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chapter 6
The world's largest dump truck, the Caterpillar 797B, is as tall as a three-storey building and has a 345-
tonne capacity. In 1998, Caterpillar sent six of its predecessor Cat 797s to Fort McMurray, Alberta-no
easy feat, since many highways and bridges can’t take their weight-to be tested at Syncrude Canada, the
world's largest producer of crude oil from oil sands. Syncrude evaluated the Cat 797 for long-term
production capability, durability, and maintenance in an oil sands mine, one of the toughest mining
environments. The trucks scored top marks. By 2005, Syncrude had 33 Cat 797s and another nine on
order.
A Cat 797B can cost millions of dollars and requires one heck of a big garage for storage. Obviously,
Caterpillar needs to avoid having too much of this kind of inventory sitting around. Still, it has to have
enough to meet its customers' demands. In short, Caterpillar has big inventory challenges.
And big sales. Caterpillar enjoys record sales, profits, and growth. In fact, 2004 was a banner year, with
$30.25 billion in revenues and a record profit of $2.03 billion, an 85 percent increase from 2003.
Expectations for 2005 were even better.
Effective inventory management is key to this success. From 1993 to 2003, Caterpillar's sales increased
by more than 97 percent, while its inventory increased by only 49 percent. To achieve this inventory
reduction, Caterpillar used a two-pronged approach. First, a factory modernization program increased
production efficiency, reducing the time required to manufacture a part by 75 percent. Second, an
improved distribution system allows Caterpillar to fill more than 180 million order lines annually from
19 distribution centres located on six continents. It can now ship an order in less than 24 hours more
than 99 percent of the time.
In fact, Caterpillar is so well known for its parts distribution expertise, it formed a wholly-owned
subsidiary in 1987 to market integrated supply chain solutions to other companies. Caterpillar Logistics
Services now serves more than 50 global corporations in a variety of industries.
Caterpillar's inventory management and accounting practices make a crucial contribution to its own and
other companies' profitability.
The Navigator
Complete assignments
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
Study Objectives
Preview of Chapter 6
In the previous chapter, we discussed the accounting for merchandise inventory using a perpetual inventory
system. In this chapter, we explain the procedures for determining inventory quantities. We then discuss the cost
flow assumptions used to calculate the cost of goods sold during the period and the cost of inventory on hand at the
end of the period. We also discuss the effects of inventory errors on a company's financial statements, and we
conclude by illustrating methods to report and analyze inventory.
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
http://edugen.wiley.com/edugen/courses/crs1562/pc/c06/content/kimmel6792c06_6_2.xform?course=crs1562&id=ref29/02/2008 10:44:52 AM
Determining Inventory Quantities
study objective 1
Describe the steps in
determining inventory
quantities.
In a periodic inventory system, inventory quantities are not updated on a continuous basis. Companies
that use a periodic inventory system must take a physical inventory to determine the inventory on hand
at the balance sheet date. Once the ending inventory amount is determined, this amount is then used to
calculate the cost of goods sold for the period.
Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand
and (2) determining the ownership of goods.
To make fewer errors in taking the inventory, a company should ensure that it has a good system of
internal control in place. Internal control consists of policies and procedures to optimize resources,
prevent and detect errors, safeguard assets, and enhance the accuracy and reliability of accounting
records. 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
recordkeeping for 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.
After the physical inventory is taken, the quantity of each kind of inventory is listed on inventory
summary sheets. To ensure accuracy, the listing should be verified by a second employee, or auditor.
Unit costs are then applied to the quantities in order to determine the total cost of the inventory—this
will be explained later in the chapter when we discuss inventory costing.
Goods in Transit
Goods in transit at the end of the period (on board a truck, train, ship, or plane) make determining
ownership a bit more complicated. The company may have purchased goods that have not yet been
received, or it may have sold goods that have not yet been delivered. To arrive at an accurate count,
ownership of these goods must be determined.
Goods in transit should be included in the inventory of the company that has legal title to the
goods. As we learned in Chapter 5, legal title, or ownership, is determined by the terms of the sale as
follows:
1. FOB (free on board) shipping point: Legal title (ownership) of the goods passes to the buyer when
the public carrier accepts the goods from the seller.
2. FOB destination: Legal title (ownership) of the goods remains with the seller until the goods reach
the buyer.
If the shipping terms are FOB shipping point, the buyer is responsible for paying the shipping costs and
has legal title to the goods while they are in transit. If the shipping terms are FOB destination, the seller
is responsible for paying the shipping costs and has legal title to the goods while they are in transit.
These terms will be important in determining the exact date that a purchase or sale should be recorded
and what items should be included in inventory, even if the items are not physically present at the time
of the inventory count.
For example, publishers normally ship textbooks to campus bookstores on FOB shipping point terms.
This means that the bookstores (and ultimately the students) pay the cost of shipping. This also means
that if the bookstore has a December 31 year end, it must adjust its inventory count for any textbooks
still in transit for the beginning of the winter term. The bookstore also accepts the risk of damage or loss
when the books are in transit.
The following table summarizes who pays the shipping costs, and who has legal title to (owns) the
goods, while they are in transit between the seller's location (the shipping point) and the buyer's location
(the destination):
Consigned Goods
In some lines of business, it is customary to hold goods belonging to other parties and sell them, for a
fee, without ever taking ownership of the goods. These are called consigned goods. 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 (called the consignor) until the goods are actually sold
to a customer. Because consigned goods are not owned by the consignee, they should not be included in
the consignee's physical inventory count. Conversely, the consignor should include in its inventory any
of the consignor's merchandise that is being held by the consignee.
