prepared by coby harmon university of california, santa...

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Prepared byCoby Harmon

University of California, Santa BarbaraWestmont College

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6Learning Objectives

After studying this chapter, you should be able to:

[1] Determine how to classify inventory and inventory quantities.

[2] Explain the accounting for inventories and apply the inventory cost flow methods.

[3] Explain the financial effects of the inventory cost flow assumptions.

[4] Explain the lower-of-cost-or-market basis of accounting for inventories.

[5] Indicate the effects of inventory errors on the financial statements.

[6] Compute and interpret the inventory turnover.

Inventories

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Preview of Chapter 6

Accounting PrinciplesEleventh Edition

Weygandt Kimmel Kieso

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One Classification:

Inventory

Three Classifications:

Raw Materials

Work in Process

Finished Goods

Merchandising Company

Manufacturing Company

Classifying Inventory

Helpful Hint Regardless of theclassification, companies reportall inventories under CurrentAssets on the balance sheet.

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(See page 324)

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Physical Inventory taken for two reasons:

Perpetual System

1. Check accuracy of inventory records.

2. Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.

Periodic System

1. Determine the inventory on hand.

2. Determine the cost of goods sold for the period.

LO 1 Determine how to classify inventory and inventory quantities.

Determining Inventory Quantities

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Involves counting, weighing, or measuring each kind of inventory on hand.

Taken,

when the business is closed or business is slow.

at the end of the accounting period.

Taking a Physical Inventory



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Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.

Determining Ownership of Goods

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.



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Illustration 6-2 Terms of sale


Goods in Transit

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.


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Goods in transit should be included in the inventory of the buyer when the:

a. public carrier accepts the goods from the seller.

b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.


Review Question


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Consigned Goods

To hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods.

Many car, boat, and antique dealers sell goods on consignment, why?


Determining Ownership of Goods


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1. Goods of $15,000 held on consignment should be deducted from the inventory count.

2. The goods of $10,000 purchased FOB shipping point should be added to the inventory count.

3. Item 3 was treated correctly.

Hasbeen Company completed its inventory count. It arrived at a total inventory value of $200,000. You have been given the information listed below. Discuss how this information affects the reported cost of inventory.1. Hasbeen included in the inventory goods held on consignment for Falls Co.,

costing $15,000.2. The company did not include in the count purchased goods of $10,000, which

were in transit (terms: FOB shipping point).3. The company did not include in the count inventory that had been sold with a

cost of $12,000, which was in transit (terms: FOB shipping point).

Solution

Inventory should be $195,000($200,000 - $15,000 + $10,000).

LO 1

DO IT!>

6-146-14LO 1 Determine how to classify

inventory and inventory quantities.Advance slide in presentation

mode to reveal answer.

6-156-15 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory is accounted for at cost.

Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale.

Unit costs are applied to quantities to determine the total cost of the inventory and the cost of goods sold using the following costing methods:

► Specific identification

► First-in, first-out (FIFO)

► Last-in, first-out (LIFO)

► Average-cost

Cost Flow Assumptions

Inventory Costing

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Illustration: 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 6-3

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing

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Specific IdentificationIf 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 6-4


Inventory Costing

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Specific IdentificationActual 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

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Illustration 6-12Use of cost flow methods in

major U.S. companies

Cost Flow Assumption

does not need to be consistent with the

physical movement of goods


Inventory Costing

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Illustration: Data for Houston Electronics’ Astro condensers.

Illustration 6-5

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold



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Costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold.

Often parallels actual physical flow of merchandise.

Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.

First-In, First-Out (FIFO)



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COST OF GOODS AVAILABLE FOR SALE

Illustration 6-6

LO 2


STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD


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Illustration 6-6

Helpful Hint Another way ofthinking about the calculationof FIFO ending inventory is theLISH assumption—last in still here.




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Costs of the latest goods purchased are the first to be recognized in determining cost of goods sold.

Seldom coincides with actual physical flow of merchandise.

Exceptions include goods stored in piles, such as coal or hay.



Last-In, First-Out (LIFO)

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Illustration 6-8

LO 2





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Illustration 6-8

Helpful Hint Another way ofthinking about the calculationof LIFO ending inventory is theFISH assumption—first in still here.




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Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred.

Applies weighted-average unit cost to the units on hand to determine cost of the ending inventory.

Average-Cost



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Illustration 6-11



Average-Cost



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Illustration 6-11



Average-Cost

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Comparative effects of cost flow methods

LO 3 Explain the financial effects of inventory cost flow assumptions.

Illustration 6-13

HOUSTON ELECTRONICSCondensed Income Statements

Financial Statement and Tax Effects

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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

Illustration 6-15Disclosure of change in cost flow method

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The cost flow method that often parallels the actual physical flow of merchandise is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

Review Question



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In a period of inflation, the cost flow method that results in the lowest income taxes is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

Review Question

Helpful Hint A tax rule,often referred to as the LIFOconformity rule, requires thatif companies use LIFO for taxpurposes, they must also use itfor financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.



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(See page 324)

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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 “write down” the inventory to its market value in the period in which the price decline occurs.

Market value = Replacement Cost

Example of conservatism. International Note UnderU.S. GAAP, companies cannotreverse inventory write-downsif inventory increases invalue in subsequent periods.IFRS permits companies toreverse write-downs in somecircumstances.

Inventory Costing

6-366-36 LO 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 6-16

Inventory Costing

6-376-37 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

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Inventory errors affect the computation of cost of goods sold and net income.

Illustration 6-18

Illustration 6-17

LO 5 Indicate the effects of inventory errors on the financial statements.

Income Statement Effects

Inventory Errors

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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

Inventory Errors

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Incorrect Correct Incorrect Correct

Sales 80,000$ 80,000$ 90,000$ 90,000$ Beginning inventory 20,000 20,000 12,000 15,000 Cost of goods purchased 40,000 40,000 68,000 68,000 Cost of goods available 60,000 60,000 80,000 83,000 Ending inventory 12,000 15,000 23,000 23,000 Cost of good sold 48,000 45,000 57,000 60,000 Gross profit 32,000 35,000 33,000 30,000 Operating expenses 10,000 10,000 20,000 20,000 Net income 22,000$ 25,000$ 13,000$ 10,000$

2013 2014

($3,000)Net Income understated

$3,000Net Income overstated

Combined income for 2-year period is correct.

Illustration 6-19


Inventory Errors

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Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.

Question


Inventory Errors

6-426-42 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 6-17

Illustration 6-20

Balance Sheet Effects

Inventory Errors

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Balance Sheet - Inventory classified as current asset.

Income Statement - Cost of goods sold subtracted from sales.

There also should be disclosure of

1) major inventory classifications,

2) basis of accounting (cost or LCM), and

3) costing method (FIFO, LIFO, or average).

Statement Presentation and Analysis

Presentation

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Inventory management is a double-edged sword

1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage).

2. Low Inventory Levels – may lead to stockouts and lost sales.

LO 6 Compute and interpret the inventory turnover.


Analysis

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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 =



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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.


Illustration 6-22

Days in Inventory: Inventory turnover of 9.1 times divided into 365 is approximately 40.1 days. This is the approximate time that it takes a company to sell the inventory.


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Illustration:

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 Cost Flow MethodsPerpetual Inventory System

HOUSTON ELECTRONICSAstro Condensers

6-496-49 LO 7 Apply the inventory cost flow methods to perpetual inventory records.


Cost of Goods Sold Ending Inventory

Illustration 6A-2




Cost of Goods Sold Ending Inventory

Illustration 6A-3



Average-CostIllustration 6A-4

Cost of Goods Sold

Ending Inventory


6-526-52 LO 8 Describe the two methods of estimating inventories.

A method of estimating the cost of ending inventory by applying a gross profit rate to net sales. A company needs to know

► its net sales, cost of goods available for sale, and gross profit rate.

Illustration 6B-1

APPENDIX 6B Estimating Inventories

Gross Profit Method

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Illustration 6B-1


Illustration: Kishwaukee Company records show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. In the preceding year, the company realized a 30% gross profit rate. It expects to earn the same rate this year. Compute the estimated cost of the ending inventory at January 31 under the gross profit method.

Illustration 6B-2

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► Retail companies establish a relationship between cost and sales price.

► Company applies cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost.

Illustration 6B-3


Retail Inventory Method

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Illustration 6B-1


Illustration: Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time.

Illustration 6B-4

The major disadvantage of the retail method is that it is an averaging technique. It may produce an incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale.

LO 8

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Key Points

A Look at IFRS

LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.

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).

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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.

Key Points

A Look at IFRS


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Key Points

A Look at IFRS


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.

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Key Points

A Look at IFRS


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. GAAP, on the other hand, defines market as essentially replacement cost.

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Key Points

A Look at IFRS


Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. 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.

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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.

IFRS allows companies to report inventory at standard cost if it does not differ significantly from actual cost. Standard cost is addressed in managerial accounting courses.

Key Points

A Look at IFRS


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Looking to the Future

A Look at IFRS


One convergence issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income.

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Which of the following should not be included in the inventory of a company using IFRS?

a) Goods held on consignment from another company.

b) Goods shipped on consignment to another company.

c) Goods in transit from another company shipped FOB shipping point.

d) None of the above.

IFRS Self-Test Questions

A Look at IFRS


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A Look at IFRS


Which method of inventory costing is prohibited under IFRS?

a) Specific identification.

b) FIFO.

c) LIFO.

d) Average-cost.

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A Look at IFRS


Specific identification:

a) must be used under IFRS if the inventory items are not interchangeable.

b) cannot be used under IFRS.

c) cannot be used under GAAP.

d) must be used under IFRS if it would result in the most conservative net income.

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prepared by coby harmon university of california, santa...

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