1. John Wiley & Sons, Inc. Financial A ccounting 5e Prepared by Kurt M. Hull, MBA CPA California State University, Los Angeles Weygandt, Kieso, & Kimmel

2. CHAPTER 6 INVENTORIES CHAPTER 6 INVENTORIES STUDY OBJECTIVES After studying this chapter, you should understand: How to determine inventory quantities LCM for determining inventory values Inventory accounting & cost flow methods Inventory errors and their effects Tax effects of inventory cost flow methods How to compute and interpret inventory turnover

3. CLASSIFYING INVENTORY INVENTORY RAW MATERIALS WORK IN PROCESS FINISHED GOODS For manufacturers, inventory has three distinct categories.

4. STUDY OBJECTIVE 1 DETERMINING INVENTORY QUANTITIES STUDY OBJECTIVE 1 DETERMINING INVENTORY QUANTITIES At the balance sheet date, companies must determine how many units are on hand, and value those units. Two steps are required to achieve this: 1. Take a physical inventory count 2. Determine ownership of goods

5. INTERNAL CONTROLS FOR PHYSICAL INVENTORY INTERNAL CONTROLS FOR PHYSICAL INVENTORY 1Count done by employees with no custodial responsibilities. ( 由負責保管存貨以外的員工負責盤點 ) 2Counters establish authenticity of each item. ( 每位盤點人員必須確定每個存貨項目的正確性 ) 3Second count by another employee. ( 必須由另一位員工複點 ) 4Pre-numbered inventory tags and sequence checks. ( 使用預先編號的存貨標籤 ) 5 Supervisory review. ( 盤點結束後，必須確定所有的存貨上附 上標籤，且只有一個標籤。 ) Proper internal control over inventory can be achieved by the implementing the following procedures:

6. Seller Buyer Public Carrier Co. FOB Shipping Point FOB Destination Point Public Carrier Co. Buyer Seller Ownership passes to the buyer here DETERMINING OWNERSHIP OF GOODS IN TRANSIT DETERMINING OWNERSHIP OF GOODS IN TRANSIT

7. DETERMINING OWNERSHIP OF CONSIGNED GOODS DETERMINING OWNERSHIP OF CONSIGNED GOODS A consignment agreement transfers goods from a Consignor to a consignee, who agrees to sell the goods. Consignor ( 寄銷人 ) Consignee ( 承銷人 ) Customer Consignee remits proceeds (less fee) to consignor when inventory is sold. Inventory on consignment is included in the consignor’s inventory until sold. Sale

8. Pool of Costs Cost of Goods Available for Sale Beginning inventory $ 20,000 Cost of goods purchased 100,000 Cost of goods available for sale $120,000 Step 1 Step 2 Ending Inventory Cost of Goods Sold Unit Total Cost of goods available for sale $120,000 Units Cost Less: Ending inventory 15,000 5,000 $ 3.00 $15,000 Cost of goods sold $105,000 STUDY OBJECTIVE 2 INVENTORY COSTING – PERIODIC SYSTEM STUDY OBJECTIVE 2 INVENTORY COSTING – PERIODIC SYSTEM

9. 1 SPECIFIC IDENTIFICATION Inventory Purchases Item 1 $700 Item #2 $750 Item #3 $800 SOLD Cost of Goods Sold $1,500 Tracks actual flow of goods. Each item marked with its unit cost.

10. ASSUMED COST FLOW METHODS These methods assume cost flows that may be unrelated to the actual physical flow of goods. FIFOLIFO AVERAGE COST These cost flow assumptions do not have to be consistent with the actual flow of goods.

