Perpetual vs. Periodic Inventory Accounting

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1 Chapter 6 INVENTORY In the balance sheet of merchandising and manufacturing companies, inventory is frequently the most significant current asset. In the income statement, inventory is vital in determining the results of operations for a particular period. Gross profit (net sales cost of goods sold) closely watched by management, owners, and other interested parties. is Perpetual vs. Periodic Inventory Accounting Perpetual Updates inventory and cost of goods sold after every purchase and sales transaction Periodic Delays updating of inventory and cost of goods sold until end of the period Misstates inventory during the period This chapter covers the periodic inventory method. 1

2 DETERMINING In order to prepare financial statements, it is necessary to determine the number of units of inventory owned by company at the statement date, and to value them. The determination of inventory quantities involves 1. taking a physical inventory of goods on hand, and 2. determining the ownership of goods. Taking a physical inventory involves counting, weighing, or measuring each kind of inventory on hand. TAKING A PHYSICAL A company, in order to minimize errors in taking the inventory, must follow internal control principles: 1. Employees who do not have custodial responsibility for the inventory should do the counting (segregation of duties). 2. Each counter should establish the authenticity of each inventory item (establishment of responsibility). 2

3 TAKING A PHYSICAL 3. Another employee should make a second count (independent verification). 4. All inventory tags should be pre numbered and accounted for (documentation procedures). 5. At the end of the count, a designated supervisor should ascertain that all inventory items are tagged and that no items have more than one tag (independent verification). TERMS OF SALE FOB Shipping Point Selle FOB Destination Selle Public Carrie Ownership Ownership Public Carrie passes t passes to Buy Buy 3

4 DETERMINING 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 (consignor) until the goods are actually sold to a customer. Consigned goods should be included in the consignor s inventory, not the consignee s inventory. Owned by a consignor; do Consignee 1 What should not be included in the physical inventory of a company? A B C D Goods held on consignment from another company Goods shipped on consignment to another company Goods shipped to you that are FOB shipping point None of the above. Mar 8 3:25 PM 4

5 SALES TRANSACTIONS Only one entry is required to record a sale under a periodic RECORDING SALES RETURNS AND The normal balance of Sales Returns and Allowances is a debit. Sales Returns and Allowances is a 5

6 PURCHASES OF MERCHANDISE For purchases on account, Purchases is debited and Accounts Payable is credited. For cash PURCHASE RETURNS AND ALLOWANCES For purchases returns and allowances that were originally made on account, Accounts Payable is debited and Purchase Returns and Allowances is 6

7 ACCOUNTING FOR FREIGHT COSTS When the purchaser directly incurs the freight costs, the 2 When goods are purchased, using the periodic method: A B C D purchases are DR. to Merchandise Inventory purchases are DR. to Purchases purchase returns are DR. to purchase returns and allowances freight costs are debiteed to Purchases Mar 8 3:28 PM 7

8 The multi step income statement under the periodic system requires more detail in the cost of goods sold section, as shown above. 3 In determining the cost of goods purchased: A B C D beginning inventory is added to net purchases freight out is added to net purchases purchase returns and allowances are deducted from net purchases freight in is added to net purchases Mar 8 3:33 PM 8

9 4 If beginning inventory is $60K, COG purchased is $380K and ending inventory is $50K than COGS is: A $330K B $370K C $390K D $420K Mar 8 3:35 PM 5 An I/S for a company that uses the periodic method differs from the perpetual method because it has: A B C D a detailed COGS section net sales gross profit operating expenses Mar 8 3:37 PM 9

10 ALLOCATION OF INVENTORIABLE COSTS Beginning Inventory Goods Purchased during the Cost of Goods Available for Sale Ending Inventory (Balance Cost of Goods Sold USING ACTUAL 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. It is most frequently used when the company sells a limited variety of high unit cost items. 10

11 USING ASSUMED Other cost flow methods are allowed since specific identification is often impractical. These methods assume flows of costs that may be unrelated to the physical flow of goods. Cost flow assumptions: 1. First in, first out (FIFO). 2. Average cost. 3. Last in, first out (LIFO). FIFO The FIFO method assumes that the earliest goods purchased are the first to be sold. Often reflects the actual physical flow of merchandise. Under FIFO, the costs of the earliest goods purchased are the first to be recognized as cost of goods sold. The costs of the most recent goods purchased are recognized as the ending inventory. 11

12 FIFO method assumes earliest goods purchased are the first to be sold AVERAGE COST The average cost method assumes that the goods available for sale are homogeneous. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred. The weighted average unit cost is then applied to the units sold to determine the cost of goods sold and to the units on hand to determine the ending inventory. 12

13 Allocation of the cost of goods available for sale in average cost method is Average cost method assumes that goods available for sale are homogeneous 13

14 LIFO The LIFO method assumes that the latest goods purchased are the first to be sold and that the earliest goods purchased remain in ending inventory. Seldom coincides with the actual physical flow of inventory. Under the periodic method, all goods purchased during the year are assumed to be available for the first sale, regardless of date of purchase. Rarely used in Canada. LIFO method assumes latest goods purchased are the first to be sold 14

15 INCOME STATEMENT EFFECTS In periods of rising prices, FIFO reports the highest net income, LIFO the lowest and average cost falls in the middle. The reverse is true when prices are falling. When prices are constant, all cost flow methods will yield the same results. 6 In periods of rising prices, LIFO will produce: A B C D higher net income than FIFO the same net income as FIFO lower net income than FIFO higher net income than avg. costing Mar 8 3:39 PM 15

16 BALANCE SHEET EFFECTS FIFO produces the best balance sheet valuation since the inventory costs are closer to their current, or replacement, costs. USING INVENTORY COST A company needs to use its chosen cost flow method consistently from one accounting period to another. Such consistent application enhances the comparability of financial statements over successive time periods. When a company adopts a different cost flow method, the change and its effects on net income should be disclosed in the financial statements. 16

17 INVENTORY ERRORS Both beginning and ending inventories appear on the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Inventory errors affect the determination of cost of goods sold and net income. FORMULA FOR Beginni Cost of Goods Ending + _ = Cost of The effects on cost of goods sold can be determined by entering the incorrect data in the above formula and then substituting the correct data. 17

18 EFFECTS OF INVENTORY ERRORS Understate beginning inventory Understated Overstated Overstate beginning inventory Overstated Understated Understate ending inventory Overstated Understated Overstate ending inventory Understated Overstated An error in ending inventory of the current period ENDING INVENTORY The effect of ending inventory errors on the balance sheet ca Assets = Liabilities + Owner s Equity Overstated Overstated None Overstated Understated Understated None Understated 18

19 VALUING INVENTORY AT When the value of inventory is lower than the cost, the inventory is written down to its market value. This is known as the lower of cost and market (LCM) method. Market is defined as replacement cost or net realizable value. ILLUSTRATION 6 20 ALTERNATIVE LOWER OF COST AND MARKET (LCM) RESULTS The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation. 19

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