6-1. 6-2 chapter6 inventories 6-3 previewofchapter6

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CHAPTER6Inventories

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PreviewofCHAPTER6

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One Classification:

Inventory

Three Classifications:

Raw Materials

Work in Process

Finished Goods

Merchandising Company

Manufacturing Company

Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

Classifying Inventory

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Physical Inventory taken for two reasons:

Perpetual System

1. Check accuracy of inventory records.

2. Determine amount of inventory lost (wasted raw

materials, shoplifting, or employee theft).

Periodic System

1. Determine the inventory on hand.

2. Determine the cost of goods sold for the period.

SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

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Involves counting, weighing, or measuring each kind of inventory on hand.

Taken,

when the business is closed or business is slow.

at end of the accounting period.

Taking a Physical Inventory



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Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.

Determining Ownership of Goods


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

determined by the terms of sale.


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Illustration 6-1 Terms of sale

Ownership of the goods passes to the buyer when the

public carrier accepts the goods from the seller.

Ownership of the goods remains with the seller until the goods reach the buyer.

Goods in Transit


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Goods in transit should be included in the inventory of the

buyer when the:

a. public carrier accepts the goods from the seller.

b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

Question



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Consigned Goods

Goods held for sale by one party.

Ownership of the goods is retained by another

party.



Determining Ownership of Goods

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Unit costs can be applied to quantities on hand using

the following costing methods:

Specific Identification

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Average-cost

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Cost Flow Assumptions

Inventory Costing

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Illustration: Assume that Crivitz TV Company purchases

three identical 50-inch TVs on different dates at costs of $700,

$750, and $800. During the year Crivitz sold two sets at $1,200

each. These facts are summarized below.

Illustration 6-2

Inventory Costing


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If Crivitz sold the TVs it purchased on February 3 and May 22,

then its cost of goods sold is $1,500 ($700 + $800), and its

ending inventory is $750.

Illustration 6-3

Inventory Costing


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Actual physical flow costing method in which items still in

inventory are specifically costed to arrive at the total cost of

the ending inventory.

Practice is relatively rare.

Most companies make assumptions (Cost Flow

Assumptions) about which units were sold.

Inventory Costing



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Illustration 6-11Use of cost flow methods in

major U.S. companies

Cost Flow

Assumptions

do not need to match the

physical movement of

goods

Inventory Costing


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Illustration: Data for Houston Electronics’ Astro condensers.

Illustration 6-4

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

Inventory Costing


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Earliest goods purchased are first to be sold.

Often parallels actual physical flow of merchandise.

Generally good business practice to sell oldest units

first.

First-In-First-Out (FIFO)

Inventory Costing


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Illustration 6-5

SO 2 SO 2


Inventory Costing

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Illustration 6-5

Inventory Costing



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Latest goods purchased are first to be sold.

Seldom coincides with actual physical flow of

merchandise.

Includes goods stored in piles, such as coal or hay.

Inventory Costing

Last-In-First-Out (FIFO)


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Illustration 6-7

Inventory Costing


SO 2 SO 2

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Illustration 6-7

Inventory Costing



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Allocates cost of goods available for sale on the basis

of weighted-average unit cost incurred.

Assumes goods are similar in nature.

Applies weighted-average unit cost to the units on

hand to determine cost of the ending inventory.

Inventory Costing

Average Cost


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Illustration 6-10

Inventory Costing

Average Cost


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Illustration 6-10

Inventory Costing

Average Cost


6-29 SO 3 Explain the financial effects of the inventory cost flow assumptions.

Financial Statement and Tax EffectsIllustration 6-12

Inventory Costing

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The cost flow method that often parallels the actual

physical flow of merchandise is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

Question

Inventory Costing

SO 3 Explain the financial effects of the inventory cost flow assumptions.

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In a period of inflation, the cost flow method that results

in the lowest income taxes is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

Question

Inventory Costing


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Using Cost Flow Methods Consistently

Method should be used consistently, enhances

comparability.

Although consistency is preferred, a company may

change its inventory costing method.Illustration 6-14Disclosure of change in cost flow method

Inventory Costing


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Lower-of-Cost-or-Market

SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

When the value of inventory is lower than its cost

Companies can “write down” the inventory to its market

value in the period in which the price decline occurs.

