Chapter+6+Notes+-+Merchandising+Operations+-+Periodic+Inventory+System+-+Inventory+Valuation


 * __SO 1 & SO 8 - Inventory basics__**
 * Homework**: SS1, SS10; BE6-1, BE6-11; E6-1
 * SO 1 Highlights**: too much inventory can lead to unnecessary costs (storage, security, etc.) while too little inventory can lead to unsatisfied customers (stockouts, lack of variety, etc.); for a merchandising firm, inventory appears as both a current asset on the balance sheet (Merchandise Inventory) and as a distinct expense category on the income statement (Cost of Goods Sold); end-of-period physical inventory count is necessary in both periodic inventory system (to determine actual inventory on hand) and perpetual inventory system (to confirm accuracy of inventory records); internal control policies and procedures are generally designed to optimize use of resources, identify and prevent errors, protect assets and improve reliability of accounting records - several internal control procedures are commonly applied to physical inventory counts including: (i) count should be performed by employees with neither physical nor record-keeping responsibility over inventory (ii) count should take place in teams of two (iii) initial count should be confirmed by follow-up count performed by another employee or auditor (iv) prenumbered inventory tags should be affixed to all counted items and later confirmed by supervisor; following physical inventory count, unit costs (price per unit) are applied to inventory quantities using cost flow methods discussed later in chapter (specific identification, FIFO, average cost, LIFO) so as to determine total __cost__ of inventory on hand at end of period; (where physical inventory count cannot be undertaken, cost estimating methods such as gross profit and retail inventory methods may be used instead - see Appendix 6B);


 * goods in transit** (in hands of public carrier such as plane, train, delivery truck, etc.) may or may not be included in end-of-period inventory figures depending on who actually holds legal title to (or ownership of) said items -> **legal title often determined by terms of sale** -> **FOB shipping point** (ownership passes to purchaser once goods placed in transit, i.e. once the goods are in the hands of a public carrier like a trucking or courier company) or **FOB destination** (ownership remains with seller until arrival of goods at purchaser's place of business); **consigned goods** (e.g. artwork) remain the property of the consignor (e.g., artist) until the goods are actually sold by the consignee (e.g., art gallery) to third party customer and therefore should never be included in the inventory figures of the consignee; **goods temporarily taken home by customers with approval of retailer but not formally purchased** (e.g., to sample or try out) remain property of retailer and __should__ be included in inventory figures of retailer; **goods already sold but temporarily held by retailer** (e.g., goods receiving alterations or items awaiting pick up or delivery) should __not__ be included in inventory figures of retailer; **damaged goods** that are unsaleable should __not__ be included in inventory figures and any loss should be recorded as an expense, e.g., Inventory Shrinkage, Written Off Goods


 * SO 8 Highlights**: **inventory** values often fall over time due to changes in technology and trends -> in accordance with principle of conservatism (assets and profits should never be overstated), inventory is often valued at **"lower of cost or market" or LCM** -> "cost" refers to original purchase price while "market" refers to either (i) **replacement value** (i.e., current purchase/cost price available from vendors/suppliers) or more often (ii) **net realizable value or NRV** (current estimated selling price in the market minus any disposition costs necessary to complete sale such as packing, delivery, inspections and commissions) -> **under recently-adopted IFRS in Canada, "market" always refers to NRV and not replacement value;** income tax legislation in Canada also requires NRV as preferred method of calculating "market value"; LCM is only utilized after one of the inventory cost flow methods (specific identification, FIFO, average cost, LIFO - see below) has been applied to inventory quantities -> **LCM is usually applied to __total__ inventory on hand but may also be applied to specific __categories/types__ of inventory or to specific __individual items__ of inventory** -> if application of LCM reveals that "market" value of inventory has fallen below original "cost" price, the difference must be journalized with a debit to a non-operating expense account (e.g., Write down of inventory, Loss in NRV of inventory) and a credit to Merchandise Inventory; while merchandising firms who sell finished goods list only one inventory account on their balance sheets (Merchandise Inventory), **manufacturing firms** may employ up to three separate current asset accounts to classify inventory on their balance sheets, namely **raw materials** (to be used in production), **works in progress** (unfinished goods) and **finished goods** (awaiting sale and/or shipment); in the accompanying notes to the financial statements or annual report of a merchandising firm, there must be disclosure of (i) major inventory classifications (ii) cost flow method employed (iii) use of cost or LCM basis of accounting