For example, artists often display their paintings and other works of art at galleries on consignment. In
such cases, the art gallery does not take ownership of the art—it still belongs to the artist. Therefore, if
an inventory count is taken, any art on consignment should not be included in the art gallery's inventory.
When the art sells, the gallery then takes a commission and pays the artist the remainder. Many craft
stores, second-hand clothing stores, sporting goods stores, and antique dealers sell goods on
consignment to keep their inventory costs down and to avoid the risk of purchasing an item they will not
be able to sell.
Other Situations
Sometimes goods are not physically on the premises because they have been taken home on approval by
a customer. Goods on approval should be added to the physical inventory count because they still belong
to the seller. The customer will either return the item or decide to buy it at some point in the future.
In other cases, goods are sold but the seller is holding them for alteration, or until they are picked up or
delivered to the customer. These goods should not be included in the physical count, because legal title
to ownership has passed to the customer. Damaged or unsaleable goods should also be separated from
the physical count, and any loss should be recorded.
Over the years, inventory has played a role in many fraud cases. A classic one involved salad
oil. Management filled storage tanks mostly with water, and since oil rises to the top, the
auditors thought the tanks were full of oil. In this instance, management also said the company
had more tanks than it really did—numbers were repainted on the tanks to confuse the
auditors.
Today, inventory theft is a serious problem for companies, estimated to amount to around $60
billion a year. Surprisingly, a significant amount of this theft takes place from the inside out. A
2002 Ipsos-Reid survey found that 20 percent of Canadians were personally aware of
employees stealing from their companies. A physical inventory count helps identify inventory
losses, which then enables a company to put preventive security measures into place.
Source: Kira Vermond, “From the Inside Out,” CMA Management, May 2003, p. 36.
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
Before You Go On . . .
Review It
Do It
The Too Good To Be Threw Corporation completed its inventory count. It arrived at a total inventory
amount of $200,000, counting everything currently on hand in its warehouse. Discuss how the
following additional information will affect the reported cost of the inventory.
1. Goods costing $15,000 and held on consignment were included in the inventory.
2. Purchased goods of $10,000 were in transit (terms FOB shipping point) and not included in the
count.
3. Sold inventory with a cost of $12,000 was in transit (terms FOB shipping point) and not included in
the count.
Action Plan
FOB shipping point: Goods sold or purchased and shipped FOB shipping point belong to the
buyer.
FOB destination: Goods sold or purchased and shipped FOB destination belong to the seller
until they reach their destination.
Solution
1. The goods held on consignment should be deducted from Too Good To Be Threw's inventory count
($200,000 − $15,000 = $185,000).
2. The goods in transit purchased FOB shipping point should be added to the company's inventory
count ($185,000 + $10,000 = $195,000).
3. The goods in transit sold FOB shipping point were correctly excluded from Too Good To Be
Threw's ending inventory, since title passed when the goods were handed over to the shipping
company.
The correct inventory total is $195,000, and not $200,000 as originally reported.
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
Inventory Costing
After the number of units of inventory has been determined, unit costs are applied to those quantities to determine
the total cost of the goods sold and cost of the ending inventory. When all inventory items have been purchased at
the same unit cost, this calculation is simple. However, when items have been purchased at different costs during
the period, it can be difficult to determine what the unit costs are of the items that remain in inventory and what the
unit costs are of the items that were sold.
study objective 2
Apply the inventory cost
flow assumptions under
a periodic inventory
system.
For example, assume that throughout the calendar year Wynneck Electronics Ltd. buys at different prices 1,000
Astro Condenser units for resale. Some Astro Condensers cost $10 when originally purchased last year. Units
purchased in April cost $11, those purchased in August cost $12, and those acquired in November cost $13. Now
suppose Wynneck Electronics has 450 Astro Condensers remaining in inventory at the end of December. Should
these inventory items be assigned a cost of $10, $11, $12, $13, or some combination of all four?
To determine the cost of goods sold as well as the cost of ending inventory, we need a way of allocating the
purchase cost to each item in inventory and each item that has been sold. One allocation method—specific
identification—uses the actual physical flow of the goods to determine cost. We will look at this method next.
Specific Identification
The specific identification method tracks the actual physical flow of the goods. Each item of inventory is marked,
tagged, or coded with its specific unit cost. Items still in inventory at the end of the year are specifically costed to
determine the total cost of the ending inventory.
Assume, for example, that Wynneck Electronics buys three DVD recorder/players at costs of $700, $750, and
$800. During the year, two are sold at a selling price of $1,200 each. At December 31, the company determines
that the $750 DVD recorder/player is still on hand. The ending inventory is $750 and the cost of goods sold is
$1,500 ($700 + $800).
Illustration 6-1
Specific identification
Specific identification is the ideal method for determining cost. This method reports ending inventory at actual cost
and matches the actual cost of goods sold against sales revenue. However, there are also disadvantages to this
method. For example, specific identification may allow management to manipulate net earnings. To see how,
assume that Wynneck Electronics wants to maximize its net earnings just before its year end. When selling one of
the three DVD recorder/players referred to earlier, management could choose the recorder/player with the lowest
cost ($700) to match against revenues ($1,200). Or, it could minimize net earnings by selecting the highest-cost
($800) recorder/player.
