaining units on hand, to determine ending inventory

22
 LIFO

• Latest goods purchased assumed to be first sold

• Seldom coincides with actual physical flow of
inventory
• Costing:
– Costs of earliest goods purchased remain in ending
inventory
– Costs of most recent goods purchased are first to be
recognized as Cost of Goods Sold
• Recent changes prohibit its use in Canada
 Using LIFO
COST OF GOODS AVAILABLE FOR SALE

Date Explanation Units Unit Cost Total Cost

J an-01 Beginning inventory 100 10 $ 1,000
Apr-15 Purchase 200 11 2,200
Aug-24 Purchase 300 12 3,600
Nov-27 Purchase 400 13 5,200
Total 1,000 $ 12,000

Step 1: Ending Inventory Step 2: Cost of Goods Sold

Date Units Unit Cost Total Cost

J an-01 100 $ 10 $1,000 Cost of goods available for sale $ 12,000
Apr-15 200 11 2,200 Less: Ending inventory 5,000
Aug-24 150 12 1,800 Cost of goods sold $ 7,000
Total 450 $5,000

Alternate Calculation of Cost of Goods Sold

Date Units Unit Cost Cost of Goods Sold
Nov. 27 400 $13 $5,200
Aug. 24 150 12 1,800
Total 550 $7,000
Perpetual System Inventory Costing –
Weighted Average (Cont’d)
 CHAPTER 6: Inventory Costing
LEARNING OBJECTIVES

1. Describe the steps in determining inventory quantities.

2. Calculate cost of goods sold and ending inventory in a perpetual
inventory system using the specific identification, FIFO, and
weighted average methods of cost determination.
3. Explain the financial statement effects of inventory cost
determination methods.
4. Determine the financial statement effects of inventory errors.
5. Value inventory at the lower of cost or net realizable value.
6. Demonstrate the presentation and analysis of inventory.
7. Calculate ending inventory and cost of goods sold in a periodic
inventory system using FIFO and weighted average inventory
cost formulas (Appendix 6A).
8. Estimate ending inventory using the gross profit and retail
inventory methods (Appendix 6B).

26
 Financial Statement Effects

• Income statement effect:

– When prices rising, FIFO produces higher profit
– When prices falling, opposite is true
• Balance sheet effect:
– FIFO provides the most current valuation of inventory
– More closely approximates replacement cost
• Cost formula should be used consistently
– Enhances comparability of statements over time
– Choose the method that best corresponds with actual
physical flow

27
 CHAPTER 6: Inventory Costing
LEARNING OBJECTIVES

1. Describe the steps in determining inventory quantities.

2. Calculate cost of goods sold and ending inventory in a
perpetual inventory system using the specific identification,
FIFO, and weighted average methods of cost determination.
3. Explain the financial statement effects of inventory cost
determination methods.
4. Determine the financial statement effects of inventory errors.
5. Value inventory at the lower of cost or net realizable value.
6. Demonstrate the presentation and analysis of inventory.
7. Calculate ending inventory and cost of goods sold in a
periodic inventory system using FIFO and weighted average
inventory cost formulas (Appendix 6A).
8. Estimate ending inventory using the gross profit and retail
inventory methods (Appendix 6B).

28
 Inventory Errors

• Errors in inventory affect both income

statement and balance sheet
– Through the calculation of cost of goods sold
• Ending inventory of one period becomes
beginning inventory of the next period
– Errors in ending inventory carry over to the
following period

29
 Income Statement Effects

• Effect of inventory errors on the current year’s income

statement:

• An error in ending inventory of one period will have the

reverse effect on profit of the next period

30
 Balance Sheet Errors

• Effect can be determined by using the

basic accounting equation:
Assets = Liabilities + Owner’s Equity

• An error in ending inventory in one period

will cause an error in beginning inventory
in the next period
31
 CHAPTER 6: Inventory Costing
LEARNING OBJECTIVES

1. Describe the steps in determining inventory quantities.

2. Calculate cost of goods sold and ending inventory in a
perpetual inventory system using the specific identification,
FIFO, and weighted average methods of cost determination.
3. Explain the financial statement effects of inventory cost
determination methods.
4. Determine the financial statement effects of inventory errors.
5. Value inventory at the lower of cost or net realizable value.
6. Demonstrate the presentation and analysis of inventory.
7. Calculate ending inventory and cost of goods sold in a
periodic inventory system using FIFO and weighted average
inventory cost formulas (Appendix 6A).
8. Estimate ending inventory using the gross profit and retail
inventory methods (Appendix 6B).