 * __SO 2 - 4 - Accounting entries under periodic inventory system__**
 * Homework**: SS2, SS3, SS4, SS5; BE6-3, BE6-4, BE6-5; E6-4 (Co. 1 only)
 * Highlights**: unlike the perpetual inventory system, under the periodic inventory system no attempt is made to update the Merchandise Inventory account during the period or record the cost price of goods sold at the time of sale - instead a physical inventory count is conducted at the end of each period to determine the quantity and value of both ending inventory and cost of goods sold during period; accordingly, a __second__ entry at cost price is __not__ necessary in the seller's books for the sale or return of merchandise under the periodic inventory system; other differences between the two inventory systems require that under the periodic inventory system (a) purchases of inventory are recorded in the **Purchases** expense account rather than the Merchandise Inventory asset account (b) returns of defective goods are recorded in the **Purchase Returns and Allowances** contra expense account rather than the Merchandise Inventory asset account (c) freight charges paid by the purchaser on merchandise purchased and delivered to one's business are recorded in the **Freight In** expense account rather than the Merchandise Inventory asset account and finally (d) Ending Inventory is closed alongside Revenue accounts while Beginning Inventory is closed alongside Expense accounts during period-ending closing entries in order to update the Merchandise Inventory account at the end of each period (as all purchases of inventory during the period are debited to the Purchases account and not the Merchandise Inventory account)

__ **Journal entries for merchandising businesses under periodic inventory system** __

(a) Purchase of inventory for $60 plus sales taxes (13% HST in Ontario)
 * __Purchaser__ **

**Purchases** (expense) - dr - 60 (+) HST Recoverable - dr - 7.80 -- Cash or A/P - cr - 67.80

// + = Merchandise Inventory (MI) account under perpetual inventory system //

(b) Freight costs of $10 cash on purchase of inventory plus sales taxes (assuming FOB shipping point)

**Freight In (expense)** - dr - 10 (+) HST Recoverable - dr - 1.30 -- Cash - cr - 11.30

+ // = MI account under perpetual inventory system //

(c) Return of inventory (50% of original purchase) by purchaser

Cash or A/P - dr - 33.90 -- **Purchase Returns and Allowances** (contra expense) - cr - 30 (+) -- HST Recoverable - cr - 3.90

// + = MI account under perpetual inventory system //

(d) Payment on account of outstanding invoice (assuming original purchase on account)

A/P - dr - 33.90 - Cash - cr - 33.90

(a) Sale of goods for $100 ($60 cost price) plus sales taxes
 * __Seller__ **

Cash or A/R - dr - 113 -- **Sales** - cr - 100 -- HST Payable - cr - 13

(b) Freight costs of $10 cash on sale of goods (assuming FOB destination and no sales taxes)

**Freight Out (expense) or Delivery Expense** - dr -10 -- Cash - cr - 10

(c) Return of $100 goods to seller ($60 cost price)

**Sales Returns and Allowances** - dr - 100 HST Payable - dr - 13 -- Cash or A/R - cr - 113

(d) Receipt of payment on account of outstanding invoice (assuming original sale on account)

Cash - dr - 33.90 A/R - cr - 33.90


 * __Calculating__** **__net income (big picture) and cost of goods sold (little picture) under periodic inventory system__**

Net sales (S - SRA) __- **Cost of goods sold**__ Gross profit __- Operating expenses__ Net income

Beginning inventory + Net purchases (P - PRA) __+ Freight In__ Cost of goods available for sale __- Ending inventory__
 * Cost of goods sold**


 * __SO 5 - Inventory valuation under periodic inventory system__**
 * Homework:** BE6-7; E6-7, E6-8
 * Highlights:** when the __same__ inventory items have been purchased at __different__ unit costs (purchase prices) throughout the fiscal period, it becomes very difficult to assign a specific dollar value to ending inventory and cost of goods sold under the **periodic inventory system** following an end-of-period physical inventory count; at the end of the period, cost of goods available for sale (beginning inventory + purchases of inventory) must be allocated to either ending inventory or cost of goods sold; under the periodic inventory system, the timing of each individual __sale__ is ignored as the aforementioned allocation is made at the end of the period by assuming that the entire cost of goods available for sale figure is available for distribution at that time - in other words, all inventory items either on hand at the start of the period or purchased during the period are assumed to be available for the first sale regardless of the date of purchase; on the other hand, under the __perpetual__ inventory system, this allocation between ending inventory and cost of goods sold is made continuously throughout the period as each individual item is sold; in low-volume, high-unit-cost businesses (e.g., auto dealerships, furniture outlets), **physical cost flow method** known as **specific identification** is able to track the __actual__ physical flow of inventory both into and out of the firm because each individual item of inventory is marked or coded with a specific unit cost - accordingly, accurate figures can be assigned to both ending inventory and cost of goods sold following an end-of-period physical inventory count; on the other hand, in high-volume, low-unit-cost businesses (e.g., hardware stores, supermarkets), use of the specific identification method is highly impractical and so **assumed cost flow methods** must instead be utilized to allocate cost of goods available for sale to either ending inventory or cost of goods sold based on certain assumptions - three assumed cost flow methods are in use today: FIFO (first in, first out), average cost and LIFO (last in, first out); (i) **FIFO** assumes that the earliest inventory items purchased or on hand (first in, i.e., beginning inventory and initial purchases of inventory) are also the first items sold (first out) during the period - accordingly, the cost of goods sold figure is determined by utilizing early inventory unit costs while the ending inventory figure is determined by utilizing later inventory unit costs; (ii) **average cost method** assumes that all like inventory items are entirely identical to one another and so the allocation of cost of goods available for sale should be based on the **__weighted__** average unit cost (units x unit cost) of each inventory item either on hand at the start of the period (beginning inventory) or purchased during the period, i.e., cost of goods available for sale / total units available for sale - this average unit cost is then applied to the number of units in both ending inventory and cost of goods sold so as to arrive at dollar values for each figure; (iii) **LIFO,** which is the least common of the three assumed cost flow methods, assumes that the latest inventory items purchased (last in) are also the first items sold (first out) during the period - accordingly, the cost of goods sold figure is determined by utilizing later inventory unit costs while the ending inventory figure is determined by utilizing early inventory unit costs; keep in mind that assumed cost flow methods (as the name implies) make certain assumptions that may or may not represent the actual physical flow of goods into and out of the business; furthermore, keep in mind that this chapter typically assumes inventory unit costs are rising throughout the year which explains why ending inventory and cost of goods sold figures vary so greatly depending on the assumed cost flow method (FIFO, average cost, LIFO) under study (see pages 282-283)

