Chapter 6 notes

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9 Jan 2011
Chapter 6 Reporting and Analyzing Inventory Notes
Determining Inventory Quantities
x companies that use a perpetual inventory system must still take a physical inventory at year end for two purposes: (1) to check
the accuracy of their perpetual inventory records and (2) to determine the amount of inventory lost due to shrinkage and theft
x if the physical inventory count does not match what is recorded in the general ledger, then any errors or losses can be determined
and an adjusting entry made to correct the inventory balance
x in a periodic inventory system, inventory quantities are not updated on a continuous basis
x therefore companies must take a physical inventory to determine the inventory on hand at the end of the accounting period
x once the ending inventory amount is determined, this amount is then used to calculate the COGS for the period
x determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the
ownership of the goods
Taking a Physical Inventory
x internal control : the methods and measures adopted within an organization to help it achieve reliable financial reporting,
effective and efficient operations, and compliance with relevant laws and regulations
x some internal control procedures for counting inventory include the following:
1) The counting should be done by employees who do not have responsibility for the custody or record-keeping of the inventory.
2) Each counter should establish the validity of each inventory item: this means checking that the items actually exist, how many there are of
them, and what condition they are in.
3) There should be a second count by another employee or auditor. Counting should take place in teams of two.
4) Prenumbered inventory tags should be used to ensure that all inventory items are counted and that none are counted more than once.
Determining Ownership of Goods
Goods in Transit
x goods in transit should be included in the inventory of the company that has legal title to the goods
Consigned Goods
x consigned goods : goods shipped by consignor, who retains ownership, to party called consignee, who holds goods for sale
Inventory Cost Determination Methods
Specific Identification
x specific identification method : an inventory costing method used when goods are distinguishable and not ordinarily
interchangeable; it follows the actual physical flow of goods, and individual items are specifically costed to arrive at the cost of
goods sold and cost of the ending inventory
x specific identification is appropriate and required for goods that are not ordinarily interchangeable, and for goods that are
produced and segregated for specific projects
Cost Formulas: FIFO and Average
Perpetual System—First – In, First – Out (FIFO)
x first-in, first-out (FIFO) cost formula : inventory cost formula that assumes that the costs of the earliest (oldest) goods acquired
are the first to be recognized as the COGS; the costs of the latest goods acquired are assumed to remain in ending inventory
Perpetual Inventory System—Average
x average cost formula : formula that assumes that goods available for sale are homogenous or non-distinguishable; COGS and
ending inventory are determined using average cost, calculated by dividing cost of goods available for sale by units
x weighted average unit cost : the average cost of inventory weighted by the number of units purchased at each unit cost; it is
calculated as the cost of goods available for sale divided by the number of units available for sale
x a new average is calculated each time a purchase (or purchase return) is made
Financial Statement Effects
Choice of Cost Determination Method
x a company should consider the following objectives in making its choice:
1) choose a method that corresponds as closely as possible to the physical flow of goods
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