32
 Inventory Valuation

• Sometimes, before reporting inventory we

must first ensure that it’s properly valued
• Lower of cost and net realizable value (LCM)
– when realizable value of inventory is lower than
cost, it is written down to that lower value
– Net realizable value: selling price less any costs
to make the goods ready for sale
• Assessed on an item-by-item basis
• Reversed if net realizable value increases
before goods are sold

33
 LCM

Cost Market LCM

Television sets
Consoles $ 60,000 $ 55,000 $55,000
Portables 45,000 52,000 45,000
Total 105,000 107,000 100,000
Video equipment
Recorders 48,000 45,000 45,000
Movies 15,000 14,000 14,000
Total 63,000 59,000 59000
Total inventory $ 168,000 $ 166,000 $ 159,000
 LCM

• If Nemesis TV company applied the LCM rule, it

would report its inventory at $159 000 on its
balance sheet
• What is the accounting entry to reflect the Net
Realizable Value?
• Dr COGS 9000
Cr Merchandising Inventory 9000
To record decline inventory value from original cost
of $168 000 to market value of $159 000
 LCM Cont’d

• What happens to our Net Income and

Owner’s Equity in this example?
• Reduces both by 9000
 CHAPTER 6: Inventory Costing
LEARNING OBJECTIVES

1. Describe the steps in determining inventory quantities.

2. Calculate cost of goods sold and ending inventory in a
perpetual inventory system using the specific identification,
FIFO, and weighted average methods of cost determination.
3. Explain the financial statement effects of inventory cost
determination methods.
4. Determine the financial statement effects of inventory errors.
5. Value inventory at the lower of cost or net realizable value.
6. Demonstrate the presentation and analysis of inventory.
7. Calculate ending inventory and cost of goods sold in a
periodic inventory system using FIFO and weighted average
inventory cost formulas (Appendix 6A).
8. Estimate ending inventory using the gross profit and retail
inventory methods (Appendix 6B).

37
 Classifying and Reporting Inventory

• Depends on whether company is a merchandiser

or manufacturer
– Merchandiser buys its inventory – only one
classification used
– Manufacturer produces its inventory – classified
into raw materials, work in process and finished
goods
• Typically recorded as a current asset, but can be
non-current if not sold in one year

38
 Analysis of Inventory

• Must balance competing objectives:

– Excessive levels of inventory leads to
high carrying costs
– Too little inventory may result in lost
sales
• Ratios help determine whether a
company has too much or too little
inventory:
– Inventory turnover ratio
– Days sales in inventory
39
 Inventory Turnover Ratio

= Cost of Goods Sold ÷ Average Inventory

• The number of times inventory is sold (“turns
over”) during a given period
• The more times inventory turns over, the more
efficiently sales are being made
• Average inventory is usually average of
beginning and ending inventories

40
 Days Sales in Inventory

= Days in Year ÷ Inventory Turnover

• The number of days on average that the
inventory is on hand before being sold
• Compare over years and with industry
averages

41
 CHAPTER 6: Inventory Costing
LEARNING OBJECTIVES

1. Describe the steps in determining inventory quantities.

2. Calculate cost of goods sold and ending inventory in a
perpetual inventory system using the specific identification,
FIFO, and weighted average methods of cost determination.
3. Explain the financial statement effects of inventory cost
determination methods.
4. Determine the financial statement effects of inventory errors.
5. Value inventory at the lower of cost or net realizable value.
6. Demonstrate the presentation and analysis of inventory.
7. Calculate ending inventory and cost of goods sold in a
periodic inventory system using FIFO and weighted average
inventory cost formulas (Appendix 6A).
8. Estimate ending inventory using the gross profit and retail
inventory methods (Appendix 6B).

42
Appendix 6A: Inventory Cost Formulas in
Periodic Systems: FIFO

43
Inventory Cost Formulas in Periodic
Systems: Weighted Average

44
 CHAPTER 6: Inventory Costing
LEARNING OBJECTIVES

1. Describe the steps in determining inventory quantities.

2. Calculate cost of goods sold and ending inventory in a
perpetual inventory system using the specific identification,
FIFO, and weighted average methods of cost determination.
3. Explain the financial statement effects of inventory cost
determination methods.
4. Determine the financial statement effects of inventory errors.
5. Value inventory at the lower of cost or net realizable value.
6. Demonstrate the presentation and analysis of inventory.
7. Calculate ending inventory and cost of goods sold in a
periodic inventory system using FIFO and weighted average
inventory cost formulas (Appendix 6A).
8. Estimate ending inventory using the gross profit and retail
inventory methods (Appendix 6B).

45
 Appendix 6B: Estimating Inventories

• Not always possible or practical to count

inventory – must be estimated
– Two estimating methods are available
Gross profit method
– Estimated gross profit = net sales × gross
profit margin
– Estimated cost of goods sold = net sales −
estimated gross profit
– Estimated ending inventory = goods available
for sale − cost estimated cost of goods sold
46
 Appendix 6B: Estimating Inventories 2

• Retail inventory method uses the cost-to-retail

ratio applied to ending inventory at retail to
determine the estimated cost of the inventory
• Calculation:
1. Ending inventory at retail = goods available for sale
at retail − net sales
2. Cost-to-retail ratio = goods available for sale at cost
÷ goods available for sale at retail
3. Estimated cost of ending inventory = ending
inventory at retail × cost-to-retail ratio

47
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