1. Copyright © by Houghton Mifflin Company. All rights reserved.1 Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College

2. Copyright © by Houghton Mifflin Company. All rights reserved.2 Chapter 8 Inventories

3. Copyright © by Houghton Mifflin Company. All rights reserved.3 LEARNING OBJECTIVES 1.Identify and explain the management issues associated with accounting for inventories. inventory cost 2.Define inventory cost and relate it to goods flow and cost flow. 3.Calculate the pricing of inventory, using the cost basis under the periodic inventory system, according to the specific identification method; average-cost method; first-in, first-out (FIFO) method; and last-in, first-out (LIFO) method.

4. Copyright © by Houghton Mifflin Company. All rights reserved.4 4.Apply the perpetual inventory system to the pricing of inventories at cost. 5.State the effects of inventory methods and misstatements of inventory on income determination, income taxes and cash flows. 6.Apply the lower-of-cost-or-market (LCM) rule to inventory valuation. LEARNING OBJECTIVES (continued)

5. Copyright © by Houghton Mifflin Company. All rights reserved.5 7.Estimate the cost of ending inventory using the retail inventory method and gross profit method. SUPPLEMENTAL OBJECTIVE SUPPLEMENTAL OBJECTIVE

6. Copyright © by Houghton Mifflin Company. All rights reserved.6 OBJECTIVE 1 Identify and explain the management issues associated with accounting for inventories. Management Issues Associated with Accounting for Inventories

7. Copyright © by Houghton Mifflin Company. All rights reserved.7 Accounting for Inventories u Inventory is considered a current asset because it will normally be sold within a year’s time or within a company’s operating cycle. u Merchandise Inventory u Merchandise Inventory consists of all goods owned and held for sale in the regular course of business. u Manufacturing entities maintain other types of inventories. 4 Raw Materials. 4 Work in Process. 4 Finished Goods.

8. Copyright © by Houghton Mifflin Company. All rights reserved.8 Applying the Matching Rule to Inventories u “A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.” AICPA u The objective is the proper determination of income through the matching of costs and revenues, not the most realistic inventory value. u The reason inventory accounting is so important to income measurement is linked to the way income is measured on the merchandising income statement.

9. Copyright © by Houghton Mifflin Company. All rights reserved.9 Applying the Matching Rule u Gross Margin = Net Sales - COGS. u COGS = COGAFS - Ending Inventory. u EI up COGS down Gross Margin up. u EI down COGS up Gross Margin down.

10. Copyright © by Houghton Mifflin Company. All rights reserved.10 u The amount assigned to ending inventory has a direct effect on net income. u In effect, the value assigned to the ending inventory determines what portion of COGAFS is assigned to COGS and what portion is assigned to the balance sheet as inventory to be carried over into the next accounting period. The Effect of Ending Inventory

11. Copyright © by Houghton Mifflin Company. All rights reserved.11 Management Choices in Accounting for Inventories

12. Copyright © by Houghton Mifflin Company. All rights reserved.12 Assessing the Impact of Inventory Decisions u Decisions regarding inventory usually result in different amounts of reported income, which affect: 4 External evaluation by investors and creditors. 4 Internal evaluation, e.g. Executive compensation. 4 Income taxes. u Management must balance: 4 The goal of proper income determination. 4 The goal of minimizing income taxes. 4 The effects on the company’s cash flows.

13. Copyright © by Houghton Mifflin Company. All rights reserved.13 Evaluating the Level of Inventory u The level of inventory has important economic consequences for a company. u Management wants a great variety and quantity on hand so that sales are maximized. 4 The costs of carrying inventory are usually substantial. 4 Maintaining low inventory levels may result in lost sales and unhappy customers. u Merchandising and manufacturing companies are attempting to reduce their levels of inventory by changing to a JIT environment.

