Accounting, Third Edition Reporting and Analyzing Inventory Accounting, Third Edition

Study Objectives Describe the steps in determining inventory quantities. Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Explain the lower-of-cost-or-market basis of accounting for inventories. Compute and interpret the inventory turnover ratio. Describe the LIFO reserve and explain its importance for comparing results of different companies. Apply the inventory cost flow methods to perpetual inventory records. Indicate the effects of inventory errors on the financial statements. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Reporting and Analyzing Inventory Classifying Inventory Determining Inventory Quantities Inventory Costing Analysis of Inventory 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-market Inventory turnover ratio LIFO reserve Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation. Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt. Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets. Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees. Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss: difference between the actual return and the expected return on plan assets and, amortization of the unrecognized net gain or loss from previous periods

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 balance sheet.

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.

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.

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.

Determining Inventory Quantities Terms of Sale 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.

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. Answer = A SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities Determining Ownership of Goods Consigned Goods Goods held for sale by one party although ownership of the goods is retained by another party. SO 1 Describe the steps in determining inventory quantities.

Inventory Costing 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 Cost Flow Assumptions SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

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. These facts are summarized below. Illustration 6-2 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing “Specific Identification” 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 basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Specific Identification Method 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 basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions does not need to equal Physical Movement of Goods Illustration 6-11 Use of cost flow methods in major U.S. companies SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions Illustration: Data for Houston Electronics’ Astro condensers. Illustration 6-4 (Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions “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 basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions “First-In-First-Out (FIFO)” Illustration 6-5 Solution on notes page SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions “First-In-First-Out (FIFO)” Illustration 6-5 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions “Last-In-First-Out (LIFO)” 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. SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions “Last-In-First-Out (LIFO)” Illustration 6-7 Solution on notes page SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions “Last-In-First-Out (LIFO)” Illustration 6-7 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions “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 basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions “Average Cost” Illustration 6-10 Solution on notes page SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions ”Average Cost” Illustration 6-10 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions Comparative Financial Statement Summary FIFO Average LIFO Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions In Period of Rising Prices, FIFO Reports: FIFO Average LIFO Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 Lowest Highest LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions In Period of Rising Prices, LIFO Reports: FIFO Average LIFO Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 Highest Lowest LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions Review Question The cost flow method that often parallels the actual physical flow of merchandise is the: FIFO method. LIFO method. average cost method. gross profit method. Answer = A LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions Review Question In a period of inflation, the cost flow method that results in the lowest income taxes is the: FIFO method. LIFO method. average cost method. gross profit method. Answer = B LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Using Cost Flow Methods Consistently 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. Illustration 6-14 Disclosure of change in cost flow method LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Lower-of-Cost-or-Market Inventory Costing Lower-of-Cost-or-Market 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. SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Lower-of-Cost-or-Market Inventory Costing Lower-of-Cost-or-Market Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. $ 55,000 45,000 45,000 12,800 $157,800 SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Analysis of Inventory Analysis of Inventory 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 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory 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 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory Illustration: The following data are available for Wal-Mart. Inventory Turnover 2007 $264,152 = 8.1 times = (33,685 + 31,910) / 2 Days in inventory 2007 365 Days = 45.1 Days = 8.1 SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory Illustration: The following data are available for Wal-Mart. Inventory Turnover 2006 $237,649 = 7.7 times = (31,910 + 29,419) / 2 Days in inventory 2006 365 Days = 47.4 Days = 7.7 SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory Analysts’ Adjustments for LIFO Reserve Companies using LIFO are required to report the amount that inventory would increase (or occasionally decrease) if the company had instead been using FIFO. This amount is referred to as the LIFO reserve. Illustration 6-17 SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.

Analysis of Inventory Analysts’ Adjustments for LIFO Reserve The LIFO reserve can have a significant effect on ratios analysts commonly use. Illustration 6-19 SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.

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

+ Cost Flow Methods in Perpetual Systems Perpetual Inventory FIFO Method Solution on notes page SO 7 Apply the inventory cost flow methods to perpetual inventory records.

+ Cost Flow Methods in Perpetual Systems Perpetual Inventory LIFO Method Solution on notes page SO 7 Apply the inventory cost flow methods to perpetual inventory records.

+ Cost Flow Methods in Perpetual Systems Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. SO 7 Apply the inventory cost flow methods to perpetual inventory records.

+ Cost Flow Methods in Perpetual Systems Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Common Cause: Inventory Errors Appendix 6B 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. SO 8 Indicate the effects of inventory errors on the financial statements.

Income Statement Effects Inventory Errors Income Statement Effects Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-B1 Illustration 6-B2 SO 8 Indicate the effects of inventory errors on the financial statements.

Income Statement Effects 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 8 Indicate the effects of inventory errors on the financial statements.

Net Income understated Inventory Errors Illustration 6-B3 Combined income for 2-year period is correct. ($3,000) Net Income understated $3,000 Net Income overstated SO 8 Indicate the effects of inventory errors on the financial statements.

Review Question Inventory Errors Understating ending inventory will overstate: assets. cost of goods sold. net income. owner's equity. SO 8 Indicate the effects of inventory errors on the financial statements.

Balance Sheet Effects Inventory Errors Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:. Illustration 6-B1 Illustration 6-B4 SO 8 Indicate the effects of inventory errors on the financial statements.

Copyright “Copyright © 2009 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.”