1. Chapter Eight Inventory

2. Copyright © Houghton Mifflin Company.All rights reserved.8 - 2 Inventory Assets a company holds that will ultimately be sold to its customers Often the largest current asset that a firm holds Can take the form of finished goods, raw materials, or work in process

3. Copyright © Houghton Mifflin Company.All rights reserved.8 - 3 The Purchasing Cycle

4. Copyright © Houghton Mifflin Company.All rights reserved.8 - 4 Shipping Terms FOB shipping point: Buyer pays the transportation costs Purchase is recorded by the buyer when the inventory is shipped by the vendor FOB destination: Seller pays the transportation costs Purchase is recorded by the buyer when the inventory is received

5. Copyright © Houghton Mifflin Company.All rights reserved.8 - 5 The Sales Cycle Customer purchase Record sale and cost of sale Increase Cash or A/R Increase Sales Decrease Inventory Increase Cost of Goods Sold Credit payment received by firm

6. Copyright © Houghton Mifflin Company.All rights reserved.8 - 6 Accounting for Inventory Initially record at full cost (purchase price plus shipping, handling, shipping insurance, and taxes) Perpetual Inventory System Periodic Inventory System Inventory account adjusted for every purchase or sale Inventory account adjusted only at end of accounting period

7. Copyright © Houghton Mifflin Company.All rights reserved.8 - 7 Perpetual Inventory System Illustration When Vanya Co. purchases an inventory item on account for $10, the following entry is made: When the item is sold for $15 to a customer on account, the following entries are made: Inventory 10 Accounts Payable 10 Accounts Receivable 15 Sales 15 Cost of Sales 10 Inventory 10

8. Copyright © Houghton Mifflin Company.All rights reserved.8 - 8 Periodic Inventory System Illustration Vanya Co. purchases an inventory item on account for $10 and the following entry is made: Purchases 10 Accounts Payable 10 Accounts Receivable 15 Sales 15 When the item is sold for $15 to a customer on account, the following entry is made: The Inventory account is not updated until the end of the period by performing a physical count of inventory.

9. Copyright © Houghton Mifflin Company.All rights reserved.8 - 9 Costing Inventory Cost-Flow Methods: Specific Identification Average Cost First-in, first-out (FIFO) Last-in, first-out (LIFO) As inventories turn over, with items rapidly entering and exiting the pool of items, how should the value of inventory be determined?

10. Copyright © Houghton Mifflin Company.All rights reserved.8 - 10 Specific Identification Method Inventory account reflects the physical flow of goods Ideal for a firm that has low sales volume and can easily track its goods When an item is sold, its actual cost is used to increase Cost of Sales and decrease Inventory Each item bought and sold is matched with its actual cost

11. Copyright © Houghton Mifflin Company.All rights reserved.8 - 11 Average-Cost Method Suited for firms that carry homogeneous items, such as grocery and office supply stores A new average cost must be computed after each purchase Cost of an inventory item is the average of the costs of all goods available for sale at that point in time

12. Copyright © Houghton Mifflin Company.All rights reserved.8 - 12 Average-Cost Method: Computing the Average Cost 1.Add the cost of new purchases to any previous inventory balance. 2.Divide this total by the number of units on hand. 3.Yields new average cost of units of inventory.

13. Copyright © Houghton Mifflin Company.All rights reserved.8 - 13 Average-Cost Method: Illustration Shoe Warehouse has a beginning inventory that consists of 25 pairs of shoes at $60 per pair. SW purchases 100 pairs at $70 per pair and makes the following entry: Inventory 7,000 Cash 7,000 Compute the average unit cost after the purchase: Beg. Inventory (25 x $60) $1,500 Purchase (100 x $70) 7,000 $8,500  125 = $68 Continue

14. Copyright © Houghton Mifflin Company.All rights reserved.8 - 14 Average-Cost Method: Illustration Shoe Warehouse sells 80 pairs of shoes at $125 per pair. When recording the cost of sales, use the newly computed average unit cost of $68. Cash (80 x $125) 10,000 Sales 10,000 Cost of Sales (80 x $68) 5,440 Inventory 5,440 Remember: After each purchase, the new average cost per unit must be computed

15. Copyright © Houghton Mifflin Company.All rights reserved.8 - 15 First-in, First-Out (FIFO) Method Inventory is carried at more current costs and cost of sales consists of older costs Under a perpetual system, the Inventory and Cost of Sales accounts are updated after each purchase and sale. Assumes that the first item into inventory is the first item sold to the customer