11. 1.Earliest goods purchased are the first to be sold. 2.Cost of earliest goods purchased are the first to be recognized as cost of goods sold. 3.Ending inventory consists of items purchased late in the year. FIFO FIRST-IN, FIRST-OUT FIFO FIRST-IN, FIRST-OUT FIFO ASSUMPTIONS

12. Step 1 Step 2 Ending Inventory Cost of Goods Sold Unit Total Date Units Cost 11/27 400 $ 13 $ 5,200 Cost of goods available for sale $ 12,000 08/24 50 12 600 Less: Ending inventory 5,800 450 $5,800 Cost of goods sold $6,200 ALLOCATION OF COSTS FIFO METHOD ALLOCATION OF COSTS FIFO METHOD 12,000

13. The accuracy of the cost of goods sold can be verified by recognizing that the first units acquired are the first units sold. UnitTotal DateUnitsCost 01/01X= 04/15X= 08/24X= Total 100 $ 10 $ 1,000 200 11 2,200 250 12 3,000 550 $ 6,200 COGS PROOF FIFO METHOD COGS PROOF FIFO METHOD

14. REVIEW QUESTION FIFO METHOD REVIEW QUESTION FIFO METHOD In a period of rising prices, will FIFO will produce a higher or lower net income than LIFO? Why? Answer: FIFO will produce a higher net income when prices are rising because cost of goods sold is made up of items purchased early in the year at lower prices.

15. 1.Latest goods purchased are the first to be sold. 2.Cost of latest goods purchased are the first to be recognized as cost of goods sold. 3.Ending inventory consists of items purchased early in the year. LIFO LAST-IN, FIRST-OUT LIFO LAST-IN, FIRST-OUT LIFO ASSUMPTIONS

16. Step 1 Step 2 Ending Inventory Cost of Goods Sold Unit Total Date Units Cost 01/01 100 $ 10 $ 1,000 04/15 200 11 2,200 Cost of goods available for sale $ 12,000 08/24 150 12 1,800 Less: Ending inventory 5,000 450 $5,000 Cost of goods sold $7,000 ALLOCATION OF COSTS LIFO METHOD ALLOCATION OF COSTS LIFO METHOD $12,000

17. The cost of the last goods in are the first to be assigned to cost of goods sold. Under a periodic inventory system, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase. UnitTotal DateUnitsCost 11/27X= X= 08/24 Total 400 $ 13 $ 5,200 150 12 1,800 550 $ 7,000 COGS PROOF LIFO METHOD COGS PROOF LIFO METHOD

18. REVIEW QUESTION LIFO METHOD REVIEW QUESTION LIFO METHOD In a period of rising prices, will LIFO will produce a higher or lower ending inventory than FIFO? Why? Answer: LIFO will produce a lower ending inventory than FIFO when prices are rising because ending inventory is made up of items purchased early in the year at lower prices.

19. 1.Goods available for sale are homogeneous. 2.Cost of goods available for sale is allocated on the basis of the weighted average unit cost incurred. 3.The weighted average unit cost is applied to the units on hand to determine the cost of ending inventory. AVERAGE COST AVERAGE COST ASSUMPTIONS

20. Step 1Step 2 Ending InventoryCost of Goods Sold $ 12,000÷1,000=$12.00 UnitTotalCost of goods available for sale$ 12,000 UnitsCost Less: Ending inventory5,400 450x$ 12.00=Cost of goods sold $ 12,000 $ 5,400 $ 6,600 ALLOCATION OF COSTS AVERAGE COST ALLOCATION OF COSTS AVERAGE COST

21. Cost of goods sold 4,000 (200 x $20) 4,800 (200 x $24) Kralik Company purchases: January 10200 units at $20 each December 31200 units at $24 each Kralik Company sold 200 units at $30 each Cost of goods sold and gross profit under FIFO and LIFO are: STUDY OBJECTIVE 3 FINANCIAL STATEMENT & EFFECTS STUDY OBJECTIVE 3 FINANCIAL STATEMENT & EFFECTS

22. The impact of Cost Flow Method on I/S The impact of Cost Flow Method on B/S The impact of Cost Flow Method on tax STUDY OBJECTIVE 3 FINANCIAL STATEMENT & EFFECTS

