1 Financial Accounting: Tools for Business Decision Making, 4th Ed. Kimmel, Weygandt, Kieso CHAPTER 6 Prepared by Dr. Joseph Otto

2 Chapter 6 REPORTING AND ANALYZING INVENTORY

3 Chapter 6 Reporting and Analyzing Inventory 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.

4 Inventory-Merchandiser Consists of many different items Owned by the company In a form ready for sale to customers One inventory classification: Merchandise Inventory

5 Inventory - Manufacturing Finished goods inventory Work in process Raw materials

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

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

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

9 Determine Inventory Quantities Determine inventory quantities by counting, weighting or measuring each type of inventory. Determine ownership of goods, including goods in transit, consigned goods. 11 1

10 Questions Concerning Ownership Do all the goods included in the count belong to the company? Does the company own any goods not included in the count?

11 Goods in Transit These are goods on board a truck, train, ship, or plane at the end of the period. 36 Who includes these in inventory? zBuyer? zSeller? The Company with Legal Title

Terms of Sale- FOB (free-on-board)

13 Consigned Goods Goods of others you hold. You do not pay for the goods until they sell. The company does not take ownership.

14 Inventory Costing - Periodic 1. Determine quantity of units of inventory 2. Apply unit costs to the quantities 3. Determine total cost of inventory 4. Determine cost of goods sold Process can be complicated if units are purchased at different times and at different prices! 11 2

15 Illustrative Data – Crivitz TV Co. Purchases February 3 1 set $ 700 March 51 set $ 750 May 22 1 set $ 800 Sales June 12 sets $2,400

16 Inventory Costing Specific Identification method Cost Flow Assumptions FIFO- First-in, First-Out- earliest goods purchased are the first to be sold LIFO- Last-in,First-Out- latest goods purchased are the first to be sold Average Cost Method- costs are charged on the basis of weighted average unit cost

Specific Identification An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of ending inventory.

18 Is Specific Identification Possible? Yes – with bar coding, electronic product codes and radio frequency identification However, it is rarely used

19 What Is a Cost Flow Assumption? To presume the order in which goods are sold even if flow of costs is unrelated to the physical flow of goods. What Makes Cost Flow Assumptions Necessary? Changing Inventory Costs

The FIFO method assumes the earliest goods purchased are the first to be sold. FIFO

The LIFO method assumes the last goods purchased are the first to be sold. LIFO

Weighted-Average Cost The average cost method allocates the cost of goods available for sale on the basis of weighted-average unit cost incurred.

The average cost method allocates the cost of goods available for sale on the basis of weight- average unit cost incurred. Weighted Average

24 Factors Used in Selecting an Inventory Cost Method zIncome statement effects zBalance sheet effects zTax effects

Balance Sheet Effects of Cost Flow Methods

26 Income Statement Effects COGAS is the same

27 Ending Inventory is different Income Statement Effects

28 COGS is different Income Statement Effects

29 Gross Profit is different Income Statement Effects

30 Net Income is different Income Statement Effects

31 Income Statement Effects In periods of increasing prices In periods of increasing prices FIFO reports the highest net income FIFO reports the highest net income LIFO the lowest LIFO the lowest average cost falls in the middle. average cost falls in the middle. In periods of decreasing prices In periods of decreasing prices FIFO will report the lowest net income FIFO will report the lowest net income LIFO the highest LIFO the highest average cost in the middle. average cost in the middle.

32 Balance Sheet Effects In a period of increasing prices, costs allocated to ending inventory using: FIFO will approximate current costs FIFO will approximate current costs LIFO will be significantly understated LIFO will be significantly understated

33 Why Do Companies Use LIFO? During periods of rising prices, During periods of rising prices, Higher cost of goods sold Higher cost of goods sold Lower net income Lower net income Lower Income Taxes

34 Income Tax Effects Taxes are different Taxes are different

35 Consistency Whatever cost flow method a company chooses, it must use it consistently… OR Disclose the change and its effects on net income in the financial statement.

36 Review Which inventory cost flow method produces the highest net income in a period of rising prices? a. Weighted average cost b.Lifo c.Fifo d.Specific Identification.

37 Review Which inventory cost flow method produces the highest net income in a period of rising prices? a. Weighted average cost b.Lifo c.Fifo d.Specific Identification.

38 Which inventory cost flow method produces the lowest income taxes in a period of rising prices? Review a. Weighted average cost b. Lifo c. Fifo d. Specific Identification.

39 Which inventory cost flow method produces the lowest income taxes in a period of rising prices? Review a. Weighted average cost b. Lifo c. Fifo d. Specific Identification.

40 Using the above data, assume there are 9,000 units on hand at Dec. 31, what is the cost of ending inventory under FIFO? Review 5,000 $13 = $ 65,000 4,000 = $ 48,000 TOTAL $113,000

41 Review Using the above data, assume there are 9,000 units on hand at Dec. 31, what is the cost of ending inventory under LIFO? 8,000 $11 = $ 88,000 1,000 = $ 12,000 TOTAL $100,000

42 Review Using the above data, assume there are 9,000 units on hand at Dec. 31, what is the cost of ending inventory under Weighted-average costs? 309,000/26,000 = $ ,000 units X $11.88 = $ = 88,000 =156,000 = 65, ,000 26,000

43 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. 11 4

44 Lower of Cost or Market (LCM) Under LCM, market is defined as current replacement cost – NOT selling price Under LCM, market is defined as current replacement cost – NOT selling price Departure from cost principle, but follows conservatism concept Departure from cost principle, but follows conservatism concept LCM applied after costing with one of methods (FIFO, LIFO, average, specific) LCM applied after costing with one of methods (FIFO, LIFO, average, specific) Apply to individual items or major categories or total inventory Apply to individual items or major categories or total inventory

45 Inventory Turnover Ratio = Cost of Goods Sold Average Inventory An indication of how quickly a company sells its goods. Higher is better. 11 5

46 Days in Inventory= 365 days Inventory Turnover Ratio Lower is better. Measures average number of days inventory is held.

47 LIFO RESERVE Accounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO. This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods. 11 6

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