1. 6-1

2. 6-2 REPORTING AND ANALYZING INVENTORY Financial Accounting, Sixth Edition 6

3. 6-3 1. 1.Describe the steps in determining inventory quantities. 2. 2.Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. 3. 3.Explain the financial statement and tax effects of each of the inventory cost flow assumptions. 4. 4.Explain the lower-of-cost-or-market basis of accounting for inventories. 5. 5.Compute and interpret the inventory turnover ratio. 6. 6.Describe the LIFO reserve and explain its importance for comparing results of different companies. Study Objectives

4. 6-4 Classifying Inventory MerchandisingManufacturingJust-in-time Inventory turnover ratio LIFO reserve Specific identification Cost flow assumptions Financial statement and tax effects Consistent use Lower-of-cost- or-market Taking a physical inventory Determining ownership of goods Determining Inventory Quantities Inventory Costing Analysis of Inventory Reporting and Analyzing Inventory

5. 6-5 Classifying Inventory One Classification:   Merchandise Inventory Three Classifications:   Raw Materials   Work in Process   Finished Goods Merchandising Company Manufacturing Company Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

6. 6-6

7. 6-7 Physical Inventory taken for two reasons: Perpetual System 1. 1.Check accuracy of inventory records. 2. 2.Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft). Periodic System 1. 1.Determine the inventory on hand 2. 2.Determine the cost of goods sold for the period. Determining Inventory Quantities SO 1 Describe the steps in determining inventory quantities.

8. 6-8 Involves counting, weighing, or measuring each kind of inventory on hand. Taken,   when the business is closed or business is slow.   at end of the accounting period. Taking a Physical Inventory Determining Inventory Quantities SO 1 Describe the steps in determining inventory quantities.

9. 6-9

10. 6-10 Goods in Transit   Purchased goods not yet received.   Sold goods not yet delivered. Determining Ownership of Goods Determining Inventory Quantities SO 1 Describe the steps in determining inventory quantities. 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.

11. 6-11 Illustration 6-1 Terms of sale 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. Goods in Transit Determining Inventory Quantities

12. 6-12 Goods in transit should be included in the inventory of the buyer when the: a. a.public carrier accepts the goods from the seller. b. b.goods reach the buyer. c. c.terms of sale are FOB destination. d. d.terms of sale are FOB shipping point. Review Question Determining Inventory Quantities SO 1 Describe the steps in determining inventory quantities.

13. 6-13 Consigned Goods Goods held for sale by one party although ownership of the goods is retained by another party. Determining Inventory Quantities SO 1 Describe the steps in determining inventory quantities. Determining Ownership of Goods

14. 6-14 $

15. 6-15 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 Inventory Costing SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Cost Flow Assumptions

16. 6-16 Illustration: Assume that Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of $700, $750, and $800. During the year Crivitz sold two sets at $1,200 each. These facts are summarized below. Inventory Costing Illustration 6-2 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

17. 6-17 “Specific Identification” Inventory Costing If Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 + $800), and its ending inventory is $750. Illustration 6-3 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

18. 6-18 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. Inventory Costing SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. “Specific Identification”

19. 6-19 Inventory Costing Illustration 6-11 Use of cost flow methods in major U.S. companies Cost Flow Assumption does not need to equal Physical Movement of Goods SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

20. 6-20 Illustration: Data for Houston Electronics’ Astro condensers. Inventory Cost Flow Assumptions Illustration 6-4 (Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

21. 6-21   Earliest goods purchased are first to be sold.   Often parallels actual physical flow of merchandise.   Generally good business practice to sell oldest units first. Inventory Cost Flow Assumptions SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. “First-In-First-Out (FIFO)”

22. 6-22 Inventory Cost Flow Assumptions Illustration 6-5 SO 2 “First-In-First-Out (FIFO)”

23. 6-23 Inventory Cost Flow Assumptions Illustration 6-5 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. “First-In-First-Out (FIFO)”

24. 6-24   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. Inventory Cost Flow Assumptions SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. “Last-In-First-Out (LIFO)”

25. 6-25 Illustration 6-7 Inventory Cost Flow Assumptions “Last-In-First-Out (LIFO)”

26. 6-26 Illustration 6-7 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Inventory Cost Flow Assumptions “Last-In-First-Out (LIFO)”

27. 6-27   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. Inventory Cost Flow Assumptions SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. “Average-Cost”

28. 6-28 Illustration 6-10 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Inventory Cost Flow Assumptions “Average-Cost”

29. 6-29 Illustration 6-10 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Inventory Cost Flow Assumptions “Average-Cost”

30. 6-30 FIFO Sales$9,000$9,000$9,000 Cost of goods sold6,2006,6007,000 Gross profit2,8002,4002,000 Admin. & selling expense330330330 Income before taxes2,4702,0701,670 Income tax expense140120110 Net income$2,330$1,950$1,560 Inventory balance$5,800$5,400$5,000 LIFOAverage Comparative Financial Statement Summary LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Financial Statement and Tax Effects

31. 6-31 FIFO Sales$9,000$9,000$9,000 Cost of goods sold6,2006,6007,000 Gross profit2,8002,4002,000 Admin. & selling expense330330330 Income before taxes2,4702,0701,670 Income tax expense140120110 Net income$2,330$1,950$1,560 Inventory balance$5,800$5,400$5,000 LIFOAverage In Period of Rising Prices, FIFO Reports: Highest Lowest LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Financial Statement and Tax Effects

32. 6-32 FIFO Sales$9,000$9,000$9,000 Cost of goods sold6,2006,6007,000 Gross profit2,8002,4002,000 Admin. & selling expense330330330 Income before taxes2,4702,0701,670 Income tax expense140120110 Net income$2,330$1,950$1,560 Inventory balance$5,800$5,400$5,000 LIFOAverage In Period of Rising Prices, LIFO Reports: Lowest Highest LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Financial Statement and Tax Effects

33. 6-33 The cost flow method that often parallels the actual physical flow of merchandise is the: a. a.FIFO method. b. b.LIFO method. c. c.average cost method. d. d.gross profit method. Review Question LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Inventory Cost Flow Assumptions

34. 6-34 In a period of inflation, the cost flow method that results in the lowest income taxes is the: a. a.FIFO method. b. b.LIFO method. c. c.average cost method. d. d.gross profit method. LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Inventory Cost Flow Assumptions Review Question

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36. 6-36 Using Cost Flow Methods Consistently Inventory Costing   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 statement and tax effects of each of the inventory cost flow assumptions.

37. 6-37 Lower-of-Cost-or-Market Inventory Costing SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories. 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.

38. 6-38 Inventory Costing SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories. Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. Lower-of-Cost-or-Market Illustration 6-15

39. 6-39 Analysis of Inventory Inventory management is a double-edged sword 1. 1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). 2. 2. Low Inventory Levels – may lead to stockouts and lost sales. SO 5 Compute and interpret the inventory turnover ratio.

40. 6-40 Analysis of Inventory SO 5 Compute and interpret the inventory turnover ratio. Inventory Turnover Ratio Illustration 6-16

41. 6-41 Illustration: Data available for Wal-Mart. Analysis of Inventory SO 5 Compute and interpret the inventory turnover ratio. Illustration 6-16

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43. 6-43 Analysis of Inventory Companies using LIFO are required to report the amount that inventory would increase (or occasionally decrease) if the company had instead been using FIFO. This amount is referred to as the LIFO reserve. Analysts’ Adjustments for LIFO Reserve SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies. Illustration 6-17

44. 6-44 Analysis of Inventory The LIFO reserve can have a significant effect on ratios analysts commonly use. SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies. Illustration 6-19 Analysts’ Adjustments for LIFO Reserve

45. 6-45 Illustration: SO 7 Apply the inventory cost flow methods to perpetual inventory records. Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. Illustration 6A-1 appendix 6A Perpetual Inventory System