16. Copyright © Houghton Mifflin Company.All rights reserved.8 - 16 FIFO: Illustration Shoe Warehouse inventory activity: Jan. 1, purchased 25 pairs of shoes at $60 per pair. Jan. 3, purchased 100 pairs at $70 per pair. Jan. 8, sold 80 pairs at $125 per pair. Using the FIFO method, how will the sale and cost of the sale on Jan. 8 be recorded? Cash 10,000 Sales 10,000 Cost of Sales [(25 x $60) + (55 x $70)] 5,350 Inventory 5,350

17. Copyright © Houghton Mifflin Company.All rights reserved.8 - 17 Last-in, First-Out (LIFO) Method Inventory is carried at older costs and cost of sales consists of recent costs Under a perpetual system, the Inventory and Cost of Sales accounts are updated after each purchase and sale. Assumes that the last item into inventory is the first item sold to the customer

18. Copyright © Houghton Mifflin Company.All rights reserved.8 - 18 LIFO: Illustration Shoe Warehouse inventory activity: Jan. 1, purchased 25 pairs of shoes at $60 per pair. Jan. 3, purchased 100 pairs at $70 per pair. Jan. 8, sold 80 pairs at $125 per pair. Using the LIFO method, how will the sale on Jan. 8 as well as the cost of the sale be recorded? Cash 10,000 Sales 10,000 Cost of Sales (80 x $70) 5,600 Inventory 5,600

19. Copyright © Houghton Mifflin Company.All rights reserved.8 - 19 Comparing LIFO and FIFO Results in lower pretax earnings and tax payments Closer match between earnings and current-cost income Requires more complex record keeping Risk of LIFO liquidation Results in higher pretax earnings and tax payments Stronger correlation between inventory amount and current replacement cost Easier record keeping LIFOFIFO

20. Copyright © Houghton Mifflin Company.All rights reserved.8 - 20 Critical Thinking Discussion: What factors do you think businesses consider when choosing one inventory method over another? When businesses choose inventory methods, they consider the flow of merchandise, type of merchandise, how each method will impact net income and income tax, and what method competitors use. Some methods are more suitable to distinct goods while others are more suitable to homogeneous goods.

21. Copyright © Houghton Mifflin Company.All rights reserved.8 - 21 Choosing an Inventory Method Four Key Questions: 1.What cost-flow assumption will be used for tax purposes? If firms use LIFO for tax purposes, they must use FIFO for reporting purposes. 2.Which cost-flow assumption will result in the most cash flow? In times of rising prices, LIFO results in lower income and lower tax payments, which means that the firm will have more cash left after paying taxes.

22. Copyright © Houghton Mifflin Company.All rights reserved.8 - 22 Choosing an Inventory Method (continued) Four Key Questions: 3.What cost-flow assumptions are competitors using? Choose a method equivalent to competitors so that financial results and ratios will be comparable. 4.Which cost-flow assumption is easiest to implement? The FIFO method requires less record keeping as compared to the other methods.

23. Copyright © Houghton Mifflin Company.All rights reserved.8 - 23 Special LIFO Issues Use of LIFO causes older, less current values to be reported as inventory amounts Change in the LIFO reserve from one period to another is called the LIFO effect LIFO ReserveCurrent costs -Inventory valued using LIFO = Disclose in notes to the financial statements

24. Copyright © Houghton Mifflin Company.All rights reserved.8 - 24 LIFO Liquidation If a period’s ending inventory is ever lower than its beginning inventory, it is assumed that older, less costly inventory has been sold = LIFO liquidation Effect: Cost of sales does not reflect current costs and gross profit is inflated. Thus higher earnings are reported (not the intended effect of the LIFO method).

25. Copyright © Houghton Mifflin Company.All rights reserved.8 - 25 Inventory Pools Tracking entire inventory as a whole or in pools of like items reduces the danger of LIFO liquidation. A reduction in one inventory item within the pool is likely to be offset by an increase in another item in the pool.

26. Copyright © Houghton Mifflin Company.All rights reserved.8 - 26 Dollar-Value LIFO Based on the assumption that inventory is a quantity of value rather than a quantity of physical goods. Increases and decreases in inventory are measured in dollar amounts, not numbers of items.

27. Copyright © Houghton Mifflin Company.All rights reserved.8 - 27 Dollar-Value LIFO Illustration 1.Determine whether inventory has increased or decreased in real dollars. (Prices in the firm’s industry have risen such that the price index is 107 percent at year end.) $42,000  107% = $39,252 2.Compare beginning inventory to computed amount. $39,252 - $35,000 = $4,252 Continue Komanda Co. begins using FIFO on Jan. 1, 2004 and has a beginning inventory of $35,000. At year end 2004, ending inventory is $42,000.

