Chapter 6 Inventories

Objectives: Discuss inventory cost flow assumptions. Apply cost flow assumptions to determine the CGS and the value of ending inventory. Explain the lower-of-cost-or-market (LCM) rule for inventory reporting. Discuss the financial effects of the inventory cost flow assumptions. Learn the effects of inventory errors on financial statements. Discuss the inventory turnover rate and the gross margin ratio. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Defining Inventory 1. Assets held for resale purpose in a normal course of business. 2. Assets used to produce products for resale purpose. Merchandising Firms: merchandise Manufacturing Firms: raw materials Work-in-process Finished Goods Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

How to Account for Inventory Purchases, Sales and Reporting? Applying either the periodic inventory system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories. Both inventory systems require a physical count of inventory at the end of a period to determine the units which can be included in the inventory count. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Inventory Systems A. Perpetual Inventory System. B. Periodic Inventory System. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Perpetual vs. Periodic Inventory System Perpetual system Periodic System At purchase Inventory xxx Purchases xxx A/P xxx A/P xxx At sale: CGS xxx None Inventory xxx A/R xxx A/R xxx Sales xxx Sales xxx Inventories

Perpetual Inventory System Inventory account is used for the purchase and sale. The balance of inventory is available at all time. A physical count is needed at the end of a period. Any discrepancy of book balance with physical count should be adjusted to a loss or gain account. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Perpetual Inventory System (contd.) CGS account is used to record the CGS of a sale. Therefore, the CGS is also known at all time. CGS is determined by selecting a cost flow assumption. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Cost Flow Assumptions In order to apply these assumptions, companies must keep a record of the cost of each inventory unit purchased. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Cost Flow Assumptions (contd.) 1. First-In, First Out (FIFO) method. 2. Last-in, First-Out (LIFO) method. 3. Weighted-Average Cost method. 4. Specific Identification method. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Perpetual Inventory System Example The following inventory information is available for March: Beginning balance of inventory on 3/1: Beginning balance of 100 units at $5 per unit 3/5: Purchased 150 units at $6 3/7: Sold 200 units at $10 3/14: Purchased 100 units at $7 3/28: Sold 30 units at $11 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Perpetual Inventory System Example (contd.) The following is a perpetual record using different cost flow assumptions: Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Perpetual Inventory System Example (contd.) Inventory (FIFO) 500 1100 900 180 700 820 Inventory (LIFO) 500 1150 900 210 700 740 Inventory (WA) 500 1120 900 195.9 700 784.1 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

J. E. for Perpetual (FIFO) 3/5 Inventory 900 Cash 900 3/7 Cash 2,000 Sales Rev. 2,000 Cost of Goods Sold 1,100* Inventory 1,100 3/14 Inventory 700 Cash 700 3/28 Cash 330 Sales Rev. 330 Cost of Good Sold 180** Inventory 180 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

J. E. for Perpetual (FIFO) (contd.) Notes: * Cost of goods sold of 200 units on 3/7 is based on a FIFO assumption: Balance before the sale of 200 units on 3/7 $100 x 5 + 100 x 6 = $1100 100 $5 150 $6 ** Balance before the sale 50 $6 of 30 units on 3/28 100 $7 30 x $6 = $180 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

If the CGS Is Based on LIFO: 3/7 Cost of good sold* 1,150 Inventory 1,150 * Balance before the sale: 100 $5 150 $6 $150 x $6 + 50 x $5 = $1,150 3/28 Cost of goods sold** 210 Inventory 210 ** Balance before the sale: 50 $5 100 $7 30 x $7 = $210 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

If the CGS Is Based on Weighted-Average Method: 3/7 Cost of good sold* 1,120 Inventory 1,120 * 200 x $5.6 = $1,120 3/28 Cost of goods sold** 195.90 Inventory 195.90 ** 30 x 6.53 = $195.90 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

The T Accounts of CGS at the End of Period (3/31): CGS (FIFO) 1,100 180 1,280 CGS (LIFO) 1,150 200 1,360 CGS (WA) 1,120 195.90 1,315.90 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

