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Financial Accounting, IFRS Edition

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Presentation on theme: "Financial Accounting, IFRS Edition"— Presentation transcript:

1

2 Financial Accounting, IFRS Edition
Chapter 6 Inventories Financial Accounting, IFRS Edition Weygandt Kimmel Kieso

3 Study Objectives Describe the steps in determining inventory quantities. Explain the accounting for inventories and apply the inventory cost flow methods. Explain the financial effects of the inventory cost flow assumptions. Explain the lower-of-cost-or-net realizable value basis of accounting for inventories. Indicate the effects of inventory errors on the financial statements. Compute and interpret the inventory turnover ratio.

4 Inventories Finished goods Work in process Raw materials
Classifying Inventory Determining Inventory Quantities Inventory Costing Inventory Errors Statement Presentation and Analysis Finished goods Work in process Raw materials Taking a physical inventory Determining ownership of goods Specific identification Cost flow assumptions Financial statement and tax effects Consistent use Lower-of-cost-or-net realizable value Income statement effects Statement of financial position effects Presentation Analysis using inventory turnover

5 Classifying Inventory
Merchandising Company Manufacturing Company One Classification: Merchandise Inventory Three Classifications: Raw Materials Work in Process Finished Goods Regardless of the classification, companies report all inventories under Current Assets on the statement of financial position.

6 p. 251 How Wal-Mart Tracks Inventory
Q: Why is inventory control important to managers such as those at Wal-Mart and Best Buy? A: In the very competitive environment of discount retailing, where Wal-Mart is the major player, small differences in price matter to the customer.Wal-Mart sells a high volume of inventory at a low gross profit rate. When operating in a high-volume, low-margin environment, small cost savings can mean the difference between being profitable or going out of business. The same holds true for Best Buy. Answer on notes page

7 Determining Inventory Quantities
Physical Inventory taken for two reasons: Perpetual System Check accuracy of inventory records. Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft). Periodic System Determine the inventory on hand Determine the cost of goods sold for the period. SO 1 Describe the steps in determining inventory quantities.

8 Determining Inventory Quantities
Taking a Physical Inventory Involves counting, weighing, or measuring each kind of inventory on hand. Taken, when the business is closed or when business is slow. at end of the accounting period. SO 1 Describe the steps in determining inventory quantities.

9 Determining Inventory Quantities
Determining Ownership of Goods Goods in Transit Purchased goods not yet received. Sold goods not yet delivered. 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. SO 1 Describe the steps in determining inventory quantities.

10 Determining Inventory Quantities
Goods in Transit Illustration 6-1 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. SO 1 Describe the steps in determining inventory quantities.

11 Determining Inventory Quantities
Review Question Goods in transit should be included in the inventory of the buyer when the: public carrier accepts the goods from the seller. goods reach the buyer. terms of sale are FOB destination. terms of sale are FOB shipping point. SO 1 Describe the steps in determining inventory quantities.

12 Determining Inventory Quantities
Determining Ownership of Goods Consigned Goods In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods. These are called consigned goods. SO 1 Describe the steps in determining inventory quantities.

13 Inventory Costing Unit costs can be applied to quantities on hand using the following costing methods: Specific Identification First-in, first-out (FIFO) Average-cost Cost Flow Assumptions SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

14 Inventory Costing Specific Identification Method
An 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. SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

15 Inventory Costing Illustration: Assume that Crivitz TV Company purchases three identical 46-inch TVs on different dates at costs of $700, $750, and $800. During the year Crivitz sold two sets at $1,200 each. Illustration 6-2 SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

16 Inventory Costing Illustration: 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 SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

17 Inventory Costing Cost Flow Assumptions
Illustration 6-4 Ishikawa uses a periodic inventory system. Physical inventory determined that Ishikawa sold 550 units and had 450 units in inventory at December 31. SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

18 Inventory Costing “First-In-First-Out (FIFO)”
Earliest goods purchased are first to be sold. Often parallels actual physical flow of merchandise. Generally good business practice to sell oldest units first. SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

19 “First-In-First-Out (FIFO)”
Inventory Costing “First-In-First-Out (FIFO)” Illustration 6-5 SO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Answer on notes page

20 “First-In-First-Out (FIFO)”
Inventory Costing “First-In-First-Out (FIFO)” Illustration 6-5 SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

21 Inventory Costing “Average-Cost”
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. SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

22 Inventory Costing “Average Cost”
Illustration 6-8 SO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Answer on notes page

23 Inventory Costing “Average Cost”
Illustration 6-8 SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

24 Inventory Costing Financial Statement and Tax Effects
Illustration 6-9 Income Statement Effects SO 3 Explain the financial effects of the inventory cost flow assumptions.

