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

Chapter 6

3 Chapter 6 Reporting and Analyzing Inventory After studying Chapter 6, you should be able to: zDescribe the steps in determining inventory quantities. zExplain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. zExplain the financial statement and tax effects of each of the inventory cost flow assumptions. zExplain the lower of cost or market basis of accounting for inventories. zCompute and interpret the inventory turnover ratio.  Describe the LIFO reserve and explain its importance for comparing results of different companies.

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

6 Manufacturing Inventory zFinished goods inventory zWork in process zRaw materials

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

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

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

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

32 Companies that use perpetual inventory take a physical count to... zcheck the accuracy of their perpetual inventory records zto determine the amount of inventory lost due to: zwasted raw materials zshoplifting zemployee theft

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: zCost of merchandise on hand; zCost of goods sold. Periodic Inventory

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

34 Inventory Involved in Many Frauds zThe Great Salad Oil Scandal zLeslie Faye zCraig Consumer Electronics

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

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

36 Goods in Transit Who includes these in inventory? zBuyer? zSeller? The Company with Legal Title

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

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

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

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

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

45 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

44 Inventory Costing zSpecific Identification method zCost Flow Assumptions yFIFO- First-in, First-Out- earliest goods purchased are the first to be sold yLIFO- Last-in,First-Out- latest goods purchased are the first to be sold yAverage Cost Method- costs are charged on the basis of weighted average unit cost

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

51 Factors Used in Selecting an Inventory Cost Method zIncome statement effects zBalance sheet effects zTax effects

52 Income Statement Effects zIn periods of increasing prices yFIFO reports the highest net income yLIFO the lowest yaverage cost falls in the middle. zIn periods of decreasing prices y FIFO will report the lowest net income yLIFO the highest yaverage cost falls in the middle.

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

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

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.

55 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.

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

57 Market Is... CURRENT REPLACEMENT COST

58 How Much Inventory Should a Company Have? yOnly enough for sales needs yExcess inventory costs: xstorage costs xinterest costs xobsolescence - technology, fashion

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.

Days in Inventory = 365 days Inventory Turnover Ratio

61 Lifo Reserve And Its Importance For Comparing Results Of Different Companies zAccounting 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. zThis 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.

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