6-1 6 Learning Objectives After studying this chapter, you should be able to: [1] Determine how to classify inventory and inventory quantities. [2] Explain the accounting for inventories and apply the inventory cost flow methods. [3] Explain the financial effects of the inventory cost flow assumptions. [4] Explain the lower-of-cost-or-market basis of accounting for inventories. [5] Indicate the effects of inventory errors on the financial statements. [6] Compute and interpret the inventory turnover. Inventories

6-2 Preview of Chapter 6 Accounting Principles Weygandt Kimmel Kieso

6-3 One Classification:  Inventory Three Classifications:  Raw Materials  Work in Process  Finished Goods Merchandising Company Manufacturing Company Classifying Inventory Helpful Hint Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

6-4 (See page 324)

6-5 Physical Inventory taken for two reasons: Perpetual System 1.Check accuracy of inventory records. 2.Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. Periodic System 1.Determine the inventory on hand. 2.Determine the cost of goods sold for the period. LO 1 Determine how to classify inventory and inventory quantities. Determining Inventory Quantities

6-6 Involves counting, weighing, or measuring each kind of inventory on hand. Taken,  when the business is closed or business is slow.  at the end of the accounting period. Taking a Physical Inventory LO 1 Determine how to classify inventory and inventory quantities. Determining Inventory Quantities

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6-8 Goods in Transit  Purchased goods not yet received.  Sold goods not yet delivered. Determining Ownership of Goods 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. LO 1 Determine how to classify inventory and inventory quantities. Determining Inventory Quantities

6-9 Illustration 6-2 Terms of sale LO 1 Determine how to classify inventory and inventory quantities. Goods in Transit 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. Determining Inventory Quantities

6-10 Goods in transit should be included in the inventory of the buyer when the: a.public carrier accepts the goods from the seller. b.goods reach the buyer. c.terms of sale are FOB destination. d.terms of sale are FOB shipping point. LO 1 Determine how to classify inventory and inventory quantities. Review Question Determining Inventory Quantities

6-11 Consigned Goods To hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. Many car, boat, and antique dealers sell goods on consignment, why? LO 1 Determine how to classify inventory and inventory quantities. Determining Ownership of Goods Determining Inventory Quantities

6-12 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory is accounted for at cost.  Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale.  Unit costs are applied to quantities to determine the total cost of the inventory and the cost of goods sold using the following costing methods: ► Specific identification ► First-in, first-out (FIFO) ► Last-in, first-out (LIFO) ► Average-cost Cost Flow Assumptions Inventory Costing

6-13 Illustration: Crivitz TV Company purchases three identical 50- inch TVs on different dates at costs of $700, $750, and $800. During the year Crivitz sold two sets at $1,200 each. These facts are summarized below. Illustration 6-3 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing

6-14 Specific Identification If Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 + $800), and its ending inventory is $750. Illustration 6-4 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing

6-15 Specific Identification Actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory.  Practice is relatively rare.  Most companies make assumptions (cost flow assumptions) about which units were sold. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing

6-16 Illustration 6-12 Use of cost flow methods in major U.S. companies Cost Flow Assumption does not need to be consistent with the physical movement of goods LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Inventory Costing

6-17 Illustration: Data for Houston Electronics’ Astro condensers. Illustration 6-5 (Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions

6-18  Costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold.  Often parallels actual physical flow of merchandise.  Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. First-In, First-Out (FIFO) LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions

6-19 COST OF GOODS AVAILABLE FOR SALE Illustration 6-6 LO 2 Cost Flow Assumptions STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD First-In, First-Out (FIFO)

6-20 Illustration 6-6 Helpful Hint Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions First-In, First-Out (FIFO)

6-21  Costs of the latest goods purchased are the first to be recognized in determining cost of goods sold.  Seldom coincides with actual physical flow of merchandise.  Exceptions include goods stored in piles, such as coal or hay. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions Last-In, First-Out (LIFO)

6-22 Illustration 6-8 LO 2 Cost Flow Assumptions COST OF GOODS AVAILABLE FOR SALE STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD Last-In, First-Out (LIFO)

6-23 Illustration 6-8 Helpful Hint Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—first in still here. LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions Last-In, First-Out (LIFO)