Market value = Replacement Cost

Example of conservatism.

Inventory Costing

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Illustration: Assume that Ken Tuckie TV has the following

lines of merchandise with costs and market values as

indicated.Illustration 6-15

Inventory Costing

Lower-of-Cost-or-Market

SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

6-36 SO 5 Indicate the effects of inventory errors on the financial statements.

Common Cause:

Failure to count or price inventory correctly.

Not properly recognizing the transfer of legal title to

goods in transit.

Errors affect both the income statement and balance

sheet.

Inventory Errors

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Inventory errors affect the computation of cost of goods sold and net income.

Illustration 6-17

Illustration 6-16

SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing

Income Statement Effects

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Inventory errors affect the computation of cost of goods

sold and net income in two periods.

An error in ending inventory of the current period will have a

reverse effect on net income of the next accounting

period.

Over the two years, the total net income is correct because

the errors offset each other.

Ending inventory depends entirely on the accuracy of taking

and costing the inventory.


Inventory Costing

Income Statement Effects

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Incorrect Correct Incorrect Correct

Sales 80,000$ 80,000$ 90,000$ 90,000$

Beginning inventory 20,000 20,000 12,000 15,000

Cost of goods purchased 40,000 40,000 68,000 68,000

Cost of goods available 60,000 60,000 80,000 83,000

Ending inventory 12,000 15,000 23,000 23,000

Cost of good 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 20,000 20,000

Net income 22,000$ 25,000$ 13,000$ 10,000$

2011 2012

($3,000)Net Income understated

$3,000Net Income overstated

Combined income for 2-year period is correct.

Illustration 6-18


Inventory Costing

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Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.

Question


Inventory Costing

6-41 SO 5 Indicate the effects of inventory errors on the financial statements.

Effect of inventory errors on the balance sheet is determined

by using the basic accounting equation:.

Illustration 6-16

Illustration 6-19

Inventory Costing

Balance Sheet Effects

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Balance Sheet - Inventory classified as current asset.

Income Statement - Cost of goods sold subtracted from

sales.

There also should be disclosure of

1) major inventory classifications,

2) basis of accounting (cost or LCM), and

3) costing method (FIFO, LIFO, or average).

Statement Presentation and Analysis

Presentation

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Inventory management is a double-edged sword

1. High Inventory Levels - may incur high carrying costs

(e.g., investment, storage, insurance, obsolescence, and

damage).

2. Low Inventory Levels – may lead to stockouts and lost

sales.

SO 6 Compute and interpret the inventory turnover ratio.


Analysis

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Inventory turnover measures the number of times on

average the inventory is sold during the period.

Cost of Goods Sold

Average Inventory

Inventory Turnover

=

Days in inventory measures the average number of days

inventory is held.

Days in Year (365)

Inventory Turnover

Days in Inventory

=



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Illustration: Wal-Mart reported in its 2010 annual report a beginning

inventory of $34,511 million, an ending inventory of $33,160 million, and

cost of goods sold for the year ended January 31, 2010, of $304,657

million. The inventory turnover formula and computation for Wal-Mart are

shown below.


Illustration 6-21

Days in Inventory: Inventory turnover of 9 times divided into 365 is

approximately 40.6 days. This is the approximate time that it takes a

company to sell the inventory.


6-47 SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Assuming the Perpetual Inventory System, compute Cost of Goods

Sold and Ending Inventory under FIFO, LIFO, and Average cost.

Illustration 6A-1

APPENDIX6APerpetual Inventory Systems

6-48SO 7 Apply the inventory cost flow methods to perpetual inventory records.


Cost of Goods Sold

Ending Inventory

Illustration 6A-2

Perpetual Inventory System

6-49SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Last-In-First-Out (LIFO)

Cost of Goods Sold

Ending Inventory

Illustration 6A-3


6-50 SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Average-CostIllustration 6A-4

Cost of Goods Sold

Ending Inventory


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Estimates the cost of ending inventory by applying a gross profit

rate to net sales.

Gross Profit Method

SO 8 Describe the two methods of estimating inventories.