End of Period Adjustments 1. Adjustment for lost units 2. Adjustments for LCM (Lower-of-Cost-or-market) valuation Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Adjustment for Lost Units Assuming ending units = 110 units on 3/31. The lost units on 3/31 are 10. Cost of 10 lost units (under FIFO) => $6  10 = $60 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Adjustment for Lost Units (contd.) Adjusting Ending: 3/31 Loss from Declining in inventory units 60 Inventory 60 Inventory (FIFO) 820 60 760 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Adjustments for LCM Valuation LCM rule requires that inventory be reported in the statements at the lower of cost or market value (an application of conservatism) Inventory (FIFO) B.B 500 1,100 900 180 700 820 60 -- 3/31 760 Cost (on 3/31, FIFO) = $760 Assuming market price = $600 LCM = $600. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

2. Adjustments for LCM Valuation (contd.) Adjusting entry ==>Given Allowance for declining in market value of inventory with a beginning balance of zero. Allowance 0 -- 3/1 160 160 -- 3/31 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

I/S (for the period ended 3/31) B/S (3/31) Inventory 760 Allowance (160) Inv. At LCM 600 3/31 Loss Due to Market Decline of Inventory 160 Allowance to reduce Inventory to market 160 I/S (for the period ended 3/31) Loss(from declining in units) $ 60 Loss (or CGS) $160 CGS $1,280 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 24

Periodic Inventory System Using the example on page 11, the following entries will be recorded under the periodic inventory system: 3/5 Purchases 900 Cash 900 3/7 Cash 2,000 Sales Revenue 2,000 3/14 Purchases 700 Cash 700 3/28 Cash 330 Sales Revenue 330 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Periodic Inventory System (contd.) At the end of an accounting period, the following steps must be followed to determine the cost of ending inventory and for the cost of goods sold: 1. Do an inventory count. 2. Apply a cost flow assumption to determine the cost of ending inventory. 3. Determine the cost of goods sold using: CGS = Beg. Inv. + Net Pur. - Ending Inv.* * No adjusting entries are required for lost units. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Periodic Inventory System Example Using the example on Page 11 and assuming the physical count of inventory indicates 105 units on hand on 3/31, the cost of ending inventory (105 units) would be (given a FIFO cost flow assumption): $7  100 + $6  5 = $730 Inventory Data: Units Cost 3/1 (B.B) 100 $5 3/ 5 Pur 150 $6 3/ 7 Pur 100 $7 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Periodic Inventory System Example (contd.) The cost of goods sold (based on a FIFO cost flow) equals: Beg. Inv. + Pur - Ending Inv. = 500 + 1,600 - 730 = 1,370 If a LIFO cost assumption is used, the cost of ending inventory equals: The CGS = 500 + 1,600 - 530* = 1,570 * Cost of Ending Inv. = $5 x 100 + 6 x 5 = 530 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Periodic Inventory System Example (contd.) A weighted-average cost flow assumption: WAUC = 100 x 5 + 150 x 6 + 100 x 7 350 = 6 Cost of ending inventory: 6 x 105 = 630 Cost of goods sold = 500 +1600 - 630 = 1470 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Periodic Inventory System End of Period Adjustments 1. No adjustment is needed for lost units (because the cost of lost units is embedded in the CGS). 2. Adjustment for the LCM valuation assuming FIFO, cost = $730 Assuming the market price = $600 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Periodic Inventory System End of Period Adjustments (contd.) Adjusting entry: Loss Due to Market Value Decline of Inventory (or CGS) 130 Allowance to Reduce Inventory to Market Value 130 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

I/S (for the period ended 3/31) B/S (3/31) Inventory 730 Allowance (130) Inv. At LCM 600 I/S (for the period ended 3/31) Loss Due to Market Value Decline of Inv. (or CGS) 130 Cost of Good Sold: Beginning Inventory $ 500 Net Purchase 1,600 Total Goods Available for Sale $2,100 Ending Inventory (730) 1,370 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 32

