Chapter 6 Inventories Skyline College Lecture Notes

6–26–2 Copyright © Houghton Mifflin Company. All rights reserved. What Is Inventory?  Inventory is a current asset  Items normally sold within a year or a company’s operating cycle Merchandising Businesses (Walgreens or Costco) Inventory consists of goods held for sale in regular course of business Manufacturing Businesses (Cisco or Hewlett Packard) Inventory consists of: Raw materials or goods used in production of products Work in process or partially completed products Finished goods ready for sale

6–36–3 Copyright © Houghton Mifflin Company. All rights reserved. Accounting for Inventories

6–46–4 Copyright © Houghton Mifflin Company. All rights reserved. Inventory Decisions Inventory processing systems Costing methods Valuation methods Result in different amounts of reported net income, taxes paid, and cash flows Impact external evaluation of company by investors Impact internal evaluations like performance reviews and bonuses

6–56–5 Copyright © Houghton Mifflin Company. All rights reserved. Determining Inventory Levels Costs of handling and storage are high Customers will be satisfied with quick order fulfillment and large selections Lower storage costs May result in lost sales or dissatisfied customers Keep large quantities and selections of inventory? Keep low quantities of inventory?

6–66–6 Copyright © Houghton Mifflin Company. All rights reserved. Cisco’s Inventory Turnover = Inventory Turnover Measurement of the number of times a company’s average inventory is sold during an accounting period Inventory Turnover = Cost of Goods Sold Average Inventory $5,766 m ($1,207 m + $873 m) ÷ 2 = 5.5 times

6–76–7 Copyright © Houghton Mifflin Company. All rights reserved. Inventory Turnover for Selected Industries

6–86–8 Copyright © Houghton Mifflin Company. All rights reserved. Cisco’s Days’ Inventory on Hand = Days’ Inventory On Hand Indicates the average number of days required to sell the inventory on hand Days’ Inventory on Hand = Number of Days in a Year Inventory Turnover 365 days 5.5 times = 66.4 days

6–96–9 Copyright © Houghton Mifflin Company. All rights reserved. Days’ Inventory on Hand for Selected Industries

6–10 Copyright © Houghton Mifflin Company. All rights reserved. Supply Chain Management Computerized system that a company uses to order and track inventory A just-in-time (JIT) operating environment helps reduce inventory levels by coordinating orders and shipments of products so that they arrive “just in time” for customer orders Using these procedures and processes mean that less money is tied up in carrying inventory

6–11 Copyright © Houghton Mifflin Company. All rights reserved. How Do Inventory Mistakes Affect Income? Cost of goods sold is overstated Cost of goods sold is understated Income before income taxes is understated If ending inventory is understated… Income before income taxes is overstated If ending inventory is overstated… Important: Errors not only affect the current year, but also the following year. (An overstatement of ending inventory in year 1 will cause an overstatement in beginning inventory in year 2, resulting in an understatement of income in year 2.)

6–12 Copyright © Houghton Mifflin Company. All rights reserved. Inventory Errors: Examples Column 1 Ending Inventory Correctly Stated Net Sales$100,000 Beg. Inv.$12,000 Net cost of purchases 58,000 Cost of goods available for sale $70,000 End. Inv. 10,000 Cost of Goods Sold60,000 Gross margin$ 40,000 Operating expenses32,000 Income before income taxes $ 8,000 Column 2 Ending Inventory Overstated Column 3 Ending Inventory Understated $100,000 $12,000 58,000 $100,000 $12,000 58,000 $70,000 16,000 4,000 54,00066,000 $ 46,000$ 34,000 32,000 $ 14,000$ 2,000

6–13 Copyright © Houghton Mifflin Company. All rights reserved. Inventory Cost Invoice price less purchases discounts Freight-in, including insurance in transit Applicable taxes and tariffs Goods flow—movement of goods in operations Cost flow—association of cost with its assumed flow in operations versus Inventory cost includes: Inventory costing and valuation methods really depend on the flow of costs rather than the flow of physical inventory

6–14 Copyright © Houghton Mifflin Company. All rights reserved. Merchandise in Transit

6–15 Copyright © Houghton Mifflin Company. All rights reserved. Lower-of-Cost-or-Market Rule Cost is usually the most appropriate basis for the valuation of inventory. BUT The lower-of-cost-or-market (LCM) rule requires that when the replacement cost of inventory falls below historical cost, the inventory is written down to the lower value and a loss is recorded.

