2. Accounting, Third Edition
Reporting and Analyzing Inventory
Accounting, Third Edition

3. Study Objectives
Describe the steps in determining inventory quantities.
Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
Explain the lower-of-cost-or-market basis of accounting for inventories.
Compute and interpret the inventory turnover ratio.
Describe the LIFO reserve and explain its importance for comparing results of different companies.
Apply the inventory cost flow methods to perpetual inventory records.
Indicate the effects of inventory errors on the financial statements.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

4. Reporting and Analyzing Inventory
Classifying Inventory
Determining Inventory Quantities
Inventory Costing
Analysis of Inventory
Finished goods
Work in process
Raw materials
Taking a physical inventory
Determining ownership of goods
Specific identification
Cost flow assumptions
Financial statement and tax effects
Consistent use
Lower-of-cost-or-market
Inventory turnover ratio
LIFO reserve
Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.
Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.
Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.
Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:
difference between the actual return and the expected return on plan assets and,
amortization of the unrecognized net gain or loss from previous periods

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

7. Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
Check accuracy of inventory records.
Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft).
Periodic System
Determine the inventory on hand
Determine the cost of goods sold for the period.
SO 1 Describe the steps in determining inventory quantities.

8. Determining Inventory Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of inventory on hand.
Taken,
when the business is closed or when business is slow.
at end of the accounting period.
SO 1 Describe the steps in determining inventory quantities.

9. Determining Inventory Quantities
Determining Ownership of Goods
Goods in Transit
Purchased goods not yet received.
Sold goods not yet delivered.
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.
SO 1 Describe the steps in determining inventory quantities.

10. Determining Inventory Quantities
Terms of Sale
Illustration 6-1
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.
SO 1 Describe the steps in determining inventory quantities.

11. Determining Inventory Quantities
Review Question
Goods in transit should be included in the inventory of the buyer when the:
public carrier accepts the goods from the seller.
goods reach the buyer.
terms of sale are FOB destination.
terms of sale are FOB shipping point.
Answer = A
SO 1 Describe the steps in determining inventory quantities.

12. Determining Inventory Quantities
Determining Ownership of Goods
Consigned Goods
Goods held for sale by one party although ownership of the goods is retained by another party.
SO 1 Describe the steps in determining inventory quantities.

13. Inventory Costing
Unit costs can be applied to quantities on hand using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Average-cost
Cost Flow Assumptions
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

14. Inventory Costing
Illustration: Assume that Crivitz TV Company purchases three identical 46-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 6-2
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

15. Inventory Costing “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 6-3
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

16. Specific Identification Method
Inventory Costing
Specific Identification Method
An 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.
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

17. Inventory Costing – Cost Flow Assumptions
does not need to equal
Physical Movement of Goods
Illustration 6-11
Use of cost flow methods in major U.S. companies
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

18. Inventory Costing – Cost Flow Assumptions
Illustration: Data for Houston Electronics’ Astro condensers.
Illustration 6-4
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

19. Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Earliest goods purchased are first to be sold.
Often parallels actual physical flow of merchandise.
Generally good business practice to sell oldest units first.
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

20. Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Illustration 6-5
Solution on notes page
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

21. Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Illustration 6-5
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

22. Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Latest goods purchased are first to be sold.
Seldom coincides with actual physical flow of merchandise.
Exceptions include goods stored in piles, such as coal or hay.
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

23. Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Illustration 6-7
Solution on notes page
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

24. Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Illustration 6-7
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

25. Inventory Costing – Cost Flow Assumptions
“Average Cost”
Allocates cost of goods available for sale on the basis of weighted average unit cost incurred.
Assumes goods are similar in nature.
Applies weighted average unit cost to the units on hand to determine cost of the ending inventory.
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

26. Inventory Costing – Cost Flow Assumptions
“Average Cost”
Illustration 6-10
Solution on notes page
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

27. Inventory Costing – Cost Flow Assumptions
”Average Cost”
Illustration 6-10
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

28. Inventory Costing – Cost Flow Assumptions
Comparative Financial Statement Summary
FIFO
Average
LIFO
Sales $9,000 $9,000 $9,000
Cost of goods sold 6,200 6,600 7,000
Gross profit 2,800 2,400 2,000
Admin. & selling expense
Income before taxes 2,470 2,070 1,670
Income tax expense
Net income $2,330 $1,950 $1,560
Inventory balance $5,800 $5,400 $5,000
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

29. Inventory Costing – Cost Flow Assumptions
In Period of Rising Prices, FIFO Reports:
FIFO
Average
LIFO
Sales $9,000 $9,000 $9,000
Cost of goods sold 6,200 6,600 7,000
Gross profit 2,800 2,400 2,000
Admin. & selling expense
Income before taxes 2,470 2,070 1,670
Income tax expense
Net income $2,330 $1,950 $1,560
Inventory balance $5,800 $5,400 $5,000
Lowest
Highest
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