6-24  Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred.  Applies weighted-average unit cost to the units on hand to determine cost of the ending inventory. Average-Cost LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions

6-25 Illustration 6-11 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions Average-Cost COST OF GOODS AVAILABLE FOR SALE STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

6-26 Illustration 6-11 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods. Cost Flow Assumptions Average-Cost

6-27 Comparative effects of cost flow methods LO 3 Explain the financial effects of inventory cost flow assumptions. Illustration 6-13 HOUSTON ELECTRONICS Condensed Income Statements Financial Statement and Tax Effects

6-28 Using Cost Flow Methods Consistently  Method should be used consistently, enhances comparability.  Although consistency is preferred, a company may change its inventory costing method. Inventory Costing Illustration 6-15 Disclosure of change in cost flow method

6-29 The cost flow method that often parallels the actual physical flow of merchandise is the: a.FIFO method. b.LIFO method. c.average cost method. d.gross profit method. Review Question LO 3 Explain the financial effects of inventory cost flow assumptions. Cost Flow Assumptions

6-30 In a period of inflation, the cost flow method that results in the lowest income taxes is the: a.FIFO method. b.LIFO method. c.average cost method. d.gross profit method. Review Question Helpful Hint A tax rule, often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes, they must also use it for financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements. LO 3 Explain the financial effects of inventory cost flow assumptions. Cost Flow Assumptions

6-31 (See page 324)

6-32 Lower-of-Cost-or-Market LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories. When the value of inventory is lower than its cost  Companies “write down” the inventory to its market value in the period in which the price decline occurs.  Market value = Replacement Cost  Example of conservatism. International Note Under U.S. GAAP, companies cannot reverse inventory write-downs if inventory increases in value in subsequent periods. IFRS permits companies to reverse write-downs in some circumstances. Inventory Costing

6-33 LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories. Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. Lower-of-Cost-or-Market Illustration 6-16 Inventory Costing

6-34 LO 5 Indicate the effects of inventory errors on the financial statements. Common Cause:  Failure to count or price inventory correctly.  Not properly recognizing the transfer of legal title to goods in transit.  Errors affect both the income statement and balance sheet. Inventory Errors

6-35 Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-18 Illustration 6-17 LO 5 Indicate the effects of inventory errors on the financial statements. Income Statement Effects Inventory Errors

6-36 Inventory errors affect the computation of cost of goods sold and net income in two periods.  An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.  Over the two years, the total net income is correct because the errors offset each other.  Ending inventory depends entirely on the accuracy of taking and costing the inventory. LO 5 Indicate the effects of inventory errors on the financial statements. Income Statement Effects Inventory Errors

6-37 ($3,000) Net Income understated $3,000 Net Income overstated Combined income for 2-year period is correct. Illustration 6-19 LO 5 Indicate the effects of inventory errors on the financial statements. Inventory Errors

6-38 Understating ending inventory will overstate: a.assets. b.cost of goods sold. c.net income. d.owner's equity. Question LO 5 Indicate the effects of inventory errors on the financial statements. Inventory Errors

6-39 LO 5 Indicate the effects of inventory errors on the financial statements. Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:. Illustration 6-17 Illustration 6-20 Balance Sheet Effects Inventory Errors

6-40 Balance Sheet - Inventory classified as current asset. Income Statement - Cost of goods sold subtracted from sales. There also should be disclosure of 1) major inventory classifications, 2) basis of accounting (cost or LCM), and 3) costing method (FIFO, LIFO, or average). Statement Presentation and Analysis Presentation

6-41 Inventory management is a double-edged sword 1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). 2. Low Inventory Levels – may lead to stockouts and lost sales. LO 6 Compute and interpret the inventory turnover. Statement Presentation and Analysis Analysis

6-42 Inventory turnover measures the number of times on average the inventory is sold during the period. Cost of Goods Sold Average Inventory Inventory Turnover = Days in inventory measures the average number of days inventory is held. Days in Year (365) Inventory Turnover Days in Inventory = LO 6 Compute and interpret the inventory turnover. Statement Presentation and Analysis