Specific identification is most practical to use when a company sells a limited number of items that have a high
unit cost and that can be clearly identified from purchase through to sale. Automobiles are a good example of a
type of inventory that works well with the specific identification method as they can easily be distinguished by
serial number. On the other hand, automobile dealers also sell hundreds of relatively low-unit-cost items as parts.
These are often identical to each other, so it may not be possible to track the cost of each item separately.
Today, with bar coding, it is theoretically possible to use specific identification with nearly any type of product.
The reality is, however, that this practice is still relatively expensive and rare. Instead, rather than keep track of the
cost of each particular item sold, most companies make assumptions—called cost flow assumptions—about
which units are sold. Even Caterpillar, in the feature story, uses a cost flow assumption instead of specific
identification to track its sales of the Cat 797.
These three cost flow assumptions can be used in both the perpetual inventory system and the periodic inventory
system. Under a perpetual inventory system, the cost of goods available for sale (beginning inventory plus the cost
of goods purchased) is allocated to the cost of goods sold and ending inventory as each item is sold. Under a
periodic inventory system, the allocation is made only at the end of the period.
The periodic inventory system will be used to illustrate cost flow assumptions in this chapter. We have several
reasons for doing this. First, many companies that use a perpetual inventory system use it only to keep track of
quantities on hand. When they determine the cost of goods sold at the end of the period, they use one of the three
cost flow assumptions under a periodic inventory system. Second, most companies that use the average cost flow
assumption use it under a periodic inventory system. Third, the FIFO cost flow assumption gives the same results
under the periodic and perpetual systems. Finally, it is simpler to demonstrate the cost flow assumptions under the
periodic inventory system, which makes them easier to understand. (The chapter appendix explains how these cost
flow assumptions are used under a perpetual inventory system.)
To illustrate these three inventory cost flow assumptions in a periodic inventory system, we will assume that
Wynneck Electronics Ltd. has the following information for one of its products, the Astro Condenser:
The company had a total of 1,000 units available for sale during the period. The total cost of these units was
$12,000. A physical inventory count at the end of the year determined that 450 units remained on hand at the end
of the year. Consequently, it can be calculated that 550 (1,000 – 450) units were sold during the year.
The question to be answered next is this: as the 1,000 units available for sale had different unit costs, how does
Wynneck determine which unit costs to allocate to the 450 units remaining so that it can determine the cost of the
ending inventory? Once this question is answered and the cost of the ending inventory is determined, we can then
calculate the cost of goods sold.
The total cost (or “pool of costs”) of the 1,000 units available for sale was $12,000. We will demonstrate the
allocation of this pool of costs, using FIFO, average, and LIFO in the next sections. Note that, throughout these
sections, the total cost of goods available for sale will remain the same under all three inventory cost flow
assumptions. The pool of costs does not change with the choice of cost flow assumption—only the allocation of
these costs between the ending inventory and the cost of goods sold changes, as shown in Illustration 6-2.
Illustration 6-2
Allocation of cost of goods available for sale
In the periodic inventory system, we ignore the different dates of each of the sales. Instead we make the allocation
at the end of a period and assume that the entire pool of costs is available for allocation at that time. The
allocation of the cost of goods available for sale at Wynneck Electronics under FIFO is shown in Illustration 6-3
on the following page.
Illustration 6-3
Periodic system—FIFO
The cost flow assumption—FIFO in this case—always indicates the order of selling. In other words, with FIFO the
order in which the goods are assumed to be sold is first in, first out. The cost of the ending inventory is determined
by taking the unit cost of the most recent purchase and working backward until all units of inventory have been
costed. In this example, the 450 units of ending inventory must be costed using the most recent purchase costs. The
last purchase was 400 units at $13 on November 27. The remaining 50 units are costed at the price of the second
most recent purchase, $12, on August 24.
Once the cost of the ending inventory is determined, the cost of goods sold is calculated by subtracting the cost of
the units not sold (ending inventory) from the cost of all goods available for sale (the pool of costs).
The cost of goods sold can also be separately calculated or proven as shown below. To determine the cost of goods
sold, simply start at the first item of beginning inventory and count forward until the total number of units sold
(550) is reached. Note that of the 300 units purchased on August 24, only 250 units are assumed sold. This agrees
with our calculation of the cost of the ending inventory, where 50 of these units were assumed unsold and thus
included in ending inventory.
Because of the potential for calculation errors, we recommend that the cost of goods sold amounts be separately
calculated and proven in your assignments. The ending inventory and cost of goods sold total can then be
compared to the cost of goods available for sale to check the accuracy of the calculations, which would be as
follows for Wynneck: $5,800 + $6,200 = $12,000.
Average
The average cost flow assumption assumes that the goods available for sale are homogeneous or
nondistinguishable. Under this assumption, the allocation of the cost of goods available for sale is made based on
the weighted average unit cost incurred. Note that this average cost is not calculated by taking a simple average
[($10 + $11 + $12 + $13) ÷ 4 = $11.50 per unit], but by weighting the quantities purchased at each unit cost.
The formula and calculation of the weighted average unit cost are given in Illustration 6-4.
Illustration 6-4
Calculation of weighted average unit cost
The weighted average unit cost is then applied to the units on hand to determine the cost of the ending inventory.
The allocation of the cost of goods available for sale at Wynneck Electronics using average cost is shown in
Illustration 6-5.