6–16 Copyright © Houghton Mifflin Company. All rights reserved. Disclosure of Inventory Methods Cisco Annual Report Inventories Inventories are stated at the lower of cost or market. Cost is computed…on a first-in, first-out basis. The company provides allowances on excess and obsolete inventories. Users should pay attention to the inventory disclosures in the notes to the financial statements. If Cisco holds inventory too long, the items can become out of date and lose value.

6–17 Copyright © Houghton Mifflin Company. All rights reserved. Inventory Costing Methods Inventory cost is determined using one of the following generally accepted methods, each based on a different assumption of cost flow: 1.Specific identification method 2.Average-cost method 3.First-in, first-out (FIFO) method 4.Last-in, first-out (LIFO) method

6–18 Copyright © Houghton Mifflin Company. All rights reserved. Specific Identification Method Units in the ending inventory are identified as coming from specific purchases Inventory Data June 1Inventory 80 $10.00$ 800 June 6Purchase220 $12.502,750 June 25Purchase200 $14.002,800 Goods available for sale500 units$6,350 Sales280 units On hand June units Specific Identification Method $3,620Cost of goods sold 2,730Less June 30 inventory $6,350Cost of goods avail. for sale Specific Identification Method $ , $12.50 $2, units at cost of $ $10.00

6–19 Copyright © Houghton Mifflin Company. All rights reserved. Periodic Average-Cost Method Inventory is priced at the average cost of the goods available for sale during the period Inventory Data June 1Inventory 80 $10.00$ 800 June 6Purchase220 $12.502,750 June 25Purchase200 $14.002,800 Goods available for sale500 units$6,350 Sales280 units On hand June units Cost of Goods Available for Sale ÷ Units Available for Sale = Average Unit Cost $6,350 ÷ 500 units = $12.70 Ending Inventory = 220 $12.70 = $2,794 $3,556Cost of goods sold 2,794Less June 30 inventory $6,350Cost of goods avail. for sale

6–20 Copyright © Houghton Mifflin Company. All rights reserved. Periodic First-In, First-Out (FIFO) Assumes that the first units purchased will be the first units sold; Ending inventory is priced using the most recent purchases Inventory Data June 1Inventory 80 $10.00$ 800 June 6Purchase220 $12.502,750 June 25Purchase200 $14.002,800 Goods available for sale500 units$6,350 Sales280 units On hand June units First-In, First-Out (FIFO) Method 200 $14.00 from purchase of June 25$2, $12.50 from purchase of June units at a cost of $3,050 $3,300Cost of goods sold 3,050Less June 30 inventory $6,350Cost of goods avail. for sale

6–21 Copyright © Houghton Mifflin Company. All rights reserved. Periodic Last-In, First-Out (LIFO) Ending inventory is priced using the earliest purchases Inventory Data June 1Inventory 80 $10.00$ 800 June 6Purchase220 $12.502,750 June 25Purchase200 $14.002,800 Goods available for sale500 units$6,350 Sales280 units On hand June units Last-In, First-Out (LIFO) Method 80 $10.00 from June 1 inventory $ $12.50 from purchase of June 6 1, units at a cost of $2,550 $3,800Cost of goods sold 2,550Less June 30 inventory $6,350Cost of goods avail. for sale

6–22 Copyright © Houghton Mifflin Company. All rights reserved. Impact of Inventory Methods

6–23 Copyright © Houghton Mifflin Company. All rights reserved. Discussion: Ethics on the Job Rite Aid Corporation, a large drugstore chain, falsified income by manipulating its computerized inventory system to cover losses from shoplifting, employee theft, and spoilage. Q. To increase income, what manipulation of inventory amounts would have been necessary?

