Reporting and Analyzing Inventories

Reporting and Analyzing Inventories
Chapter 5 Reporting and Analyzing Inventories In this chapter, we will learn how to determine the cost of inventory.

Conceptual Chapter Objectives
C1: Identify the items making up merchandise inventory C2: Identify the costs of merchandise inventory

Analytical Chapter Objectives
A1: Analyze the effects of inventory methods for both financial and tax reporting A2: Analyze the effects of inventory errors on current and future financial statements A3: Assess inventory management using both inventory turnover and days’ sales in inventory

Procedural Chapter Objectives
P1: Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted average P2: Compute the lower of cost or market amount of inventory P3: Appendix 6A: Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average P4: Appendix 6B: Apply both the retail inventory and gross profit methods to estimate inventory.

Determining Inventory Items
C 1 Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Items requiring special attention include: Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. We must pay special attention to include inventory that we own but that is in transit or on consignment. We should also consider the condition of inventory that is damaged or obsolete when determining a cost for the inventory. Goods in Transit Goods Damaged or Obsolete Goods on Consignment

Ownership passes to the buyer here.
Goods in Transit C 1 Public Carrier Seller Buyer FOB Shipping Point Ownership passes to the buyer here. Transportation costs are sometimes included in the cost of Merchandise Inventory. The FOB terms designate when title passes and who pays the transportation costs. FOB stands for Free On Board. So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that buyer will pay the transportation cost. On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means that seller will pay the transportation cost. So, if goods are shipped FOB Shipping Point, then the buyer owns the goods in transit and will pay the transportation costs. In this case, the transportation cost will be added to the merchandise inventory account. FOB Destination Point Public Carrier Seller Buyer

Thanks for selling my inventory in your store.
Goods on Consignment C 1 Merchandise is included in the inventory of the consignor, the owner of the inventory. Thanks for selling my inventory in your store. Consignee Goods on consignment are goods that we own, but that are on display for sale at another place of business. Even though these goods are not in our physical possession, we still have ownership of them and should include them in our inventory count. Consignor

Goods Damaged or Obsolete
C 1 Damaged or obsolete goods are not counted in inventory if they cannot be sold. Any inventory that is damaged or obsolete should be reduced to net realizable value. Net realizable value is the value we can expect to get from the damaged or obsolete inventory when it is sold. Cost should be reduced to net realizable value if they can be sold.

Determining Inventory Costs
Include all expenditures necessary to bring an item to a salable condition and location. Invoice Cost Minus Discounts and Allowances Plus Insurance The cost of inventory includes any cost that is necessary and reasonable to get the inventory to your place of business and to get it in a salable condition. We already know that the invoice price and transportation costs are included in the total cost of inventory. Other costs to include are insurance, storage and duties. Any purchase discounts or allowances received reduce the cost of the inventory purchased. Plus Import Duties Plus Storage Plus Freight

Internal Controls and Taking a Physical Count
Inventory Count Tag Counted by _______ Quantity Counted ___ Most companies take a physical count of inventory at least once each year. When the physical count does not match the Merchandise Inventory account, an adjustment must be made. Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in our inventory records. In reality, this is not the case. The physical count does not match our records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps us get our records up to date to reflect what we actually have on hand.

Inventory Costing Under a Perpetual System
Inventory affects . . . Balance Sheet Income Statement The matching principle requires matching cost of sales with sales. Inventory transactions impact both the balance sheet and the income statement. Ending Inventory is reported as a current asset on the balance sheet and cost of goods sold is reported on the income statement. The matching principle requires matching cost of sales with sales.

Inventory Costing Under a Perpetual System
Accounting for inventory requires several decisions . . . Costing Method Specific Identification, FIFO, LIFO, or Weighted Average Inventory System Perpetual or Periodic A couple decisions must be made related to accounting for inventory. First, a costing method must be selected. We will review specific identification; first-in, first-out; last-in, first-out; and weighted average. Second, we must select either a perpetual or periodic inventory system. We will focus our attention on a perpetual inventory system.

