1. 6-1

2. 6-2 Chapter 6 Inventories Learning Objectives After studying this chapter, you should be able to: 1. 1.Describe the steps in determining inventory quantities. 2. 2.Explain the accounting for inventories and apply the inventory cost flow methods. 3. 3.Explain the financial effects of the inventory cost flow assumptions. 4. 4.Explain the lower-of-cost-or-market basis of accounting for inventories. 5. 5.Indicate the effects of inventory errors on the financial statements. 6. 6.Compute and interpret the inventory turnover ratio.

3. 6-3 Financial Accounting Eighth Edition Weygandt Kieso Kimmel Preview of Chapter 6

4. 6-4 One Classification:   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. Classifying Inventory

5. 6-5

6. 6-6 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. LO 1 Describe the steps in determining inventory quantities. Determining Inventory Quantities

7. 6-7 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 LO 1 Describe the steps in determining inventory quantities. Determining Inventory Quantities

8. 6-8

9. 6-9 Goods in Transit   Purchased goods not yet received.   Sold goods not yet delivered. Determining Ownership of Goods LO 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. Determining Inventory Quantities

10. 6-10 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 LO 1 Describe the steps in determining inventory quantities.

11. 6-11 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. Question LO 1 Describe the steps in determining inventory quantities. Determining Inventory Quantities

12. 6-12 Consigned Goods   Goods held for sale by one party.   Ownership of the goods is retained by another party. LO 1 Describe the steps in determining inventory quantities. Determining Inventory Quantities Determining Ownership of Goods

13. 6-13

14. 6-14 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 LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions Inventory Costing

15. 6-15 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. Illustration 6-2 Inventory Costing LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

16. 6-16 Specific Identification 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 Inventory Costing LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

17. 6-17 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 Specific Identification LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

18. 6-18 Illustration 6-11 Use of cost flow methods in major U.S. companies Cost Flow Assumptions do not need to match the physical movement of goods Inventory Costing LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

19. 6-19 Illustration: Data for Houston Electronics’ Astro condensers. Illustration 6-4 (Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold Inventory Costing LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods. Houston Electronics Astro Condensers

20. 6-20   Earliest goods purchased are first to be sold.   Often parallels actual physical flow of merchandise.   Generally good business practice to sell oldest units first. First-In-First-Out (FIFO) Inventory Costing LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

21. 6-21 Illustration 6-5 LO 2 First-In-First-Out (FIFO) Inventory Costing

22. 6-22 Illustration 6-5 Inventory Costing First-In-First-Out (FIFO) LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

23. 6-23   Latest goods purchased are first to be sold.   Seldom coincides with actual physical flow of merchandise.   Includes goods stored in piles, such as coal or hay. Inventory Costing Last-In-First-Out (LIFO) LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

24. 6-24 LO 2 Illustration 6-7 Inventory Costing Last-In-First-Out (LIFO)

25. 6-25 Illustration 6-7 Inventory Costing Last-In-First-Out (LIFO) LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

26. 6-26   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 Costing Average Cost LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

27. 6-27 Illustration 6-10 Inventory Costing Average Cost LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

28. 6-28 Illustration 6-10 Inventory Costing Average Cost LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

29. 6-29 LO 3 Explain the financial effects of the inventory cost flow assumptions. Financial Statement and Tax Effects Illustration 6-12 Inventory Costing

30. 6-30 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. Question Inventory Costing LO 3 Explain the financial effects of the inventory cost flow assumptions.

31. 6-31 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. Question Inventory Costing LO 3 Explain the financial effects of the inventory cost flow assumptions.

32. 6-32

33. 6-33 Using Cost Flow Methods Consistently   Method should be used consistently, enhances comparability.   Although consistency is preferred, a company may change its inventory costing method. Inventory Costing LO 3 Explain the financial effects of the inventory cost flow assumptions. Illustration 6-14 Disclosure of change in cost flow method

34. 6-34 Lower-of-Cost-or-Market LO 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. Inventory Costing

35. 6-35 Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. Illustration 6-15 Inventory Costing Lower-of-Cost-or-Market LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

36. 6-36 LO 5 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. Inventory Errors

37. 6-37 Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-17 Illustration 6-16 LO 5 Indicate the effects of inventory errors on the financial statements. Inventory Costing Income Statement Effects

38. 6-38 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. LO 5 Indicate the effects of inventory errors on the financial statements. Inventory Costing Income Statement Effects

39. 6-39 ($3,000) Net Income understated $3,000 Net Income overstated Combined income for 2- year period is correct. Illustration 6-18 LO 5 Indicate the effects of inventory errors on the financial statements. Inventory Costing

40. 6-40 Understating ending inventory will overstate: a. a.assets. b. b.cost of goods sold. c. c.net income. d. d.owner's equity. Question LO 5 Indicate the effects of inventory errors on the financial statements. Inventory Costing

41. 6-41 LO 5 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: Illustration 6-16 Illustration 6-19 Inventory Costing Balance Sheet Effects

42. 6-42 LCM Basis; Inventory Errors (a) Tracy Company sells three different types of home heating stoves (wood, gas, and pellet). The cost and market value of its inventory of stoves are as follows. Solution The total inventory value is the sum of these amounts, $430,000. LO 5 Indicate the effects of inventory errors on the financial statements.

43. 6-43 LCM Basis; Inventory Errors (b) Visual Company overstated its 2013 ending inventory by $22,000. Determine the impact this error has on ending inventory, cost of goods sold, and stockholders’ equity in 2013 and 2014. LO 5 Indicate the effects of inventory errors on the financial statements.

44. 6-44 Balance Sheet - Inventory classified as current asset. Income Statement - Cost of goods sold subtracted from sales. There also should be disclosure of 1) 1) major inventory classifications, 2) 2) basis of accounting (cost or LCM), and 3) 3) costing method (FIFO, LIFO, or average). Statement Presentation and Analysis Presentation LO 5 Indicate the effects of inventory errors on the financial statements.

45. 6-45 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. LO 6 Compute and interpret the inventory turnover ratio. Statement Presentation and Analysis Analysis

46. 6-46 Inventory turnover measures the number of times on average the inventory is sold during the period. Cost of Goods Sold Average Inventory Inventory Turnover = Days in inventory measures the average number of days inventory is held. Days in Year (365) Inventory Turnover Days in Inventory = LO 6 Compute and interpret the inventory turnover ratio. Statement Presentation and Analysis

47. 6-47 Illustration: Wal-Mart reported in its 2011 annual report a beginning inventory of $32,713 million, an ending inventory of $36,318 million, and cost of goods sold for the year ended January 31, 2011, of $315,287 million. The inventory turnover formula and computation for Wal-Mart are shown below. LO 6 Compute and interpret the inventory turnover ratio. Illustration 6-21 Days in Inventory: Inventory turnover of 9.13 times divided into 365 is approximately 40 days. This is the approximate time that it takes a company to sell the inventory. Statement Presentation and Analysis

48. 6-48

49. 6-49 LO 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 SYSTEMS

50. 6-50 LO 7 First-In-First-Out (FIFO) Cost of Goods Sold Ending Inventory Illustration 6A-2 APPENDIX 6A PERPETUAL INVENTORY SYSTEMS

51. 6-51 Last-In-First-Out (LIFO) Cost of Goods Sold Ending Inventory Illustration 6A-3 LO 7 APPENDIX 6A PERPETUAL INVENTORY SYSTEMS

52. 6-52 LO 7 Apply the inventory cost flow methods to perpetual inventory records. Illustration 6A-4 Cost of Goods Sold Ending Inventory APPENDIX 6A PERPETUAL INVENTORY SYSTEMS Average Cost

53. 6-53 Estimates the cost of ending inventory by applying a gross profit rate to net sales. Gross Profit Method LO 8 Describe the two methods of estimating inventories. Illustration 6B-1 APPENDIX 6B ESTIMATING INVENTORIES

54. 6-54 Illustration: Kishwaukee Company’s records for January show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. The company expects to earn a 30% gross profit rate. Compute the estimated cost of the ending inventory at January 31 under the gross profit method. LO 8 Illustration 6B-2 APPENDIX 6B ESTIMATING INVENTORIES

55. 6-55 Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost. LO 8 Describe the two methods of estimating inventories. Illustration 6B-3 Retail Inventory Method APPENDIX 6B ESTIMATING INVENTORIES

56. 6-56 LO 8 Describe the two methods of estimating inventories. Note that it is not necessary to take a physical inventory to estimate the cost of goods on hand at any given time. Illustration 6B-4 Illustration: APPENDIX 6B ESTIMATING INVENTORIES

57. 6-57   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).   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. Key Points

58. 6-58   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.   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. Key Points

59. 6-59   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.   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. Key Points

60. 6-60   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. Key Points

61. 6-61   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. Key Points

62. 6-62 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. Looking to the Future

63. 6-63 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. IFRS Self-Test Questions

64. 6-64 Which method of inventory costing is prohibited under IFRS? a) a)Specific identification. b) b)FIFO. c) c)LIFO. d) d)Average-cost. IFRS Self-Test Questions

65. 6-65 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. IFRS Self-Test Questions

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