Accounting Principles, Eighth Edition CHAPTER 6 INVENTORIES Accounting Principles, Eighth Edition

Study Objectives Describe the steps in determining inventory quantities. Explain the accounting for inventories and apply the inventory cost flow methods. Explain the financial effects of the inventory cost flow assumptions. Explain the lower-of-cost-or-market basis of accounting for inventories. Indicate the effects of inventory errors on the financial statements. Compute and interpret the inventory turnover ratio. 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 Inventory Errors Statement Presentation and Analysis 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 Income statement effects Balance sheet effects Presentation Analysis 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. LO 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. LO 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. LO 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. LO 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. LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities Determining Ownership of Goods Consigned Goods In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods. These are called consigned goods. LO 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 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing Example Young & Crazy Company makes the following purchases: One item on 2/2/08 for $10 One item on 2/15/08 for $15 One item on 2/25/08 for $20 Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 28, 2008, assuming the company used the Specific Identification method to cost inventories and the item purchased on 2/15/08 is sold? Assume a tax rate of 30%. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

“Specific Identification” Inventory Costing “Specific Identification” Inventory Balance = $ 30 Young & Crazy Company Income Statement For the Month of Feb. 2008 Sales $ 90 Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 Taxes 13 Net Income $ 29 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions Example Young & Crazy Company makes the following purchases: One item on 2/2/08 for $10 One item on 2/15/08 for $15 One item on 2/25/08 for $20 Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 2008, assuming the company used the FIFO, LIFO, and Average-cost flow assumptions? Assume a tax rate of 30%. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “First-In-First-Out (FIFO)” Inventory Balance = $ 35 Young & Crazy Company Income Statement For the Month of Feb. 2008 Sales $ 90 Cost of goods sold 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 47 Taxes 14 Net Income $ 33 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “Last-In-First-Out (LIFO)” Inventory Balance = $ 25 Young & Crazy Company Income Statement For the Month of Feb. 2008 Sales $ 90 Cost of goods sold 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 37 Taxes 11 Net Income $ 26 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “Average Cost” Inventory Balance = $ 30 Young & Crazy Company Income Statement For the Month of Feb. 2008 Sales $ 90 Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 Taxes 13 Net Income $ 29 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions Comparative Financial Statement Summary FIFO Average LIFO Sales $90 $90 $90 Cost of goods sold 10 15 20 Gross profit 80 75 70 Admin. & selling expense 33 33 33 Income before taxes 47 42 37 Income tax expense 14 13 11 Net income $33 $29 $26 Inventory balance $35 $30 $25 LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions In Period of Rising Prices, FIFO Reports: FIFO Average LIFO Sales $90 $90 $90 Cost of goods sold 10 15 20 Gross profit 80 75 70 Admin. & selling expense 33 33 33 Income before taxes 47 42 37 Income tax expense 14 13 11 Net income $33 $29 $26 Inventory balance $35 $30 $25 Lowest Highest LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions In Period of Rising Prices, LIFO Reports: FIFO Average LIFO Sales $90 $90 $90 Cost of goods sold 10 15 20 Gross profit 80 75 70 Admin. & selling expense 33 33 33 Income before taxes 47 42 37 Income tax expense 14 13 11 Net income $33 $29 $26 Inventory balance $35 $30 $25 Highest Lowest LO 3 Explain the financial effects 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. LO 3 Explain the financial effects 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. LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions Discussion Question Q6-12 Casey Company has been using the FIFO cost flow method during a prolonged period of rising prices. During the same time period, Casey has been paying out all of its net income as dividends. What adverse effects may result from this policy? Question 6-12 (textbook) Barto Company is using the FIFO method of inventory costing. Cecil Company is using the LIFO method. Under FIFO, the latest goods purchased remain in inventory. Thus, the inventory on the balance sheet should be close to current costs. The reverse is true of the LIFO method. Barto Company will have the higher gross profit because cost of goods sold will include a higher proportion of goods purchased at earlier (lower) costs. See notes page for discussion LO 3 Explain the financial effects 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 effects 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. LO 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 BE6-7 Alou Appliance Center accumulates the following cost and market data at December 31. $ 12,000 9,000 12,800 $ 33,800 Compute the lower-of-cost-or-market valuation for the company’s total inventory. LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Errors 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. LO 5 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 6-16 Illustration 6-17 LO 5 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. LO 5 Indicate the effects of inventory errors on the financial statements.

Net Income understated Inventory Errors Illustration 6-18 Combined income for 2-year period is correct. ($3,000) Net Income understated $3,000 Net Income overstated LO 5 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. LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors Balance Sheet Effects Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:. Illustration 6-16 Illustration 6-19 LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis Balance Sheet - Inventory classified as current asset. Income Statement - Cost of goods sold subtracted from sales. There also should be disclosure of major inventory classifications, basis of accounting (cost or LCM), and costing method (FIFO, LIFO, or average). LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis 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. LO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis 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 LO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis BE6-9 At December 31, 2008, the following information was available for J. Graff Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000. Calculate inventory turnover and days in inventory for J. Graff Company. $270,000 Inventory Turnover 5.4 = ($60,000 + 40,000) / 2 365 Days in Inventory 67.59 days = 5.4 LO 6 Compute and interpret the inventory turnover ratio.

Inventory Cost Flow Methods in Perpetual Inventory Systems The following data from Houston Electronics will be used to illustrate inventory costing under a perpetual system. Illustration 6A-1 LO 7 Apply the inventory cost flow methods to perpetual inventory records.

Inventory Cost Flow Methods in Perpetual Inventory Systems Computation of cost of goods sold and ending inventory under FIFO for Houston Electronics. Illustration 6A-2 Cost of goods sold Ending inventory LO 7 Apply the inventory cost flow methods to perpetual inventory records.

Inventory Cost Flow Methods in Perpetual Inventory Systems Computation of cost of goods sold and ending inventory under LIFO for Houston Electronics. Illustration 6A-3 Cost of goods sold Ending inventory LO 7 Apply the inventory cost flow methods to perpetual inventory records.

Inventory Cost Flow Methods in Perpetual Inventory Systems Computation of cost of goods sold and ending inventory under moving average for Houston Electronics. Illustration 6A-4 Cost of goods sold Ending inventory LO 7 Apply the inventory cost flow methods to perpetual inventory records.

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