Frequency in Use of Inventory Methods
P1 As this graph indicates, the majority of inventory methods used can be classified as first-in, first-out; last-in, first-out; and weighted average.

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 We must make assumptions about the inventory cost flow. First-in, first-out assumes costs flow in the order incurred. Last-in, first-out assumes costs flow in the reverse order incurred. Weighted average assumes costs flow at an average of the costs available. Now, let’s see how these methods work in an example. Assumes costs flow at an average of the costs available.

Inventory Costing Illustration
P1 Take a minute and review this chart. We will use this data throughout our inventory examples so we can compare our results at the end.

Specific Identification
When units are sold, the specific cost of the unit sold is added to cost of goods sold. First, let’s look at the specific identification method. In this method, we know the specific cost of each unit that is sold. It is most commonly used in businesses that have low sales volume of high dollar items, like car dealerships, exclusive jewelry stores, and custom builders.

The above purchases were made in August. On August 14, a company sold eight bikes originally costing $91 and 12 bikes originally costing $106. On August first and third, a company purchases inventory. On August fourteenth, they sold eight bikes that cost ninety-one dollars each and twelve bikes that cost one hundred six dollars each. What is the total cost of goods sold on August fourteenth?

The Cost of Goods Sold for the August 14 sale is $2,000. = $ = $1,272 After this sale, there are five units in inventory at $500: 2 $91 = $ $106 = $ 318 The Cost of Goods Sold for August fourteenth is two thousand dollars. This is calculated by multiplying the eight bikes in the first lot by their cost of ninety one dollars each, and then multiplying 12 bikes in the second lot at one hundred six dollars each for a total of two thousand dollars. Can you determine how much is left in ending inventory after the sale? After this sale, the company has five units in inventory: two units that cost ninety-one dollars each and three units that cost one hundred six dollars each, for a total of five hundred dollars.

Additional purchases were made on August 17 and 28. The cost of the 23 items sold on August 31 were as follows: $91 $106 $115 $119 Next, the company makes two purchases on August seventeenth and August twenty eighth. On August thirty first, Trekking sold twenty-three bikes: two that cost ninety-one dollars each; three that cost one hundred, six dollars each; fifteen that cost one hundred fifteen dollars each; and three that cost one hundred nineteen dollars each. How much is the cost of goods sold on August thirty first?

The Cost of Goods Sold for August thirty first is two thousand, five hundred eighty-two dollars. Cost of Goods Sold for August 31 = $2,582

After the August thirty first sale, the company has twelve units in inventory: five units that cost one hundred fifteen dollars each and seven units that cost one hundred nineteen dollars each. After the August 31 sale, there are 12 units in inventory at $1,408: $115 $119

Income Statement COGS = $4,582 Using the specific identification method, the company would report Cost of Goods Sold on their August income statement of four thousand, five hundred eighty-two dollars. And, they would report Ending Inventory on their balance sheet of one thousand, four hundred eight dollars. Balance Sheet Inventory = $1,408

Here are the entries to record the purchases and sales. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $ / Here are the entries to record the purchases and sales discussed previously. All purchases and sales are made on credit. The selling price of inventory was one hundred thirty dollars on August fourteenth and one hundred fifty dollars on August thirty first. The numbers in red were determined using the specific identification method.

First-In, First-Out (FIFO)
P1 Oldest Costs Cost of Goods Sold Recent Costs Ending Inventory The first-in, first-out method is abbreviated as FIFO, and pronounced as Fifo. When using FIFO, we assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory.

P1 The above purchases were made in August. On August 14, the company sold 20 bikes. On August first and third, the company purchases inventory. On August fourteenth, they sold twenty bikes. What is the total cost assigned to the bikes sold on August fourteenth?

P1 The Cost of Goods Sold for the August 14 sale is $1,970. After this sale, there are five units in inventory at $530: $106 First, the company assigns the cost of the ten oldest inventory items from beginning inventory on August first at ninety-one dollars each. Now, they need ten more units; so they move down to the next purchase on August third, and include the cost of ten units from this purchase at one hundred six dollars. The Cost of Goods Sold for August fourteenth is one thousand, nine hundred seventy dollars. After this sale, there are five units left in inventory at a cost of one hundred six dollars each.

P1 Next, the company makes two purchases on August seventeenth and August twenty eighth. On August thirty first, they sold twenty-three bikes. How much is the cost of goods sold on August thirty first? Additional purchases were made on August 17 and 28. Twenty-three bikes were sold on August 31.

P1 First, the company takes the cost of the five remaining units from the August third purchase at one hundred six dollars each. Then, they move down to the next purchase on August seventeenth and take the cost of eighteen units at one hundred fifteen dollars each. The Cost of Goods Sold for August thirty first is two thousand, six hundred dollars. Cost of Goods Sold for August 31 = $2,600

P1 After the August thirty first sale, there are twelve units in inventory: two units at one hundred fifteen dollars each and ten units at one hundred nineteen dollars each. After the August 31 sale, there are 12 units in inventory at $1,420: $115 $119

P1 Income Statement COGS = $4,570 Using the FIFO method, the company would report Cost of Goods Sold on their August income statement of four thousand, five hundred seventy dollars. And, they would report Ending Inventory on their balance sheet of one thousand, four hundred twenty dollars. Balance Sheet Inventory = $1,420

P1 Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $ / Here are the entries to record the purchases and sales for the company. All purchases and sales are made on credit. The selling price of inventory was one hundred thirty dollars on August 14th and one hundred fifty dollars on August 31st. The numbers in red were determined using the FIFO method.

Last-In, First-Out (LIFO)
P1 Recent Costs Cost of Goods Sold Oldest Costs Ending Inventory The last-in, first-out method is abbreviated as LIFO, and pronounced as Lifo. When using LIFO, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory.

P1 The above purchases were made in August. On August 14, the company sold 20 bikes. On August first and third, the company purchases inventory. On August fourteenth, they sold twenty bikes. What is the total cost assigned to the bikes sold on August fourteenth?

P1 The Cost of Goods Sold for the August 14 sale is $2,045. After this sale, there are five units in inventory at $455: $91 First, the company assigns the cost of the fifteen most recent inventory items purchased on August third at one hundred six dollars each. Now, they need five more units, so they move up to the beginning inventory on August first, and include the cost of five units from this purchase at ninety-one dollars each. The Cost of Goods Sold for August fourteenth is two thousand, forty-five dollars. After this sale, there are five units in inventory at a cost of ninety-one dollars each.

P1 Next, two purchases are made on August seventeenth, and August twenty eighth. On August thirty first, the company sold twenty-three bikes. How much is the cost of goods sold on August thirty first? Additional purchases were made on August 17 and 28. Twenty-three bikes were sold on August 31.

P1 First, the company takes the cost of the ten units from the most recent purchase on August twenty eighth at one hundred nineteen dollars each. Then, they move up to the next most recent purchase on August seventeenth, and take the cost of thirteen units at one hundred fifteen dollars each. The Cost of Goods Sold for August thirty first is two thousand, six hundred eighty-five dollars. Cost of Goods Sold for August 31 = $2,685

P1 After the August thirty first sale, there are twelve units in inventory: five units at ninety-one dollars each and seven units at one hundred fifteen dollars each. After the August 31 sale, there are 12 units in inventory at $1,260: $91 $115

P1 Income Statement COGS = $4,730 Using LIFO, Trekking would report Cost of Goods Sold on their August income statement of four thousand, seven hundred thirty dollars. And, they would report Ending Inventory on their balance sheet of one thousand, two hundred sixty dollars. Balance Sheet Inventory = $1,260

P1 Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $ / Here are the entries to record the purchases and sales. All purchases and sales are made on credit. The selling price of inventory was one hundred, thirty dollars on August fourteenth and one hundred fifty dollars on August thirty first. The numbers in red were determined using LIFO.

Weighted Average P1 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 ÷ When using weighted average, we assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand.

Weighted Average The above purchases were made in August.
On August 14, 20 bikes were sold. On August first and third, the company purchases inventory. On August fourteenth, they sold twenty bikes. What is the total cost assigned to the bikes sold on August fourteenth?

