1. Financial Accounting: Tools for Business Decision Making Prepared by: Dr. Jessica J. Frazier and Philip Li Eastern Kentucky University Kimmel, Weygandt, Kieso

2. CHAPTER 6 Reporting and Analyzing Inventory After reading Chapter 6, you should be able to: zExplain the recording of purchases and sales of inventory under a periodic inventory system. zExplain how to determine cost of goods sold under a periodic inventory system. zDescribe the steps in determining inventory quantities.

3. CHAPTER 6 Reporting and Analyzing Inventory After reading Chapter 6, you should be able to: zIdentify the unique features of the income statement for a merchandising company under a periodic inventory system. zExplain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. zExplain the financial statement and tax effects of each of the inventory cost flow assumptions.

4. CHAPTER 6 Reporting and Analyzing Inventory zExplain the lower of cost or market basis of accounting for inventories. zCompute and interpret the inventory turnover ratio. zDescribe the LIFO reserve and explain its importance for comparing results of different companies.

5. PURCHASES AND SALES OF INVENTORY UNDER A PERIODIC INVENTORY SYSTEM zRevenues from sale of merchandise recorded when sales are made. zOn date of sale, no attempt is made to record the cost of the merchandise sold.

6. Recording Purchases of Merchandise Under a Periodic Inventory System zPurchases account is increased and accounts payable increased when merchandise is purchased. zFreight-in is increased and accounts payable are increased or cash decreased when buyer pays freight for merchandise purchased.

7. Purchase Discounts zPurchase discounts, a contra account to purchases, is increased and accounts payable decreased when discounts are earned.

8. Purchase Returns and Allowances zPurchase returns and allowances, a contra account to purchases, is increased and accounts payable decreased when merchandise is returned or an allowance is given.

9. COST OF GOODS SOLD UNDER A PERIODIC INVENTORY SYSTEM To determine cost of goods sold: zFind balance in merchandise inventory at beginning of period. zAdd the amount of purchases of merchandise inventory for the period to find cost of goods available. zSubtract ending balance in merchandise inventory to get find cost of goods sold. yThe amount of the ending inventory must be determined by a physical count.

10. DETERMINING INVENTORY QUANTITIES Determining inventory quantities involves two steps: zTaking a physical inventory of goods on hand. zDetermining ownership of goods.

11. Taking a Physical Inventory of Goods on Hand zInvolves actually counting, weighing, or measuring each individual of inventory on hand. zQuantity of each kind of inventory is listed on inventory summary sheets where unit costs will be applied to the quantities to determine total cost of the inventory.

12. Determining Ownership of Goods zGoods in transit should be included in the inventory of the company that has legal title to the goods. zConsigned goods are counted in the inventory of the owner rather than the consignor.

13. Goods in Transit FOB Shipping Point zOwnership of goods shipped FOB (free on board) shipping point passes to the buyer when the public carrier accepts the goods from the seller. Therefore, goods should be counted in inventory of buyer.

14. Goods in Transit FOB Destination zOwnership of goods shipped FOB (free on board) destination remains with the seller until the goods reach the buyer and should be included in the inventory of the seller.

15. INCOME STATEMENT FOR A MERCHANDISING COMPANY UNDER A PERIODIC INVENTORY SYSTEM zSales revenue zCost of goods sold zGross profit

16. Sales Revenue zThe income statement for a merchandising concern typically presents gross sales revenues for the period and deducts the contra revenue accounts (sales returns and allowances and sales discounts) to arrive at net sales.

17. Cost of Goods Sold zCost of goods sold under periodic inventory system will usually be more detailed, starting with beginning inventory, adding purchases, subtracting ending inventory.

18. Goods Sold in Units Beginning inventory Purchases Goods available Ending inventory Goods sold -0- 1,250 250 1,000

19. Gross Profit zCost of goods sold is deducted from net sales to determine gross profit. zGross profit is the merchandising profit of the company.

20. ACCOUNTING FOR INVENTORIES AND APPLY THE INVENTORY COST FLOW METHODS zDetermining ending inventory can be complicated if the units on hand for a specific item of inventory have been purchased at different prices.