46. 6-46 SO 7 Apply the inventory cost flow methods to perpetual inventory records. “First-In-First-Out (FIFO)” Cost of Goods Sold Ending Inventory Illustration 6A-2 appendix 6A Perpetual Inventory System

47. 6-47 SO 7 Apply the inventory cost flow methods to perpetual inventory records. “Last-In-First-Out (LIFO)” Cost of Goods Sold Ending Inventory Illustration 6A-3 appendix 6A Perpetual Inventory System

48. 6-48 SO 7 Apply the inventory cost flow methods to perpetual inventory records. “Average-Cost” Illustration 6A-4 Cost of Goods Sold Ending Inventory appendix 6A Perpetual Inventory System

49. 6-49 Inventory Errors SO 8 Indicate the effects of inventory errors on the financial statements. 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. appendix 6B Inventory Errors

50. 6-50 SO 8 Indicate the effects of inventory errors on the financial statements. Inventory errors affect the computation of cost of goods sold and net income. Income Statement Effects Illustration 6-B2 Illustration 6-B1 appendix 6B Inventory Errors

51. 6-51 SO 8 Indicate the effects of inventory errors on the financial statements. 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.   Ending inventory depends entirely on the accuracy of taking and costing the inventory. Income Statement Effects appendix 6B Inventory Errors

52. 6-52 SO 8 Indicate the effects of inventory errors on the financial statements. ($3,000) Net Income understated $3,000 Net Income overstated Combined income for 2-year period is correct. Illustration 6-B3 appendix 6B Inventory Errors

53. 6-53 Understating ending inventory will overstate: a. a.assets. b. b.cost of goods sold. c. c.net income. d. d.owner's equity. Review Question SO 8 Indicate the effects of inventory errors on the financial statements. appendix 6B Inventory Errors

54. 6-54 SO 8 Indicate the effects of inventory errors on the financial statements. Effect of inventory errors on the balance sheet is determined by using the basic accounting equation: Balance Sheet Effects Illustration 6-B1 Illustration 6-B4 appendix 6B Inventory Errors

55. 6-55 Key Points   The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.   The definitions for inventory are essentially similar under IFRS and GAAP. Both define inventory as assets held-for- sale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).

56. 6-56 Key Points   Who owns the goods — goods in transit or consigned goods — as well as the costs to include in inventory, are accounted for the same under IFRS and GAAP.   Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used.

57. 6-57 Key Points   A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS.   IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.

58. 6-58 Key Points   In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. In other words, net realizable value is the best estimate of the net amounts that inventories are expected to realize. GAAP, on the other hand, defines market as essentially replacement cost.

59. 6-59 Key Points   Under GAAP, if inventory is written down under the lower-of- cost-or-market valuation, the new value becomes its cost basis. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement as an expense. An item-by-item approach is generally followed under IFRS.

60. 6-60 Key Points   Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost.   Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.

61. 6-61 Looking into the Future One convergence issue relates to the use of the LIFO cost flow assumption. IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. With a new conceptual framework being developed, it is highly probable that the use of the concept of conservatism will be eliminated. Similarly, the concept of “ prudence ” in the IASB literature will also be eliminated. This may ultimately have implications for the application of the lower-of-cost-or-net realizable value.

62. 6-62 Which of the following should not be included in the inventory of a company using IFRS? a) a)Goods held on consignment from another company. b) b)Goods shipped on consignment to another company. c) c)Goods in transit from another company shipped FOB shipping point. d) d)None of the above.

63. 6-63 Which method of inventory costing is prohibited under IFRS? a) a)Specific identification. b) b)FIFO. c) c)LIFO. d) d)Average-cost.

64. 6-64 Specific identification: a) a)must be used under IFRS if the inventory items are not interchangeable. b) b)cannot be used under IFRS. c) c)cannot be used under GAAP. d) d)must be used under IFRS if it would result in the most conservative net income.

65. 6-65 “Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.” CopyrightCopyright