6-1 ©2006 Prentice Hall, Inc.

6-2 ©2006 Prentice Hall, Inc. REPORTING AND ANALYZING INVENTORY  Learning objectives Learning objectives  Inventory cost flow assumptions Inventory cost flow assumptions  How inventory cost flow assumptions affect financial statements How inventory cost flow assumptions affect financial statements  Lower-of-cost-or-market rule Lower-of-cost-or-market rule  Financial statement analysis Financial statement analysis  Business risk, control, and ethics Business risk, control, and ethics

6-3 ©2006 Prentice Hall, Inc. Learning Objectives (1 of 2)  Explain and apply the four cost flow assumptions for valuing inventory and cost of goods sold  Explain the effects of the inventory cost flow assumption on the financial statements  Explain the lower-of-cost-or-market rule for valuing inventory

6-4 ©2006 Prentice Hall, Inc. Learning Objectives (2 of 2)  Evaluate a firm’s inventory management using the inventory turnover ratio.  Recognize special risks and controls associated with inventory.

6-5 ©2006 Prentice Hall, Inc. Inventory Cost Flow Assumptions (1 of 3)  During March, Jeremy’s Friendly Market showed the following results:  Beginning inventory of Big Q Beans was 400 cans at $0.75 per can  Purchased 1,000 cans of Big Q Beans for $0.79 per can. Later that month, they purchased 2,000 more cans of Big Q Beans for $0.84 per can  It sells 2,400 cans of beans during March

6-6 ©2006 Prentice Hall, Inc. Inventory Cost Flow Assumptions (2 of 3)  What is the cost of the beans sold?  What is the cost of the beans remaining in merchandise inventory?  Cost flow assumptions allocate goods available for sale (GAS) to cost of goods sold and ending inventory (EI)  BI + Purch = GAS  GAS – EI + GoGS (GAS = EI + GoGS)

6-7 ©2006 Prentice Hall, Inc. Inventory Cost Flow Assumptions (3 of 3)  Alternate inventory cost flow assumptions  Specific identification Specific identification  Weighted average Weighted average  First-in, first-out (FIFO) First-in, first-out (FIFO)  Last-in, last-out (LIFO) Last-in, last-out (LIFO)

6-8 ©2006 Prentice Hall, Inc. Specific Identification  Specific identification does NOT make any cost-flow assumptions  The accounting system tracks the actual cost of each item in merchandise inventory and the actual cost of items sold  For what types of goods would a company use specific identification?

6-9 ©2006 Prentice Hall, Inc. Weighted Average Cost (1 of 2)  Same cost is assigned to all GAS for each inventory item carried by the business.  For what types of goods would a company use weighted average?  Average cost per unit in GAS: Total cost of inventory item _ Total # of units of inventory item

6-10 ©2006 Prentice Hall, Inc. Weighted Average Cost (2 of 2)  Cost of goods sold  # of units sold x avg cost per unit  Ending inventory  # of units in EI x avg cost per unit  Calculate for Big Q Beans:  GAS, CoGS, and EI

6-11 ©2006 Prentice Hall, Inc. FIFO  Assumes that FIRST items purchased are first items sold  Oldest costs are in CoGS  Most recent costs are in EI  Calculate for Big Q Beans:  GAS, CoGS, and EI  Are your answers different than for weighted average? Why or why not?

6-12 ©2006 Prentice Hall, Inc. LIFO (1 of 3)  Assumes that LAST items purchased are first items sold  Most recent costs are in CoGS  Oldest costs are in EI  Calculate for Big Q Beans:  GAS, CoGS, and EI  Are your answers different than for FIFO? Why or why not?

6-13 ©2006 Prentice Hall, Inc. LIFO (2 of 3)  Use of LIFO requires extra disclosures in financial statement footnotes  What effect would making an extra purchase of inventory at the end of the period have on CoGS under LIFO if:  Inventory costs are rising? Falling?  How would the extra purchase affect CoGS under FIFO?

6-14 ©2006 Prentice Hall, Inc. LIFO (3 of 3)  What would happen company using LIFO kept an inventory reserve (never sold all of its inventory)?  If a company sells all of its inventory each period (no BI), would CoGS change under the different methods? Why or why not?