28. Copyright © Houghton Mifflin Company.All rights reserved.8 - 28 ValuePrice Balance in Base-YearIndexSheet Value Layer 1: Base-year $35,000 100% $35,000 Layer 2: Inventory increase for 2004 in terms of price index 4,252 107% 4,550 Dollar-value LIFO inventory at 12/31/04 $39,252 $39,550 Dollar-Value LIFO Illustration 3.To determine how the inventory should be valued on the balance sheet, group inventories into layers: Record on the balance sheet

29. Copyright © Houghton Mifflin Company.All rights reserved.8 - 29 Reported Amt Correct Amt Effect of Error Sales $105,000 $105,000 Cost of Sales: Beg. Inv. 25,000 25,000 Purchases 60,000 60,000 Available 85,000 85,000 Less End. Inv. (25,000) (27,000) $2,000 understated Cost of sales 60,000 58,000 $2,000 overstated Gross Profit 45,000 47,000 $2,000 understated Other expenses (25,000) (25,000) Income before taxes 20,000 22,000 $2,000 understated Tax expense (7,000) (7,700) $700 understated Net income $13,000 $14,300 $1,300 understated The Effect of Inventory Errors

30. Copyright © Houghton Mifflin Company.All rights reserved.8 - 30 Lower-of-Cost-or-Market Rule for Valuing Inventory Write down inventory to the lower value and record the loss If market value of inventory < original cost How is the market value of the inventory determined? Continue

31. Copyright © Houghton Mifflin Company.All rights reserved.8 - 31 Lower-of-Cost-or-Market Rule Illustration Rockwood Co. purchases inventory at a cost of $100. This inventory sells for $125, yielding a 20 percent gross profit. At the end of period, the replacement cost has fallen to $80. Under the LCM rule, in most cases, the inventory is reflected at its replacement cost, the more conservative value. Accounting Research Bulletin No. 43 Inventory’s current replacement cost should not exceed the net realizable value and should not be less than the net realizable value less gross margin.

32. Copyright © Houghton Mifflin Company.All rights reserved.8 - 32 Analyzing Inventory How well is inventory being managed? Are items in inventory turned (sold) quickly? Does a firm have too much inventory? Is the inventory profitable? Analysis Ratios Inventory Turnover Days in InventoryInventory Yield

33. Copyright © Houghton Mifflin Company.All rights reserved.8 - 33 Inventory Turnover Ratio Measures how quickly inventory flows through a business The higher the ratio, the more effectively management is controlling inventory Cost of Sales Average Inventory

34. Copyright © Houghton Mifflin Company.All rights reserved.8 - 34 Days in Inventory Measures how many days, on average, a firm holds inventory before selling it If a firm has a 3.76 inventory ratio, it would hold inventory, on the average, for 97 days 365  Inventory Turnover Ratio

35. Copyright © Houghton Mifflin Company.All rights reserved.8 - 35 Check Your Understanding QIf you purchase goods FOB shipping point, are you responsible for shipping charges? AFOB shipping point requires the buyer to pay the shipping charges.

36. Copyright © Houghton Mifflin Company.All rights reserved.8 - 36 Check Your Understanding QIf you want your accounting records (Inventory account) to reflect an accurate count of inventory at all times, which system of accounting for inventory purchases and sales would you use? AUnder the perpetual inventory system, the Inventory account is adjusted each time inventory is purchased or sold.

37. Copyright © Houghton Mifflin Company.All rights reserved.8 - 37 Check Your Understanding QMust a company employ the same cost- flow assumption for all its inventory items? ANo. Companies may employ different assumptions for various products.

38. Copyright © Houghton Mifflin Company.All rights reserved.8 - 38 Check Your Understanding QWhich inventory method is based on the assumption that each inventory item bought and sold can be matched with its actual cost? ASpecific identification method

39. Copyright © Houghton Mifflin Company.All rights reserved.8 - 39 Check Your Understanding QIf your company seeks to lower its externally reported net income, would it use FIFO or LIFO to accomplish this goal? ALIFO

40. Copyright © Houghton Mifflin Company.All rights reserved.8 - 40 Check Your Understanding QWhat situation causes a LIFO liquidation? AA LIFO liquidation occurs if a period’s ending inventory is lower than its beginning inventory.

41. Copyright © Houghton Mifflin Company.All rights reserved.8 - 41 Check Your Understanding QIf a company makes an error in counting inventory and it overstates inventory, how will net income be affected in the current year? ANet income will be overstated