Chapter 6 Inventories Student Version Principles of Financial and Managerial Accounting 11e Principles of Corporate Financial Accounting 11e Chapter 6 Principles of Financial and Managerial Accounting Using excel for Success Student Version These slides should be viewed using the presentation mode (left click your mouse on the icon). Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reeve Warren Duchac

Describe the importance of control over inventory. Learning Objective 1 Describe the importance of control over inventory.

LO 1 Control of Inventory Two primary objectives of control over inventory are: Safeguarding the inventory from damage or theft. Reporting inventory in the financial statements.

Safeguarding Inventory LO 1 Safeguarding Inventory The purchase order authorizes the purchase of the inventory from an approved vendor. The receiving report establishes an initial record of the receipt of the inventory. Recording inventory using a perpetual inventory system is also an effective means of control. The amount of inventory is always available in the subsidiary inventory ledger.

Safeguarding Inventory LO 1 Safeguarding Inventory Controls for safeguarding inventory should include security measures to prevent damage and customer or employee theft. Some examples of security measures include: Storing inventory in areas that are restricted to only authorized employees. Locking high-priced inventory in cabinets. Using two-way mirrors, cameras, security tags, and guards.

LO 1 Reporting Inventory A physical inventory or count of inventory should be taken near year-end to make sure that the quantity of inventory reported in the financial statements is accurate.

Learning Objective 2 Describe three inventory cost flow assumptions and how they impact the income statement and balance sheet.

Inventory Cost Flow Assumptions

Inventory Cost Flow Assumptions Assume that one unit is sold on May 30 for $20. Depending upon which unit was sold, the gross profit varies from $11 to $6 as shown below:

Inventory Cost Flow Assumptions Under the specific identification inventory cost flow method, the unit sold is identified with a specific purchase.

Inventory Cost Flow Assumptions Under the first-in, first out (FIFO) inventory cost flow method, the first units purchased are assumed to be sold first and the ending inventory is made up of the most recent purchases.

Inventory Cost Flow Assumptions Under the last-in, first out (LIFO) inventory cost flow method, the last units purchased are assumed to be sold first and the ending inventory is made up of the first units purchased.

Inventory Cost Flow Assumptions Under the average inventory cost flow method, the cost of the units sold and in ending inventory is an average of the purchase costs.

Learning Objective 3 Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and average cost methods.

Inventory Costing Methods LO 3 Inventory Costing Methods For purposes of illustration, the data for Item 127B are used, as shown below. We will examine the perpetual inventory system first.

First-In, First-Out Method LO 3 First-In, First-Out Method

Last-In, First-Out Method LO 3 Last-In, First-Out Method

LO 3 Average Cost Method When the average cost method is used in a perpetual system, an average unit cost for each item is computed each time a purchase is made. This unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed. This averaging technique is called a moving average.

Learning Objective 4 Determine the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and average cost methods.

First-In, First-Out Method LO 4 First-In, First-Out Method Using FIFO, the earliest batch purchased is considered the first batch of merchandise sold. The physical flow does not have to match the accounting method chosen. This time we will be examining the periodic inventory system.

First-In, First-Out Method LO 4 First-In, First-Out Method Beginning inventory and purchases of Item 127B in January are as follows: Cost of merchandise available for sale

First-In, First-Out Method LO 4 First-In, First-Out Method The physical count on January 31 shows that 150 units are on hand. (Conclusion: 130 units were sold.) What is the cost of the ending inventory?

First-In, First-Out Method LO 4 First-In, First-Out Method Now we can calculate the cost of merchandise sold as follows:

Last-In, First-Out Method LO 4 Last-In, First-Out Method Using LIFO, the most recent batch purchased is considered the first batch of merchandise sold. The actual flow of goods does not have to be LIFO. For example, a store selling fresh fish would want to sell the oldest fish first (which is FIFO), even though LIFO is used for accounting purposes.

Last-In, First-Out Method LO 4 Last-In, First-Out Method Using the last-in, first-out method, the cost of the ending inventory on January 31 is determined as follows: Inventory, January 31

Last-In, First-Out Method LO 4 Last-In, First-Out Method Assume again that the physical count on January 31 is 150 units (and that 130 units were sold). What is the cost of the merchandise sold?