21. Inventory Costing Methods There are a number of inventory costing methods: zSpecific identification is practical when a company can positively identify which particular units were sold and which are still in ending inventory. zThere is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods.

22. Cost Flows Assumptions When items are indistinguishable from one another, making it impossible or impractical to track each item's cost, one of the three cost flow assumptions may be used: First-in, First-out (FIFO) method zLast-in, First-out (LIFO) method zAverage cost method

23. First-in, First-out (FIFO) Method zFirst-in, First-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. zUnder FIFO, the cost of the ending inventory is obtained by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.

24. Cost of Goods Sold - FIFO

25. Last-in, First-out (LIFO) Method zLast-in, First-out (LIFO) method assumes that the last goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. zUnder LIFO, the cost of the ending inventory is obtained by taking the unit cost the earliest goods available for sale and working forward until all units of inventory have been costed.

26. Cost of Goods Sold - LIFO

27. Average Cost Method zAverage cost method assumes that the goods available for sale are homogeneous and allocates the cost of goods available for sale on the basis of weighted average unit cost incurred. zThe weighted average unit cost is then applied to the units on hand to determine the cost of the ending inventory.

28. Cost of Goods Sold - Average Cost $145,500 / 1,250 = 116.4 per unit

29. Cost of Goods Sold - Average Cost

30. FINANCIAL STATEMENT AND TAX EFFECTS OF EACH OF THE INVENTORY COST FLOW ASSUMPTIONS The reasons companies adopt different inventory cost flow methods are varied, but usually involve on the three following factors: Income statement effects zBalance sheet effects zTax Effects

31. Income Statement Effects zIn periods of increasing prices, FIFO reports the highest net income, LIFO the lowest net income and average cost falls in the middle. zIn periods of decreasing prices, the converse is true, FIFO will report the lowest net income, LIFO the highest, with average cost in the middle.

32. Balance Sheet Effects zIn a period of inflation, the costs allocated to ending inventory using FIFO will approximate current costs. zConversely, During a period of increasing prices, the costs allocated the ending inventory using LIFO will be significantly understated.

33. Tax Effects zBoth inventory on the balance sheet and net income on the income statement are higher when FIFO is used in a period of inflation. zMany companies have switched to LIFO because LIFO yields the lowest net income and therefore, the lowest income tax liability in a period of increasing prices.

34. THE LOWER OF COST OR MARKET BASIS OF ACCOUNTING FOR INVENTORIES zWhen the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline occurs.

35. Lower of Cost or Market (LCM) Under the LCM basis, market is defined as current replacement cost, not selling price. zFor a merchandising company, market is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. zThe lower of cost or market basis may be applied to individual items of inventory, major categories of inventory, or total inventory.

36. COMPUTE AND INTERPRET THE INVENTORY TURNOVER RATIO zInventory turnover ratio is computed by dividing cost of goods sold by average inventory. zThe ratio tells how many times the inventory is turning over during the year. yDays in inventory, computed by dividing 365 days by the inventory turnover ratio, indicates the average age of the inventory.

37. LIFO RESERVE AND ITS IMPORTANCE FOR COMPARING RESULTS OF DIFFERENT COMPANIES zAccounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO. zThis amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods.

38. Chapter 6 Review zKnow how to record purchases of inventory under a periodic inventory system. zKnow how to record sales of inventory under a periodic inventory system. zBe able to calculate cost of goods sold and ending inventory under a periodic inventory system. zWhat are the steps in determining inventory quantities?

39. Chapter 6 Review zWhat are the unique features of the income statement for a merchandising company under a periodic inventory system? zExplain the basis of accounting for inventories and apply the inventory cost flow methods-- FIFO, LIFO, weighted-average--under a periodic inventory system. zCompare the financial statement and tax effects of each of the inventory cost flow assumptions-- FIFO, LIFO, weighted-average.

40. Chapter 6 Review zWhat is the lower of cost or market basis of accounting for inventories? zWhat is the inventory turnover ratio? How is it computed? zWhat is the LIFO reserve? Explain its importance for comparing results of different companies.

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