Chapter 10 Inventories Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University.

Chapter 10 Inventories Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Learning Objectives Identify and explain the management issues associated with accounting for inventories. Define inventory cost and relate it to goods flow and cost flow. Calculate the pricing of inventory, using the cost basis under the periodic inventory system. Copyright © Houghton Mifflin Company. All rights reserved.

Learning Objectives (cont’d)
Apply the perpetual inventory system to the pricing of inventories at cost. State the effects of inventory methods and misstatements of inventory on income determination, income taxes, and cash flows. Apply the lower-of-cost-or-market (LCM) rule to inventory valuation. Copyright © Houghton Mifflin Company. All rights reserved.

Supplemental Objective
Estimate the cost of ending inventory using the retail method and gross profit method. Copyright © Houghton Mifflin Company. All rights reserved.

Management Issues Associated with Accounting for Inventories
Objective 1 Identify and explain the management issues associated with accounting for inventories Copyright © Houghton Mifflin Company. All rights reserved.

Inventory … is considered a current asset because it will normally be sold within a year’s time or within a company’s operating cycle Merchandising entities Merchandise inventory consists of all goods owned and held for sale in the regular course of business Manufacturing entities Maintain other types of inventories Raw Materials Work in Process Finished Goods Copyright © Houghton Mifflin Company. All rights reserved.

Management Issues Associated with Accounting for Inventories
Applying the matching rule to inventories Assessing the impact of inventory decisions Evaluating the level of inventory Copyright © Houghton Mifflin Company. All rights reserved.

Applying the Matching Rule to Inventories
A major objective of accounting for inventories is the proper determination of income (not to determine the most realistic inventory value) This is achieved through the process of matching appropriate costs against revenues Copyright © Houghton Mifflin Company. All rights reserved.

Effect of Inventory Accounting on Income
Recall that cost of goods sold is dependent upon the cost assigned to ending inventory, or goods not sold The higher the cost of ending inventory The lower the cost of goods sold And, the lower the cost of goods sold, the higher the gross margin Gross margin has a direct effect on the amount of net income so the higher the amount of gross margin, the higher the amount of net income reported on the income statement Copyright © Houghton Mifflin Company. All rights reserved.

Effect of Inventory Accounting on Income
The reverse is also true The lower the cost of ending inventory The higher the cost of goods sold And the higher the cost of goods sold, the lower the gross margin Gross margin has a direct effect on the amount of net income so the lower the amount of gross margin, the lower the amount of net income reported on the income statement Copyright © Houghton Mifflin Company. All rights reserved.

Management Choices in Accounting for Inventories
Copyright © Houghton Mifflin Company. All rights reserved.

Assessing the Impact of Inventory Decisions
Decisions regarding inventory usually result in different amounts of reported income, which affect External evaluation by investors and creditors Internal evaluation, e.g. executive compensation Income taxes Management must balance The goal of proper income determination The goal of minimizing income taxes The effects on the company’s cash flows Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating the Level of Inventory
Management issues involving the level of inventory Balancing the handling and storage costs of maintaining inventory with the demands of customers Costs of high inventory levels can be substantial Costs of low inventory levels include disgruntled customers and lost sales Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating the Level of Inventory (cont’d)
Measures used in evaluating the level of inventory include Inventory turnover Average days’ inventory on hand Copyright © Houghton Mifflin Company. All rights reserved.

Inventory Turnover Illustrated
J.C. Penney’s cost of goods sold was $22,573 million at the end of 2002, and its merchandise inventory was $4,945 million at the end of 2002 and $4,930 at the end of 2001 This means that J.C. Penney sold its average inventory 4.6 times during the year 2002 Copyright © Houghton Mifflin Company. All rights reserved.

Inventory Turnover for Selected Industries

Average Days’ Inventory on Hand
… indicates the average number of days required to sell the inventory on hand Copyright © Houghton Mifflin Company. All rights reserved.

Average Days’ Inventory on Hand Illustrated
J.C. Penney’s inventory turnover for 2002 was 4.6 times This means that it took an average of 79.3 days for J.C. Penney to sell its inventory on hand during the year 2002 Copyright © Houghton Mifflin Company. All rights reserved.