LO 4 Average Cost Method The average cost method is sometimes called the weighted average method. It uses the average unit cost for determining cost of merchandise sold and the ending merchandise inventory.

Total Cost of Units Available for Sale Units Available for Sale LO 4 Average Cost Method The weighted average unit cost is determined as follows: Average Unit Cost = Total Cost of Units Available for Sale Units Available for Sale Average Unit Cost = $5,880 280 units Average Unit Cost = $21 per unit

Cost of merchandise available for sale LO 4 Average Cost Method Cost of merchandise available for sale Average cost per unit Ending Inventory

LO 4 Average Cost Method

Compare and contrast the use of the three inventory costing methods. Learning Objective 5 Compare and contrast the use of the three inventory costing methods.

Comparing Inventory Cost Methods LO 5 Comparing Inventory Cost Methods Using the periodic inventory system illustration with sales of $3,900 (130 units x $30), the differences in ending inventory, cost of merchandise sold, and gross profit are illustrated in the next slide, Exhibit 7.

Comparing Inventory Cost Methods LO 5 Comparing Inventory Cost Methods

Learning Objective 6 Describe and illustrate the reporting of merchandise inventory in the financial statements.

Reporting Merchandise Inventory LO 6 Reporting Merchandise Inventory Cost is the primary basis for valuing and reporting inventories in the financial statements. However, inventory may be valued at other than cost in the following cases: The cost of replacing items in inventory is below the recorded cost. The inventory cannot be sold at normal prices due to imperfections, style changes, or other causes.

Valuation at Lower of Cost or Market Market, as used in lower-of-cost-or-market method, is the cost to replace the merchandise on the inventory date. Cost and replacement cost can be determined for: Each item in the inventory. Each major class or category of inventory. Total inventory as a whole.

Valuation at Net Realizable Value LO 6 Valuation at Net Realizable Value Merchandise that is out of date, spoiled, or damaged should be written down to its net realizable value. This is the estimated selling price less any direct costs of disposal, such as sales commissions or special advertising.

Valuation at Net Realizable Value LO 6 Valuation at Net Realizable Value Assume the following data about an item of damaged merchandise: Original cost $1,000 Estimated selling price 800 Selling expenses 150 The merchandise should be valued at its net realizable value of $650 ($800 – $150).

Merchandise Inventory on the Balance Sheet LO 6 Merchandise Inventory on the Balance Sheet Merchandise inventory is usually presented in the Current Assets section of the balance sheet, following receivables. The method of determining the cost of the inventory (FIFO, LIFO, or weighted average) and the method of valuing the inventory (cost or the lower of cost or market) should be shown.

Inventory Errors Some reasons that inventory errors may occur include: LO 6 Inventory Errors Some reasons that inventory errors may occur include: Physical inventory on hand was miscounted. Costs were incorrectly assigned to inventory. Inventory in transit was incorrectly included or excluded from inventory. Consigned inventory was incorrectly included or excluded from inventory.

LO 6 Inventory Errors Inventory errors often arise from consigned inventory. Manufacturers sometimes ship merchandise to retailers who act as the manufacturer’s agent.

LO 6 Inventory Errors The manufacturer, called the consignor, retains title until the goods are sold. Such merchandise is said to be shipped on consignment to the retailer, called the consignee.

Learning Objective 7 Describe and illustrate the inventory turnover and the number of days’ sales in inventory in analyzing the efficiency and effectiveness of inventory management.

Cost of Merchandise Sold LO 7 Inventory Turnover Inventory turnover measures the relationship between cost of merchandise sold and the amount of inventory carried during the period. It is calculated as follows: Inventory Turnover = Cost of Merchandise Sold Average Inventory

LO 7 Inventory Turnover Inventory turnover for Best Buy is shown below (in millions).

Average Daily Cost of Merchandise Sold LO 7 Inventory Turnover The number of days’ sales in inventory measures the length of time it takes to acquire, sell, and replace the inventory. It is computed as follows: Number of Days’ Sales in Inventory Average Inventory Average Daily Cost of Merchandise Sold =

LO 7 Inventory Turnover The number of days’ sales in inventory for Best Buy is computed below (in millions).

Inventories The End