Financial Accounting: Tools for Business Decision Making, 3rd Ed. Kimmel, Weygandt, Kieso ELS

Chapter 6

Chapter 6 Reporting and Analyzing Inventory After studying Chapter 6, you should be able to: 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. 3

Merchandise Inventory Owned by the company In form ready to sale to customers in ordinary course of business 5

Manufacturing Inventory Finished goods inventory Work in process Raw materials 6

Finished Goods Inventory Manufactured items that are complete and ready for sale. 7

Work in Process Manufactured inventory that has been placed into production but is not yet complete. 8

Raw Materials The basic goods that will be used in production, but have not been placed in production. 9

Key difference between periodic and perpetual inventory… is the point at which the costs of goods sold is computed.

Companies that use perpetual inventory take a physical count to... check the accuracy of their perpetual inventory records to determine the amount of inventory lost due to: wasted raw materials shoplifting employee theft 32

Periodic Inventory No attempt is made on date of sale to record the cost of merchandise sold... A physical count of inventory is taken at end of period to determine: Cost of merchandise on hand; Cost of goods sold.

Questions Concerning Ownership Do all the goods included in the count belong to the company? Does the company own any goods not included in the count? 34

Inventory Involved in Many Frauds The Great Salad Oil Scandal Leslie Faye Craig Consumer Electronics 34

Comparing Periodic and Perpetual Inventory Systems Inventory Purchased Item Sold End of Period Perpetual Perpetual No Entry Record Purchase of Inventory Record Revenue and Cost of Goods Sold End of Period Inventory Purchased Item Sold Periodic Record Purchase of Inventory Record Revenue Only Compute Cost of Goods Sold

Businesses that use the periodic method generally do not have sophisticated computer systems required to compute cost of goods sold when sale is made.

Goods in Transit These are goods on board a truck, train, ship, or plane at the end of the period. 35

The Company with Legal Title Goods in Transit Who includes these in inventory? Buyer? Seller? The Company with Legal Title 36

Shipping Terms FOB (free on board) shipping point- ownership of goods passes to buyer when public carrier accepts the goods from the seller FOB (free on board) destination- ownership of goods remains with the seller until the goods reach the buyer 38

Ownership passes to owner here FOB Shipping Point Public Carrier Co Seller Buyer Ownership passes to buyer here FOB Destination Point Public Carrier Co Seller Buyer

Take a Physical Inventory Determine inventory quantities by counting, weighting or measuring each type of inventory. Determine ownership of goods, including goods in transit, consigned goods. Quantity of each kind of inventory is listed on inventory summary sheets where unit costs are applied. 33

Consigned Goods Goods of others you hold that you don’t pay for until they sell… The company does not take ownership. 39

Specific Identification Cost of goods sold = $700 + $800 An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of ending inventory.

What Wrong with Specific Identification? COST BENEFIT - EXPENSIVE TO SET-UP AND MAINTAIN 45

What Is a Cost Flow Assumption? To presume the order in which goods are sold. 45

What Makes Cost Flow Assumptions Necessary? Changing Prices 45

Inventory Costing Specific Identification method Cost Flow Assumptions FIFO- First-in, First-Out- earliest goods purchased are the first to be sold LIFO- Last-in,First-Out- latest goods purchased are the first to be sold Average Cost Method- costs are charged on the basis of weighted average unit cost 44

The FIFO method assumes the earliest goods purchased are the first to be sold.

The LIFO method assumes the latest goods purchased are the first to be sold.

The average cost method assumes that goods available for sale are the same. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred.

The average cost method assumes that goods available for sale are similar in nature. Illustration 6-10 The average cost method assumes that goods available for sale are homogeneous.

Factors Used in Selecting an Inventory Cost Method Income statement effects Balance sheet effects Tax effects 51

Income Statement Effects In periods of increasing prices FIFO reports the highest net income LIFO the lowest average cost falls in the middle. In periods of decreasing prices FIFO will report the lowest net income LIFO the highest 52

Balance Sheet Effects In a period of increasing prices costs allocated to ending inventory using: FIFO will approximate current costs LIFO will be understated 53

Lower Income Taxes Tax Effects Why do companies use lifo? Higher cost of goods sold Lower net income Lower Income Taxes 54

Consistency Whatever cost flow method a company chooses, it must use it consistently… OR Disclose the change and its effects on net income in the financial statement. 54

The Lower of Cost or Market Basis of Accounting for Inventories When the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline occurs. 55

Lower of Cost or Market (LCM) departure from cost principle follows conservatism concept can be used only after one of the cost flow methods ( Specific Identification FIFO, LIFO, or Average Cost) 56

CURRENT REPLACEMENT COST Market Is... CURRENT REPLACEMENT COST 57

How Much Inventory Should a Company Have? Only enough for sales needs Excess inventory costs: storage costs interest costs obsolescence - technology, fashion 58

Inventory Turnover Ratio = An indication of how quickly a company sells its goods. Higher is better.

Inventory Turnover Ratio = Cost of Goods Sold Average Inventory

Days in Inventory = An indication of how quickly a company sells its goods. Lower is better.

Inventory Turnover Ratio Days in Inventory = 365 days Inventory Turnover Ratio

Lifo Reserve And Its Importance For Comparing Results Of Different Companies Accounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO. This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods. 61

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