Chapter 6: Reporting and Analyzing Inventory – Study Notes

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Reporting and Analyzing Inventory

Learning Objectives

Describe the steps in determining inventory quantities.
Apply cost formulas using specific identification, FIFO, and average cost under a perpetual inventory system.
Explain the effects on the financial statements of choosing each of the inventory cost formulas.
Identify the effects of inventory errors on the financial statements.
Demonstrate the presentation and analysis of inventory.

Determining Inventory Quantities

Physical Inventory Counts

Regardless of whether a company uses a periodic or perpetual inventory system, a physical count of inventory must be performed at the end of each accounting period.

Purpose: To verify the accuracy of inventory records and to determine inventory lost to shrinkage or theft.

Determining Ownership

Ownership of goods must be established when taking inventory, especially for goods in transit or on consignment.

Goods in transit: Ownership depends on shipping terms (FOB shipping point or FOB destination).
Consigned goods: Remain the property of the consignor, not the consignee.
Goods on approval: Still owned by the company until the customer accepts them.

Summary of Transfer of Ownership for Shipped Goods

Shipping Terms	Seller	Buyer
FOB destination	Inventory belongs to seller until it reaches the buyer's destination	Inventory belongs to buyer when it reaches the buyer's destination
FOB shipping point	Inventory belongs to the seller until shipped	Inventory belongs to the buyer once the shipment leaves the seller's place of business

Taking Inventory and Internal Controls

Companies must have strong internal controls to ensure inventory is properly counted.
Counting inventory is a control activity that allows reconciliation with inventory records.

Inventory Cost Formulas

Overview

After determining inventory quantities, companies must assign costs to inventory units. Purchases may occur at different prices, so cost formulas are used to allocate costs to inventory and cost of goods sold (COGS).

Journal entries for purchases record total cost, not per unit cost.

Specific Identification

Tracks the actual physical flow of goods; each unit is tagged with its specific cost.
Used only in perpetual inventory systems.
Appropriate when actual costs can be determined and goods are easily distinguishable or segregated for specific projects.

FIFO (First-In, First-Out)

Assumes the oldest inventory items are sold first.
Cost of goods sold is based on the cost of the earliest purchases; ending inventory is based on the most recent purchases.
Under FIFO, ending inventory and COGS are the same for both periodic and perpetual systems.

Example: Perpetual Inventory Schedule – FIFO

Date	Explanations	Units	Unit Cost/Price	Total Cost	Balance in Units
Jan. 1	Beginning inventory	100	$10	$1,000	100
Apr. 15	Purchases	200	$11	$2,200	300
May 1	Sales	(150)	$10, $11	$1,550	150
Aug. 24	Purchases	300	$12	$3,600	450
Sept. 10	Sales	(400)	$11, $12	$4,650	50
Nov. 27	Purchases	400	$13	$5,200	450

Average Cost

Used when the physical flow of inventory cannot be specifically measured.
Under a perpetual system, a new weighted average unit cost is calculated after each purchase.
Weighted average unit cost is used for both COGS and ending inventory.

Formula:

Example: Perpetual Inventory Schedule – Average Cost

Date	Units	Unit Cost	Total Cost	Balance Units	Balance Unit Cost	Balance Total Cost
Jan. 1	100	$10.00	$1,000.00	100	$10.00	$1,000.00
Apr. 15	200	$11.00	$2,200.00	300	$10.67	$3,200.00
May 1	(150)	$10.67	($1,600.00)	150	$10.67	$1,600.00
Aug. 24	300	$12.00	$3,600.00	450	$11.56	$5,200.00
Sept. 10	(400)	$11.56	($4,622.22)	50	$11.56	$577.78
Nov. 27	400	$13.00	$5,200.00	450	$12.84	$5,777.78

Choice of Inventory Cost Formula

Choose a formula that best represents the physical flow of goods and reports ending inventory at recent cost.
Use the same formula for inventories of similar nature and usage.

