1. Corporate Financial Accounting 14e Warren Reeve Duchac Chapter 6 Inventories

2. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objectives Obj. 1: Describe the importance of control over inventory. Obj. 2: Describe three inventory cost flow assumptions and how they impact the income statement and balance sheet. Obj. 3: Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and weighted average cost methods. Obj. 4: Determine the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and weighted average cost methods. Obj. 5: Compare and contrast the use of the three inventory costing methods. Obj. 6: Describe and illustrate the reporting of inventory in the financial statements. ADM: Describe and illustrate the inventory turnover and the number of days’ sales in inventory in analyzing the efficiency and effectiveness of inventory management.

3. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Control of Inventory Two primary objectives of control over inventory are as follows: o Safeguarding the inventory from damage or theft. o Reporting inventory in the financial statements.

4. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Safeguarding Inventory (slide 1 of 3) Controls for safeguarding inventory begin as soon as the inventory is ordered. The following documents are often used for inventory control: o Purchase order o Receiving report o Vendor’s invoice

5. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Safeguarding Inventory (slide 2 of 3) The purchase order authorizes the purchase of the inventory from an approved vendor. The receiving report establishes an initial record of the receipt of the inventory. The price, quantity, and description of the item on the purchase order and receiving report are compared to the vendor’s invoice before the inventory is recorded in the accounting records.

6. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Safeguarding Inventory (slide 3 of 3) Recording inventory using a perpetual inventory system is also an effective means of control. The amount of inventory is always available in the subsidiary inventory ledger. Controls for safeguarding inventory should include security measures to prevent damage and customer or employee theft. Some examples of security measures include: o Storing inventory in areas that are restricted to only authorized employees o Locking high-priced inventory in cabinets o Using two-way mirrors, cameras, security tags, and guards

7. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Reporting Inventory A physical inventory or count of inventory should be taken near year-end to make sure that the quantity of inventory reported in the financial statements is accurate. After the quantity of inventory on hand is determined, the cost of the inventory is assigned for reporting in the financial statements. o Most companies assign costs to inventory using one of three inventory cost flow assumptions.

8. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Flow Assumptions

9. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inventory Cost Flow Assumptions (slide 1 of 3) Assume that three identical units of merchandise are purchased during May, as follows:

10. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inventory Cost Flow Assumptions (slide 2 of 3) Assume that one unit is sold on May 30 for $20. Depending upon which unit was sold, the gross profit varies from $11 to $6 and the ending inventory value varies from $27 to $22, computed as follows:

11. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inventory Cost Flow Assumptions (slide 3 of 3) Under the specific identification inventory cost flow method, the unit sold is identified with a specific purchase and the ending inventory is made up of the remaining units on hand. o Because the specific identification inventory cost method requires each inventory unit to be separately identified, it is not practical for most businesses to use. Under the first-in, first-out (FIFO) inventory cost flow method, the first units purchased are assumed to be sold and the ending inventory is made up of the most recent purchases. Under the last-in, first out (LIFO) inventory cost flow method, the last units purchased are assumed to be sold and the ending inventory is made up of the first purchases. Under the weighted average inventory cost flow method, sometimes called the average cost flow method, the cost of the units sold and in ending inventory is a weighted average of the purchase costs. o The purchase costs are weighted by the quantities purchased at each cost, thus the term weighted average.

12. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inventory Costing Methods Under a Perpetual Inventory System For purposes of illustration, the data for Item 127B are used, as shown below. We will examine the perpetual inventory system first.

13. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. First-In, First-Out Method When the FIFO method is used in a perpetual inventory system, costs are included in the cost of goods sold in the order in which they were purchased. This is often the same as the physical flow of the goods. For example, grocery stores shelve milk and other perishable products by expiration dates. Products with early expiration dates are stocked in front. In this way, the oldest products (earliest purchases) are sold first.

14. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Entries and Perpetual Inventory Account (FIFO)

15. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Last-In, First-Out Method When the LIFO method is used in a perpetual inventory system, the cost of the units sold is the cost of the most recent purchases. The LIFO method was originally used in those rare cases where the units sold were taken from the most recently purchased units. However, for tax purposes, LIFO is now widely used even when it does not represent the physical flow of units.

16. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Entries and Perpetual Inventory Account (LIFO)

17. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Weighted Average Cost Method When the weighted average cost method is used in a perpetual inventory system, a weighted average unit cost for each item is computed each time a purchase is made. This unit cost is used to determine the cost of each sale until another purchase is made and a new average is computed. o This technique is called a moving average.

18. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Entries and Perpetual Inventory Account (Weighted Average)

19. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inventory Costing Methods Under a Periodic Inventory System When the periodic inventory system is used, only revenue is recorded each time a sale is made. No entry is made at the time of the sale to record the cost of the goods sold. At the end of the accounting period, a physical inventory is taken to determine the cost of the inventory and the cost of the goods sold. Like the perpetual inventory system, a cost flow assumption must be made when identical units are acquired at different unit costs during a period.

20. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. First-In, First-Out Method (slide 1 of 2) The beginning inventory and purchases of Item 127B in January are as follows: The physical count on January 31 shows that 800 units are on hand. The cost of the 800 units in the ending inventory on January 31 is determined as follows:

21. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. First-In, First-Out Method (slide 2 of 2) Deducting the cost of the January 31 inventory from the cost of goods available for sale yields the cost of goods sold, computed as follows: o The $18,460 cost of the ending inventory on January 31 is made up of the most recent costs. o The $26,720 cost of goods sold is made up of the beginning inventory and the earliest costs.

22. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. First-In, First-Out Flow of Costs

23. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Last-In, First-Out Method (slide 1 of 2) Assume again that the physical count on January 31 shows that 800 units are on hand. The cost of the 800 units in ending inventory on January 31 is $16,000, which consists of 800 units from the beginning inventory at a cost of $20.00 per unit.

24. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Last-In, First-Out Method (slide 2 of 2) Deducting the cost of the January 31 inventory from the cost of goods available for sale yields the cost of goods sold, computed as follows: o The $16,000 cost of the ending inventory on January 31 is made up of the earliest costs. o The $29,180 cost of goods sold is made up of the most recent costs.

25. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Last-In, First-Out Flow of Costs

26. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Weighted Average Cost Method (slide 1 of 3) The weighted average unit cost is determined as follows: Total Cost of Units Available for Sale Weighted Average Unit Cost = Units Available for Sale

27. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Weighted Average Cost Method (slide 2 of 3) What is the average cost per unit and the ending inventory? Average cost per unit Ending inventory

28. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Weighted Average Cost Method (slide 3 of 3) Deducting the cost of the January 31 inventory from the cost of goods available for sale yields the cost of goods sold, computed as follows:

29. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comparing Inventory Costing Methods (slide 1 of 5) A different cost flow is assumed for the FIFO, LIFO, and weighted average inventory cost flow methods. As a result, the three methods normally yield different amounts for the following: o Cost of goods sold o Gross profit o Net income o Ending inventory Note that if costs (prices) remain the same, all three methods would yield the same results. However, costs (prices) normally do change.

30. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comparing Inventory Costing Methods (slide 2 of 5) Using the perpetual inventory system illustration with sales of $39,000 (1,300 units × $30), the differences in cost of goods sold, gross profit, and ending inventory are illustrated below.

31. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comparing Inventory Costing Methods (slide 3 of 5) FIFO reports higher gross profit and net income than the LIFO method when costs (prices) are increasing. However, in periods of rapidly rising costs, the inventory that is sold must be replaced at increasingly higher costs. o In such cases, the larger FIFO gross profit and net income are sometimes called inventory profits or illusory profits.

32. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comparing Inventory Costing Methods (slide 4 of 5) During a period of increasing costs, LIFO matches more recent costs against sales on the income statement. LIFO also offers an income tax savings during periods of increasing costs. o This is because LIFO reports the lowest amount of gross profit and, thus, lower taxable net income. However, under LIFO, the ending inventory on the balance sheet may be quite different from its current replacement cost.

33. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comparing Inventory Costing Methods (slide 5 of 5) The weighted average cost method is, in a sense, a compromise between FIFO and LIFO. The effect of cost (price) trends is averaged in determining the cost of goods sold and the ending inventory.

34. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Reporting Inventory in the Financial Statements Cost is the primary basis for valuing and reporting inventories in the financial statements. However, inventory may be valued at other than cost in the following cases: o The cost of replacing items in inventory is below the recorded cost. o The inventory cannot be sold at normal prices due to imperfections, style changes, spoilage, damage, obsolescence, or other causes.

35. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Valuation at Lower of Cost or Market (slide 1 of 3) If the market is lower than the purchase cost, the lower-of-cost-or-market (LCM) method is used to value the inventory. Market, as used in lower of cost or market, is the net realizable value of the inventory. Net realizable value is determined as follows: Net Realizable Value = Estimated Selling Price – Direct Costs of Disposal o Direct costs of disposal include selling expenses such as special advertising or sales commissions.

36. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Valuation at Lower of Cost or Market (slide 2 of 3) Assume the following data about an item of damaged inventory: In applying LCM, the market value of the inventory is $650, computed as follows: Thus, the inventory would be valued at $650, which is the lower of its cost of $1,000 and its market value of $650.

37. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Valuation at Lower of Cost or Market (slide 3 of 3) The lower-of-cost-or-market method can be applied in one of three ways. The cost, market price, and any declines could be determined for the following: o Each item in the inventory o Each major class or category of inventory o Total inventory as a whole

38. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Determining Inventory at Lower of Cost or Market (LCM)

39. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Inventory on the Balance Sheet Inventory is usually reported in the current assets section of the balance sheet. In addition to this amount, the following are reported: o The method of determining the cost of the inventory (FIFO, LIFO, or weighted average) o The method of valuing the inventory (cost or the lower of cost or market)

40. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Inventory Errors on the Financial Statements (slide 1 of 3) Any errors in merchandise inventory will affect the balance sheet and income statement. Some reasons that inventory errors may occur include the following: o Physical inventory on hand was miscounted. o Costs were incorrectly assigned to inventory. o Inventory in transit was incorrectly included or excluded from inventory. o Consigned inventory was incorrectly included or excluded from inventory.

41. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Inventory Errors on the Financial Statements (slide 2 of 3) Inventory errors often arise from merchandise that is in transit at year-end. Shipping terms determine when the title to merchandise passes. o When goods are purchased or sold FOB shipping point, title passes to the buyer when the goods are shipped. o When the terms are FOB destination, title passes to the buyer when the goods are received.

42. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Inventory Errors on the Financial Statements (slide 3 of 3) Inventory errors often arise from consigned inventory. Manufacturers sometimes ship merchandise to retailers who act as the manufacturer’s selling agent. The manufacturer, called the consignor, retains title until the goods are sold. Such merchandise is said to be shipped on consignment to the retailer, called the consignee. Any unsold merchandise at year-end is part of the manufacturer’s (consignor’s) inventory, even though the merchandise is in the hands of the retailer (consignee).

43. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Inventory Errors on Current Period’s Income Statement

44. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Inventory Errors on Two Years’ Income Statements

45. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Inventory Errors on Current Period’s Balance Sheet

46. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analysis for Decision Making: Inventory Turnover (slide 1 of 2) Inventory turnover measures the relationship between cost of goods sold and the amount of inventory carried during the period. It measures the number of times inventory is turned into sold goods during the year. Inventory turnover is calculated as follows: Cost of Goods Sold Inventory Turnover = Average Inventory

47. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analysis for Decision Making: Inventory Turnover (slide 2 of 2) To illustrate, inventory turnover for Best Buy is computed from the following data (in millions) taken from two recent annual reports:

48. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analysis for Decision Making: Number of Days’ Sales in Inventory (slide 1 of 2) The number of days’ sales in inventory measures the length of time it takes to acquire, sell, and replace the inventory. The number of days’ sales in inventory is computed as follows: Average Inventory Number of Days’ Sales in Inventory = Average Daily Cost of Goods Sold

49. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Analysis for Decision Making: Number of Days’ Sales in Inventory (slide 2 of 2) To illustrate, the number of days’ sales in inventory for Best Buy is computed from the following data (in millions) taken from two recent annual reports:

50. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Estimating Inventory Cost A business may need to estimate the amount of inventory for the following reasons: o Perpetual inventory records are not maintained. o A disaster such as a fire or flood has destroyed the inventory records and the inventory. o Monthly or quarterly financial statements are needed, but a physical inventory is taken only once a year. Two widely used methods of estimating inventory cost are the retail inventory method and gross profit method.

51. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Retail Method of Inventory Costing (slide 1 of 2) The retail inventory method of estimating inventory cost requires costs and retail prices to be maintained for the merchandise available for sale. A ratio of cost to retail price is then used to convert ending inventory at retail to estimate the ending inventory cost.

52. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Retail Method of Inventory Costing (slide 2 of 2) The retail inventory method is applied as follows: o Step 1. Determine the total merchandise available for sale at cost and retail. o Step 2. Determine the ratio of the cost to retail of the merchandise available for sale. o Step 3. Determine the ending inventory at retail by deducting the sales from the merchandise available for sale at retail. o Step 4. Estimate the ending inventory cost by multiplying the ending inventory at retail by the cost to retail ratio.

53. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Determining Inventory by the Retail Method

54. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Gross Profit Method of Inventory Costing (slide 1 of 2) The gross profit method uses the estimated gross profit for the period to estimate the inventory at the end of the period. The gross profit is estimated from the preceding year, adjusted for any current-period changes in the cost and sales prices.

55. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix: Gross Profit Method of Inventory Costing (slide 2 of 2) The gross profit method is applied as follows: o Step 1. Determine the merchandise available for sale at cost. o Step 2. Determine the estimated gross profit by multiplying the sales by the gross profit percentage. o Step 3. Determine the estimated cost of goods sold by deducting the estimated gross profit from the sales. o Step 4. Estimate the ending inventory cost by deducting the estimated cost of goods sold from the merchandise available for sale.

56. © 2017 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Estimating Inventory by Gross Profit Method