6–24 Copyright © Houghton Mifflin Company. All rights reserved. Impact to Gross Margin June Example: Period of Rising Inventory Purchase Prices In times of declining prices: FIFO results in lowest gross margin, LIFO results in highest gross margin. Highest gross margin Lowest gross margin

6–25 Copyright © Houghton Mifflin Company. All rights reserved. Which Costing Methods Are Used Most Frequently?

6–26 Copyright © Houghton Mifflin Company. All rights reserved. LIFO Method Best suited for the income statement because it matches revenues and cost of goods sold Not the best measure of the current balance sheet value of inventory, particularly during a prolonged period of price increases and decreases Used for durable goods in times of rising prices—pay less income tax

6–27 Copyright © Houghton Mifflin Company. All rights reserved. Average Cost Used for low-cost durable goods Blends old prices with new prices so levels out the effects of cost increases and decreases

6–28 Copyright © Houghton Mifflin Company. All rights reserved. FIFO Method Best suited to the balance sheet because the ending inventory is closest to current values Does not provide as good a matching of current costs and revenues for income statement purposes Used for perishable goods and durable goods in times of declining prices

6–29 Copyright © Houghton Mifflin Company. All rights reserved. Inventory and Income Taxes Method chosen must be used consistently from year to year (may change with IRS approval if there is a good reason, exception—a change from LIFO) If a company uses LIFO for tax purposes, the IRS requires the same method for financial reporting IRS will not allow lower-of-cost-or-market (LCM) inventory valuation if LIFO is used

6–30 Copyright © Houghton Mifflin Company. All rights reserved. Perpetual versus Periodic Systems PerpetualPeriodic Continuous record of quantities & costs is maintained as purchases and sales are made Cost of goods sold is accumulated as sales are made; costs are transferred from the Merchandise Inventory account to the Cost of Goods Sold account Cost of ending inventory is the balance of the Merchandise Inventory account Only ending inventory is counted and priced Cost of goods sold is determined by deducting the cost of the ending inventory from the cost of goods available for sale

6–31 Copyright © Houghton Mifflin Company. All rights reserved. FIFO Under the Perpetual Inventory System: Example Inventory Data June 1Inventory 80 $10.00$ 800 June 6Purchase220 $12.502,750 June 10Sale 80 $10.00($ 800) 200 $12.50(2,500)(3,300) June 10 Balance 20 $12.50 $ 250 June 25Purchase200 $14.002,800 June 25Inventory 20 $12.50$ $14.002,800$3,050 Cost of goods sold$3,300 Keep track of inventory costs and amounts in date order Cost of goods sold is the total of sales on June 10

6–32 Copyright © Houghton Mifflin Company. All rights reserved. LIFO Under the Perpetual Inventory System: Example Keep track of inventory costs and amounts in date order Inventory Data June 1Inventory 80 $10.00$ 800 June 6Purchase220 $12.502,750 June 10Sale220 $12.50($2,750) 60 $10.00(600)(3,350) June 10 Balance 20 $10.00 $ 200 June 25 Purchase200 $14.002,800 June 25 Inventory 20 $10.00$ $14.00$2,800$3,000 Cost of goods sold$3,350 Cost of goods sold is the total of sales on June 10

6–33 Copyright © Houghton Mifflin Company. All rights reserved. Impact of Cost Flow Assumptions Under a Perpetual Inventory System

6–34 Copyright © Houghton Mifflin Company. All rights reserved. Retail Method for Estimating Ending Inventory Uses the ratio of cost to retail price to estimate ending inventory Can be used instead of actually determining the cost of items in inventory Retail products can be scanned at their retail price and cost calculated through the use of ratios

6–35 Copyright © Houghton Mifflin Company. All rights reserved. Retail Method Records must show: Beginning inventory at cost and at retail Amount of goods purchased during period at cost and at retail

6–36 Copyright © Houghton Mifflin Company. All rights reserved. Gross Profit Method for Estimating Ending Inventory It is a useful way of estimating the amount of inventory lost or destroyed (ie theft, fire, etc) Estimate the cost of goods sold by deducting the estimated gross margin from sales Step 2 Figure the cost of goods available for sale add purchases to beginning inventory Step 1 Deduct the estimated cost of goods sold from the cost of goods available for sale to arrive at the estimated cost of ending inventory Step 3