Illustration 6-5
Periodic system—Average
We can verify the cost of goods sold under the average cost flow assumption by multiplying the units sold by the
weighted average unit cost (550 × $12 = $6,600). And, again, we can prove our calculations by ensuring that the
total of the ending inventory and cost of goods sold equals the cost of goods available for sale ($5,400 + $6,600 =
$12,000).
sold, would LIFO match the actual physical flow of goods. But, as explained earlier, this does not mean that the
LIFO cost flow assumption cannot be used in other cases. It is the flow of costs that is important, not the physical
flow of goods.
The allocation of the cost of goods available for sale at Wynneck Electronics under LIFO is shown in Illustration 6-
6.
Illustration 6-6
Periodic system—LIFO
Under LIFO, since it is assumed that the goods that are sold first are the ones that are purchased most recently,
ending inventory is based on the costs of the oldest units purchased. That is, the cost of the ending inventory is
determined by taking the unit cost of the earliest goods available for sale and working forward until all units of
inventory have been costed.
In our example, therefore, the 450 units of ending inventory must be costed using the earliest purchase prices. The
first purchase was 100 units at $10 in the January 1 beginning inventory. Then 200 units were purchased at $11.
The remaining 150 units are costed at $12 per unit, the August 24 purchase price.
Under LIFO, the cost of the last goods in is the first cost to assign to the cost of goods sold. We can prove the cost
of goods sold in our example by starting at the end of the period and counting backwards until we reach the total
number of units sold (550). The result is that 400 units from the last purchase (November 27) are assumed to be
sold first, and only 150 units from the next purchase (August 24) are needed to reach the total 550 units sold.
When the ending inventory and cost of goods sold amounts are then added together, they should equal the cost of
goods available for sale, which is as follows for Wynneck: $5,000 + $7,000 = $12,000.
Remember that, under a periodic inventory system, all goods purchased during the period are assumed to be
available for allocation, regardless of when they were purchased. Note also that because goods that are purchased
late in a period are assumed to be available for the first sale, earnings could be manipulated in LIFO by a last
minute end-of-period purchase of inventory.
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
Before You Go On . . .
Review It
1. Why is the specific identification method not practical to use in all circumstances?
2. Distinguish between the three cost flow assumptions—FIFO, average, and LIFO.
3. Which inventory cost flow assumption best approximates the actual physical flow of goods?
4. Which inventory method and cost flow assumption can be manipulated?
Do It
Determine the cost of ending inventory and cost of goods sold under a periodic inventory system using
(a) FIFO, (b) average, and (c) LIFO.
Action Plan
Solution
Cost of goods available for sale: (4,000 × $3) + (6,000 × $4) = $36,000
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
study objective 3
Explain the financial
statement effects of the
inventory cost flow
assumptions and
inventory errors.
Ault Foods, Canadian Tire, and Sobeys use FIFO. Abitibi-Price, Andrés Wines, and Mountain Equipment Co-op
use average. Caterpillar, Cominco, and Suncor use LIFO for part or all of their inventory. Indeed, a company may
use more than one cost flow assumption at the same time. Finning International, for example, uses specific
identification to account for its equipment inventory, FIFO to account for about two-thirds of its inventory of parts
and supplies, and average to account for the rest.
About an equal number of companies in Canada use FIFO and the average cost flow assumptions. Only a very few
companies, about three percent, use LIFO. The Canadian companies that do use LIFO tend to use it to harmonize
their reporting practices with the U.S., where LIFO is used more often.
Although the FIFO and average cost flow assumptions are more commonly used in Canada, in order to understand
global financial reporting, students still need to have some understanding of the impact of the LIFO cost flow
assumption. It is important to be able to compare the financial statement impacts of these choices when competing
companies use different cost flow assumptions. For example, Hudson's Bay uses the average cost flow assumption,
while its competitor Wal-Mart uses the LIFO cost flow assumption.
earnings in Illustration 6-7 assume that Wynneck sold its 550 units for $11,500, had operating expenses of $2,000,
and has an income tax rate of 30%.
Illustration 6-7
Comparative effects of cost flow assumptions
For simplicity, we have assumed that the beginning inventory ($1,000) is the same under all three inventory cost
flow assumptions. In reality, the cost of the beginning inventory may very well differ under each assumption. For
the purposes of this illustration, since the beginning inventory is the same, the cost of goods available for sale
($12,000) is also the same under each of the three inventory cost flow assumptions. But the ending inventories and
costs of goods sold are both different. This difference is because of the unit costs that are allocated under each
method. Each dollar of difference in ending inventory results in a corresponding dollar difference in earnings
before income tax. For Wynneck, there is an $800 difference between the FIFO and LIFO cost of goods sold.
In periods of changing prices, the choice of cost flow assumption can have a significant impact on earnings. In a
period of inflation (rising prices), as is the case for Wynneck, FIFO produces higher net earnings because the lower
unit costs of the first units purchased are matched against revenues. As indicated in Illustration 6-7, FIFO reports
the highest net earnings ($2,310) and LIFO the lowest ($1,510). Average falls roughly in the middle ($2,030). To
management, higher net earnings are an advantage: they cause external users to view the company more
favourably. In addition, if management bonuses are based on net earnings, FIFO will provide the basis for higher
bonuses.
If prices are falling, the results from the use of FIFO and LIFO are reversed: FIFO will report the lowest net
earnings and LIFO the highest. If prices are stable, all three cost flow assumptions will report the same results.
