Merchandise Inventory Chapter 6 6-1Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

Accounting principles and controls related to merchandise inventory 6-2

Consistency Principle Businesses should use the same accounting methods and procedures from period to period. Consistency helps users of financial statement information to compare financial statements from one period to the next. 6-3 A change in the accounting methods, must be reported to the investors and creditors in the Notes to the Financial Statements.

Disclosure Principle A company should report enough information to allow users to make knowledgeable decisions about the company. Information should be relevant and have faithful representation. 6-4 Source: Green Mountain Coffee Roasters, Inc., 2011 Financial Statements, Note 1.

Materiality Concept onlyA company must follow strictly proper accounting only for significant items. Information is significant when it would cause someone to change a decision. 6-5 Many large companies report their financial numbers in millions. Cash on the balance sheet of $7,500 might be $7,500,000,000 because the last six zeroes have been left off. Anything below $1,000,000 is considered to be immaterial.

Conservatism A company should report the least favorable figures in the financial statements when two or more possible options are presented. Goal: Never overstate assets or net income. Anticipate no gains Provide for probable losses Conservatively report assets and liabilities When in doubt record an expense instead of an asset Choose options that undervalue the business 6-6

Inventory Costing Methods There are four basic GAAP-acceptable approaches to assigning cost to inventory 1.Specific Identification 2.First-in, first-out (FIFO) 3.Last-in, last-out (LIFO) 4.Weighted-Average 6-7 4

Perpetual Specific Identification Used when the specific cost for each unit of inventory can be tracked. As each unit is sold, its specific cost is transferred from inventory to Cost of Goods Sold. 6-8 Used for inventories that include: Automobiles Unique Artwork Jewels Real Estate

Perpetual FIFO oldestAs inventory is sold, the cost of the oldest item in inventory is assigned to each unit as it is sold. Ending inventory closely reflects current replacement cost. 6-9 Compared to LIFO, FIFO will result in lower COGS and higher Net Income when costs are constantly increasing.

Perpetual LIFO As inventory is sold, the cost of the newest item in inventory is assigned to each unit as it is sold. Cost of Goods Sold closely reflects current replacement cost Compared to FIFO, LIFO will result in higher COGS and lower Net Income when costs are constantly increasing.

Perpetual Weighted-Average After each purchase, the average cost of the inventory on hand is computed. Sold inventory is costed using the average cost at the time of the sale Average cost BEFORE the sale and AFTER the sale should be the same.

Periodic Inventory Accounting (Appendix 6A) Inventory is not tracked in the accounting system continuously. Beginning inventory balance is carried until the end of the period. Purchases are accumulated during the period. Ending inventory balance replaces the beginning inventory balance. 6-12

Inventory Costing Methods Three approaches to assigning cost to inventory in a periodic system. 1.First-in, first-out (FIFO) 2.Last-in, last-out (LIFO) 3.Weighted-Average

Using the information below, let’s see how we would apply a periodic system to determine Cost of Goods Sold. 6-14

Periodic Inventory—FIFO Ending Inventory will be costed out using the NEWEST items in inventory. Cost of Goods Sold will include the OLDEST costs. 6-15

Using the information below, let’s see how we would apply a periodic system to determine Cost of Goods Sold. 6-16

Periodic Inventory—LIFO Ending Inventory will be costed out using the OLDEST items in inventory. Cost of Goods Sold will include the NEWEST costs. 6-17

Weighted Average-Cost The average-cost per unit is assigned to cost of goods sold and to units remaining in inventory. 18 Average Cost Cost of Inventory Available Number of Units Available ÷=

Periodic Inventory—Weighted Average Ending Inventory is costed using the AVERAGE cost of inventory. Cost of Goods Sold will also be costed using AVERAGE cost of inventory Average cost $6,700 ÷18 = $372.22

6-20 5,280 1,420 5,211 1,489

Note that FIFO results in the highest Gross Profit, while LIFO shows the highest Cost of Goods Sold ,2805,211 1,720 1,789

6-22

Lower-of-Cost-or-Market The LCM rule requires that inventory should be reported in the financial statements at the lower of the inventory’s original cost or its market value Big Inc. is holding inventory that cost $2 million. However, due to technological developments, the market value of that inventory is only $1.2 million. The inventory should be written down to $1.2 million.

Adjusting Inventory for Lower-of-Cost- or-Market Smart Touch Learning paid $3,000 for its TAB0503 inventory. By December 31, it can be replaced for only $2,

Kohl's Footnote Disclosure 6-25©2014 Pearson Education, Inc. Publishing as Prentice Hall Eastman Chemical Footnote Disclosure

Effect of Inventory Errors An error in inventory can lead to errors in other accounts. Because the ending inventory number is used in other computations, when ending inventory is incorrect, other numbers will also be incorrect Smart Touch Learning reported $5,000 more ending inventory than it actually had. How does this error impact other numbers?

Effect of Inventory Errors 6-27

Effect of Inventory Errors A common fraud is for a company to intentionally overstate ending inventory, because it leads to higher Net Income. Sometimes ending inventory is understated Suppose that Smart Touch Learning understated inventory by $1,200. How does this error impact other numbers?

Effect of Inventory Errors 6-29

Inventory Errors: Multiple Periods 30

Use inventory turnover and days’ sales in inventory to evaluate business performance(liquidity) 6-31

Inventory Turnover Measures how rapidly inventory is sold. Inventory turnover should be evaluated against industry averages or company trends –A high turnover rate indicates ease of selling. –A low turnover rate indicates difficulty of selling. 6-32

Example 33 Average Inventory = $467,363

Days’ Sales in Inventory Measures average number of days inventory is held by the company. Different types of inventory will move faster. For inventory with an expiration date, this measure is very important. 6-34

Example 35

Gross profit method and the retail method (Appendix 6B) 6-36 Inventory Estimation methods

Gross Profit Method If the ending inventory cannot be counted, it can be estimated. Cost of Goods Sold can be estimated using Sales Revenue and the Gross Profit percent. Not acceptable for Financial reporting Used for interim reporting or casualty loss estimates 6-37

Gross Profit Method Suppose Smart Touch Learning’s ending inventory was destroyed. Assume: 1.Beginning Inventory was $14, Purchases for the period were $66, Sales for the period were $100,000 and the gross profit percent = 40%. 6-38

Gross Profit Method estimateTo estimate Cost of Goods Sold, subtract the normal gross profit from sales. $100,000 – $40,000 = $60,000 estimateThis will allow you to estimate Ending Inventory. 6-39

Retail Method estimatedIf the ending inventory cannot be counted, it can be estimated. Ending Inventory is estimated using the ratio of Goods Available for Sale at Cost to Goods Available for Sale at Retail. Acceptable for financial reporting purposes 6-40 Kohl's Footnote