Chapter 5  Inventories

Chapter Inventory Quantities - Merchandiser Consists of many different itemsConsists of many different items Owned by the companyOwned by the company In a form ready for sale to customersIn a form ready for sale to customers One inventory classification: merchandise inventoryOne inventory classification: merchandise inventory

Chapter Inventory Quantities - Manufacturer Some inventory not ready for saleSome inventory not ready for sale Classify inventory into three categoriesClassify inventory into three categories –Finished goods –Work in process –Raw materials

Chapter Finished Goods Inventory Manufactured items that are complete and ready for sale.

Chapter Work in Process Manufactured inventory that has been placed into production but is not yet complete.

Chapter Raw Materials The basic goods that will be used in production, but have not been placed in production.

Chapter Inventory Accounting Systems Perpetual systems maintain a running record to show the inventory on hand at all times. Perpetual systems maintain a running record to show the inventory on hand at all times. Periodic systems do not keep a continuous record of inventory on hand. Periodic systems do not keep a continuous record of inventory on hand.

Chapter Perpetual System Debit Inventory Credit Cash or Accounts Payable Debit Inventory Credit Cash or Accounts Payable Debit Cash or Accounts Receivable Credit Sales Revenue Debit Cash or Accounts Receivable Credit Sales Revenue Debit Cost of Goods Sold Credit Inventory Debit Cost of Goods Sold Credit Inventory

Chapter Cost of Goods Sold Beginning Inventory $100,000 + Net Purchases $560,000 = Cost of Goods Available for Sale $660,000 – Ending Inventory $120,000 = Cost of Goods Sold $540,000

Chapter Gross Profit Sales revenues – Cost of goods sold = Gross margin (before operating expenses) Sales revenues – Cost of goods sold = Gross margin (before operating expenses) Gross margin – Operating expenses = Net income Gross margin – Operating expenses = Net income

Chapter Why inventories are so important?

Chapter % of current assets

Chapter Composition of Inventories Quantity taking a physical count of inventories determining the ownership of goods. INVENTORY = Unit cost * Quantity Unit Cost Cost Flow Assumptions

Chapter Physical Inventory Involves counting, weighing, or measuring each kind of inventory on handInvolves counting, weighing, or measuring each kind of inventory on hand

Chapter Taking Physical Count During the physical count, a company should pay very close attention to the following issues in order to have an effective internal control and also to minimize the errors and fraud: 1.the employees who are responsible from safekeeping of inventory items should not count them, 2.it has to be made sure that the items are complete and what they are supposed to be, 3.items should be re-counted by another independent employee for verification, 4.counting process should be documented by tagging the inventory items, 5.a supervisor should oversee that each item has only one tag, and that each item is counted, and 6.there should be no inventory movements during the count

Chapter Determine Ownership Do all the goods included in the count belong to the company?Do all the goods included in the count belong to the company? Does the company own any goods that were not included in the count?Does the company own any goods that were not included in the count?

Chapter Whose ? Determination of the owner of goods: Consignment goods –consignor (owner of the merchandise) and the consignee (the holder of the goods) Goods in transit are goods that are on the way to the company (purchases) or goods that are on a carrier being shipped to the customer

Chapter Goods in Transit Goods are shipped on board trucks, trains, ships, and airplanesGoods are shipped on board trucks, trains, ships, and airplanes To arrive at an accurate count, ownership of goods in transit must be determinedTo arrive at an accurate count, ownership of goods in transit must be determined Goods in transit should be included in the inventory of the company that has legal title to the goodsGoods in transit should be included in the inventory of the company that has legal title to the goods

Chapter Goods in Transit FOB (free on board) shipping point Ownership passes to buyer when public carrier accepts goods from seller

Chapter Goods in Transit FOB (free on board) destination Ownership remains with seller until the goods reach the buyer

Chapter Consigned Goods In some lines of business, it is customary to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownershipIn some lines of business, it is customary to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership

Chapter Inventory Costs Beginning Inventory + Purchases - Ending Inventory = COGS Available for Sale

Chapter Computing the Cost of Inventory Cost of inventory on hand = Quantity × unit cost Physical count is made at least once a year, even with a perpetual system. Consigned goods are excluded.

Chapter Inventory Cost Flows Specific Identification Method First-in First-out Weighted Average Last-in First-out – not allowed by IFRS or CMB

Chapter Specific Identification Method Works best with limited variety of high-unit itemsWorks best with limited variety of high-unit items particular units were sold and which are still in ending inventory)used when the actual cost of the item is tracked (which particular units were sold and which are still in ending inventory) closely follows the actual flow of goods whether a company uses a periodic or perpetual inventory system does not make any difference on cost of goods sold or the amount of inventory

Chapter Specific Identification MethodDate1/1 4/15 8/24Explanation Unit s Unit Cost Total Cost Beg. Inventory Purchase Purchase Purchase $20$20$20$20 $21 $22 $23$23$23$23 $20$20$20$20 $42 $66 $23 $151 Dec. 31 physical inventory shows 4 in ending inventory, so how many were sold?