Overall, LIFO provides the best statement of earnings valuation. It matches current costs with current revenues
since, under LIFO, the cost of goods sold is assumed to be the cost of the most recently acquired goods. You will
recall that the matching principle is important in accounting. The CICA recommends that in those cases “where the
choice of method of inventory valuation is an important factor in determining income, the most suitable method for
determining cost is that which results in charging against operations costs which most fairly match the sales
revenue for the period.”
However, even though LIFO may produce the best match of revenues and expenses, it can also result in distortions
of earnings if beginning inventory is ever liquidated. It can also be manipulated by timing purchases. The use of
LIFO is not permitted for income tax purposes in Canada and most firms do not want to maintain two sets of
inventory records—one for accounting purposes and another for income tax purposes. Companies can use FIFO or
average to determine their income tax, but not LIFO. That is why, in Illustration 6-7, it was assumed that the
income tax expense amount was the same under both the FIFO and LIFO alternatives.
Conversely, a major limitation of LIFO is that in a period of inflation the costs that are allocated to ending
inventory may be significantly understated in terms of the current cost of inventory. This is true for Wynneck,
where the cost of the ending inventory includes the $10 unit cost of the beginning inventory. The understatement
becomes greater over extended periods of inflation if the inventory includes goods that were purchased in one or
more earlier accounting periods.
FIFO LIFO
Cost of goods sold Lowest Highest
Gross profit/Net earnings Highest Lowest
Pre-tax cash flow Same Same
Ending inventory Highest Lowest
We have seen that both inventory on the balance sheet and net earnings on the statement of earnings are highest
when FIFO is used in a period of inflation. Do not confuse this with cash flow. All three cost flow assumptions
produce exactly the same cash flow before income taxes. Sales and purchases are not affected by the choice of cost
flow assumption. The only thing affected is the allocation between ending inventory and the cost of goods sold,
which does not involve cash.
It is also worth remembering that all three cost flow assumptions will give exactly the same results over the life
cycle of the business or its product. That is, the allocation between the cost of goods sold and ending inventory
may vary annually, but it will produce the same cumulative results over time. Although much has been written
about the impact of the choice of inventory cost flow assumption on a variety of performance measures, in reality
there is little real economic distinction among the assumptions over time.
In the U.S., unlike in Canada, use of LIFO is permitted for income tax purposes. Not surprisingly, many
U.S. corporations choose LIFO because it reduces earnings and taxes when prices are rising. It also
increases after-tax cash flow, since less income tax has to be paid in the short term. However, because
of the impact of LIFO on the balance sheet, U.S. companies must also disclose in the notes to their
statements what their inventory cost would have been if they had used FIFO.
International accounting standards have designated FIFO and average as the recommended cost flow
assumptions. In some countries, such as Canada and the UK, even though LIFO may be used for
financial reporting, it cannot be used for income taxes. This is why LIFO is not very popular around the
Inventory Errors
Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by mistakes
in counting or costing the inventory. In other cases, errors occur because the transfer of legal title is not recognized
properly for goods that are in transit. When errors occur, they affect both the statement of earnings and the balance
sheet.
The dollar effects of inventory errors can be calculated by entering data in the earnings formula.
Illustration 6-8
Earnings formula
If beginning inventory is understated, cost of goods sold will be understated (assuming no other offsetting errors
have occurred). On the other hand, understating ending inventory will overstate cost of goods sold. Cost of goods
sold is deducted from sales to determine gross profit, and finally net earnings. An understatement in cost of goods
sold will produce an overstatement in gross profit and net earnings (assuming that there are no errors in operating
expenses). An overstatement in cost of goods sold will produce an understatement in gross profit and net earnings.
As you know, both the beginning and ending inventories appear in the statement of earnings for companies that
use the periodic inventory system. The ending inventory of one period automatically becomes the beginning
inventory of the next period. Consequently, an error in the ending inventory of the current period will have a
reverse effect on net earnings of the next accounting period. This is shown in Illustration 6-9.
Illustration 6-9
Effects of inventory errors on statement of earnings for two years
In this illustration, ending inventory in 2006 was understated by $2,250. The understatement of ending inventory
results in an overstatement of the cost of goods sold and an under-statement of net earnings in the same year. It
also results in an understatement of the beginning inventory and cost of goods sold in 2007 and an overstatement
of net earnings for that year.
Over the two years, total net earnings are correct because the errors offset each other. Notice that total earnings
using incorrect data are $26,250 ($16,500 + $9,750), which is the same as the total earnings of $26,250 ($18,750 +
$7,500) using correct data. Also note in this example that an error in the beginning inventory does not result in a
corresponding error in the ending inventory for that period. Under the periodic inventory system, the correctness of
the ending inventory depends entirely on the accuracy of taking and costing the inventory at the balance sheet date.
equation: assets = liabilities + shareholders' equity. Errors in the ending inventory have the effects shown below. U
is for understatement, O is for overstatement, and NE is for no effect.
Recall from the previous section that errors in ending inventory affect net earnings. If net earnings are affected,
then shareholders' equity will be affected by the same amount since net earnings are closed into the Retained
Earnings account, which is part of shareholders' equity. Consequently, an error in ending inventory affects the
asset account Merchandise Inventory and the shareholders' equity account Retained Earnings.
Depending on whether income tax has been paid or not, the Income Tax Payable account might also be affected.
For simplicity in this chapter, we will assume that all income tax has been paid, so that the effects on assets and
shareholders' equity are equal.