Average Days’ Inventory on Hand for Selected Industries

Managing Inventory Levels
To reduce inventory levels, many companies use, in conjunction with each other Supply-chain management Managing inventory and purchasing through business-to-business transactions over the Internet Just-in-time operating environment Working closely with suppliers to coordinate and schedule inventory shipments so they arrive just as they are needed Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What are some of the costs associated with carrying inventory? Insurance, property tax, and storage costs. There is also the possibility of additional spoilage and employee theft. Copyright © Houghton Mifflin Company. All rights reserved.

Inventory Cost and Goods Flow
Objective 2 Define inventory cost and relate it to goods flow and cost flow Copyright © Houghton Mifflin Company. All rights reserved.

The Primary Basis of Accounting for Inventories
… is cost, which has been defined generally as the price paid or consideration given to acquire an asset According to the AICPA Copyright © Houghton Mifflin Company. All rights reserved.

Inventory Cost Includes the following costs
Invoice price less purchases discounts Freight in, including insurance in transit Applicable taxes and tariffs Costs of ordering, receiving, and storing In principle, should be included in inventory cost In practice, are usually considered expenses of the period Are too difficult to allocate to specific inventory items Copyright © Houghton Mifflin Company. All rights reserved.

Merchandise in Transit
The status of merchandise in transit must be examined to determine if it should be included in the inventory count Merchandise inventory includes all merchandise owned by the company Includes Outgoing goods shipped FOB destination Incoming goods shipped FOB shipping point Copyright © Houghton Mifflin Company. All rights reserved.

Merchandise In Transit

Merchandise on Hand Not Included in Inventory
Merchandise sold but not yet shipped Goods held on consignment Title stays with the consignor until consignee sells the goods Must not be included in the physical inventory of the consignee Copyright © Houghton Mifflin Company. All rights reserved.

Goods Flow Versus Cost Flow
It is necessary to make assumptions about the order in which items have been sold When identical items are bought and sold, it is often impossible to identify which have been sold and which remain in inventory Assumption is about cost flows rather than goods flow Copyright © Houghton Mifflin Company. All rights reserved.

Goods Flow Versus Cost Flow
Refers to the actual physical movement of goods in the operations of a company Cost flow Refers to the association of costs with their assumed flow in the operations of a company Several choices of assumed cost flow are available under generally accepted accounting principles Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Why can cost flow differ from goods flow?
Because cost flow can be based on assumptions about goods flow Copyright © Houghton Mifflin Company. All rights reserved.

Methods of Pricing Inventory at Cost Under the Periodic System
Objective 3 Calculate the pricing of inventory, using the cost basis under the periodic inventory system Copyright © Houghton Mifflin Company. All rights reserved.

Methods of Pricing Inventory at Cost Under the Periodic System
The value of ending inventory is the result of two measurements Quantity Determined by taking a physical count Price Based on the assumed cost flow of the goods as they are bought and sold Copyright © Houghton Mifflin Company. All rights reserved.

Methods of Pricing Inventory at Cost
Accountants use one of four generally accepted methods to price inventory Specific identification method Average-cost method First-in, first-out (FIFO) method Last-in, first-out (LIFO) method The choice of method depends on the Nature of the business Financial effects of the method Cost of implementing the method Copyright © Houghton Mifflin Company. All rights reserved.

Illustrative Data for the Four Periodic Inventory Methods

Specific Identification Method
… identifies the cost of each item in ending inventory as coming from a specific purchase May be used for high-priced articles Disadvantages Difficulty and impracticality of keeping track of the purchase and sale of individual items When items are identical but purchased at different costs, deciding which items were sold becomes arbitrary Company can raise or lower income by choosing the lower- or higher-cost items Copyright © Houghton Mifflin Company. All rights reserved.

Specific Identification Method Illustrated
Assume that the June 30 inventory consisted of 50 units from the June 1 inventory 100 units from the June 13 purchase and 70 units from the June 25 purchase Copyright © Houghton Mifflin Company. All rights reserved.