Chapter Cost Flow Methods When there is sales of thousand units of identical products, the identity of the goods purchased at a specific cost is lost and management may choose a cost flow method such as FIFO, WA instead of Specific Identification Method.When there is sales of thousand units of identical products, the identity of the goods purchased at a specific cost is lost and management may choose a cost flow method such as FIFO, WA instead of Specific Identification Method.

Chapter Cost Flow vs. Physical Flow First-in First-out (FIFO), and weighted average methods assume that flow of costs may be unrelated to physical flow of goods The accounting regulations do not require that the physical flow of goods and the related cost flow to be the same

Chapter Example-Cost Flow

Chapter First-in First-out Method FIFO FIFO method assumes that the goods purchased earlier will be sold first The cost of the first units on hand is assigned to the units sold first Under FIFO, take the unit cost of most recent purchase and work backward until all units have been costedUnder FIFO, take the unit cost of most recent purchase and work backward until all units have been costed

Chapter Start with most recent prices and work backward!

Chapter FIFO

Chapter Weighted Average Goods available are homogeneous and the cost to be assigned to each unit sold is the same Assumes goods are similar in natureAssumes goods are similar in nature

Chapter Weighted Average-Perpetual

Chapter Summary Perpetual Inventory System

Chapter Summary In periods of increasing pricesIn periods of increasing prices –FIFO reports the highest net income –LIFO the lowest –average cost falls in the middle. In periods of decreasing pricesIn periods of decreasing prices – FIFO will report the lowest net income –LIFO the highest –average cost in the middle.

Chapter Let’s Review Which of the following should be included in the physical inventory of XYZ Co.? a. Goods in transit from a supplier shipped FOB destination b. Goods in transit to a buyer shipped FOB shipping point c. Goods on consignment from another company d. Goods on consignment to another company

Chapter Let’s Review Which inventory cost flow method produces the highest net income in a period of rising prices? a. Average cost. b. LIFO. c. FIFO. d. Specific identification.

Chapter Let’s Review Which inventory cost flow method produces the lowest income taxes in a period of rising prices? a. Average cost. b. LIFO. c. FIFO. d. Specific identification.

Chapter Let’s Review Using the above data, assume there are 9,000 units on hand at Dec. 31, what is the cost of ending inventory under FIFO? a. $99,000 b. $108,000 c. $113,000 d. $100,000

Chapter The Lower of Cost or Market Basis of Accounting for Inventories When the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline occurs.

Chapter Lower of Cost or Market as time passes the value of the inventories might decline in the market because of the obsolescence factor IFRS specify that the companies should use the lower- of-cost-or market (LCM) valuation basis the market value is the current replacement cost (market value- NOT SELLING PRICE)of the inventory LCM rule can be applied with any of the cost flow methods, or the specific identification method LCM may be applied to individual items or major categories of inventory the decline in value is not expected to increase in the very near future

Chapter Example-LCM-1 Item by item

Chapter Example-LCM-2 on 15 August 2005, the company sold 15 units of Item W at TL 126 per unit

Chapter Example-LCM-3 Using item-by-item basis 31 December 2005

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Chapter Cost of Goods Sold Formula Beginning inventoryBeginning inventory + Purchases+ Purchases - Ending inventory- Ending inventory = Cost of Good sold= Cost of Good sold

Chapter Inventory Errors

Chapter Inventory Errors

Chapter

Chapter Inventory Management and Ethical Issues inventories are closely related with net income and thus with the shareholders’ equity, and the assets taking decisions that would affect the ending inventory and cost of goods sold amount, the management can manipulate income for example, management might decide to make a large purchase at the end of the period, in order to maximize profits in that period, and then return the goods at the beginning of the following period stating that they are not according to specifications

Chapter Analysis of Inventories To check whether adequate profits are generated by the operations To check whether inventory is adequate to meet future demands

Chapter Some Ratios very low ratio might point to some problems that are related to pricing policies, and inefficiencies in the production process a high turnover ratio usually shows that a company does not have obsolete products that it cannot sell Average Number of Days' Inventory on Hand = 365 days / Inventory Turnover Ratio shows whether a company has adequate stock on hand; can be used as an indicator of holding obsolete inventory

Chapter Moving fast… Are we not?

Chapter Last-in First-out Method LIFO Costs are matched against the revenues in the reverse order of incurrence Cost of the most recent purchased goods are assigned to units that are sold first

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