30. Inventory Costing – Cost Flow Assumptions
In Period of Rising Prices, LIFO Reports:
FIFO
Average
LIFO
Sales $9,000 $9,000 $9,000
Cost of goods sold 6,200 6,600 7,000
Gross profit 2,800 2,400 2,000
Admin. & selling expense
Income before taxes 2,470 2,070 1,670
Income tax expense
Net income $2,330 $1,950 $1,560
Inventory balance $5,800 $5,400 $5,000
Highest
Lowest
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

31. Inventory Costing – Cost Flow Assumptions
Review Question
The cost flow method that often parallels the actual physical flow of merchandise is the:
FIFO method.
LIFO method.
average cost method.
gross profit method.
Answer = A
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

32. Inventory Costing – Cost Flow Assumptions
Review Question
In a period of inflation, the cost flow method that results in the lowest income taxes is the:
FIFO method.
LIFO method.
average cost method.
gross profit method.
Answer = B
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

34. Using Cost Flow Methods Consistently
Inventory Costing
Using Cost Flow Methods Consistently
Method should be used consistently, enhances comparability.
Although consistency is preferred, a company may change its inventory costing method.
Illustration 6-14
Disclosure of change in cost flow method
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

35. Lower-of-Cost-or-Market
Inventory Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
Companies can “write down” the inventory to its market value in the period in which the price decline occurs.
Market value = Replacement Cost
Example of conservatism.
SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

36. Lower-of-Cost-or-Market
Inventory Costing
Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.
$ 55,000
45,000
45,000
12,800
$157,800
SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

37. Analysis of Inventory Analysis of Inventory
Inventory management is a double-edged sword
High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage).
Low Inventory Levels – may lead to stockouts and lost sales.
SO 5 Compute and interpret the inventory turnover ratio.

38. Analysis of Inventory
Inventory turnover measures the number of times on average the inventory is sold during the period.
Cost of Goods Sold
Inventory Turnover =
Average Inventory
Days in inventory measures the average number of days inventory is held.
Days in Year (365)
Days in Inventory =
Inventory Turnover
SO 5 Compute and interpret the inventory turnover ratio.

39. Analysis of Inventory
Illustration: The following data are available for Wal-Mart.
Inventory Turnover 2007
$264,152 =
8.1 times =
(33, ,910) / 2
Days in inventory 2007
365 Days =
45.1 Days =
8.1
SO 5 Compute and interpret the inventory turnover ratio.

40. Analysis of Inventory
Illustration: The following data are available for Wal-Mart.
Inventory Turnover 2006
$237,649 =
7.7 times =
(31, ,419) / 2
Days in inventory 2006
365 Days =
47.4 Days =
7.7
SO 5 Compute and interpret the inventory turnover ratio.

42. Analysis of Inventory Analysts’ Adjustments for LIFO Reserve
Companies using LIFO are required to report the amount that inventory would increase (or occasionally
decrease) if the company had instead been using FIFO. This amount is referred to as the LIFO reserve.
Illustration 6-17
SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.

43. Analysis of Inventory Analysts’ Adjustments for LIFO Reserve
The LIFO reserve can have a significant effect on ratios analysts commonly use.
Illustration 6-19
SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.

44. Cost Flow Methods in Perpetual Systems
Illustration:
Appendix 6A
Illustration 6A-1
Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

45. + Cost Flow Methods in Perpetual Systems Perpetual Inventory
FIFO Method
Solution on notes page
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

46. + Cost Flow Methods in Perpetual Systems Perpetual Inventory
LIFO Method
Solution on notes page
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

47. + Cost Flow Methods in Perpetual Systems Perpetual Inventory
Moving Average
Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase.
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

48. + Cost Flow Methods in Perpetual Systems Perpetual Inventory
Moving Average
Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase.
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

49. Common Cause: Inventory Errors
Appendix 6B
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.
SO 8 Indicate the effects of inventory errors on the financial statements.

50. Income Statement Effects
Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income.
Illustration 6-B1
Illustration 6-B2
SO 8 Indicate the effects of inventory errors on the financial statements.

51. Income Statement Effects
Inventory Errors
Income Statement Effects
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.
The ending inventory depends entirely on the accuracy of taking and costing the inventory.
SO 8 Indicate the effects of inventory errors on the financial statements.

52. Net Income understated
Inventory Errors
Illustration 6-B3
Combined income for 2-year period is correct.
($3,000)
Net Income understated
$3,000
Net Income overstated
SO 8 Indicate the effects of inventory errors on the financial statements.

53. Review Question Inventory Errors
Understating ending inventory will overstate:
assets.
cost of goods sold.
net income.
owner's equity.
SO 8 Indicate the effects of inventory errors on the financial statements.

54. Balance Sheet Effects Inventory Errors
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Illustration 6-B1
Illustration 6-B4
SO 8 Indicate the effects of inventory errors on the financial statements.

55. Copyright
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