Inventory valuation using **assumed cost flow methods (FIFO, LIFO, weighted average cost)** under **periodic inventory system** in period of rising prices (**inflation**) assuming **ending inventory (EI) of 300 units** (calculated following period-ending physical inventory count) and **Cost of Goods Sold (COGS) of 500 units**
 * __Exercise__ (T) **

Jan 1 - Beginning inventory - 100 u @ $10/u - $1000 May 1 - Inventory purchase - 200 u @ $11/u - $2200 Aug 1 - Inventory purchase - 300 u @ $12/u - $3600 Oct 1 - Inventory purchase -- __200 u__ @ $15/u - __$3000__


 * Cost of goods available for sale = 800 units for a total of $9800**


 * __ FIFO __**
 * COGS ** (100 u @ $10/u + 200 u @ $11/u + 200 u @ $12/u = $5600)
 * EI ** (100 u @ $12/u + 200 u @ $15/u = $4200)

**COGS** (200 u @ $15/u + 300 u @ $12/u = $6600) **EI** (200 u @ $11/u + 100 u @ $10/u = $3200)
 * __ LIFO __**

Average cost per unit at end of period: $9800 divided by 800 units = $12.25/u
 * __ Weighted average cost __**

**EI** (300 u @ $12.25/u = $3675)
 * COGS ** (500 u @ $12.25/u = $6125)

__**SO 6 - 7** **-** **I****nventory valuation under periodic inventory system**__
 * Homework:** SS8, SS9; BE6-9, BE6-10; E6-12(a)(b)
 * SO 6 Highlights:** businesses may choose to use any one (or more than one) of the four cost flow methods (specific identification, FIFO, average cost, LIFO) under discussion; FIFO and average cost are clearly the most popular methods in Canada (perhaps because LIFO is not permitted here for income tax purposes and given that IFRS, recently adopted in Canada, does not allow for LIFO), while LIFO enjoyed moderate popularity in the U.S. before adoption of IFRS there; choice of assumed cost flow method ultimately affects both income statement and balance sheet figures; income statement effects: during periods of rising prices (inflation), FIFO (first purchased, first sold) results in lowest COGS and highest gross profit/net income, LIFO results in highest COGS and lowest gross profit/net income, while average cost method results in COGS and gross profit/net income figures somewhere in the middle - during periods of falling prices (deflation), opposite results are true - during periods of steady prices, all three methods report exact same results - accordingly, LIFO provides most accurate __income statement (profitability) valuation__ of a business as it is the only method that matches current costs (most recent inventory purchases) with current revenues (most recent sales); balance sheet effects: during periods of rising prices (inflation), FIFO results in highest ending inventory figure and highest owner's equity, LIFO results in lowest ending inventory figure and lowest owner's equity, while average cost method results in ending inventory and owner's equity figures somewhere in the middle - during periods of falling prices (deflation), opposite results are true - during periods of steady prices, all three methods report exact same results - accordingly, FIFO provides most accurate __balance sheet (equity or worth) valuation__ of a business as it is the only method that matches inventory on hand at year-end (most recent inventory purchases) with their current replacement values; keep in mind that all three assumed cost flow methods produce the same cash flow figures (cash in and cash out) as inventory valuation has nothing to do with the flow of monies; also keep in mind that all three assumed cost flow methods produce the same results __over time__, i.e., while income statement and balance sheet figures may differ among the three methods __within__ a given fiscal period, __cumulative results over time__ will be identical regardless of the cost flow method chosen; choice of cost flow method should not be based on any consideration other than utility to decision-makers; GAAP principle of consistency suggests that the same cost flow method should be used from period to period; GAAP principle of full disclosure suggests that changes in cost flow method and resulting effects should be disclosed to decision-makers


 * SO 7 Highlights**: **errors in counting (physical inventory count) or costing (cost flow methods) of inventory** (e.g., beginning inventory or purchases of inventory or ending inventory) will result in overstatements or understatements on both the income statement (COGS and gross profit/net income) and balance sheet (merchandise inventory and owner's equity); because the current period's ending inventory becomes the subsequent period's beginning inventory, errors in ending inventory will always have a reverse effect on net income in the following period which suggests that __combined__ net income over the two year period will be correct as the two errors (overstatement and understatement) eventually offset one another


 * Don't forget that on the periodic income statement:**

Net sales (S - SRA) __- **Cost of goods sold**__ Gross profit __- Operating expenses__ Net income

Beginning inventory + Net purchases (P - PRA) __+ Freight In__ Cost of goods available for sale __- Ending inventory__
 * Cost of goods sold**


 * And don't forget that on the balance sheet:**

total assets = total liabilities + owner's equity (beginning capital + net income - drawings = ending capital)

As a result, when ending inventory is understated for the period, cost of goods sold will be overstated which leads to gross profit and net income being understated for the same period. Similarly, assets (which includes ending inventory) and owner's equity (which includes net income) will also be understated for the same period.

On the other hand, when ending inventory is overstated for the period, cost of goods sold will be understated which leads to gross profit and net income being overstated for the same period. Similarly, assets (which includes ending inventory) and owner's equity (which includes net income) will also be overstated for the same period.

__**SO 9 - Inventory valuation under perpetual inventory system**__
 * Homework**: SS11; BE6-13; E6-14
 * Highlights**: all assumed cost flow methods (FIFO, average cost and LIFO) can also be used under the perpetual inventory system; (i) using **FIFO**, the cost of the earliest goods on hand (beginning inventory and earliest inventory purchases) __prior to each sale__ is charged to COGS - accordingly, results under periodic and perpetual inventory systems do __not__ differ using FIFO; (ii) using **average cost method**, a new **__moving__** average cost is calculated __after each purchase__ by dividing cost of goods available for sale by the units available for sale - on the date of the first sale, the average cost is then applied to units sold to determine COGS, and to the remaining units on hand (plus any additional purchases of inventory) to determine ending inventory - accordingly, results under periodic and perpetual inventory systems will differ using average cost method; (iii) using **LIFO**, the cost of the latest inventory purchases __prior to each sale__ are charged to COGS - accordingly, results under periodic and perpetual inventory systems will differ using LIFO; just like under the periodic inventory system, under the perpetual inventory system in a period of rising prices, FIFO still produces the lowest COGS and the highest ending inventory and gross profit/net income figures, LIFO still produces the highest COGS and the lowest ending inventory and gross profit/net income figures, and the (moving) average cost method still produces results in the middle - on the other hand, in a period of falling prices the opposite results are once again true

Inventory valuation using **assumed cost flow methods (FIFO, LIFO, moving average cost)** under **perpetual inventory system** in period of rising prices (**inflation**) assuming **ending inventory (EI) of 300 units** and **Cost of Goods Sold (COGS) of 500 units**
 * __Exercise__**

Jan 1 - Beginning inventory - 100 u @ $10/u - $1000 May 1 - Inventory purchase - 200 u @ $11/u - $2200 Aug 1 - Inventory purchase - 300 u @ $12/u - $3600 Oct 1 - Inventory purchase - 200 u @ $15/u - $3000
 * Sep 1 - Inventory sale - 500 units**


 * Cost of goods available for sale = 800 units for a total of $9800**

COGS = 100 u @ $10/u + 200 u @ $11/u + 200 u @ $12/u = $5600 EI = 100 u @ $12/u + 200 u @ $15/u = $4200
 * __FIFO__**

COGS = 300 u @ $12/u + 200 u @ $11/u = $5800 EI = 100 u @ $10/u + 200 u @ $15/u = $4000
 * __LIFO__**

Average cost per unit __prior to__ sale of Sep 1: 100 u @ $10/u = $1000 + 200 u @ $11/u = $2200 + 300 u @ $12/u = $3600 => $6800 divided by 600 units = $11.33/u COGS = 500 u @ $11.33/u = $5666.67
 * __Moving average cost__**

Average cost per unit of __remaining__ inventory: 100 u @ $11.33/u = $1133.33 + 200 u @ $15/u = $3000 => $4133.33 divided by 300 units = $13.78/u EI = 300 u @ $13.78/u = $4133.33