Chapter 6

Inventory Costing -

Periodic

Periodic Inventory Valuation

a physical count of inventory is taken at the end of the fiscal year to determine how many units make up ending inventory.

Throughout the year, the inventory amount is often estimated, because it is expensive and difficult to do a physical count, except at year end, when it's required.

Options for the Valuation of

Inventory

Specific Identification

Actual Flow of Goods

FIFO (First in First Out)

LIFO (Last in First Out)

Average Cost

Specific Identification

Each item matched with actual cost

usually used with expensive or unique items

this method used if sell a fairly low variety of items and can identify each one easily, either because it's unique, or it may have a serial number.

Some examples: cars, art, electronics, etc.

If a business can use this method, it is easy to record the cost of items, while they're in inventory and when they're sold.

When inventory costs are rising, a company can take advantage of this method by selling off the cheapest inventory to show a high Net Income (low cost of goods sold).

Specific Identification

Valley Electronics buys three identical LCD

TVs at cost of $700, $750, $800

-during the year two are sold at selling

price of $1200 each.

-Dec 31 determined that the $750 LCD TV

is still on hand therefore ending inventory

is $750

COGS is $1500 ($700+$800)

FIFO (First In, First Out)

goods that are purchased first, are sold

first (think conveyor belt i.e. perishables)

FIFO (First In, First Out)

Athabasca Company (periodic inventory system) 2005

80 units were sold:

FIFO

LIFO (Last in First Out)

The last goods purchased are sold first,

much like a pile of logs. The last logs

purchased will be on top and will be sold

first. This method is suitable if the

company has a similar flow of goods.

LIFO

Average Cost Method

When inventory is mixed together when comes in, an average of the costs over the period can be used to value inventory.

very hard to tell which piece of inventory is which and which will be sold first. That is when this method is most appropriate. Hardware stores that sell items like these bolts in bulk, might use this method.

In Canada, FIFO is the most popular

method of inventory valuation; LIFO is

not allowed because of Income Tax

regulations, but is occasionally used for

business analysis.

Journal Entries

For the purchase of new inventory, the journal entry is:

Date Purchases XXXX

Bank or Accounts Payable XXXX To record the purchase of inventory

For a sale, the journal entry is:

Date Cash or A/R 2,000

Sales 2,000

To record a sale

The inventory is adjusted when you close the books at the end of the accounting period.

Effects on Financial Statements

Using the information from our Athabasca

example:

http://download.elearningontario.ca/repository/1054650000/BAT4MC

U3/BAT4MPU3A02/mme/Inventory%20Comparison.htm

Effects on Income Statement

Effects on Income Statement

Period of rising prices:

FIFO produces a higher income.

FIFO reports the highest income and LIFO the lowest. Average cost falls somewhere in the middle.

To management, higher net income is an advantage. It causes external users to view the company more favourably.

Also, if management bonuses are based on net income, FIFO will provide the higher income for higher bonuses.

Effects on Income Statement

Period of falling prices:

the results from the use of FIFO and

LIFO are reversed. FIFO will report the

lowest income and LIFO the highest.

If prices are stable, all three cost flow

assumptions will report the same results.

Balance Sheet Implications

account affected is Merchandise Inventory

This account will have the same value as the

Ending Inventory on the Income Statement.

Assets for a company will be highest using

FIFO and lowest using LIFO, in a period of

rising prices. WHY?

FIFO gives the best balance sheet valuation

Analysis of Inventory

Inventory is usually the largest current

asset on the balance sheet and the

largest expense (COGS) on the income

statement

Therefore these numbers are critical for

analyzing how well a company manages

its inventory

Analysis of Inventory

value of inventory items sometimes fall below cost due to changes in technology or style

When the value of inventory is lower than its cost, the inventory is written down to its market value.

done by valuing the inventory at the lower of cost and market (LCM) in the period in which the decline occurs

Inventory Turnover Ratio

Cost of goods sold ÷ average

inventory

The number of times inventory “turns

over” during a given period

Average inventory is usually average of

beginning and ending inventories

Days Sales in Inventory

Days in year ÷ inventory turnover ratio

The number of days on average that the

inventory is on hand before being sold