25 Inventory Costing Statement of Financial Statement Effects
A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost. A shortcoming of the average-cost method is that in a period of inflation, the costs allocated to ending inventory may be understated in terms of current cost. SO 3 Explain the financial effects of the inventory cost flow assumptions.

26 Inventory Costing Tax Effects In a period of inflation:
FIFO - inventory and net income higher. AVERAGE Cost - lower income taxes. SO 3 Explain the financial effects of the inventory cost flow assumptions.

27 Review Question Inventory Costing
In a period of rising prices, average cost will produce: higher net income than FIFO. the same net income as FIFO. lower net income than FIFO. net income is equal to the specific identification method. SO 3 Explain the financial effects of the inventory cost flow assumptions.

28 Inventory Costing Using Cost Flow Methods Consistently
Method should be used consistently, enhances comparability. Although consistency is preferred, a company may change its inventory costing method. SO 3 Explain the financial effects of the inventory cost flow assumptions.

29 Q: What are the arguments for and against the use of LIFO?
p. 260 Is LIFO Fair? Q: What are the arguments for and against the use of LIFO? A: Proponents of LIFO argue that it is conceptually superior because it matches the most recent cost with the most recent selling price. Critics contend that it artificially understates the company’s net income and consequently reduces tax payments. Also, because most foreign companies are not allowed to use LIFO, its use by U.S. companies reduces the ability of investors to compare results across companies. Answer on notes page

30 Inventory Costing Lower-of-Cost-or-Net Realizable Value
When the value of inventory is lower than its cost Companies can “write down” the inventory to its net realizable value in the period in which the price decline occurs. Net realizable value refers to the net amount that a company expects to realize (receive) from the sale of inventory. SO 4 Explain the lower-of-cost-or-net realizable value basis of accounting for inventories.

31 Inventory Costing Lower-of-Cost-or-Net Realizable Value
Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. Illustration 6-10 SO 4 Explain the lower-of-cost-or-net realizable value basis of accounting for inventories.

32 Inventory Errors 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 statement of financial position. SO 5 Indicate the effects of inventory errors on the financial statements.

33 Inventory Errors Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-11 Illustration 6-12 SO 5 Indicate the effects of inventory errors on the financial statements.

34 Inventory Errors Income Statement Effects
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. The ending inventory depends entirely on the accuracy of taking and costing the inventory. SO 5 Indicate the effects of inventory errors on the financial statements.

35 Net Income understated
Inventory Errors Illustration 6-13 Combined income for 2-year period is correct. ($3,000) Net Income understated $3,000 Net Income overstated SO 5 Indicate the effects of inventory errors on the financial statements.

36 Review Question Inventory Errors
Understating ending inventory will overstate: assets. cost of goods sold. net income. equity. SO 5 Indicate the effects of inventory errors on the financial statements.

37 Inventory Errors Statement of Financial Position Effects
Effect of inventory errors on the statement of financial position is determined by using the accounting equation: Illustration 6-11 Illustration 6-14 SO 5 Indicate the effects of inventory errors on the financial statements.

38 Statement Presentation and Analysis
Statement of Financial Position - Inventory classified as current asset. Income Statement - Cost of goods sold. There also should be disclosure of major inventory classifications, basis of accounting (cost, or lower-of-cost-or-net realizable value), and Cost method (specific identification, FIFO, or average-cost).

39 Statement Presentation and Analysis
Analysis Using Inventory Turnover Inventory management is a double-edged sword High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). Low Inventory Levels – may lead to stockouts and lost sales. SO 6 Compute and interpret the inventory turnover ratio.

