Inventories and Cost of Sales Chapter 5 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Wild, Shaw, and Chiappetta Financial & Managerial Accounting 6th Edition Wild, Shaw, and Chiappetta Financial & Managerial Accounting 6th Edition

6 - 2 Determining Inventory Items Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Goods in Transit Goods Damaged or Obsolete Goods on Consignment C1 Items requiring special attention include: 2

6 - 3 FOB Destination Point Public Carrier SellerBuyer Goods in Transit Public Carrier Seller Buyer FOB Shipping Point Ownership passes to the buyer here. C1 3

6 - 4 Goods on Consignment Merchandise is included in the inventory of the consignor, the owner of the inventory. C1 4

6 - 5 Goods Damaged or Obsolete Damaged or obsolete goods are not counted in inventory if they cannot be sold. Cost should be reduced to net realizable value if they can be sold. C1 5

6 - 6 Determining Inventory Costs Invoice Cost Include all expenditures necessary to bring an item to a salable condition and location. Minus Discounts and Allowances Plus Import Duties Plus Freight Plus Storage Plus Insurance C2 6

6 - 7  Most companies take a physical count of inventory at least once each year. Internal Controls and Taking a Physical Count  When the physical count does not match the Merchandise Inventory account, an adjustment must be made. Good internal controls over count include: 1.Pre-numbered inventory tickets. 2.Counters have no inventory responsibility. 3.Counts confirm existence, amount, and quality of inventory item. 4.Second count is taken. 5.Manager confirms all items counted. Good internal controls over count include: 1.Pre-numbered inventory tickets. 2.Counters have no inventory responsibility. 3.Counts confirm existence, amount, and quality of inventory item. 4.Second count is taken. 5.Manager confirms all items counted. C2 7

6 - 8 Inventory Costing under a Perpetual System Inventory affects... The matching principle requires matching costs with sales. Balance Sheet Income Statement C2 8

6 - 9 Inventory Cost Flow Assumptions C2 Management decisions in accounting for inventory involve the following: 1.Items included in inventory and their costs. 2.Costing method (specific identification, FIFO, LIFO, or weighted average). 3.Inventory system (perpetual or periodic). 4.Use of market values or other estimates. 9

Inventory Cost Flow Assumptions First-In, First-Out (FIFO) Assumes costs flow in the order incurred. Last-In, First-Out (LIFO) Assumes costs flow in the reverse order incurred. Weighted Average Assumes costs flow at an average of the costs available. P1 10

Inventory Costing Illustration Here is information about the mountain bike inventory of Trekking for the month of August. P1 11

Specific Identification P1 12

First-In, First-Out (FIFO) Cost of Goods Sold Ending Inventory Oldest Costs Recent Costs P1 13

First-In, First-Out (FIFO) P1 14

Last-In, First-Out (LIFO) Cost of Goods Sold Ending Inventory Recent Costs Oldest Costs P1 15

Last-In, First-Out (LIFO) P1 16

Weighted Average When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Cost of Goods Available for Sale Units on hand on the date of sale ÷ P1 17

Weighted Average P1 18

Financial Statement Effects of Costing Methods Because prices change, inventory methods nearly always assign different cost amounts. A1 19

Financial Statement Effects of Costing Methods Advantages of Methods Smoothes out price changes. Better matches current costs in cost of goods sold with revenues. Ending inventory approximates current replacement cost. First-In, First-Out Weighted Average Last-In, First-Out A1

Tax Effects of Costing Methods The Internal Revenue Service (IRS) identifies several acceptable inventory costing methods for reporting taxable income. If LIFO is used for tax purposes, the IRS requires it be used in financial statements. A1 21

Consistency in Using Costing Methods The consistency principle requires a company to use the same accounting methods period after period so that financial statements are comparable across periods. A1 22

Lower of Cost or Market Inventory must be reported at market value when market is lower than cost. Can be applied three ways: (1)separately to each individual item. (2)to major categories of assets. (3)to the whole inventory. Can be applied three ways: (1)separately to each individual item. (2)to major categories of assets. (3)to the whole inventory. Defined as current replacement cost (not sales price). Consistent with the conservatism principle. Defined as current replacement cost (not sales price). Consistent with the conservatism principle. P2 23

Lower of Cost or Market A motor sports retailer has the following items in inventory: P2 24

Financial Statement Effects of Inventory Errors A2 25

Financial Statement Effects of Inventory Errors A2 26

Global View Items and Costs Making Up Inventory Both U.S. GAAP and IFRS include in inventory all items that a company owns and holds for sale plus all cost expenditures necessary to bring those items to a salable condition and location. Assigning Costs to Inventory Both U.S. GAAP and IFRS allow companies to use specific identification, FIFO, and Weighted Average. IFRS does not currently allow use of LIFO. Estimating Inventory Costs Both U.S. GAAP and IFRS require companies to write down inventory when its value falls below recorded cost. U.S. GAAP prohibits any later increase in value. IFRS does allow reversals of write downs up to the original acquisition cost. Neither allow inventory to be adjusted upward beyond the original cost. 27

Inventory Turnover Inventory turnover = Cost of goods sold Average inventory Shows how many times a company turns over its inventory during a period. Indicator of how well management is controlling the amount of inventory available. Average Inventory = (Beg. Inv. + End Inv.) ÷ 2 A3 28

Days’ Sales in Inventory Reveals how much inventory is available in terms of the number of days’ sales. A3 29

Appendix 5B: Inventory Estimation Methods P4 Inventory sometimes requires estimation for interim statements or if some casualty such as fire or flood makes taking a physical count impossible. Retail Inventory Method Gross Profit Method 30