The effect of an error in ending inventory on the next period was shown in Illustration 6-9. Recall that if the error
is not corrected, the combined total net earnings for the two periods would be correct. In the example, therefore,
the assets and shareholders' equity reported on the balance sheet at the end of 2007 will be correct.
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Review It
1. What factors should be considered by management when choosing an inventory cost flow
assumption?
2. Which inventory cost flow assumption produces the highest net earnings in a period of rising
prices? The highest ending inventory valuation? The highest pre-tax cash flow?
3. How do inventory errors affect the statement of earnings? How do they affect the balance sheet?
Do It
On July 31, 2006, Zhang Inc. counted and recorded $600,000 of inventory. This count did not include
$90,000 of goods in transit that were purchased on July 29 on account and shipped to Zhang FOB
shipping point. Determine the correct July 31 inventory. Identify any accounts that are in error at July
31, 2006. State the amount and direction (e.g., understated or overstated) of the error for each of these
accounts. You can ignore any income tax effects.
Action Plan
Use the earnings formula to determine the error's impact on statement of earnings accounts.
Use the accounting equation to determine the error's impact on balance sheet accounts.
Solution
The correct inventory count should have been $690,000 ($600,000 + $90,000).
Purchases are understated (U) by $90,000. However, since ending inventory is also understated, the
cost of goods sold, gross profit, and net earnings will be correct [beginning inventory + cost of goods
purchased (U $90,000) − ending inventory (U $90,000) = cost of goods sold].
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
study objective 4
Demonstrate the
presentation and
analysis of inventory.
In addition, these reported numbers are critical for analyzing a company's effectiveness in managing its inventory.
In the next sections, we will discuss issues that are related to the presentation and analysis of inventory.
As you probably reasoned, when this situation occurs, the cost basis of accounting is no longer followed. When the
value of inventory is lower than its cost, inventory is written down to its market value. This is done by valuing the
inventory at the lower of cost and market (LCM) in the period in which the decline occurs. LCM is an example
of the accounting concept of conservatism. You will recall from our discussion of conservatism in Chapter 2 that
the method that is least likely to overstate assets and net earnings is the one that should be used.
The term market in the phrase lower of cost and market is not specifically defined in Canada. It can mean the
replacement cost or the net realizable value, among other things. The majority of Canadian companies use net
realizable value to define market for LCM purposes. For a merchandising company, net realizable value is the
selling price, less any costs required to make the goods ready for sale.
LCM is applied to the inventory after specific identification or one of the cost flow assumptions (FIFO, average, or
LIFO) has been used to determine the cost. Assume that Wacky World has the following lines of merchandise with
costs and market values as indicated. LCM produces the following results:
LCM can be applied separately to each individual item, to categories of items (e.g., television sets and video
equipment), or to total inventory. It is common practice to use total inventory rather than individual items or major
categories when determining the LCM valuation.
Using total inventory, the journal entry to record the loss for Wacky World would be as follows under a periodic
inventory system:
The loss would be reported as part of cost of goods sold on the statement of earnings. In a perpetual inventory
system, the loss would be debited directly to the Cost of Goods Sold account.
Classifying Inventory
How a company classifies its inventory depends on whether it is a merchandiser or a manufacturer. In a
merchandising company, such as those described in Chapter 5, the inventory includes many different items. For
example, in a grocery store like Loblaw, canned goods, dairy products, meats, and produce are just a few of the
inventory items on hand. In a merchandising company, inventory has two common characteristics: (1) it is owned
by the company, and (2) it is in a form that is ready for sale to customers in the ordinary course of business. Thus,
only one inventory classification, merchandise inventory, is needed to describe the many different items that make
up the total inventory.
In a manufacturing company, some of its inventory may not yet be ready for sale. As a result, inventory is
usually classified into three categories: finished goods, work in process, and raw materials. Finished goods
inventory includes manufactured items that are completed and ready for sale. Work in process is that portion of
manufactured inventory that has been placed into the production process but is not yet complete. Raw materials
are the basic goods that will be used in production but have not yet been sent into production. For example,
Caterpillar in the feature story classifies “earth-moving trucks completed and ready for sale” as finished goods. The
trucks on the assembly line in various stages of production are classified as work in process. The steel, glass, tires,
and other components that are on hand waiting to be used in the production of trucks are identified as raw materials.
By observing the levels of these three inventory types and changes in these levels, financial statement users can
gain insight into management's production plans. For example, low levels of raw materials and high levels of
finished goods could suggest that management believes it has enough inventory on hand and will slow down
production—perhaps because it expects a recession. On the other hand, high levels of raw materials and low levels
of finished goods probably indicate that management is planning to increase production.
In the notes to the financial statements, the following information related to inventory should be disclosed: (1) the
major inventory classifications, (2) the basis of valuation (cost or lower of cost and market), and (3) the cost flow
assumption (specific identification, FIFO, average, or LIFO).
Inventory Turnover
The inventory turnover and days in inventory ratios help companies manage their inventory levels. The inventory
turnover ratio measures the number of times, on average, that inventory is sold (“turns over”) during the period. It
is calculated as the cost of goods sold divided by the average inventory.
Whenever a ratio compares a balance sheet figure (e.g., inventory) to a statement of earnings figure (e.g., cost of
goods sold), the balance sheet figure must be averaged. Averages for balance sheet figures are determined by
adding the beginning and ending balances together and then dividing the result by two. Averages are used to ensure
that the balance sheet figures (which represent end-of-period amounts) cover the same period of time as the
statement of earnings figures (which represent amounts for the entire period).