23. A company needs to use its chosen cost flow method consistently from one period to another. Consistent application makes more comparable financial statements. Changes in cost flow method should be disclosed in the financial statements. USE COST FLOW METHODS CONSISTENTLY USE COST FLOW METHODS CONSISTENTLY

24. The inventory is written down to its market value. STUDY OBJECTIVE 4 LOWER OF COST OR MARKET STUDY OBJECTIVE 4 LOWER OF COST OR MARKET Market Value Cost IF When using LCM: Market value = Replacement cost

25. Lower of Cost or Cost Market Television sets Consoles $ 60,000 $ 55,000 Portables 45,000 52,000 45,000 Total 105,000 107,000 Video equipment Recorders 48,000 45,000 Movies 15,000 14,000 Total 63,000 59,000 Total inventory $ 168,000 $ 166,000 $ 159,000 VALUING INVENTORY AT LOWER OF COST OR MARKET VALUING INVENTORY AT LOWER OF COST OR MARKET Illustration 6-18

26. Inventory errors thus affect both COGS and NET INCOME. STUDY OBJECTIVE 5 INVENTORY ERRORS STUDY OBJECTIVE 5 INVENTORY ERRORS Ending inventory Period 1 Beginning inventory Period 2 =

27. + = Beginning Inventory Cost of Goods Purchased Ending Inventory Cost of Goods Sold _ To find the effect of an inventory error using this formula: 1.Input INCORRECT DATA 2.Input CORRECT DATA 3.Compare results. FORMULA FOR COST OF GOODS SOLD FORMULA FOR COST OF GOODS SOLD

28. An error in ending inventory in the current period will have the reverse effect on net income in the next period. INCOME STATEMENT EFFECTS OF INVENTORY ERRORS INCOME STATEMENT EFFECTS OF INVENTORY ERRORS OverstatedUnderstatedEnding inventory overstated UnderstatedOverstatedEnding inventory understated UnderstatedOverstatedBeginning inventory understated OverstatedUnderstatedBeginning inventory understated NET INCOMECOGSINVENTORY ERROR

29. INCOME STATEMENT EFFECTS OF INVENTORY ERRORS INCOME STATEMENT EFFECTS OF INVENTORY ERRORS UnderstatedNoneUnderstated OverstatedNoneOverstated Stockholders’ EquityLiabilitiesAssetsEnding Inventory Error The effect of ending-inventory errors on the balance sheet can be determined by using the accounting equation: ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

30. Inventory is classified as a current asset in the balance sheet. COGS is subtracted from sales in the income statement. INVENTORY DISCLOSURES Notes to financial statements should include: Major inventory classes (if not on balance sheet) Basis of accounting (Cost or LCM) Costing Method (FIFO, LIFO, AVERAGE COST)

31. STUDY OBJECTIVE 6 INVENTORY TURNOVER STUDY OBJECTIVE 6 INVENTORY TURNOVER Measures the number of times on average the inventory is sold during a period. COGS AVERAGE INVENTORY = INVENTORY TURNOVER $198,747 ($24,401 +26,612) / 2 = 7.79 times Average days to sell = 365 / 7.79 = 47 days

32. The product data shown below for Bow Valley Electronics will be used to explain perpetual inventory costing using three assumed cost flow methods: Bow Valley Electronics Z202 Astro Condensers Unit Total DateExplanationUnitsCost 01/01Beginning inventory100 $10$ 1,000 04/15Purchase200 112,200 08/24Purchase300 123,600 11/27Purchase400 135,200 Total $ 12,000 APPENDIX 6A COST FLOWS—PERPETUAL INVENTORY APPENDIX 6A COST FLOWS—PERPETUAL INVENTORY FIFOAVERAGE COSTLIFO

33. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and August 24. DatePurchasesSalesBalance January 1(100 @ $10) $1,000 April 15(200 @ $11) $2,200(100 @ $10) (200 @ $11) $3,200 August 24(300 @ $12) $3,600(100 @ $10) (200 @ $11) (300 @ $12) $6,800 September 10(100 @ $10) (200 @ $11) $6,200 (250 @ $12) (50 @ $12) $600 November 27(400 @ $13) $5,200(50 @ $12) (400 @ $13) $5,800 APPENDIX 6A PERPETUAL INVENTORY – FIFO APPENDIX 6A PERPETUAL INVENTORY – FIFO

