Accounting principles chapter 06

J1 Date Account Title and Explanation Ref Debit CreditMay 8 Accounts Payable 300 Purchase Returns and Allowances 300 To record return of goods General Journal PURCHASE RETURNS AND ALL

Accounting Principles

Second Canadian Edition

Prepared by:

Carole Bowman, Sheridan College

Weygandt · Kieso · Kimmel ·

Trenholm

INVENTORY COSTING

CHAPTER

6

 In the balance sheet of merchandising and

manufacturing companies, inventory is frequently the most significant current asset.

 In the income statement , inventory is vital in

determining the results of operations for a

particular period.

 Gross profit (net sales - cost of goods sold)

is closely watched by management, owners, and other interested parties.

INVENTORY BASICS

Perpetual vs Periodic Inventory Accounting

 In order to prepare financial statements, it is necessary

to determine the number of units of inventory owned by the company at the statement date, and to value them

 The determination of inventory quantities involves

1 taking a physical inventory of goods on hand, and

2 determining the ownership of goods.

 Taking a physical inventory involves counting, weighing,

or measuring each kind of inventory on hand.

DETERMINING INVENTORY

QUANTITIES

TAKING A PHYSICAL INVENTORY

A company, in order to minimize errors in

taking the inventory, should adhere to

internal control principles by adopting the

following procedures:

1 Employees who do not have custodial

responsibility for the inventory should do the counting ( segregation of duties ).

2 E ach counter should establish the

authenticity of each inventory item

( establishment of responsibility ).

TAKING A PHYSICAL INVENTORY

3 Another employee should make a second count ( independent verification ).

4 A ll inventory tags should be pre-numbered and accounted for ( documentation

procedures ).

5 At the end of the count, a designat ed

supervisor should ascertain that all

inventory items are tagged and that no

items have more than one tag

( independent verification ).

Buyer

Public

Carrier

Co.

Ownership

passes to

buyer here

Ownership

passes to

buyer here

FOB Shipping Point FOB Destination Point

TERMS OF SALE

Public Carrier Co.

Buyer Seller

 Under a consignment arrangement , the

holder of the goods (called the consignee )

does not own the goods

 Ownership remains with the shipper of the

goods ( consignor ) until the goods are

actually sold to a customer

 Consigned goods should be included in the

consignor’s inventory, not the consignee’s

SALES TRANSACTIONS

J1

Date Account Title and Explanation Ref Debit Credit

May 4 Accounts Receivable 3,800

Sales 3,800

To record credit sale.

General Journal

Only one entry is required to record a sale

under a periodic method

Only one entry is required to record a sale

under a periodic method

RECORDING SALES RETURNS

AND ALLOWANCES

The normal balance of Sales Returns and

Allowances is a debit Sales Returns and

Allowances is a contra revenue account to the

Sales account

The normal balance of Sales Returns and

Allowances is a debit Sales Returns and

Allowances is a contra revenue account to the

Sales account

J1

Date Account Title and Explanation Ref Debit Credit

May 8 Sales Returns and Allowances 300

Accounts Receivable 300

To record returned goods.

General Journal

PURCHASES OF MERCHANDISE

For purchases on account, Purchases is debited and Accounts Payable is credited For

cash purchases, Purchases is debited and Cash

J1 Date Account Title and Explanation Ref Debit Credit

May 8 Accounts Payable 300

Purchase Returns and Allowances 300

To record return of goods

General Journal

PURCHASE RETURNS AND

ALLOWANCES

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.

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.

J1 Date Account Title and Explanation Ref Debit Credit

debited and Cash is credited.

When the purchaser directly incurs the freight costs, the account Freight In is

debited and Cash is credited.

ACCOUNTING FOR FREIGHT COSTS

Cost of goods available for sale $ 356,000

ALLOCATION OF INVENTORIABLE COSTS

Ending Inventory (Balance Sheet)

Cost of Goods Sold (Income Statement)

USING ACTUAL PHYSICAL

FLOW COSTING

 The specific identification method t racks the

actual physical flow of the goods.

 Each item of inventory is marked, tagged, or coded with its specific unit cost.

 It is most frequently used when the company sells a limited variety of high unit-cost items.

USING ASSUMED COST

 Cost flow assumptions:

1 First-in, first-out (FIFO)

2 Average cost.

3 Last-in, first-out (LIFO)

recent goods purchased are recognized as the ending inventory.

FIFO method assumes earliest goods purchased are the first to

be sold

AVERAGE COST

 The average cost method assumes that the goods available for sale are homogeneous.

 The allocation of the cost of goods

available for sale is made on the basis of the weighted average unit cost incurred

 The weighted average unit cost is then

applied to the units sold to determine the cost of goods sold and to the units on hand

to determine the ending inventory.

Allocation of the cost of goods available for sale in average cost method is made on the basis of

Average cost method assumes that

goods available for sale are

homogeneous

 The LIFO method assumes that the latest goods purchased are the first to be sold

and that the earliest goods purchased

remain in ending inventory.

 Seldom coincides with the actual physical flow of inventory.

 Under the periodic method, all goods

purchased during the year are assumed to

be available for the first sale, regardless of date of purchase.

 Rarely used in Canada.

LIFO method assumes latest goods

purchased are the first to be sold

INCOME STATEMENT EFFECTS

 In periods of rising prices, FIFO reports the

highest net income , LIFO the lowest and

average cost falls in the middle.

 The reverse is true when prices are

falling.

 When prices are constant , all cost flow

methods will yield the same results

FIFO produces the best balance sheet

valuation since the inventory costs are closer

to their current, or replacement, costs.

BALANCE SHEET EFFECTS

USING INVENTORY COST FLOW

METHODS CONSISTENTLY

period to another.

 Such consistent application enhances the

comparability of financial statements over successive time periods

 When a company adopts a different cost

flow method, the change and its effects on net income should be disclosed in the

financial statements.

 Both beginning and ending inventories appear

on the income statement.

 The ending inventory of one period

automatically becomes the beginning

inventory of the next period.

 Inventory errors affect the

determination of cost of goods sold and net income.

INVENTORY ERRORS - INCOME

STATEMENT EFFECTS

FORMULA FOR COST OF GOODS SOLD

Beginning

Inventory

Cost of Goods Purchased

Ending Inventory

Cost of Goods Sold

_

The effects on cost of goods sold can be

determined by entering the incorrect data

in the above formula and then substituting the correct data.

The effects on cost of goods sold can be

in the above formula and then substituting the correct data.

EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S

INCOME STATEMENT

An error in ending inventory of the current period

will have a reverse effect on net income of the next

accounting period.

An error in ending inventory of the current period

will have a reverse effect on net income of the next

accounting period.

Understate beginning inventory Understated Overstated

Overstate beginning inventory Overstated Understated

Understate ending inventory Overstated Understated

Overstate ending inventory Understated Overstated

The effect of ending inventory errors on the

balance sheet can be determined by using the basic

Assets = Liabilities + Owner’s Equity

ENDING INVENTORY ERROR –

BALANCE SHEET EFFECTS

Overstated Overstated None Overstated

Understated Understated None Understated

 When the value of inventory is lower than

the cost, the inventory is written down to its market value.

 This is known as the lower of cost and

market ( LCM ) method

 Market is defined as replacement cost or

net realizable value

VALUING INVENTORY AT THE

LOWER OF COST AND MARKET

ILLUSTRATION 6-20

ALTERNATIVE LOWER OF COST

AND MARKET (LCM) RESULTS

The common practice is to use total inventory

rather than individual items or major

categories in determining the LCM valuation.

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