Weighted Average P1 First, we need to compute the weighted average cost per unit of items in inventory. First, we need to compute the weighted average cost of the items in inventory. We do this by dividing the cost of goods available for sale of two thousand, five hundred dollars by the total units in inventory of twenty-five. The average cost per unit is one hundred dollars. ÷

Weighted Average P1 The Cost of Goods Sold for the August 14 sale is $2,000. After this sale, there are five units in inventory at $500: The Cost of Goods Sold for August fourteenth is two thousand dollars. After this sale, there are five units in inventory at an average cost of one hundred dollars each.

Weighted Average Additional purchases were made on August 17 and 28.
Twenty-three bikes were sold on August 31. Next, two purchases were made on August seventeenth and August twenty eighth. On August thirty first, the company sold twenty-three bikes. What is the weighted average cost of the items in inventory on August thirty first? What is the weighted average cost per unit of items in inventory?

Weighted Average P1 The company will divide the cost of goods available for sale of three thousand, nine hundred ninety dollars by the total units in inventory of thirty-five. The average cost per unit is one hundred fourteen dollars. ÷

Cost of Goods Sold for August 31 = $2,622
Weighted Average P1 The Cost of Goods Sold for August thirty first is two thousand, six hundred twenty-two dollars. Cost of Goods Sold for August 31 = $2,622

Weighted Average P1 After this sale, there are twelve units in inventory at an average cost of one hundred fourteen dollars each. After the August 31 sale, there are 12 units in inventory at $1,368: $114

Income Statement COGS = $4,622
Weighted Average P1 Income Statement COGS = $4,622 Using the weighted average method, the company would report Cost of Goods Sold on their August income statement of four thousand, six hundred twenty-two dollars. And, they would report Ending Inventory on their balance sheet of one thousand, three hundred sixty-eight dollars. Balance Sheet Inventory = $1,368

Weighted Average P1 Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $ / Here are the entries to record the purchases and sales. All purchases and sales are made on credit. The selling price of inventory was one hundred thirty dollars on August fourteenth and one hundred fifty dollars on August thirty first. The numbers in red were determined using the weighted average method.

Financial Statement Effects of Costing Methods
Because prices change, inventory methods nearly always assign different cost amounts. This slide presents a comparison of the impact on the income statement of using the different inventory costing methods. Everything is the same in each example, except the amount of Cost of Goods Sold, and its flow through effects on Income Before Taxes, Income Tax Expense, and Net Income. Specific Identification provides the most accurate cost of goods sold amount. But, this method is very costly to use. In periods of rising prices, of the other three methods, FIFO will provide the lowest Cost of Goods Sold amount. This is because it uses the older costs which tend to be lower to arrive at this amount. LIFO will provide the highest Cost of Goods Sold amount. This is because it uses the most recent costs which tend to be higher to arrive at this amount. Weighted Average will provide a Cost of Goods Sold amount that falls between FIFO and LIFO. As you can see, the impact on net income is that FIFO results in the highest net income, LIFO results in the lowest net income, and weighted average results in net income that falls in the middle of these two.

Financial Statement Effects of Costing Methods
Advantages of Methods Weighted Average First-In, First-Out Last-In, First-Out Smoothes out price changes. Ending inventory approximates current replacement cost. Better matches current costs in cost of goods sold with revenues. An advantage of weighted average is that it smoothes out peaks and valleys in price changes that may occur during the period. FIFO does a great job of valuing Ending Inventory at an approximate replacement cost. This is because FIFO uses the most recent costs to value Ending Inventory. LIFO does a great job of matching current costs in Cost of Goods Sold with current revenues. This is because LIFO uses the most recent costs to determine Cost of Goods Sold.

Tax Effects of Costing Methods
The Internal Revenue Service (IRS) identifies several acceptable methods for inventory costing for reporting taxable income. If LIFO is used for tax purposes, the IRS requires it be used in financial statements. Using LIFO for tax reporting purposes makes sense because it provides the lowest net income figure, and, therefore, the lowest tax expense of the three methods. However, the Internal Revenue Service requires that if a company uses LIFO for tax reporting purposes, they must also use LIFO for financial reporting.

