Chapter 6-1 CHAPTER 6 INVENTORIES Accounting Principles, Eighth Edition

Chapter 6-2 Reporting and Analyzing Inventory Taking a physical inventory Determining ownership of goods Classifying Inventory Determining Inventory Quantities Inventory Costing Inventory Errors Statement Presentation and Analysis Finished goods Work in process Raw materials Specific identification Cost flow assumptions Financial statement and tax effects Consistent use Lower-of- cost-or- market Income statement effects Balance sheet effects PresentationAnalysis

Chapter 6-3 Classifying Inventory One Classification: Merchandise 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.

Chapter 6-4 INVENTORY IN A MANUFACTURING ENVIRONMENT Manufacturing inventories -may not yet be ready for sale Classified into three categories: 1 Finished goods - ready for sale 2 Work in process – in various stages of production (incomplete) 3 Raw materials - components on hand waiting to be used

Chapter 6-5 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. Determining Inventory Quantities LO 1 Describe the steps in determining inventory quantities.

Chapter 6-6 Involves counting, weighing, or measuring each kind of inventory on hand. Taken, when the business is closed or slow. at end of the accounting period. Taking a Physical Inventory Determining Inventory Quantities LO 1 Describe the steps in determining inventory quantities.

Chapter 6-7 Internal control principles for inventory: Segregation of duties - counting by employees who do not have custodial responsibility for the inventory. Why? Establishment of responsibility – the counter should establish the authenticity of each inventory item. What does this mean?

Chapter 6-8 Goods in Transit Purchased goods not yet received. Sold goods not yet delivered. Determining Ownership of Goods Determining Inventory Quantities LO 1 Describe the steps in determining inventory quantities. 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.

Chapter 6-9 Determining Inventory Quantities LO 1 Describe the steps in determining inventory quantities. 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. Terms of Sale

Chapter 6-10 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. Determining Ownership of Goods Determining Inventory Quantities LO 1 Describe the steps in determining inventory quantities.

Chapter 6-11 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 Inventory Costing LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions

Chapter 6-12 Young & Crazy Company makes the following purchases: 1. One item on 2/2/08 for $10 2. One item on 2/15/08 for $15 3. One item on 2/25/08 for $20 Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 28, 2008, assuming the company used the Specific Identification method to cost inventories and the item purchased on 2/15/08 is sold? Assume a tax rate of 30%. Example Inventory Costing LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Chapter 6-13 Purchase on 2/15/08 for $15 Young & Crazy Company Income Statement For the Month of Feb Sales $ 90 Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 Taxes 13 Net Income $ 29 “Specific Identification” Inventory Costing LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Balance = $ 30 Purchase on 2/2/08 for $10 Purchase on 2/25/08 for $20

Chapter 6-14 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. Specific Identification Method Inventory Costing LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Chapter 6-15 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing – Cost Flow Assumptions Illustration 6-11 Use of cost flow methods in major U.S. companies Cost Flow Assumption does not need to equal Physical Movement of Goods

Chapter 6-16 Young & Crazy Company makes the following purchases: 1. One item on 2/2/08 for $10 2. One item on 2/15/08 for $15 3. One item on 2/25/08 for $20 Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 2008, assuming the company used the FIFO, LIFO, and Average-cost flow assumptions? Assume a tax rate of 30%. Example Inventory Costing – Cost Flow Assumptions LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Chapter 6-17 earliest goods purchased are the first to be sold. often parallels the actual physical flow of merchandise. the costs of the earliest goods purchased are the first to be recognized as cost of goods sold. “First-In-First-Out (FIFO)” LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing – Cost Flow Assumptions Think of milk or eggs at the grocery store, why is FIFO important for these items?