14. Copyright © by Houghton Mifflin Company. All rights reserved.14 u Inventory turnover indicates the number of times a company’s average inventory is sold during an accounting period. Inventory Turnover IT = COGS Average Inventory IT = $23,374,000,000 ($5,947,000,000 + $6,031,000,000) / 2 IT = 3.9 times

15. Copyright © by Houghton Mifflin Company. All rights reserved.15 Inventory Turnover for Selected Industries

16. Copyright © by Houghton Mifflin Company. All rights reserved.16 u Average days’ inventory on hand (ADIOH) indicates the average number of days required to sell the inventory on hand. Average Days’ Inventory on Hand ADIOH = Number of Days in a Year IT ADIOH = 365 days 3.9 times ADIOH = 93.6 days

17. Copyright © by Houghton Mifflin Company. All rights reserved.17 Average Days’ Inventory on Hand for Selected Industries

18. Copyright © by Houghton Mifflin Company. All rights reserved.18Discussion Q. Q. What are some of the costs associated with carrying inventory? A. A. Insurance, property tax, and storage costs. There is also the possibility of additional spoilage and employee theft.

19. Copyright © by Houghton Mifflin Company. All rights reserved.19 OBJECTIVE 2 Define inventory cost and relate it to goods flow and cost flow. Pricing Inventory Under the Periodic Inventory System

20. Copyright © by Houghton Mifflin Company. All rights reserved.20 Inventory Cost u “The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset.” AICPA

21. Copyright © by Houghton Mifflin Company. All rights reserved.21 Inventory Cost u Inventory cost includes: 4 Invoice price less purchases discounts. 4 Freight or transportation in, including insurance in transit. 4 Applicable taxes and tariffs. u Inventory cost can also include: 4 Ordering costs. 4 Receiving costs. 4 Storing costs. u Since these costs are difficult to allocate, they are usually considered expenses of the accounting period instead of inventory costs.

22. Copyright © by Houghton Mifflin Company. All rights reserved.22 Merchandise in Transit u Merchandise inventory must be owned. u The status of merchandise in transit must be examined to determine if it should be included in the inventory count. u Inventory does not have to be in the physical possession of the buyer or seller. u Ownership of goods in transit is determined by the shipping agreement, which indicates whether title has passed.

23. Copyright © by Houghton Mifflin Company. All rights reserved.23 Merchandise in Transit (continued) u Outgoing goods (shipments): 4 Shipped FOB destination would be included in the seller’s merchandise inventory. 4 Shipped FOB shipping point would not be included. u Incoming goods (receipts): 4 Shipped FOB shipping point would be included in the buyer’s merchandise inventory. 4 Shipped FOB destination would not be included.

24. Copyright © by Houghton Mifflin Company. All rights reserved.24 Merchandise on Hand Not Included in Inventory u Merchandise sold but not yet shipped. u Goods held on consignment. 4 Title stays with the consignor until consignee sells the goods. 4 Must not be included in the physical inventory of the consignee.

25. Copyright © by Houghton Mifflin Company. All rights reserved.25 Merchandise in Transit

26. Copyright © by Houghton Mifflin Company. All rights reserved.26 u Prices of merchandise purchased vary throughout the year. u Identical products may be purchased at different prices. u It is often impossible to determine which products have been sold and which are still in inventory. u It is necessary to make an assumption about the order in which items have been sold.. u The assumption is about the flow of costs rather than the flow of physical inventory. Methods of Pricing Inventory At Cost

27. Copyright © by Houghton Mifflin Company. All rights reserved.27 Methods of Pricing Inventory at Cost (continued…) 1. Specific identification method. 2. Average-cost method. 3. First-in, first-out method. (FIFO) 4. Last-in, first-out method. (LIFO) u Accountants use one of four methods to price inventory.

28. Copyright © by Houghton Mifflin Company. All rights reserved.28 Inventory Pricing Methods u Specific Identification Method 4 Requires identifying cost of each item in ending inventory. 4 Difficult to keep track of individual items. 4 For identical items, results can be arbitrary. u Average Cost Method 4 Calculates average cost of goods available for sale during the period. 4 Levels out the effects of cost increases and decreases.

29. Copyright © by Houghton Mifflin Company. All rights reserved.29 Inventory Pricing Methods u FIFO Method 4 Assumes first items acquired are first items sold. 4 Costs of ending inventory are most recent purchase costs. 4 If prices are increasing, income is higher (and vice versa). 4 FIFO magnifies the effects of the business cycle on net income. u LIFO Method 4 Assumes last items acquired are first items sold. 4 Cost of goods sold is most recent purchase costs. 4 If prices are increasing, income is smaller (and vice versa). 4 LIFO smoothes out the effects of the business cycle on net income.

30. Copyright © by Houghton Mifflin Company. All rights reserved.30 LIFO effects: LIFO assumes income determination is more important than the physical movement of goods or the balance sheet valuation of ending inventory. Working capital can be distorted using LIFO.

31. Copyright © by Houghton Mifflin Company. All rights reserved.31 Inventory Data - June 30 June 1 Inventory 50 units @ $1.00 $ 50 6 Purchase 50 units @ $1.10 55 13 Purchase 150 units @ $1.20 180 20 Purchase 100 units @ $1.30 130 25 Purchase 150 units @ $1.40 210 GAFS 500 units $625 Sales 280 units On hand June 30 220 units Illustrative Data for the Four Methods

32. Copyright © by Houghton Mifflin Company. All rights reserved.32 OBJECTIVE 3 Calculate the pricing of inventory, using the cost basis under the periodic inventory system, according to the specific identification method; average-cost method; first-in, first-out (FIFO) method; and last-in, first-out (LIFO) method. Specific Identification Method

33. Copyright © by Houghton Mifflin Company. All rights reserved.33 Specific Identification Method for Pricing Ending Inventory Inventory Data - June 30 50 units @ $1.00 $ 50 100 units @ $1.20 120 70 units @ $1.40 98 220 units @ a cost of $268 COGAFS $625 Less June 30 inventory 268 COGS $357

34. Copyright © by Houghton Mifflin Company. All rights reserved.34 Average-Cost Method for Pricing Ending Inventory Ending Inventory: 220 units @ $1.25 = $275 COGAFS $625 Less June 30 inventory 275 COGS $350 Average Unit Cost = Cost of Goods Available for Sale Units Available for Sale $625 500 units == $1.25 Inventory Data – June 30

35. Copyright © by Houghton Mifflin Company. All rights reserved.35 First-In, First-Out (FIFO) Method for Pricing Ending Inventory Inventory Data - June 30 150 units @ $1.40 from June 25 purchase $210 70 units @ $1.30 from June 20 purchase 91 220 units @ a cost of $301 COGAFS $625 Less June 30 inventory 301 COGS $324

36. Copyright © by Houghton Mifflin Company. All rights reserved.36 Last-In, First-Out (LIFO) Method for Pricing Ending Inventory Inventory Data - June 30 50 units @ $1.00 from June 1 inventory $ 50 50 units @ $1.10 from June 6 purchase 55 120 units @ $1.20 from June 13 purchase 144 220 units @ a cost of $249 COGAFS $625 Less June 30 inventory 249 COGS $376

37. Copyright © by Houghton Mifflin Company. All rights reserved.37 Summary of Cost Flow Assumptions Impact on Income Statement and Balance Sheet Using Periodic Inventory System

38. Copyright © by Houghton Mifflin Company. All rights reserved.38Discussion Q. Q. Do the FIFO and LIFO inventory methods result in different quantities of ending inventory? A. A. The quantities of ending inventory are the same under FIFO and LIFO. These methods affect the pricing of the inventory, not the quantities.

39. Copyright © by Houghton Mifflin Company. All rights reserved.39 OBJECTIVE 4 Apply the perpetual inventory system to the pricing of inventories at cost. Pricing Inventory Under the Perpetual Inventory System

40. Copyright © by Houghton Mifflin Company. All rights reserved.40 Pricing Inventory Under the Perpetual Inventory System u The perpetual system records sales and purchase quantities and costs as they occur. u Accountants use one of three methods to price inventory. 1.Average-cost method. 2.FIFO method. 3.LIFO method. u Average costs and costs of last items purchased are affected.

41. Copyright © by Houghton Mifflin Company. All rights reserved.41 Inventory Data - June 30 June 1 Inventory 50 units @ $1.00 6 Purchase 50 units @ $1.10 10 Sale 70 units 13 Purchase 150 units @ $1.20 20 Purchase 100 units @ $1.30 25 Purchase 150 units @ $1.40 30 Sale 210 units 30 Inventory 220 units Illustrative Data for the Three Methods

42. Copyright © by Houghton Mifflin Company. All rights reserved.42 Specific Identification Method Under the Perpetual System u Pricing inventory and COGS is the same as under the periodic system. u The perpetual system facilitates the use of the specific identification method.

43. Copyright © by Houghton Mifflin Company. All rights reserved.43 Perpetual Inventory System: Average-Cost Method June 1 Inventory 50 units @ $1.00$ 50.00 6 Purchase 50 units @ $1.10 55.00 6 Balance 100 units @ $1.05$105.00 10 Sale 70 units @ $1.05 (73.50) 10 Balance 30 units @ $1.05$ 31.50 13 Purchase 150 units @ $1.20 180.00 20 Purchase 100 units @ $1.30 130.00 25 Purchase 150 units @ $1.40 210.00 25 Balance 430 units @ $1.28*$551.50 30 Sale 210 units @ $1.28*(268.80) 30 Inventory 220 units @ $1.29*$282.70 COGS ($73.50 + $268.80)$342.30 * Rounded

44. Copyright © by Houghton Mifflin Company. All rights reserved.44 Perpetual Inventory System: FIFO Method June 1 Inventory 50units @$1.00 $50.00 6 Purchase 50units @$1.10 55.00 10 Sale 50units @$1.00 ($50.00) 20units @$1.10 (22.00) (72.00) 10 Balance 30units @$1.10 $33.00 13 Purchase150units @$1.20 180.00 20 Purchase100units @$1.30 130.00 25 Purchase150units @$1.40 210.00 30 Sale 30units @$1.10 ($33.00) 150units @$1.20 (180.00) 30units @$1.30 (39.00) (252.00) 30 Inventory 70units @$1.30 $ 91.00 150units @$1.40 210.00 $301.00 COGS ($72.00 + $252.00) $324.00

45. Copyright © by Houghton Mifflin Company. All rights reserved.45 Perpetual Inventory System: LIFO Method June 1 Inventory 50units@$1.00$50.00 6 Purchase 50units@$1.10 55.00 10 Sale 50units@$1.10($55.00) 20units@$1.00 (20.00) (75.00) 10 Balance 30units@$1.00 $ 30.00 13 Purchase150units@$1.20 180.00 20 Purchase100units@$1.30 130.00 25 Purchase150units@$1.40 210.00 30 Sale150units@$1.40 ($210.00) 60units@$1.30 (78.00) (288.00) 30 Inventory 30units@$1.00$ 30.00 150units@$1.20 180.00 40units@$1.30 52.00 $262.00 COGS ($75.00 + $288.00) $363.00

46. Copyright © by Houghton Mifflin Company. All rights reserved.46Discussion Q. Q. Why do you think it is more expensive to maintain a perpetual inventory system? A. A. A perpetual inventory system is more expensive to maintain because detailed records must be kept as transactions occur. Also, businesses may need to purchase special equipment to assist in their perpetual recordkeeping efforts.

47. Copyright © by Houghton Mifflin Company. All rights reserved.47 Summary of Cash Flow Assumptions Impact on Income Statement and Balance Sheet Using Perpetual Inventory System

48. Copyright © by Houghton Mifflin Company. All rights reserved.48 OBJECTIVE 5 State the effects of inventory methods and misstatements of inventory on income determination, income taxes and cash flows. Comparison and Impact of Inventory Decisions and Misstatements

49. Copyright © by Houghton Mifflin Company. All rights reserved.49 Effects of Inventory Systems and Methods u Periodic inventory system. Gross margin by method: 4 Average-Cost $150 4 FIFO$176 4 LIFO$124 u Perpetual inventory system. Gross margin by method: 4 Average-Cost $158 4 FIFO$176 4 LIFO$137

50. Copyright © by Houghton Mifflin Company. All rights reserved.50 Effects on the Financial Statements u Each of the four methods of inventory pricing is acceptable for use in published financial statements. u Choose one over the other after considering: 4 The trend of prices. 4 The effects on the financial statements. 4 Income taxes and management decisions.

51. Copyright © by Houghton Mifflin Company. All rights reserved.51 LIFO u Is best for the income statement because it matches revenues with cost of goods sold. u Is not the best measure of value of inventory for balance sheet purposes.

52. Copyright © by Houghton Mifflin Company. All rights reserved.52 u Is better for the balance sheet because inventory is closest to current values. u Does not provide as good a matching of current costs and revenues for income statement purposes. FIFO

53. Copyright © by Houghton Mifflin Company. All rights reserved.53 Effects on Income Taxes u A business must be consistent in its use of a method once having made a choice. 4 May change if there is a good reason. u Using the FIFO and average-cost methods in periods of rising prices may cause a business to report more than its true profit and pay more income taxes. u A business wants to avoid paying income taxes on inventory profits.

54. Copyright © by Houghton Mifflin Company. All rights reserved.54 Effects on Income Taxes (continued) u A business that uses LIFO over a period of rising prices may find that for balance sheet purposes, its inventory is valued at a cost far below what it currently pays for the same items. u Management must monitor this situation carefully because if it lets the inventory quantity at year end fall below the beginning-of-the-year level, the company will pay higher income taxes.

55. Copyright © by Houghton Mifflin Company. All rights reserved.55 Inventory Costing Methods Used by 600 Large Companies

56. Copyright © by Houghton Mifflin Company. All rights reserved.56 Income Tax Issues u If a company uses LIFO for tax purposes, the IRS requires the same method for financial reporting. u IRS will not allow lower-of-cost-or- market inventory valuation if LIFO is used. u If inventory at year end is less than at the beginning, LIFO liquidation results in higher income taxes.

57. Copyright © by Houghton Mifflin Company. All rights reserved.57 Effects of Misstatements in Inventory Measurement u Ending inventory correctly stated at $10,000. 4 EI$10,000 4 COGS$60,000 4 NI$ 8,000 u Ending inventory overstated by $6,000. 4 EI$16,000 4 COGS$54,000 4 NI$14,000 (overstated by $6,000) u Ending inventory understated by $6,000. 4 EI$ 4,000 4 COGS$ 66,000 4 NI$ 2,000 (understated by $6,000)

58. Copyright © by Houghton Mifflin Company. All rights reserved.58 Year 1 Year 2 Year 1 Year 2 Ending inventory overstated Beginning inventory overstated COGS understated COGS overstated Income overstated Income understated Ending inventory understated Beginning inventory understated COGS overstated COGS understated Income understated Income overstated Summary of the Effects of Misstatements in Inventory Measurement

59. Copyright © by Houghton Mifflin Company. All rights reserved.59 Inventory Measurement and Cash Flows u Inventory methods affect 4 Reported profitability 4 Reported liquidity and cash flows

60. Copyright © by Houghton Mifflin Company. All rights reserved.60Discussion Q. Q. If merchandise inventory is mistakenly overstated at the end of 20x1, what is the effect on the: (a) 20x1 net income, (b) 20x1 year-end balance sheet value, (c) 20x2 net income, and (d) 20x2 year-end balance sheet value?