Periodic Inventory System End of period entries to update inventory and related cost of goods sold accounts based on a FIFO cost-flow assumption: a. Transfer the cost of beginning inventory to the CGS account: CGS 500 Inventory (Beg. Balance) 500 b. Transfer the cost of purchase to CGS: CGS 1,600 Purchase 1,600 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Periodic Inventory System (contd.) c. Record the cost of ending inventory based on a physical count of 105 units and a FIFO cost-flow assumption: Inventory (ending balance) 730 CGS 730 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Periodic Inventory System (contd.) T- accounts: Inventory B.B 500 a. 500 c. 730 Purchase 3/5 900 b. 1,600 3/14 700 CGS a. 500 c. 730 b. 1,600 1,370 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Comparison of FIFO vs. LIFO During an Inflation Period Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Inventories: Measurement 4/19/2017 Survey: (Source: Accounting Trends & Techniques and KWW Textbook) a, b,c Yearl Firms LIF1O FIFO W-A Others 1984 1061 100% 408 38% 366 30% 225 22% 52 5% 1988 1038 100% 379 36.5% 396 38% 213 20.5% 50 5% 1991 1032 100% 361 35% 421 41% 200 19% 50 5% 2000 887 100% 283 32% 386 44% 180 20% 38 4% 2006 802 100% 228 28% 385 48% 159 20% 30 2010 666d 176 26.4% 325 49% 147 22% 18 2.6% Inventories: Measurement

Survey: (Source: Accounting Trends & Techniques ) (contd.) 4/19/2017 Survey: (Source: Accounting Trends & Techniques ) (contd.) Sample firms are 600 firms. Most companies adopt more than one inventory method. Due to low inflation, the number of firms adopting LIFO has declined since mid-1980s. IAS No. 2 does not permit LIFO, and therefore, multinational companies use LIFO for all or most of their domestic inventories while use FIFO or average cost for their foreign subsidiaries. The number of disclosures. Inventories: Measurement

Items to Be Included in Inventory Count Any goods with the legal title transferred to the buyer should be included in the inventory count of the buyer (including goods in transit with a FOB shipping point term). Consigned Goods: Legal title remained with the consignor (i.e., the manufacturers). Inventory shipped for an “on approval” sale. Note: FOB shipping point – the ownership transfers to the buyer at the shipping point. FOB destination – the ownership transfers to the buyer at the destination. Inventories: Measurement

Reason of Switching to LIFO 1. Tax savings. 2. Income Manipulation. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Reason of Switching to LIFO Income Manipulation When LIFO cost flows assumption is used and price is rising, income maybe subject to management manipulation as follows: a. Liquidation LIFO (to reduce CGS and therefore increase income) b. To decrease income by increasing CGS Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Income Manipulation a. Liquidation LIFO When the inventory is depleted to the early layers, the CGS would be low and the income would be high. Strategy: to delay the purchase of inventory so that the cost of inventory would be depleted to the cost of early layers. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Income Manipulation b. To Decrease Income by Increasing CGS Strategy: order more inventory at the end of period so that CGS would be high (under LIFO) and income would be low. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Advantages of FIFO a. Less likely to be subject to management manipulation; b. Produce higher income during an inflation period; c. Inventory cost reported on the B/S is close to the replacement cost. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Disadvantage of FIFO a. Bad match of sales revenue with CGS; match current sales revenue with old costs; b. Producing higher income during an inflation period results in paying more income tax. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Advantages of LIFO a. Good match of sales revenue with CGS; match the most recent inventory cost against sales revenue; b. Produce lower income during an inflation period; result in tax savings (defer income tax). (This is only true when the inventory level is not decreasing. If inventory is decreasing, there would be liquidation profits). Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Disadvantages of LIFO a. Inventory cost presented on the B/S is not fair. b. Subject to management. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