Comparative Effects of Inventory Cost Formulas

	FIFO	Average Cost
Sales	$11,000	$11,000
Cost of goods sold	$6,200	$6,222
Gross profit	$4,800	$4,778
Operating expenses	$1,500	$1,500
Income before income tax	$3,300	$3,278
Income tax expense (30%)	$990	$983
Net income	$2,310	$2,295

Advantages of Each Cost Formula

Specific Identification	FIFO	Average Cost
Exactly matches costs and revenues; tracks actual physical flow	Ending inventory includes most current costs; approximates physical flow for most retailers	COGS includes more current costs than FIFO; smooths effects of price changes

Summary of Financial Statement Effects

	Rising Prices			Falling Prices
	Specific Identification	FIFO	Average Cost	Specific Identification	FIFO	Average Cost
COGS	Variable	Lower	Higher	Variable	Higher	Lower
Gross profit & net income	Variable	Higher	Lower	Variable	Lower	Higher
Ending inventory	Variable	Higher	Lower	Variable	Lower	Higher
Retained earnings	Variable	Higher	Lower	Variable	Lower	Higher

Inventory Errors

Types and Effects of Inventory Errors

Errors can occur in counting inventory or assigning costs, especially with goods in transit.
Errors affect both the statement of financial position (through inventory) and the statement of income (through COGS).

Effect of Inventory Errors on Income Statement & Statement of Financial Position

If Inventory Is:	Then Cost of Goods Sold Is:	Then Gross Profit Is:	Then Income Before Income Tax Is:	Then Retained Earnings Is:
Understated	Overstated	Understated	Understated	Understated
Overstated	Understated	Overstated	Overstated	Overstated

Example: Effect of Inventory Errors (Sample Company)

	2021 Incorrect	2021 Correct	2022 Incorrect	2022 Correct
Sales	$80,000	$80,000	$90,000	$90,000
Cost of goods sold	$48,000	$45,000	$57,000	$60,000
Gross profit	$32,000	$35,000	$33,000	$30,000
Operating expenses	$10,000	$10,000	$10,000	$10,000
Income before income tax	$22,000	$25,000	$13,000	$20,000

The combined income before income tax for two years is correct because the errors cancel each other out.

Summary of Effect of Errors

Year	Assets	Liabilities	Shareholders' Equity
2021	Inventory understated by $3,000	No effect	Retained earnings understated by $3,000
2022	No error	No effect	Retained earnings: no error (errors cancel each other)

Valuing Inventory at the Lower of Cost and Net Realizable Value (LCNRV)

LCNRV Rule

If the net realizable value (NRV) of inventory is less than its cost, inventory is written down to NRV.
NRV is the estimated selling price less any costs to complete and sell the goods.
Write-downs are reversed if the value subsequently recovers.

Example: LCNRV Application

Item	Cost	NRV	LCNRV
Vehicle A	$16,000	$15,500	$15,500
Vehicle B	$14,500	$15,000	$14,500
Vehicle C	$14,800	$14,500	$14,500
Vehicle D	$13,200	$14,800	$13,200
Vehicle E	$11,500	$12,200	$11,500
Total Inventory	$70,000	$71,500	$69,100

Reporting Inventory

Inventory is reported at the lower of cost and NRV on the statement of financial position.
Notes to the financial statements disclose:
- Total inventory amount
- Cost of goods sold
- Cost formula(s) used
- Amount of write-downs or reversals
There are no significant differences between IFRS and ASPE for inventory reporting.

Inventory Turnover and Days in Inventory Ratios

Inventory turnover ratio: Measures how many times inventory is sold during a period.
Days in inventory: Converts the turnover ratio into the average number of days inventory is held.

Formulas:

Generally, a higher inventory turnover and lower days in inventory indicate better inventory management.

Additional info: These notes are based on standard Financial Accounting curriculum and include all major concepts, formulas, and comparative tables relevant to inventory reporting and analysis under IFRS and ASPE.