A complement to the inventory turnover ratio is the days in inventory ratio. It converts the inventory turnover into
a measure of the average age of the inventory. It is calculated as 365 days divided by the inventory turnover ratio.
A low inventory turnover ratio (high days in inventory) could mean that the company has too much of its funds in
inventory. It could also mean that the company has excessive carrying costs (e.g., for interest, storage, insurance,
and taxes) or that it has obsolete inventory.
A high inventory turnover ratio (low days in inventory) could mean that the company has little of its funds in
inventory—in other words, that it has a minimal amount of inventory on hand at any specific time. Although
having minimal funds tied up in inventory suggests efficiency, too high an inventory turnover ratio may indicate
that the company is losing sales opportunities because of inventory shortages. For example, investment analysts
suggested recently that Office Depot had gone too far in reducing its inventory—analysts said they were seeing too
many empty shelves. Management should watch this ratio closely so that it achieves the best balance between too
much and too little inventory.
In Chapter 5, we discussed the increasingly competitive environment of retailers like Wal-Mart and Hudson's Bay.
We noted that Wal-Mart has implemented many technological innovations to improve the efficiency of its
inventory management. The following data are available for Wal-Mart (in U.S. millions):
Illustration 6-10 presents the inventory turnover and days in inventory ratios for Wal-Mart for 2004 and 2003. No
comparative information is presented for the Hudson's Bay Company because, as explained in Chapter 5, it does
not separately report its cost of goods sold on its statement of earnings.
Illustration 6-10
Inventory turnover and days in inventory
The calculations in Illustration 6-10 show that Wal-Mart improved its inventory turnover slightly from 2003 to
2004 and that it turns its inventory over more frequently than the industry in general. This suggests that Wal-Mart
is more efficient in its inventory management. Wal-Mart's sophisticated inventory tracking and distribution system
allows it to keep minimum amounts of inventory on hand, while still keeping the shelves full of what customers are
looking for.
Inventory management for companies that make and sell high-tech products is very complex because
the product life cycle is so short. The company wants to have enough inventory to meet demand, but
does not want to have too much inventory, because the introduction of a new product can eliminate
demand for the “old” product. Palm, Inc., maker of personal digital assistants (PDAs), learned this lesson
the hard way in the early 2000s. Sales of its existing products had been booming, and the company was
frequently faced with shortages, so it started increasing its inventories. Then sales started to slow and
inventories started to grow faster than wanted. Management panicked and decided to announce that its
new product—one that would make its old one obsolete—would be coming out in two weeks. Sales of
the old product quickly died—leaving a mountain of inventory. As it turned out, however, the new
product was not actually ready for six weeks and potential sales during those weeks were lost.
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Loblaw uses the FIFO (first-in, first-out) cost flow assumption to account for its
inventories.
3. What is the purpose of the inventory turnover ratio? What is the relationship between the
inventory turnover and days in inventory ratios?
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Inventory Cost Flow Assumptions Inperpetual Inventory Systems
Each of the inventory cost flow assumptions described in the chapter for a periodic inventory system may be used
in a perpetual inventory system. To show how to use the three cost flow assumptions (FIFO, average, and LIFO)
under a perpetual system, we will use the data below, the same as what was shown earlier in the chapter for
Wynneck Electronics' Astro Condenser.
study objective 5
Apply the inventory cost
flow assumptions under
a perpetual inventory
system.
Illustration 6A-1
Perpetual system—FIFO
As shown, the ending inventory in this situation is $5,800, and the cost of goods sold is $6,200.
Although the calculation format may differ, the results under FIFO in a perpetual system are the same as in a
periodic system (see Illustration 6-3 where, similarly, the ending inventory is $5,800 and the cost of goods sold is
$6,200). Under both inventory systems, the first costs in are the ones assigned to cost of goods sold.
Average
The average cost flow assumption in a perpetual inventory system is often called the moving average cost flow
assumption. The average cost is calculated in the same manner as we calculated the weighted average unit cost in
a periodic inventory system: by dividing the cost of goods available for sale by the units available for sale. The
difference under the perpetual inventory system is that a new average is calculated after each purchase. The
average cost is then applied (1) to the remaining units on hand, to determine the cost of the ending inventory, and
(2) to the units sold, to determine the cost of goods sold. Use of the average cost flow assumption by Wynneck
Electronics is shown in Illustration 6A-2.
Illustration 6A-2
Perpetual system—average
As indicated above, a new average is calculated each time a purchase (or purchase return) is made. On April
15, after 200 units are purchased for $2,200, a total of 300 units costing $3,200 ($1,000 + $2,200) is on hand. The
average unit cost is $10.67 ($3,200 ÷ 300). Accordingly, the unit cost of the 150 units sold on May 1 is shown at
$10.67, and the total cost of goods sold is $1,600. This unit cost is used in costing the units sold until another
purchase is made, and a new unit cost must then be calculated.
On August 24, after 300 units are purchased for $3,600, a total of 450 units costing $5,200 ($1,600 + $3,600) are
on hand. This results in an average cost per unit of $11.56 ($5,200 ÷ 450), which is used to cost the September 10
sale. After the November 27 purchase of 400 units for $5,200, there are 450 units on hand costing $5,777.78
($577.78 + $5,200), resulting in a new average cost of $12.84 ($5,777.78 ÷ 450).
In practice, these average unit costs may be rounded to the nearest cent, or even to the nearest dollar. This
illustration used the exact unit cost amounts, as would a computerized schedule, even though the unit costs have
been rounded to the nearest digit for presentation in Illustration 6A-2. However, it is important to remember that
this is an assumed cost flow, and using four digits, or even cents, suggests a false level of accuracy.
This moving average cost under the perpetual inventory system should be compared to Illustration 6-5 shown
earlier in the chapter, which presents the weighted average cost under a periodic inventory system.
For our example, the ending inventory under a LIFO cost flow assumption is calculated in Illustration 6A-3.
Illustration 6A-3
Perpetual system—LIFO
The ending inventory in this LIFO perpetual illustration is $5,700 and the cost of goods sold is $6,300. Compare
this to the LIFO periodic example in Illustration 6-6, where the ending inventory is $5,000 and the cost of goods
sold is $7,000.
The use of LIFO in a perpetual system will usually produce cost allocations that differ from using LIFO in a
periodic system. In a perpetual system, the latest units purchased before each sale are allocated to the cost of
goods sold. In a periodic system, the latest units purchased during the period are allocated to the cost of goods
sold. When a purchase is made after the last sale, the LIFO periodic system will apply this purchase to the previous
sale. See Illustration 6-6 where the 400 units at $13 purchased on November 27 are all allocated to the sale of 550
units. As shown under the LIFO perpetual system, the 400 units at $13 purchased on November 27 are all applied
to the ending inventory.
A comparison of the cost of goods sold and ending inventory figures for each of these cost flow assumptions under
a perpetual inventory system gives the same proportionate outcomes that we saw in the application of cost flow
assumptions under a periodic system. That is, in a period of rising prices (prices rose from $10 to $13 in this
example), FIFO will always result in the highest ending inventory valuation and LIFO in the lowest. On the other
hand, LIFO will always result in the highest cost of goods sold figure (and lowest net earnings), and FIFO in the
lowest. Average results fall somewhere in between FIFO and LIFO. The following table summarizes these effects
under a perpetual inventory system:
Of course, if prices are falling, the inverse relationships will result. If prices are constant, all three cost flow
assumptions will yield the same results. And, finally, remember that the sum of cost of goods sold and ending
inventory always equals the cost of goods available for sale, which is the same under all the cost flow assumptions.
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
2004 2003
Inventory turnover 5.5 times 5.3 times
Days in inventory 66 days 69 days
Gross profit margin 23.9% 22.0%
Profit margin 8.6% 5.9%
Instructions
(a) IPSCO uses the average cost flow assumption. Steel prices have risen over the last two years in response to
increased demand for steel and its raw materials, largely due to China's rapidly growing economy. If IPSCO had
used FIFO instead of average, would its net earnings have been higher or lower than currently reported?
(b) Do each of the following:
1. Calculate the inventory turnover and days in inventory for 2004 and 2003.
2. Calculate the gross profit margin and profit margin for each of 2004 and 2003.
3. Evaluate IPSCO's performance with inventories over the most recent two years and compare its
performance to that of the industry.
Solution
(a) If IPSCO used the FIFO cost flow assumption instead of the average cost flow assumption during a period of
rising prices, its cost of goods sold would be lower and its net earnings higher than currently reported.
(b)
1. Ratio 2004 2003
Inventory
turnover
Days in
inventory
Profit margin
3. IPSCO's inventory turnover and days in inventory ratios improved in 2004, although they remain below the
industry averages. That means that IPSCO has more inventory on hand and is not selling it as fast as its
competitors. IPSCO's profitability ratios increased substantially in 2004. After performing below the
industry average in 2003, IPSCO's profitability was better than that of the industry in 2004. IPSCO
attributes this to the rising prices and demand for steel. In addition, the strong Canadian dollar also
increased reported results.
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
5. Apply the inventory cost flow assumptions under a perpetual inventory system (Appendix 6A).
Under FIFO, the cost of the oldest goods on hand is allocated to the cost of goods sold. The cost of
the most recent goods purchased is allocated to ending inventory. Under average, a new weighted
(moving) average unit cost is calculated after each purchase and applied to the number of units sold
and the number of units remaining in ending inventory. Under LIFO, the cost of the most recent
purchase is allocated to the cost of goods sold. The cost of the earliest goods purchased is allocated to
ending inventory.
Each of these cost flow assumptions is applied in the same cost flow order as in a periodic
inventory system. The main difference is that in a perpetual inventory system the cost flow
assumption is applied at the date of each sale to determine the cost of goods sold. In a periodic
inventory system, the cost flow assumption is applied only at the end of the period.
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.
Demonstration Problem
Englehart Ltd. has the following inventory, purchases, and sales data for the month of March:
Instructions
Under a periodic inventory system, determine the cost of the inventory on hand at March 31 and the
cost of goods sold for March under (a) FIFO, (b) average, and (c) LIFO.
Action Plan
Ignore the dates of sale in a periodic inventory system. Assume everything happens at
the end of the period.
Allocate costs to ending inventory. Subtract ending inventory from the cost of goods
available for sale to determine the cost of goods sold.
For FIFO, allocate the latest costs to the goods on hand.
For average, calculate the weighted average unit cost (the cost of goods available for
sale ÷ the number of units available for sale). Multiply this cost by the number of units
on hand.
For LIFO, allocate the oldest costs to the goods on hand.
Prove the cost of goods sold separately and then check that ending inventory plus the
cost of goods sold equals the cost of goods available for sale.
(a) FIFO
(c) LIFO
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