Specific Identification Method (cont’d)
The cost assigned to the inventory would be Notice that the company can raise or lower income by choosing lower- or higher-cost items Copyright © Houghton Mifflin Company. All rights reserved.

Average-Cost Method … computes the average cost of all goods available for sale during the period in order to determine the value of ending inventory Tends to level out the effects of cost increases and decreases Is criticized by some who believe that recent costs are more relevant for income measurement and decision making Copyright © Houghton Mifflin Company. All rights reserved.

Average-Cost Method Illustrated

First-In, First-Out (FIFO) Method
… is based on the assumption that the costs of the first items acquired should be assigned to the first items sold The cost of ending inventory reflects the cost of merchandise from the most recent purchases The costs assigned to cost of goods sold are from the earliest purchases Copyright © Houghton Mifflin Company. All rights reserved.

FIFO Method Illustrated
Under the FIFO method, the first items purchased are assumed to be the first items sold This leaves the most recently purchased items in ending inventory Copyright © Houghton Mifflin Company. All rights reserved.

Effect of FIFO Method … is to value the ending inventory at the most recent costs and include earlier costs in cost of goods sold During periods of consistently rising prices FIFO yields the highest possible amount of net income Cost of goods sold will show earliest, lower costs incurred During periods of consistently falling prices FIFO yields the lowest possible amount of net income Cost of goods sold will show most recent, higher costs incurred A major criticism of FIFO is that it magnifies the effects of the business cycle on income Copyright © Houghton Mifflin Company. All rights reserved.

Last-In, First-Out (LIFO) Method
… is based on the assumption that the costs of the last items acquired should be assigned to the first items sold The cost of ending inventory reflects the cost of merchandise purchased earliest The costs assigned to cost of goods sold are from the most recent purchases Copyright © Houghton Mifflin Company. All rights reserved.

LIFO Method Illustrated
Under the LIFO method, the last items purchased are assumed to be the first items sold This leaves the earliest purchased items in ending inventory Copyright © Houghton Mifflin Company. All rights reserved.

Effect of LIFO Method … is to value the ending inventory at the earlier costs and include most recent costs in cost of goods sold This assumption does not agree with the actual physical movement of goods in most businesses Current value of inventory may be unrealistic Balance sheet measures (such as working capital and current ratio) may be distorted and must be interpreted carefully Copyright © Houghton Mifflin Company. All rights reserved.

Effect of LIFO Method (cont’d)
Strong logical argument for LIFO Fairest determination of income occurs if the current costs of merchandise are matched against current sales prices Smoothes out fluctuations in the business cycle As prices move upward or downward, cost of goods sold will show costs closer to the price level at the time the goods were sold Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Do the FIFO and LIFO inventory methods result in different quantities of ending inventory? The quantities of ending inventory are the same under FIFO and LIFO. These methods affect the pricing of the inventory, not the quantities Copyright © Houghton Mifflin Company. All rights reserved.

Pricing Inventory Under the Perpetual Inventory System
Objective 4 Apply the perpetual inventory system to the pricing of inventories at cost Copyright © Houghton Mifflin Company. All rights reserved.

The perpetual system records sales and purchase quantities and costs as they occur A continuous record of quantities and costs of merchandise is maintained Cost of goods sold is accumulated as sales are made Costs are transferred from the Inventory account to the Cost of Goods Sold account The cost of ending inventory is the balance in the Inventory account Copyright © Houghton Mifflin Company. All rights reserved.

Illustrative Data for the Three Perpetual Inventory Methods
The same data is used as for the periodic system, except specific sales dates and amounts have been added Copyright © Houghton Mifflin Company. All rights reserved.

Comparison of Periodic and Perpetual Inventory Systems
Specific identification method Pricing inventory and cost of goods sold the same under both the periodic and perpetual systems Perpetual system provides more detailed records of purchases and sales Average-cost method Periodic system Average cost is computed for all goods available for sale during the period Perpetual system Average is computed after each purchase or series of purchases Copyright © Houghton Mifflin Company. All rights reserved.

Average-Cost Method The ending inventory is the balance, or $282.70
The sum of the costs applied to sales becomes the cost of goods sold, $342.30 Copyright © Houghton Mifflin Company. All rights reserved.

FIFO and LIFO Methods It is necessary to keep track of the components of inventory at each step As sales are made, the costs must be assigned in the proper order Copyright © Houghton Mifflin Company. All rights reserved.

FIFO Method Note that the ending inventory and cost of goods sold are the same as those computed under the FIFO periodic inventory system This will always occur because the ending inventory under both systems consists of the last items purchased Copyright © Houghton Mifflin Company. All rights reserved.

LIFO Method Note that the ending inventory includes 30 units from beginning inventory, all the units from the June 13 purchase, and 40 units from the June 20 purchase Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Why do you think it is more expensive to maintain a perpetual inventory system? A perpetual inventory system is more expensive to maintain because detailed records must be kept as transactions occur. Also, businesses may need to purchase special equipment to assist in their perpetual recordkeeping efforts Copyright © Houghton Mifflin Company. All rights reserved.

Comparison and Impact of Inventory Decisions and Misstatements
Objective 5 State the effects of inventory methods and misstatements of inventory on income determination, income taxes, and cash flows Copyright © Houghton Mifflin Company. All rights reserved.

Effects of Inventory Systems and Methods
Note that gross margin under FIFO is the same under both the periodic and perpetual systems During periods of rising prices LIFO charges the most recent and highest prices to cost of goods sold resulting in the lowest gross margin under both systems FIFO charges the earliest and lowest prices to cost of goods sold resulting in the highest gross margin under both systems Average-cost gross margin is between that using FIFO and LIFO Has a less pronounced effect on gross margin During periods of declining prices The reverse would occur Copyright © Houghton Mifflin Company. All rights reserved.

Effects on the Financial Statements
Each of the four methods of inventory pricing is acceptable for use in published financial statements Factors to consider when choosing a method The trend of prices The effects on the financial statements Income taxes and management decisions Copyright © Houghton Mifflin Company. All rights reserved.

The LIFO Method … is best suited for the income statement because it matches revenues and cost of goods sold Not the best measure of the current balance sheet value of inventory Particularly during a prolonged period of price increases and decreases Copyright © Houghton Mifflin Company. All rights reserved.

The FIFO Method … is best suited to the balance sheet because the ending inventory is closest to current values Gives a more realistic view of the current financial assets of a business Does not provide as good a matching of current costs and revenues for income statement purposes Copyright © Houghton Mifflin Company. All rights reserved.

Effects on Income Taxes
The inventory valuation method chosen must be used consistently from year to year May change if there is a good reason If a company uses LIFO for tax purposes, the IRS requires the same method for financial reporting IRS will not allow lower-of-cost-or-market inventory valuation if LIFO is used If inventory at year end is less than at the beginning, LIFO liquidation results in higher income taxes A business wants to avoid paying income taxes on inventory profits Copyright © Houghton Mifflin Company. All rights reserved.

Effects on Income Taxes
In periods of rising prices Using the FIFO and average-cost methods May cause a business to report more than its true profit and pay more income taxes Using LIFO For balance sheet purposes, inventory may be valued at a cost far below current prices for the same items Management must monitor this situation carefully because a LIFO liquidation might occur The inventory quantity at year end falls below the beginning-of-the-year level The company will pay higher income taxes Copyright © Houghton Mifflin Company. All rights reserved.

Inventory Costing Methods Used by 600 Large Companies

Effects of Misstatements in Inventory Measurement
The figures for ending inventory and gross margin are related A misstatement in the inventory figure will create misstatements of an equal amount on the financial statements On the income statement, gross margin and income before income taxes will be misstated On the balance sheet, assets and owner’s equity will be misstated Copyright © Houghton Mifflin Company. All rights reserved.

