Ch 1 to 7 Recap
Week 1 & week 2:Accounting equation, accounting cycle, adjusting entries, and Financial
statements
✓Analyze transactions by using the accounting equation and double-entry accounting
✓Describe asset, liability, and equity accounts, identifying the effect of debits and credits on
each.
✓Analyze transactions.
✓Identify, explain, and prepare financial statements.
✓Adjusting entries.
Week 3: Merchandising Activities
✓Merchandising operation and the components of the financial statement:
✓sales, cost of goods sold,
✓merchandise inventory, and
✓gross profit.
✓Differentiate between the perpetual and periodic inventory systems.
✓Analyze and record purchase and sales transactions for a merchandiser.
✓Record adjustments to merchandise inventory.
✓Explain and identify the entries regarding purchase and sales transactions in a periodic
inventory system.
✓Week 5(Class# 4): Cash
✓What is cash?
✓The Petty Cash system
✓Control over cash
✓Reconciling bank and accounting records
✓Week 5 (class # 4): Receivable
✓Receivable fundamentals
✓Acct for bad debt: Allowance method
✓Acct for notes receivable
✓Week 6 (class #5): Mini-case
✓An integrated understanding of accounting cycle and accrual basis of accounting.
Chapter 8 Inventory
INVENTORY LEARNING OUTCOMES
❑Calculate cost of goods sold and
merchandise inventory (under both the
perpetual and periodic inventory systems)
using:
❑specific identification,
❑first-in first-out (FIFO),
❑Last-in First-out (LIFO) and
❑weighted average cost flow
❑Explain the impact on financial statements of inventory cost flows and errors.
❑Explain and calculate lower of cost and net realizable value inventory adjustments.
Inventory: Goods/merchandise (assets) that are awaiting sale as part of the principal activity
of the firm (Note: firms also sell off assets that are not inventory).
2 TYPES OF FIRMS = 2 TYPES OF INVENTORIES
• Merchandising firms: Purchased goods for resale
• Manufacturing firms: Goods manufactured from scratch within the firm for original sale.
SOME SHORT FORM TERMINOLOGY
I = Inventory
CoS = Cost of Goods Sold (also CofGS)
OI = Opening Inventory
EI = Ending Inventory
NP= Net Purchases
GP= Gross Purchases,
TI = Transportation In
PRA = Purchase Returns and Allowances;
PD = Purchase Discounts
Purchase Equation: GP + TI - PRA - PD = NP
Inventory Equation: OI + NP - CofGS = EI
OI +NP - EI = CoGS
Question: • If you had 30 widgets at the beginning of the year, you bought 50 more and had
10 at the end of the year... how many did you sell?
30 + 50 - 10 =70
MERCHANDISE AVAILABLE FOR SALE
Opening Inventory + Purchases = Merchandise Available for Sale (MAFS)
Unsold MAFS → Inventory: Balance Sheet
Sold MAFS → CoGS: Income Statement.
RECORDING ACQUISITION OF INVENTORY
“Laid Down” Cost Concept: Include all expenditures made to ready the item for resale (laid
down cost).
• purchase price - discounts, returns
• freight
• foreign exchange
• insurance
PERPETUAL VS PERIODIC
Periodic method: Compute COGS and Ending Inventory only
at the end of the accounting period or after a certain interval.
Perpetual method: Compute COGS and Ending Inventory after
each sale.
TIMING OF INVENTORY COMPUTATIONS
Perpetual Inventory
• Purchases are debited directly to inventory as items for resale are acquired
• Items sold are credited to inventory at their acquisition cost at the time of sale
Dr Accounts Receivable
Cr Sales
Dr Cost of Goods Sold
Cr Inventory
• Sub-ledger kept for inventory and is updated after each transaction
PERIODIC INVENTORY METHOD
Acquisitions:Charged to “Purchases” account
Valuation:Inventory is counted and valued only at the end of the accounting period
Weakness: On any given day during month: Clueless what balance is of inventory
Advantage:In pre-computer era…less bookkeeping.
Required…Compute…goods available for sale, ending inventory and cost of goods sold.
Can calculate units in EI, but cannot value until cost flow assumption picked.
Of 5 units in EI, how do we know if they were bought at $10, $20, or $30?