6-43 Illustration: Wal-Mart reported in its 2011 annual report a beginning inventory of $32,713 million, an ending inventory of $36,318 million, and cost of goods sold for the year ended January 31, 2011, of $315,287 million. The inventory turnover formula and computation for Wal-Mart are shown below. LO 6 Compute and interpret the inventory turnover. Illustration 6-22 Days in Inventory: Inventory turnover of 9.1 times divided into 365 is approximately 40.1 days. This is the approximate time that it takes a company to sell the inventory. Statement Presentation and Analysis

6-44 Illustration: LO 7 Apply the inventory cost flow methods to perpetual inventory records. Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. Illustration 6A-1 APPENDIX 6A Cost Flow Methods Perpetual Inventory System HOUSTON ELECTRONICS Astro Condensers

6-45 LO 7 Apply the inventory cost flow methods to perpetual inventory records. First-In, First-Out (FIFO) Cost of Goods Sold Ending Inventory Illustration 6A-2 APPENDIX 6A Cost Flow Methods Perpetual Inventory System

6-46 LO 7 Apply the inventory cost flow methods to perpetual inventory records. Last-In, First-Out (LIFO) Cost of Goods Sold Ending Inventory Illustration 6A-3 APPENDIX 6A Cost Flow Methods Perpetual Inventory System

6-47 LO 7 Apply the inventory cost flow methods to perpetual inventory records. Average-Cost Illustration 6A-4 Cost of Goods Sold Ending Inventory APPENDIX 6A Cost Flow Methods Perpetual Inventory System

6-48 LO 8 Describe the two methods of estimating inventories. A method of estimating the cost of ending inventory by applying a gross profit rate to net sales. A company needs to know ► its net sales, cost of goods available for sale, and gross profit rate. Illustration 6B-1 APPENDIX 6B Estimating Inventories Gross Profit Method

6-49 Illustration 6B-1 APPENDIX 6B Estimating Inventories Illustration: Kishwaukee Company records show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. In the preceding year, the company realized a 30% gross profit rate. It expects to earn the same rate this year. Compute the estimated cost of the ending inventory at January 31 under the gross profit method. Illustration 6B-2

6-50 LO 8 ► Retail companies establish a relationship between cost and sales price. ► Company applies cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost. Illustration 6B-3 APPENDIX 6B Estimating Inventories Retail Inventory Method

6-51 Illustration 6B-1 APPENDIX 6B Estimating Inventories Illustration: Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time. Illustration 6B-4 The major disadvantage of the retail method is that it is an averaging technique. It may produce an incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale. LO 8

6-52 Key Points A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.  The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.  The definitions for inventory are essentially similar under IFRS and GAAP. Both define inventory as assets held-for-sale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).

6-53  Who owns the goods — goods in transit or consigned goods — as well as the costs to include in inventory, are accounted for the same under IFRS and GAAP.  Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used. Key Points A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.

6-54 Key Points A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.  A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average- cost are the only two acceptable cost flow assumptions permitted under IFRS.  IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.

6-55 Key Points A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.  In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. GAAP, on the other hand, defines market as essentially replacement cost.

6-56 Key Points A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.  Under GAAP, if inventory is written down under the lower-of- cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write- down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement as an expense. An item-by-item approach is generally followed under IFRS.

6-57  Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost.  Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.  IFRS allows companies to report inventory at standard cost if it does not differ significantly from actual cost. Standard cost is addressed in managerial accounting courses. Key Points A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.

6-58 Looking to the Future A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS. One convergence issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income.

6-59 Which of the following should not be included in the inventory of a company using IFRS? a)Goods held on consignment from another company. b)Goods shipped on consignment to another company. c)Goods in transit from another company shipped FOB shipping point. d)None of the above. IFRS Self-Test Questions A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.

6-60 IFRS Self-Test Questions A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS. Which method of inventory costing is prohibited under IFRS? a)Specific identification. b)FIFO. c)LIFO. d)Average-cost.

6-61 IFRS Self-Test Questions A Look at IFRS LO 9 Compare the accounting procedures for inventories under GAAP and IFRS. Specific identification: a)must be used under IFRS if the inventory items are not interchangeable. b)cannot be used under IFRS. c)cannot be used under GAAP. d)must be used under IFRS if it would result in the most conservative net income.