Merchandise Inventory

1
Merchandise Inventory

• Owned by the company
• Ready for sale to customers

2
What We Learn Today

• Cases of inclusion of inventory
• Allocation between ending inventory and COGS

3
Manufacturing Inventory
Raw materials

• Finished goods inventory

Work in process
4
Determining Inventory Quantities

• A physical inventory count
• Determines ending inventory
• Enables cost of goods sold to be calculated

Companies that use a perpetual inventory
system must also take a physical inventory to
check the accuracy of book inventory against
actual inventory
5
Taking a Physical Inventory

• Determining inventory quantities by counting,
  weighting or measuring each type of inventory
• Determining ownership of goods, including goods
  in transit and consigned goods

6
Goods in Transit

• Goods on board a truck, train, ship, or plane at
  the end of the period
• Who includes goods in transit in inventory? The
  buyer? The seller?
• Goods in transit are included in the inventory of
  the company with legal title

7
Ownership passes to buyer here
Illustration 6-1
FOB Shipping Point
Public Carrier Co.
Seller
Buyer
Ownership passes to buyer here
FOB Destination Point
Public Carrier Co.
Seller
Buyer
8
Consigned Goods

• Goods in your store that you dont pay for until
  they sell
• Company does not take ownership

9
Inventory Costing

• After calculating the quantity of units of
  inventory, unit costs are applied
• This determines the values for the cost of goods
  sold and ending inventory
• This is a complicated process because inventory
  is purchased at different times

10
Inventory Valuation Systems

• The following inventory valuation methods are
  generally accepted. They can be used in either a
  periodic or perpetual inventory system.
• Specific Identification
• Cost Flow Assumptions
• Average cost
• First-in, first-out (FIFO)
• Last-in, first-out (LIFO)

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Specific Identification

• Concentrates on the physical tracing of the
  particular items sold
• Major limitation is in identifying the particular
  item sold
• Used in low-volume, high-priced industries
• e.g., jewellery stores

12
Average Cost Flow Assumption

• The average cost of all units in inventory is
  calculated each time there is a purchase
• Weighted average cost
• This cost is used to determine cost of goods sold
  and inventory
• Major advantage is not having to track the
  individual items of inventory

13
Weighted Average Cost
14
First-in, First-out (FIFO)

• The assumption is that the first item purchased
  is the first item sold
• Inventory is valued at the most current cost and
  cost of goods sold is valued at the oldest
  inventory cost
• Earnings reported using this cost flow assumption
  is higher than any other cost flow assumption as
  the oldest costs are used to determine cost of
  goods sold

15
First-in, First-out (FIFO)

Cost of Goods Sold
Oldest Costs
Ending Inventory
Recent Costs
16
Last-in, First-out (LIFO)

• The assumption is that the last item purchased is
  the first sold
• Inventory is valued at oldest cost and cost of
  goods sold is valued at current cost
• This method while allowed under GAAP, is not
  permitted for income tax purposes

17
Last-in, First-out (LIFO)

Cost of Goods Sold
Recent Costs
Ending Inventory
Oldest Costs
18
Financial Statement Effects
What are the effects on the balance sheet and
statement of earnings if prices are assumed to be
rising?
19
Financial Statement Effects
What are the effects on the balance sheet and
statement of earnings if prices are assumed to be
falling?
20
Financial Statement Effects
What are the effects on the balance sheet and
statement of earnings if prices are assumed to be
stable?
All three cost flow assumptions will give the
same results.
21
Use of Cost Flow Assumptions by Canadian Companies

• Each of the cost flow assumptions are acceptable
  in Canada
• Very few companies use LIFO as it is not
  permitted for income tax purposes in Canada

22
Inventory Errors

• Errors can occur in accounting for inventory
• When errors occur they affect both the statement
  of earnings and the balance sheet
• An error in ending inventory can affect the
  calculation of cost of goods sold and net
  earnings in two periods

23
Lower of Cost and Market (LCM)

• When the value of the inventory declines below
  cost, it is written down to its market value
• Market is defined as net realizable value (or
  current replacement cost), not selling price

24
Lower of Cost and Market (LCM)

• Departure from cost principle
• Follows conservatism concept
• Used only after one of the cost flow assumptions
  (specific identification, FIFO, LIFO, or average
  cost) is applied

25
How Much Inventory Should a Company Have?

• Only enough for sales needs
• Excess inventory costs
• Storage costs
• Interest costs
• Obsolescence

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Inventory Turnover
27
Days in Inventory