6-15 ©2006 Prentice Hall, Inc. Effect of Cost Flow Assumptions on Financial Statements (1 of 3) FIFO LIFO Wt. Avg. Sales$ 3,000 $ 3,000$ 3,000 Cost of G. S. 1,930 1,996 1,955 Gross Margin 1,070 1,004 1,045 Oper. exp Pretax Inc Taxes (30%) Net Income $574 $528 $556 Assumes sales price $1.25/can & op exp $250

6-16 ©2006 Prentice Hall, Inc. Effect of Cost Flow Assumptions on Financial Statements (2 of 3) FIFO LIFO Wt. Avg. Inflows: Sales collected $ 3,000 $ 3,000$ 3,000 Outflows: Purch paid for 2,470 2,470 2,470 Op. exp. paid Taxes paid Net cash flow $ 34 $ 54$ 41 Assumes sales price $1.25/can & op exp $250

6-17 ©2006 Prentice Hall, Inc. Effect of Cost Flow Assumptions on Financial Statements (3 of 3)  Effect of reported inventory and CoGS under different cost flow assumptions Effect of reported inventory and CoGS under different cost flow assumptions  Income tax effects under LIFO and FIFO Income tax effects under LIFO and FIFO  Choosing an inventory cost flow method Choosing an inventory cost flow method

6-18 ©2006 Prentice Hall, Inc. Effect of Cost Flow Assumptions on CoGS and EI  Which method produces the highest net income in times of rising inventory costs? Falling inventory costs?  Which method produces the highest ending inventory under rising inventory costs? Falling inventory costs?

6-19 ©2006 Prentice Hall, Inc. Income Tax Effects Under LIFO and FIFO  In times of rising inventory costs, which inventory method produces the highest income tax expense?  Does this affect which method produces the highest net income?  How does this affect cash flow?  How do your answers change if inventory costs are falling

6-20 ©2006 Prentice Hall, Inc. Choosing an Inventory Cost Flow Method (1 of 2)  Factors that may affect choice of inventory cost flow assumption  Compatibility with similar companies  Maximize tax savings and cash flows  Maximize net income  If LIFO is used for tax purposes, it must also be used for financial statement purposes

6-21 ©2006 Prentice Hall, Inc. Choosing an Inventory Cost Flow Method (2 of 2)  How does choice of cost flow method affect the following ratios in times of rising inventory costs? Falling costs?  Current ratio  Quick ratio  Gross profit ratio  Profit margin ratio  Inventory turnover ratio

6-22 ©2006 Prentice Hall, Inc. Lower-of-cost-or-market Rule  Which reporting constraint (see ch 2) requires inventory to be stated at lower of cost or market value? Replacement cost is used to estimate market value  If market value is lower than cost  Reduce the inventory account  Reduce net income

6-23 ©2006 Prentice Hall, Inc. Financial Statement Analysis (1 of 2)  Inventory turnover  Measures how quickly a firm is selling its inventory Cost of goods sold Average inventory  Average inventory = (BI + EI) / 2  Average days in inventory  365 (days in year) / Inventory turnover

6-24 ©2006 Prentice Hall, Inc. Financial Statement Analysis (2 of 2)  In general, do companies want higher or lower inventory turnover?  Compared to what?  What happens if inventory turnover is too high? Too low?  Which industry would have higher inventory turnover, a jeweler or grocer?  Who would have a higher profit margin?

6-25 ©2006 Prentice Hall, Inc. Business Risk, Control, and Ethics (1 of 2)  What is inventory padding?  How else can a company artificially inflate its assets?  Safeguarding assets  Physical controls  Includes ensuring that products don’t spoil

6-26 ©2006 Prentice Hall, Inc. Business Risk, Control, and Ethics (2 of 2)  RFID tags  How to they help control costs?  What inventory method do they enable businesses to use that they could not use previously?  Controlling inventory levels and monitoring product developments to prevent inventory obsolescence

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 6-27 ©2006 Prentice Hall, Inc.