Effects of Misstatements Illustrated

Effects of Misstatements from One Accounting Period to the Next
Total income for the two years is the same but the misstatements violate the matching rule Decisions are based on net income for a period and the company has an obligation to present as useful a figure as possible Copyright © Houghton Mifflin Company. All rights reserved.

Inventory Measurement and Cash Flows
Inventory methods affect Reported profitability Reported liquidity and cash flows In the case of large companies, the effects can be complex and material Copyright © Houghton Mifflin Company. All rights reserved.

Discussion If merchandise inventory is mistakenly overstated at the end of 20x4, what is the effect on the (a) 20x4 net income? (b) 20x4 year-end balance sheet value? (c) 20x5 net income? (d) 20x5 year-end balance sheet value? A. (a) The 20x4 net income will be overstated (b) The 20x4 year-end balance sheet value will also be overstated (c) The 20x5 net income will be understated (d) There will be no effect on the 20x5 year-end balance sheet value Copyright © Houghton Mifflin Company. All rights reserved.

The Lower-of-Cost-or-Market (LCM) Rule
… requires that when the replacement cost of inventory falls below historical cost, the inventory is written down to the lower value and a loss is recorded Is an application of conservatism A loss is recognized before an actual transaction takes place Loss is recognized by writing the inventory down to market, or current replacement cost Copyright © Houghton Mifflin Company. All rights reserved.

Applying the LCM Rule Inventory write-down can be done by two methods
Item-by-item method Cost and market values are compared for every item in inventory Each item is valued at its lower price Major category method The total cost and total market values for each category of items are compared Each category is valued at its lower amount Copyright © Houghton Mifflin Company. All rights reserved.

Discussion In the phrase lower of cost or market, what is meant by the word market? The word market in the phrase lower of cost or market refers to current replacement cost Copyright © Houghton Mifflin Company. All rights reserved.

Valuing Inventory by Estimation
Supplemental Objective 7 Estimate the cost of ending inventory using the retail method and gross profit method Copyright © Houghton Mifflin Company. All rights reserved.

Retail Method of Inventory Estimation
… estimates the cost of ending inventory by using the ratio of cost to retail price Used by retail merchandisers As a cost and cost saving tool for determining the cost of inventory for preparing monthly financial statements It is common practice to take physical inventory from price tags and convert the total value to cost using the retail method Copyright © Houghton Mifflin Company. All rights reserved.

Retail Method Estimated Ending Inventory at Retail = (Beg. Inv. + Purchases) at Retail – Sales During Period The term at retail means the amount of inventory at the marked selling prices To use this method, the records must show Beginning inventory at cost and retail Amount of goods purchased during the period at cost and retail Copyright © Houghton Mifflin Company. All rights reserved.

Retail Method of Inventory Estimation

Gross Profit Method of Inventory Estimation
… a way of estimating the cost of inventory based on the assumption that the ratio of gross margin for a business remains relatively stable from year to year Also called gross margin method Is used to estimate value of inventory lost in cases of fire, theft, or other hazards Copyright © Houghton Mifflin Company. All rights reserved.

Gross Profit Method Is used in place of the retail method when records of the retail prices of beginning inventory and purchases are not kept Is acceptable for interim reporting Is not acceptable for annual financial statements Copyright © Houghton Mifflin Company. All rights reserved.

Gross Profit Method of Inventory Estimation

Discussion Why is Freight In not placed under the Retail column when using the retail method of inventory valuation? Businesses automatically price their goods high enough to cover freight charges Copyright © Houghton Mifflin Company. All rights reserved.

Time for Review Identify and explain the management issues associated with accounting for inventories Define inventory cost and relate it to goods flow and cost flow Calculate the pricing of inventory, using the cost basis under the periodic inventory system Copyright © Houghton Mifflin Company. All rights reserved.

More Review Apply the perpetual inventory system to the pricing of inventories at cost State the effects of inventory methods and misstatements of inventory on income determination, income taxes, and cash flows Apply the lower-of-cost-or-market (LCM) rule to inventory valuation Copyright © Houghton Mifflin Company. All rights reserved.

Chapter 10 Inventories Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University.

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Chapter 10 Inventories Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University.

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