Consistency in Using Costing Methods
A1 The consistency principle requires a company to use the same accounting methods period after period so that financial statements are comparable across periods. The consistency principle requires a company to use the same accounting methods from period to period so that financial statements are comparable across periods. Companies can change accounting methods occasionally only for good reasons.

Lower of Cost or Market P2 Inventory must be reported at market value when market is lower than cost. Defined as current replacement cost (not sales price). Consistent with the conservatism principle. Can be applied three ways: (1) separately to each individual item. (2) to major categories of assets. (3) to the whole inventory. Part One When we report inventory on the balance sheet, we report it at the lower of cost or market value. Cost is determined using one of the methods we just discussed: Specific identification, FIFO, LIFO or weighted average. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market value follows the conservatism principle by not overstating the value of assets. Part Two We can apply the lower of cost or market concept on an individual item basis, for similar categories of inventory, or for the inventory as a whole. Let’s see how to apply the lower of cost or market concept.

A motorsports retailer has the following items in inventory:
Lower of Cost or Market P2 A motorsports retailer has the following items in inventory: Here is some information on inventory items of a motor sports retailer. Take a few minutes and review this information.

Lower of Cost or Market P2 Here is how to compute lower of cost or market for individual inventory items. If we look at the individual items, we will select the lower of cost or market for each item in inventory. So, for the Roadster, we would select the market value of one hundred forty thousand dollars because it is lower than cost of one hundred sixty thousand dollars. Continuing down the chart, we would select the lower of cost or market for each item in inventory. At the end, we would use the total of two hundred sixty-five thousand dollars as the reported value of inventory.

Lower of Cost or Market P2 Here is how to compute lower of cost or market for the two groups of inventory items. If we look at similar categories of items, we will select the lower of cost or market for each category. So, for the Cycles category, we would select the market value of two hundred thousand dollars because it is lower than the cost of two hundred ten thousand dollars. Continuing down the chart, we would select the cost of the Off-Road category because it is lower than the market value for the category. At the end, we would use the total of two hundred eighty-five thousand dollars as the reported value of inventory.

Lower of Cost or Market P2 Here is how to compute lower of cost or market for the entire inventory. If we look at the total inventory, we will select the lower market value of two hundred eighty-seven thousand dollars as compared to the cost of two hundred ninety-five thousand dollars. The reported value of inventory would be two hundred eighty-seven thousand dollars.

Financial Statement Effects of Inventory Errors
Exh. 5.10 A2 Income Statement Effects Take a few minutes and review this chart. It shows the impact of inventory errors on the income statement. For example, if Ending Inventory is understated, that will result in an overstatement of Cost of Goods Sold which will result in an understatement of Net Income.

Financial Statement Effects of Inventory Errors
Balance Sheet Effects Take a few minutes and review this chart. It shows the impact of inventory errors on the balance sheet. As we just noted on the previous slide, if Ending Inventory is understated, Cost of Goods Sold will be overstated, which will result in an understatement of Net Income. An understatement of Net Income will result in an understatement of equity. Also, if Ending Inventory is understated, then assets on the balance sheet will be understated.

Inventory Turnover A3 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. Inventory Turnover = Cost of goods sold Avg. inventory Inventory turnover is a ratio used to determine how many times a company sells its inventory during a period. It is calculated as Cost of Goods Sold divided by Average Inventory.

Days’ Sales in Inventory
Reveals how much inventory is available in terms of the number of days’ sales. Days' Sales in Inventory = Ending Inventory Cost of goods sold × 365 Days’ Sales in Inventory is a ratio that reveals how much inventory is available in terms of the number of days’ sales. It is calculated as Ending Inventory divided by Cost of Goods Sold multiplied by three hundred sixty-five.

End of Chapter 5 In this chapter we learned about several methods used to cost inventory. We also learned how to apply lower of cost or market and learned about the impact of inventory errors on the financial statements. In the next chapter, we will learn about the accounting information system.

Reporting and Analyzing Inventories

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