40 Statement Presentation and Analysis
Inventory turnover measures the number of times on average the inventory is sold during the period. Cost of Goods Sold Inventory Turnover = Average Inventory Days in inventory measures the average number of days inventory is held. Days in Year (365) Days in Inventory = Inventory Turnover SO 6 Compute and interpret the inventory turnover ratio.

41 Statement Presentation and Analysis
Illustration: Esprit Holdings reported in its 2009 annual report a beginning inventory of HK$3,170 million, an ending inventory of HK$2,997 million, and cost of goods sold for the year ended June 30, 2009, of HK$16,523 million. The inventory turnover formula and computation for Esprit Holdings are shown below. Illustration 6-16 Days in Inventory: Inventory turnover of times divided into 365 is approximately 68 days. This is the approximate time that it takes a company to sell the inventory. Answer on notes page SO 6 Compute and interpret the inventory turnover ratio.

42 Understanding U.S. GAAP Key Differences Inventories
Both GAAP and IFRS permit the specific identification method where appropriate. IFRS requires that the specific identification method must 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 that require its use. GAAP permits the use of the last-in, first-out (LIFO) cost flow assumption for inventory valuation. IFRS prohibits its use. LIFO is frequently used by U.S. companies for tax purposes. U.S. regulations require that if LIFO is used for taxes, it must also be used for financial reporting. (See Appendix 6C.)

43 Understanding U.S. GAAP Key Differences Inventories
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. When testing to see if the value of inventory has fallen below its cost, IFRS defines market value 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 (receive). GAAP, on the other hand, defines market as essentially replacement cost.

44 Understanding U.S. GAAP Key Differences Inventories
In GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. 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.

45 Understanding U.S. GAAP Looking to the Future Inventories
One convergence issue between GAAP and IFRS that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO, from a financial reporting point of view, provides a better matching of current costs against revenue and therefore enables companies to compute a more realistic income. With a new conceptual framework now being developed as this material is written, it is highly probable that the use of the GAAP concept of conservatism, which is the basis of the lower-of-cost-or-market valuation, will be eliminated. Similarly, the concept of prudence in the IASB literature will also be eliminated.

46 Cost Flow Methods in Perpetual Systems
Appendix 6A Illustration 6A-1 Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO and Average cost. SO 7 Apply the inventory cost flow methods to perpetual inventory records.

47 Cost Flow Methods in Perpetual Systems
“First-In-First-Out (FIFO)” Illustration 6A-2 Cost of Goods Sold Answer on notes page Ending Inventory SO 7 Apply the inventory cost flow methods to perpetual inventory records.

48 Cost Flow Methods in Perpetual Systems
“Average Cost” (Moving-Average System) Illustration 6A-3 Cost of Goods Sold Ending Inventory Answer on notes page SO 7 Apply the inventory cost flow methods to perpetual inventory records.

49 Estimating Inventories
Appendix 6B Gross Profit Method The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales. Illustration 6B-1 SO 8 Describe the two methods of estimating inventories.

50 Estimating Inventories
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 SO 8 Describe the two methods of estimating inventories.

51 Estimating Inventories
Retail Inventory Method Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost. Illustration 6B-3 SO 8 Describe the two methods of estimating inventories.

52 Estimating Inventories
Illustration: Illustration 6B-4 Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time. SO 8 Describe the two methods of estimating inventories.

53 LIFO Inventory Method “Last-In-First-Out (LIFO)” Appendix 6C
Latest goods purchased are first to be sold. Seldom coincides with actual physical flow of merchandise. Exceptions include goods stored in piles, such as coal or hay. Under IFRS, LIFO is not permitted for financial reporting purposes. SO 9 Apply the LIFO inventory costing method.

54 LIFO Inventory Method Illustration
Ishikawa uses a periodic inventory system. Physical inventory determined that Ishikawa sold 550 units and had 450 units in inventory at December 31. SO 9 Apply the LIFO inventory costing method.

55 “Last-In-First-Out (LIFO)”
LIFO Inventory Method “Last-In-First-Out (LIFO)” Illustration 6C-1 SO 9 Apply the LIFO inventory costing method. Solution on notes page

56 “Last-In-First-Out (LIFO)”
LIFO Inventory Method “Last-In-First-Out (LIFO)” Illustration 6C-1 SO 9 Apply the LIFO inventory costing method.

57 Copyright “Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”


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