Illustration 6B-1

APPENDIX6BEstimating Inventories

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Illustration: Kishwaukee Company’s records for January show net

sales of $200,000, beginning inventory $40,000, and cost of goods

purchased $120,000. The company expects to earn a 30% gross

profit rate. Compute the estimated cost of the ending inventory at

January 31 under the gross profit method.


Illustration 6B-2

Estimating Inventories

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Company applies the cost-to-retail percentage to ending

inventory at retail prices to determine inventory at cost.


Illustration 6B-3


Retail Inventory Method

6-54 SO 8 Describe the two methods of estimating inventories.

Note that it is not necessary to take a physical inventory to

determine the estimated cost of goods on hand at any given time.

Illustration 6B-4Illustration:


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The requirements for accounting for and reporting

inventories are more principles-based under IFRS. That is,

GAAP provides more detailed guidelines in inventory

accounting.

The definitions for inventory are essentially similar under

IFRS and GAAP. Both define inventory as assets held-for-

sale in the ordinary course of business, in the process of

production for sale (work in process), or to be consumed in

the production of goods or services (e.g., raw materials).

Key Points

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Who owns the goods—goods in transit or consigned goods

—as well as the costs to include in inventory, are accounted

for the same under IFRS and GAAP.

Both GAAP and IFRS permit specific identification where

appropriate. IFRS actually requires that the specific

identification method be used where the inventory items are

not interchangeable (i.e., can be specifically identified). If the

inventory items are not specifically identifiable, a cost flow

assumption is used. GAAP does not specify situations in

which specific identification must be used.

Key Points

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A major difference between IFRS and GAAP relates to the

LIFO cost flow assumption. GAAP permits the use of LIFO

for inventory valuation. IFRS prohibits its use. FIFO and

average-cost are the only two acceptable cost flow

assumptions permitted under IFRS.

IFRS requires companies to use the same cost flow

assumption for all goods of a similar nature. GAAP has no

specific requirement in this area.

Key Points

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In the lower-of-cost-or-market test for inventory valuation,

IFRS defines market as net realizable value. Net realizable

value is the estimated selling price in the ordinary course of

business, less the estimated costs of completion and

estimated selling expenses. In other words, net realizable

value is the best estimate of the net amounts that

inventories are expected to realize. GAAP, on the other

hand, defines market as essentially replacement cost.

Key Points

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Under GAAP, if inventory is written down under the lower-of-

cost-or-market valuation, the new value becomes its cost

basis. As a result, the inventory may not be written back up

to its original cost in a subsequent period. Under IFRS, the

write-down may be reversed in a subsequent period up to

the amount of the previous write-down. Both the write-down

and any subsequent reversal should be reported on the

income statement as an expense. An item-by-item approach

is generally followed under IFRS.

Key Points

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Unlike property, plant, and equipment, IFRS does not permit

the option of valuing inventories at fair value. As indicated

above, IFRS requires inventory to be written down, but

inventory cannot be written up above its original cost.

Similar to GAAP, certain agricultural products and mineral

products can be reported at net realizable value using IFRS.

Key Points

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One convergence issue relates to the use of the LIFO cost flow

assumption. IFRS specifically prohibits its use. Conversely, the

LIFO cost flow assumption is widely used in the United States

because of its favorable tax advantages. With a new conceptual

framework being developed, it is highly probable that the use of

the concept of conservatism will be eliminated. Similarly, the

concept of “prudence” in the IASB literature will also be

eliminated. This may ultimately have implications for the

application of the lower-of-cost-or-net realizable value.

Looking to the Future

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Which of the following should not be included in the

inventory of a company using IFRS?

a) Goods held on consignment from another company.

b) Goods shipped on consignment to another company.

c) Goods in transit from another company shipped FOB

shipping point.

d) None of the above.

IFRS Self-Test Questions

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Which method of inventory costing is prohibited under

IFRS?

a) Specific identification.

b) FIFO.

c) LIFO.

d) Average-cost.


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Specific identification:

a) must be used under IFRS if the inventory items are not

interchangeable.

b) cannot be used under IFRS.

c) cannot be used under GAAP.

d) must be used under IFRS if it would result in the most

conservative net income.


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