PHYSICAL FLOW COST FLOW
Actual physical flows: • Specific Identification (Ferrari Dealers) • FIFO (Milk Stores) • LIFO
(Coal dealers) • Average Cost
Cost Flow used for F/S valuation • Pick one, any one • Choice determined by income mgt
strategy • Sometimes constrained by government tax law and by accounting standards
SPECIFIC IDENTIFICATION
•Each unit is specifically identified, and physical flow = cost flow •Most bookkeeping effort …
worth it for Ferrari’s.
COST FLOW ASSUMPTION & INVENTORY VALUATION … UNDER PERIODIC COST
FLOW
FIFO = FIRST IN FIRST OUT (PERIODIC)
LIFO = LAST IN FIRST OUT (PERIODIC)
Note that LIFO has very recently been discontinued in Canada as an acceptable method of
GAAP. Since you may still encounter it in reading F/S of non-Canadian firms, it is worthwhile
for us to study it. If the inventory contains the oldest purchases, there is a disconnect
between the current value of the inventory and the inventory sitting in there.
Average cost (Periodic)
𝑀𝐴𝐹𝑆
𝑇𝑜𝑡𝑎𝑙 𝑈𝑛𝑖𝑡𝑠
= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑈𝑛𝑖𝑡 𝐶𝑜𝑠𝑡
($3600/300) = 12 * 80 𝑢𝑛𝑖𝑡𝑠 = $960 𝐸𝐼
(MAFS – EI = CoGS) = ($3,600 - $960) = $2,640 CoGS
SIMPLE VS. WEIGHTED AVERAGE (BOTH PERIODIC AND PERPETUAL METHODS)
Note: inventory method is a ‘weighted’ average in that it takes into account that higher
quantities purchased at one price impact the average, e.g., if purchases are 100 units @$10
and 10 units @ $2.
Weighted Average [(100x $10) + (10 x $2)] / 110 = $9.27.
Simple Average ($10 + $2)/2 = $6.
SUMMARY IMPACT OF COST FLOW ASSUMPTION (PRICE RISING)
PRICE LEVEL EFFECT AND COST FLOW ASSUMPTION
Rising Prices
• FIFO … highest NI
• Wt. Average… in between
• LIFO… lowest NI
Falling Prices
• FIFO … lowest NI
• Wt. Average… in between
• LIFO… highest NI
Specific Identification
• Always depends which items are sold … if firm can pick…. then it can manage its
earnings.
COST FLOW ASSUMPTION & INVENTORY VALUATION … UNDER PERPETUAL COST
FLOW ASSUMPTION
COGS (FIFO) = 60 * 10 + 100 * 11 + 60 * 13 = 2480
COGS (LIFO) = 100 * 13 + 100 * 11 + 20 * 10 = 2600
FIFO 1120 + 2480 = 3600
LIFO 1000 + 2600 = 3600
The perpetual method includes a moving average.
3000/260 = 11.538
S1. The selling price is used for revenue, not COGS.
3000 - 2538.8 = 461.2
220 * 11.54 = 2538.8
40 * 15 = 600
INVENTORY ERRORS
• 2-year impact on financial statements
• Impact opposite in Yr 1 and Yr 2 so effect on R/E is $0 at end of Yr 2 i.e., if understated in
Yr 1 will be overstated in Yr 2 and $0 Retained Earnings effect at end of Yr 2
• Use CoGS and I/S equations to compute effect
OI + P – EI = CoGS
Sales – CoGS = Net Income
INVENTORY ERROR EXAMPLE
Assume a purchase of $1,000 just before year-end end correctly counted in Yr 1 but invoice
(the purchase) is not recorded until year 2.
Impact:
INVENTORY VALUATION AT LCM
• GAAP: Lower of Cost or Market
• lesser of Cost or “Market Value”
• In Canada, “market” is defined as Net Realizable Value
• In the U.S., “market” is defined as Replacement Cost
• allows a company to recognize an unrealized holding loss from declines in market value
• Conservative - holding gains are not recognized until goods are sold
LOWER OF COST AND MARKET
If at year end cost = $100 and market = $80
lower of cost and market requires the recording of a loss for decline in inventory value:
Dr Loss in decline in value $20
Cr Inventory $20
If the amount is small, it is buried in C of GS… if it is large, it may be reported as a separate
line item on the income statement.
APPLICATION OF LCM: ITEM-BY-ITEM OR AGGREGATE