61. Copyright © by Houghton Mifflin Company. All rights reserved.61 A. If the merchandise inventory is overstated at the end of 20x1, (a) the 20x1 net income will be overstated, (b) the 20x1 year-end balance sheet value will also be overstated, (c) the 20x2 net income will be understated, and (d) there will be no effect on the 20x2 year-end balance sheet value.

62. Copyright © by Houghton Mifflin Company. All rights reserved.62 OBJECTIVE 6 Apply the lower-of-cost-or-market (LCM) rule to inventory valuation. Valuing Inventory at the Lower of Cost or Market (LCM)

63. Copyright © by Houghton Mifflin Company. All rights reserved.63 Lower of Cost or Market (LCM) u Cost is usually the most appropriate basis for valuation of inventory. u In cases of inventory obsolescence, physical deterioration, or decline in price level a loss has occurred. u This loss may be recognized by writing the inventory down to market, or current replacement cost. u An example of conservatism. u Inventory write-down can be done by two methods. 4 Item-by-item method. 4 Major category method.

64. Copyright © by Houghton Mifflin Company. All rights reserved.64Discussion Q. Q. In the phrase lower of cost or market, what is meant by the word market? A. A. The word market in the phrase lower of cost or market refers to current replacement cost.

65. Copyright © by Houghton Mifflin Company. All rights reserved.65 SUPPLEMENTAL OBJECTIVE 7 Estimate the cost of ending inventory using the retail inventory method and gross profit method. Valuing Inventory by Estimation

66. Copyright © by Houghton Mifflin Company. All rights reserved.66 Retail Method of Inventory Estimation u Estimates the cost of ending inventory by using the ratio of cost to retail price. u Values inventory at selling price, usually taken from each item’s price tag. at retail u Defines at retail as the amount of the inventory at the marked selling prices of the inventory items. u Requires the following information: 4 The beginning inventory at cost and at retail. 4 The amount of goods purchased during the period at cost and at retail. u Estimated Ending Inventory at Retail = (Beg. Inv. + Purchases) at Retail – Sales During Period.

67. Copyright © by Houghton Mifflin Company. All rights reserved.67 Gross Profit Method of Inventory Estimation u Assumes that the ratio of gross margin for a business stays relatively stable, year to year. u Is used in place of the retail method when records of the retail prices of beginning inventory and purchases are not kept. u Is acceptable for interim reporting. u Is not acceptable for annual financial statements. u Is used to estimate value of inventory lost in cases of fire, theft, or other hazards. u Estimated Ending Inventory at Cost = Cost of Goods Available for Sale – (Sales – Estimated Gross Margin).

68. Copyright © by Houghton Mifflin Company. All rights reserved.68 Discussion Q. Q. Why is Freight In not placed under the Retail column when using the retail method of inventory valuation? A. A. Businesses automatically price their goods high enough to cover freight charges.

69. Copyright © by Houghton Mifflin Company. All rights reserved.69 1.Identify and explain the management issues associated with accounting for inventories. inventory cost 2.Define inventory cost and relate it to goods flow and cost flow. 3.Calculate the pricing of inventory, using the cost basis under the periodic inventory system, according to the specific identification method; average-cost method; first-in, first-out (FIFO) method; and last-in, first-out (LIFO) method. OK, LET’S REVIEW OK, LET’S REVIEW...

70. Copyright © by Houghton Mifflin Company. All rights reserved.70 4.Apply the perpetual inventory system to the pricing of inventories at cost. 5.State the effects of inventory methods and misstatements of inventory on income determination, income taxes, and cash flows. 6.Apply the lower-of-cost-or-market (LCM) rule to inventory valuation. 7.Estimate the cost of ending inventory using the retail inventory method and gross profit method. WE ALSO COVERED...