1 Chapter 7: Inventory

2 1.Acquisition of inventory: What costs to capitalize? 2.Recording inventory activity: Which method? 3.Selling inventory: Which cost flow assumption? 4.Ending inventory: Lower-of-cost-or market valuation.

3 1. Acquiring Inventory What items or units to include? – General rule: (1) held for sale and (2) complete and unrestricted ownership. – Consignments: belong to consignor, ownership not based on physical possession. – Goods in transit FOB Shipping Point: belongs to the purchaser while in transit (once inventory leaves seller’s facilities). FOB Destination: belongs to seller while in transit (until inventory reaches purchaser’s facilities).

4 Class Exercise E7-1 Error if Dallas includes in ending inventory at 12/31? 1. FOB Shipping Point (purchase): 2. FOB Shipping Point (sale): 3. FOB Destination (sale): 4. FOB Destination (purchase): 5. FOB Destination (purchase):

5 Inventory Errors Inventory errors are unique in financial reporting because they involve multiple accounts and multiple periods. Because of the carryover nature of inventory, some inventory errors reverse out by the end of the second year involved. To analyze, use basic inventory formula.

6 Class Problem-Inventory Error Assume that the ending inventory of 2004 was undervalued by $9,000. If the error goes undetected in 2005, what effect would the error have on the balance sheet and income statement accounts for 2004 and Analyze using the following relationships: BI + P - EI = COGS NI A = L + SE Note that the asset account in inventory error analysis is ending inventory, and the equity effect is retained earnings, specifically the effect on net income.

7 Class Problem- Inventory Error Analysis (O = overstated, U = understated): BI + P - EI = COGS NI A = L + SE 04: 05:

8 Acquiring inventory - contd. What costs to attach? General rule: all costs associated with purchase or manufacture, including shipping to facility. – Freight-in (transportation-in) adds to the cost of inventory. – Purchase returns reduce the cost of purchases (contra) for returned inventory. – Purchase allowances reduce the cost of purchases (contra) for reduced prices due to damage or errors. – Purchase discounts from early cash payments (contra) reduce the cost of purchases.

9 2. Perpetual or Periodic Method Perpetual – Up-to-date record in inventory account. – Cost of goods sold computed for each sale. Periodic – Inventory purchases are recorded as incurred. – Inventory and cost of goods sold determined at the end of each period through physical count. Costs and benefits – Perpetual requires more bookkeeping but provides more useful information. – General application: Periodic used for external reporting; perpetual used for internal tracking of units.

10 Figure 7.3, Perpetual System December 10 Purchase of 100 $20: Inventory 2,000 Accts. Pay.2,000 December 20 Sale of 50 $30: Cash1,500 Sales1,500 COGS 1,000 Inventory1,000 December 30 AJE to recognize loss of 5 each (170 on hand, books show 175) Loss 100 Inventory 100

11 Figure 7.3, Periodic System December 10 Purchase of 100 $20: Purchases 2,000 Accts. Pay.2,000 December 20 Sale of 50 $30: Cash1,500 Sales1,500 (no COGS entry until the end of the period) December 31 AJE/CJE to recognize EI and COGS: (Note: BI given at $2,500 and EI of 175 units (125 BI Purchase -50 Sold) valued at $20 per unit, or $3,500) Inventory (end)3,500 COGS1,000 Purchases2,000 Inventory (begin)2,500

12 This AJE under periodic system follows the formula for COGS: BI + Purchases (net) - EI = COGS 2, , ,500 = 1,000 Note that Purchases (net) = Purchases + Freight-in - Purchase Discounts (see next slide) - Purchase Returns - Purchase Allowances (Alternative: BI + P(net) = EI + COGS)

13 Purchase Discounts - Gross Method Assume purchase of $100 on account on 6/1/05, terms 2/15 ( 2% discount if paid within15 days ), n/30. GJE to record purchase on 6/1/05: Purchases100 Accounts Payable100 GJE to record payment, if on or before 6/16/05: Accounts Payable100 Purchase Discounts 2 Cash 98 GJE to record payment, if after 6/16/05: Accounts Payable100 Cash100 (Purch Disc. is contra to Purchases; part of COGS calc.)

14 Class Problem: E7-3 (Periodic) March 3 purchase: March 10 purchase:

15 Class Problem: E7-3 (Periodic) March 20 payment (3% discount taken): April 25 payment (no discount taken):

16 Class Exercise: Exercise 7-4, Part (a) Note: Cost of goods available for sale = GAS, and GAS = Beginning inventory + Purchases (net) GAS = EI + COGS

17 Class Exercise: Exercise 7-4, Part (a) for 2003 Find Beginning inventory (2003): Find GAS (2003): Find EI (2003):

18 Class Exercise: Exercise 7-4, Part (a) for 2002 Find Beginning inventory (2002): Find GAS (2002): Find Purchases:

19 3. Cost Flow Assumptions Given: BI + P (net) = EI + COGS How to assign costs of inflows [BI + P(net)] to EI and COGS? Methods: Specific identification Average for both COGS and EI FIFO - (first-in, first-out) for COGS – and LISH (last-in, still here) for EI LIFO - (last-in, first-out) for COGS – and FISH (first-in, still here) for EI

20 Class Problem - Cost Flows Given the following activity for January: Cost Total Units per Unit Cost Begin Inventory 20 $ 9.00 $180 Purchase 1/ Purchase 1/ Total available 90 units $910 Sales - 55 units Ending inventory?

21 Class Problem - Cost Flows Note that, for illustrative purposes, only the periodic system is shown here. The perpetual system give similar results, but is more cumbersome to illustrate. In fact, using the FIFO method, the perpetual and periodic systems yield exactly the same results.

22 FIFO(LISH) FIFO for COGS (top down) LISH for EI (bottom up)

23 LIFO(FISH) LIFO for COGS (bottom up) FISH for EI (top down)

24 Average First calculate average: Now COGS: Now EI:

25 Comparison of FIFO, LIFO, and Average In times of rising prices: highest COGS: lowest COGS highest EI lowest EI highest Net Income lowest Net Income

26 Additional LIFO issues: LIFO and taxes – Why use LIFO for taxes? – Why use LIFO for financial statements? LIFO and market valuation – Should market value a company higher or lower if they use LIFO? LIFO liquidation – What happens to net income with liquidation of an old LIFO layer? LIFO reserve – what information is contained in this disclosure?

27 4. Ending Inventory:Applying the Lower-of-Cost-or-Market Rule Based on conservatism, ending inventory is valued at cost or market value, whichever is lower. Problem: can create hidden reserves – Recognizes price decreases immediately – Defers price increase recognition until sold

28 Class Issues for Discussion: ID7-4 a. AJE (in millions)- reduce EI and recognize loss: b. Sale next year (new basis = 40): c. Loss of $12 in first year; gain of $8 in second year: