ch 06.doc

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University of Toronto St. George
Rotman Commerce
Stojanovic Dragan

Chapter 6 –Inventory Costing 1. Determine Inventory Quantities 1.1. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. Companies often count their inventory when the business is at its slowest time of year. 1.1.1. Internal control procedures for counting inventory include: Counting should be done by employees who do not have custodial or record-keeping responsibilities for the inventory. Authenticity of each inventory item should be established. The count should be done by 2 people. Prenumbered inventory tags should be used. A supervisor should check that all inventory items have been tagged once and only once. 1.1.2. Unit costs are then applied to the quantities to determine the total cost of the inventory. 1.2. Ownership of the goods must be determined. 1.2.1. In general, goods should be included in the inventory of the owner, who has legal title to them. 1.2.2. Goods in transit should be included in the inventory count of the company with title to them. Goods shipped FOB shipping point belong to the buyer. Goods shipped FOB destination belong to the seller. 1.2.3. Goods on consignment belong to the shipper (consignor). 2. Periodic Inventory System 2.1. Recording Sales of Merchandise 2.1.1. Revenues from the sale of merchandise are recorded when sales are made, in the same way as in a perpetual inventory system, but no attempt is made on the date of sale to record the cost of the merchandise sold. 2.1.2. Sales Returns and Allowances is debited when a customer returns an item. 2.2. Recording Purchases of Merchandise 2.2.1. Unlike the perpetual system, merchandise acquired for resale is debited to the Purchases account. Purchases is a temporary expense account, whose normal balance is a debit. 2.2.2. If merchandise is subsequently returned to the supplier, the cost is credited to Purchase Returns and Allowances. Purchase Returns and Allowances is a temporary account whose normal balance is a credit. It is a contra account, deducted from Purchases, to arrive at Net Purchases. 2.2.3. When the purchaser pays for the freight costs, the amount is debited to the Freight In account. Freight In is a temporary expense account whose normal balance is a debit. It is added to Net Purchases to arrive at Cost of Goods Purchased. 3. Cost of Goods Sold 3.1. Determine the Cost of Goods Purchased. Purchases less Purchase Returns and Allowances equals Net Purchases Net Purchases plus Freight equals Cost of Goods Purchased 3.2. Determine the Cost of Goods Available for Sale Add the Beginning Inventory to the Cost of Goods Purchased to determine the Cost of Goods Available for Sale Chapter 6 –Inventory Costing 3.3. Determine the Cost of Goods on Hand A physical inventory is done to determine the Cost of Goods on Hand, which is known as the Ending Inventory. 3.4. Determine the Cost of Goods Sold The Ending Inventory is deducted from the Cost of Goods Available for Sale to arrive at Cost of Goods Sold. 4. Income Statement, Closing Entries 4.1. Income Statement Presentation The multiple-step income statement is similar to the one prepared in previous chapters. The line item “Cost of Goods Sold” is replaced with a Cost of Goods Sold section that shows detailed calculation of the cost of goods sold. Inventory, January 1 $100 Purchases $500 Less: Purchase R&A 50 Net purchases 450 Add: Freight In 30 Cost of goods purchased 480 Cost of goods available for sale 580 Inventory, December 31 75 Cost of goods sold 505 4.2 There are 2 additional closing entries needed in a periodic system. 4.2.1 The beginning inventory amount debited to Capital, and credited to Merchandise Inventory. 4.2.2 The ending inventory amount is debited to Merchandise Inventory and credited to Capital. This becomes the beginning inventory the following period. 5. Inventory Cost Flow Methods Companies that use the periodic inventory system, track the cost of goods purchased. When the cost of the beginning inventory is added, the cost of goods available for sale is known. This cost must be split between the ending inventory on the balance sheet and the cost of goods sold on the income statement in accordance with the cost and matching principles. There are a variety of methods available. If unit costs have not varied each method will yield the same results. If costs have changed, the method chosen to allocate the cost will influence the balance sheet and income statement amounts. 5.1. Specific Identification The specific identification method tracks the actual physical flow of the goods. It is primarily used when the inventory consists of a relatively small number of uniquely identifiable, high-priced items, like the inventory at a car dealership. When a vehicle is sold, the dealer knows exactly which one was sold, and exactly what it cost. The specific identification method is no appropriate for high-volume, low-cost inventory. 5.2. First-In, First-Out (FIFO) The FIFO method assumes that the earliest goods acquired are the first ones sold. The allocation of cost is done at the end of the period, once the physical inventory count has been done. The cost of the ending inventory is obtained by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. 5.3. Average Cost Under this method, a weighted average unit cost is calculated. Cost of goods available for sale ÷ Total units available for sale = Weighted average cost per unit Chapter 6 –Inventory Costing This unit cost is applied to the units still on hand to determine the cost of the ending inventory, and to the units sold to determine the cost of goods sold. 5.4. Last-In, First-Out (LIFO) The LIFO method assumes that the latest goods acquired are the first ones sold. The allocation of cost is done at the end of the period, once the physical inventory count has been done. The
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