Chapter 6-18 FIFO - explained

Chapter 6-19 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Inventory Balance = $ 35 Young & Crazy Company Income Statement For the Month of Feb Sales $ Cost of goods sold 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses Income before tax Taxes 14 $ 33 Net Income $ 33 “First-In-First-Out (FIFO)” LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing – Cost Flow Assumptions

Chapter 6-20

Chapter 6-21 The LIFO method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. Under LIFO, the costs of the latest goods purchased are the first goods to be sold. Think of LIFO as a crowded elevator… “Last-In-First-Out (LIFO)” LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing – Cost Flow Assumptions

Chapter 6-22 LIFO - explained

Chapter 6-23 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Inventory Balance = $ 25 Purchase on 2/25/08 for $20 Young & Crazy Company Income Statement For the Month of Feb Sales $ Cost of goods sold 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses Income before tax Taxes 11 $ 26 Net Income $ 26 “Last-In-First-Out (LIFO)” LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing – Cost Flow Assumptions

Chapter 6-24

Chapter 6-25 LIFO vs. FIFO Order in which items are received Order in which items are “costed”

Chapter 6-26 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. “Average-Cost” LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing – Cost Flow Assumptions

Chapter 6-27 Average Cost - explained

Chapter 6-28 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Inventory Balance = $ 30 Young & Crazy Company Income Statement For the Month of Feb Sales $ Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses Income before tax Taxes 13 $ 29 Net Income $ 29 “Average Cost” LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing – Cost Flow Assumptions

Chapter 6-29 FIFO LO 3 Explain the financial effects of the inventory cost flow assumptions. Inventory Costing – Cost Flow Assumptions Sales$90$90$90 Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense Net income$33$29$26 Inventory balance$35$30$25 LIFOAverage Comparative Financial Statement Summary

Chapter 6-30 In Period of Rising Prices, FIFO Reports: FIFO Inventory Costing – Cost Flow Assumptions Highest Lowest Sales$90$90$90 Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense Net income$33$29$26 Inventory balance$35$30$25 LIFOAverage LO 3 Explain the financial effects of the inventory cost flow assumptions.

Chapter 6-31 In Period of Rising Prices, LIFO Reports: FIFO Inventory Costing – Cost Flow Assumptions Highest Lowest Sales$90$90$90 Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense Net income$33$29$26 Inventory balance$35$30$25 LIFOAverage LO 3 Explain the financial effects of the inventory cost flow assumptions.

Chapter 6-32 x

Chapter 6-33 Q6-12 Casey Company has been using the FIFO cost flow method during a prolonged period of rising prices. During the same time period, Casey has been paying out all of its net income as dividends. What adverse effects may result from this policy? Discussion Question See notes page for discussion Inventory Costing – Cost Flow Assumptions LO 3 Explain the financial effects of the inventory cost flow assumptions.

Chapter 6-34 Using Cost Flow Methods Consistently Inventory Costing Method should be used consistently, enhances comparability. Although consistency is preferred, a company may change its inventory costing method. Illustration 6-14 Disclosure of change in cost flow method LO 3 Explain the financial effects of the inventory cost flow assumptions.

Chapter 6-35 Lower-of-Cost-or-Market Inventory Costing LO 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.

Chapter 6-36 Lower-of-Cost-or-Market Inventory Costing LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories. BE6-7 Alou Appliance Center accumulates the following cost and market data at December 31. Compute the lower-of-cost-or-market valuation for the company’s total inventory. $ 12,000 9,000 12,800 $ 33,800

Chapter 6-37 Inventory Errors LO 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.

Chapter 6-38 Inventory Errors LO 5 Indicate the effects of inventory errors on the financial statements. Inventory errors affect the computation of cost of goods sold and net income. Income Statement Effects Illustration 6-17 Illustration 6-16

Chapter 6-39 Inventory Errors LO 5 Indicate the effects of inventory errors on the financial statements. 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. Income Statement Effects

Chapter 6-40 Inventory Errors LO 5 Indicate the effects of inventory errors on the financial statements. ($3,000) Net Income understated $3,000 Net Income overstated Combined income for 2-year period is correct. Illustration 6-18

Chapter 6-41 Inventory Errors LO 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:. Balance Sheet Effects Illustration 6-16 Illustration 6-19