34. Under the LIFO method using a perpetual system, the cost of the most recent purchase prior to sale is allocated to the units sold. The cost of the goods sold on September 10 consists entirely of goods from the August 24 and April 15 purchases and 50 of the units in beginning inventory. DatePurchasesSalesBalance January 1(100 @ $10) $1,000 April 15(200 @ $11) $2,200(100 @ $10) (200 @ $11) $3,200 August 24(300 @ $12) $3,600(100 @ $10) (200 @ $11) (300 @ $12) $6,800 September 10(300 @ $20) (200 @ $11) $6,300 (50 @ $10) (50 @ $10) $500 November 27(400 @ $13) $5,200(50 @ $10) (400 @ $13) $5,700 APPENDIX 6A PERPETUAL INVENTORY – LIFO APPENDIX 6A PERPETUAL INVENTORY – LIFO

35. The average cost method in a perpetual inventory system is called the moving average method. Under this method a new average is computed after each purchase. The average cost is computed by dividing the cost of goods available for sale by the units on hand. The average cost is then applied to: APPENDIX 6A PERPETUAL INVENTORY – AVG COST APPENDIX 6A PERPETUAL INVENTORY – AVG COST Average Cost x Units Sold = COGS Average Cost x Remaining Units = ENDING INVENTORY

36. A new average is computed each time a purchase is made. On April 15, after 200 units are purchased for $2,200, a total of 300 units costing $3,200 ($1,000 + $2,200) are on hand. The average cost is $10.667 ($3,200/300). Date Purchases Sales Balance January 1 (100 @ $10) $1,000 April 15 (200 @ $11) $2,200 (300 @ 10.667) $3,200 August 24 (300 @ $12) $3,600 (600 @ 11.333) $6,800 September 10 (550 @ 11,333) $6,233 (50 @ $11.333) $567 November 27 (400 @ $13) $5,200 (450 @ 12.816) $5,767 APPENDIX 6A PERPETUAL INVENTORY – AVG COST APPENDIX 6A PERPETUAL INVENTORY – AVG COST

37. The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales. It is used in preparing monthly financial statements under a periodic system. It should NOT be used in preparing the company’s financial statements at year-end. The gross profit rate is assumed to remain constant from one year to the next. APPENDIX 6B INVENTORY ESTIMATION – GROSS PROFIT METHOD APPENDIX 6B INVENTORY ESTIMATION – GROSS PROFIT METHOD

38. Cost of Goods Available for Sale Net Sales Estimated Gross Profit Estimated Cost of Goods Sold Estimated Cost of Goods Sold Estimated Cost of Ending Inventory APPENDIX 6B GROSS PROFIT METHOD FORMULAS APPENDIX 6B GROSS PROFIT METHOD FORMULAS

39. When a store has many different types of merchandise at low unit costs, the retail inventory method is often used. To use this method, a company’s records must show both the cost and retail value of the goods available for sale. The major disadvantage of this method is that it is an averaging technique. APPENDIX 6B INVENTORY ESTIMATION – RETAIL INVENTORY METHOD APPENDIX 6B INVENTORY ESTIMATION – RETAIL INVENTORY METHOD

40. Ending Inventory at Retail Step 1 Cost to Retail Ratio Goods Available for Sale at Retail Net Sales Goods Available for Sale at Cost Goods Available for Sale at Retail Step 2 Estimated Cost of Ending Inventory Step 3 Ending Inventory at Retail Cost to Retail Ratio APPENDIX 6B RETAIN INVENTORY METHOD FORMULAS APPENDIX 6B RETAIN INVENTORY METHOD FORMULAS

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42. CHAPTER 6 INVENTORIES