CHAPTER 6

Reporting and Analyzing Inventory

Milestones
Chapter 5 Chapter 6 Chapter 7
Merchandising Operations Reporting and analyzing Internal Control and Cash
inventory

• Identify the differences • Describe the steps in • Explain the Components of

between service and determining inventory an Internal Control System,
merchandising companies. quantities Including Its Control
• Prepare entries for purchases • Apply the cost formulas using Activities and Limitations
and sales under perpetual specific identification • Apply the Key Control
inventory system. • Explain the effects on the Activities to Cash Receipts
• Prepare single-step and financial statements of and Payments.
multi-step income statement. choosing each of the • Prepare a Bank
• Calculate the gross profit inventory cost formulas Reconciliation.
margin and profit margin. • Identify the effects of • Explain the Reporting and
inventory errors on financial Management of Cash.
statements.
• Demonstrate the
presentation and analysis of
inventory.
• Apply FIFO and average cost
formulas under periodic
inventory system

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LEARNING OBJECTIVES

By the end of this lecture, learners will be able to:

• Describe the Steps in Determining Inventory Quantities.

• Apply following Cost Formulas Under a Perpetual Inventory System.
• Specific Identification,
• FIFO, and
• Average Cost Under a Perpetual Inventory System.
Determining Inventory
Quantities

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Determining Inventory Quantities

Why do we need to determine inventory quantities?

Physical inventory must be matched with accounting records at the end of the period for two
reasons:
• To ensure accuracy of perpetual inventory records.
• To ensure accuracy of physical inventory lost to shrinkage or theft

What are the steps in determining inventory quantities?

Determining inventory involves two steps:
1. Taking a physical inventory count.
2. Determining the goods owned by the company
(Goods that are physically not in hand at the end of the period make the determination of
ownership more complicated)

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Taking Inventory

• Taking a physical inventory involves counting, weighing, or measuring each kind of

inventory on hand.
• To ensure inventory is properly counted, companies must have a good system of internal
control:
• Internal control systems include control activities; an example of which is review and
reconciliation
• Counting physical inventory and reconciling that with accounting records.
• Taking physical inventory is a formidable task, hence companies often count inventory
when the business is slow or when it is not open.
• Examples: Dollarama, Lululemon,

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Taking Physical Inventory

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Determining Ownership of Goods

After counting physical inventory, accountants should consider the following two types of
inventory in determining ownership of goods:

1. Goods in Transit (usually not counted in physical inventory, but we may own them).
2. Consigned goods (usually counted in physical inventory, but we may not own them).

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Determining Ownership of Goods

Goods in Transit

• Apply freight/shipping concepts from Chapter 5 to determine title of ownership.

• Goods in transit should be included in the inventory of the company that has legal title to the
goods

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Determining Ownership of Goods

Goods in Transit – Quick Example

• Physical inventory count of Crowchild dealership shows five vehicles.
• Eight vehicles that Crowchild dealership purchased last week (FOB shipping) are in transit.

Determine the total number of vehicles that their accounting records should show?

Crowchild Dealership Calgary

8 in transit (FOB Shipping)

5 vehicles in parking lot

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Determining Ownership of Goods

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 (e.g.
paintings, jewelry, and vehicle dealerships).

• Ownership of consigned goods remains with the owner (the consignor), not the holder of the
goods (the consignee).

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Determining Ownership of Goods

Consigned Goods – Quick Example

• Physical inventory count of Bauer’s dealership shows fifteen vehicles.
• Three previously owned vehicles are held on consignment for loyal clients.
Determine the total number of vehicles that their accounting records should show?

Bauer’s Dealership Lot A Bauer’s Dealership Lot B

New Vehicles Previously Owned Vehicles

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Summary of Determining Inventory Quantities

1. Take Physical Inventory by counting it

2. Determine ownership of goods by:
Applying the rules of ownership to goods in transit:
• FOB destination: Goods belong to the seller until they reach their destination.
• FOB shipping point: Goods belong to the buyer after they have been shipped.

Applying the rules of ownership to goods held on consignment:

• Goods of consignor are not included in consignee’s inventory.
• Goods held on consignment remain in consignor’s inventory.

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Exercise 6-1
Physical inventory count of LaSalle Fashion House Corporation is $400,000 on August 31. How will the following
additional information affect the inventory count and cost? (5 minutes)

• Goods costing $30,000 held on consignment for McQueen Dress Inc. were included in the inventory.

• Purchase of $20,000 goods were in transit from Montreal at August 31 (terms FOB shipping point). This
shipment was not included in the count.

• LaSalle's purchase of $18,000 in goods from Deleau Ltd. was in transit from Winnipeg on August 31 (terms
FOB destination) and was not included in the count.

• LaSalle sold inventory for $36,000 that cost $24,000 when purchased. The items were in transit to a customer
in Vancouver as at August 31 (terms FOB destination) and were not included in the count.
Applying Cost Formulas Under
a Perpetual Inventory System

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Introduction to Cost Formulas

• Physical count in inventory determination involves quantities.

• Companies must apply unit costs to the quantities to determine the total cost of the
inventory.
• Three different cost formulas that can be used under IFRS and ASPE to determine
inventory cost.
Specific Identification First-in; First-out (FIFO) Average Cost
How to choose inventory cost formula?

• Choose a formula that

• Represents as closely as possible physical flow of goods
• Reports ending inventory at recent cost

• Other rules
• Use the same formula for inventories of similar nature and usage
• Once you pick a formula, you must stick with it

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Summary of Advantages and Financial Statement
Effects of Each Cost Formula

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Specific Identification

• Tracks physical flow of goods

• Used in perpetual system only
• Can only be used where actual costs of each item can be determined; goods are easily
distinguishable (not easily interchangeable) or for goods produced and segregated for
specific projects.
• You don’t need to prepare inventory schedule to compute cost because each item can be
uniquely identified and its cost is uniquely allocated

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Example of Specific Identification

SOLD TO VERY NICE

PEOPLE
Cost of Goods Sold Cost of Goods Available for Sale
$55,000 $55,000 $55,000 $60,000 $65,000 $65,000

Selling Price Selling Price

$85,000 $85,000 $85,000 $85,000 $85,000 $85,000

Inventory
Debit Credit
Opening 165,000 60,000
60,000
130,000

Bal 295,000
165,000
225,000
355,000
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Ability of Cost Formulas to Track Physical Flow

• Specific identification tracks the actual flow of the goods

• Other two cost formulas assume a flow of costs that may not be the same as the actual flow
of goods
• FIFO (First-in, first-out) - Cost of first item purchased is cost of first item sold.
• Average Cost - Cost is determined using a moving (weighted) average of the cost of the items
purchased

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First-in, First-out (FIFO)

• The cost of (oldest) goods purchased is recognized first in cost of goods sold.
• This does not necessarily mean that the oldest units are in fact sold first.
• The order in which goods are purchased is important to track.
• Because cost of oldest items is recognized first, inventory account shows current cost in the
current assets section of balance sheet.

• Examples – Milk, Chocolates, Medicines, Cereal, Shirts

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Example of FIFO

THE TEE-SHIRT CORPORATION

Perpetual Inventory Schedule
Inventory
Debit Credit
Opening 1,000 1,550
2,200 4,650
3,600
5,200
200 units at $11 each were purchased on April 15 Bal 5,800
5,250
600
3,200
1,650
1,000

150 units were sold on May 1

300 units at $12 each were purchased on August 24

400 units were sold on September 10

400 units at $13 each were purchased on November 27

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Average Cost

• Used when goods are homogeneous or interchangeable and cannot be distinguished from
one another.
• The cost of goods sold and cost of ending inventory is determined by weighted average
unit cost formula.

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Example of Average Cost

Inventory
Debit Credit
Opening 1,000 1,600
2,200 4,622
3,600
5,200

Bal 5,778

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Exercise 6-2
Akshay Limited uses the FIFO cost formula in a perpetual inventory system. Fill in the missing
amounts for cells with question marks in the following perpetual inventory schedule:
(5 minutes)
Exercise 6-3
Akshay Limited uses the average cost formula in a perpetual inventory system. Fill in the missing
amounts for cells with question marks in the following perpetual inventory schedule (Round numbers
to the nearest cent for presentation purposes).
• Hint: Cost of Goods Available for Sale ÷ Units Available for Sale = Weighted Average Unit Cost