IRS 1. Does not allow firms to use LCM if firms are using LIFO. 2. If firms are using LIFO for income tax filing purposes, firms must also use LIFO for financial reporting purposes (referred to as LIFO conformity rule). Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

IRS (contd.) 3. LIFO is not acceptable by the IRS until late 1930’s. Switch from FIFO to LIFO, firms do not need the approval of the IRS. However, switch from LIFO to FIFO, firms need to receive the approval of the IRS and need to pay back taxes (the cumulative effect). Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

International Perspective Many countries do not permit the use of LIFO. For example, Australia, Singapore, and United Kingdom do not permit the use of LIFO. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Accounting Principles and Theory Related to Inventories 1. Consistency Principle 2. Disclosure Principle 3. Materiality 4. Conservatism Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

The Impact of Inventory Errors on the Financial Statements Year 1: Income CGS Gross Margin = Beg Inv + Net Pur - End Inv under over under under * over under over over ** Year 2: over under over under under over under over * either understating the units or understating the value ** either overstating the units or the value *** Gross Margin = Sales Revenue - CGS Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Ethical Issues To artificially inflate the net income, a company may 1. Overstating the ending inventory to decrease the cost of goods sold. 2. Ship the goods to distributors at the end of a period (i.e., 12/20/x1). The goods are later returned but in the next period (I.e., 1/3/x2) (Parking transactions). Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Estimating Inventory: Gross Margin Method Reasons: For some companies, inventory information is needed between accounting periods. Companies cannot afford to do physical inventory count every quarter. Thus, a gross margin method (gross profit method) can be used to estimate value of ending inventory for interim reports. No physical count of inventory is needed for this method. The value of inventory is based on estimation. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Estimating Inventory: Gross Margin Method (contd.) This method is not acceptable for annual financial reporting purposes. This method is acceptable for interim reporting The insurance companies may use this method to estimate the loss of inventory in case of fire or flood. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Gross Profit Method (Gross margin Method) Data Required Beginning Inventory (at cost) Purchase (net) (at Cost) Sales Price Gross margin ratio (Gross margin/sales price) Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Example Beginning Inv. = $60,000 Purchase (net) = $200,000 Sales = $280,000 Gross margin ratio* = 30% * gross marking ratio is obtained from past years’ experience (assuming the ratio is stable over years) Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Using Gross Profit Method to Estimate the Cost of Ending Inventory Selling Price Cost Beg, Inv. $60,000 Purchase (net) 200,000 Goods Avai. For Sale 260,000 Sales 280,000 Less: gross margin* (84,000) Sales (at cost) 196,000 ** Estimated Inv. (at cost) 64,000 * gross margin = 280,000 x 30% ** also equals 280,000 x (1-30%) = 196,000 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Comments for Gross Profit Method If the relationship between the gross profit and shelling price has been changed, the ratio should be adjusted accordingly. A separate gross profit ratio should be applied to different type of inventory with different relationship between the gross profit and selling price. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Analyzing Financial Statements 1. Inventory turnover rate 2. Gross margin percentage Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

1. Inventory Turnover Rate Cost of Goods Sold = ___________________________ Average Inventory This ratio measures how fast inventory is sold. Average Inventory = (Beg. Inv. + End Inv.)/2 Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

2. Gross Margin Percentage = _______________________________ Net Sales Revenue This percentage is an indication of profitability. A 40% gross margin means that each dollar of sales generate 40 cents of gross profit. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

2. Gross Margin Percentage (contd.) This percentage varies among industries. In general, the average gross profit is 14.1% for automobile dealers, 22.8% for grocery stores and 55.7% for restaurants. Sources: Robert Morris Associates’ Annual Statement Studies). Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Inventory Control 1. Keeping inventory handles away from the accounting. 2. Physical count of inventory. ( At lease once a year) 3. Keeping perpetual inventory system for high-cost inventory. Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

Inventory Transaction on the Cash Flow Statement Cash Flows from Operating Activities: Collection from Customers $xxx Cash Payments to Suppliers ($xxx) Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit