Financial Accounting, Fifth Edition Reporting and Analyzing Inventory Financial Accounting, Fifth Edition

Study Objectives Describe the steps in determining inventory quantities. Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Explain the lower-of-cost-or-market basis of accounting for inventories. Compute and interpret the inventory turnover ratio. Describe the LIFO reserve and explain its importance for comparing results of different companies. Apply the inventory cost flow methods to perpetual inventory records. Indicate the effects of inventory errors on the financial statements. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

The Classified Balance Sheet Illustration 2-2

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

Determining Inventory Quantities Physical Inventory taken for two reasons: Perpetual System Check accuracy of inventory records. Determine amount of inventory lost. Periodic System Determine the inventory on hand. Determine the cost of goods sold for the period. SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities Taking a Physical Inventory when the business is closed or when business is slow. at end of the accounting period. SO 1 Describe the steps in determining inventory quantities.

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

Determining Inventory Quantities Terms of Sale Illustration 6-1 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. SO 1 Describe the steps in determining inventory quantities.

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

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

Specific Identification Method Inventory Costing Specific Identification Method An actual physical flow costing method. Practice is relatively rare. Most companies make assumptions (Cost Flow Assumptions) about which units were sold. SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

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

Inventory Costing – Cost Flow Assumptions Illustration: Data for Houston Electronics’ Astro condensers. 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.

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

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

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

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

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

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

Inventory Costing – Cost Flow Assumptions Comparative Financial Statement Summary FIFO Average LIFO Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions In Period of Rising Prices, FIFO Reports: FIFO Average LIFO Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 Lowest Highest LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions In Period of Rising Prices, LIFO Reports: FIFO Average LIFO Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 Highest Lowest LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions Review Question The cost flow method that often parallels the actual physical flow of merchandise is the: FIFO method. LIFO method. average cost method. gross profit method. Answer = A LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions Review Question In a period of inflation, the cost flow method that results in the lowest income taxes is the: FIFO method. LIFO method. average cost method. gross profit method. Answer = B LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

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

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

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

Analysis of Inventory Inventory turnover measures the number of times on average the inventory is sold during the period. Cost of Goods Sold Inventory Turnover = Average Inventory Days in inventory measures the average number of days inventory is held. Days in Year (365) Days in Inventory = Inventory Turnover SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory Illustration: The following data are available for Wal-Mart. Inventory Turnover 2007 = = Days in inventory 2007 = = SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory Illustration: The following data are available for Wal-Mart. Inventory Turnover 2006 $237,649 = 7.7 times = (31,910 + 29,419) / 2 Days in inventory 2006 365 Days = 47.4 Days = 7.7 SO 5 Compute and interpret the inventory turnover ratio.

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

Cost Flow Methods in Perpetual Systems “First-In-First-Out (FIFO)” Illustration 6A-2 Cost of Goods Sold Solution on notes page Ending Inventory SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Cost Flow Methods in Perpetual Systems “Last-In-First-Out (LIFO)” Illustration 6A-3 Cost of Goods Sold Solution on notes page Ending Inventory SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Cost Flow Methods in Perpetual Systems “Average Cost” (Moving-Average System) Illustration 6A-4 Cost of Goods Sold Ending Inventory Solution on notes page SO 7 Apply the inventory cost flow methods to perpetual inventory records.

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