1. Slide 6-1 Inventories Financial Accounting, Seventh Edition Chapter 6

2. Slide 6-2 Merchandise Inventory affects... The matching principle requires matching cost of goods sold with sales revenue. Balance Sheet Income Statement Why is Inventory Cost Analysis Important?

3. Slide 6-3 1. Gross profit – operating expenses = operating income 2. Sales – cost of goods sold – operating expenses = operating income 3. Net income + operating expenses = Gross Profit 4. Operating expenses – cost of goods sold = gross profit Knowledge Check Question: Which of the following expressions is incorrect ?

4. Slide 6-4 Classifying Inventory One Classification: Merchandise Inventory Three Classifications: Raw Materials Work in Process Finished Goods Merchandising Company Manufacturing Company Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

5. Slide 6-5 Physical Inventory taken for two reasons: Perpetual System 1. Check accuracy of inventory records. 2. Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft). Periodic System 1. Determine the inventory on hand 2. Determine the cost of goods sold for the period. Determining Inventory Quantities

6. Slide 6-6 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. Taking a Physical Inventory Determining Inventory Quantities

7. Slide 6-7 FOB Destination Point Public Carrier SellerBuyer Public Carrier Seller Buyer FOB Shipping Point Ownership passes to the buyer here. 5-7 Determining Ownership of Goods in Transit 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.

8. Slide 6-8 1. Merchandise in transit sold to customers, FOB shipping point 2. Merchandise in transit sold to customers, FOB destination 3. The cost of all inventory purchased during the period 4. Merchandise purchased in transit with terms FOB destination Knowledge Check Question: Ending Inventory is equal to inventory on hand plus:

9. Slide 6-9 Consigned Goods In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods. These are called consigned goods. Determining Ownership of Goods Determining Inventory Quantities

10. Slide 6-10 Wally Mart buys and sells toasters and had the following transactions for 2012: w June 1 Purchased 10 toasters at $6 per unit. w July 1 Purchased 10 toasters at $9 per unit. w Oct 1 Sold 10 toasters at $11 per unit w What was Wally Mart’s Gross Profit in 2012? Effect of Inventory Cost Flow Assumption

11. Slide 6-11 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 Inventory Costing Cost Flow Assumptions

12. Slide 6-12 Illustration for Bikers’ Bikes Company

13. Slide 6-13 + + Cost of Beginning inventory Net cost of purchases Cost of goods available for sale Cost of Ending inventory Cost of Ending inventory Cost of goods sold = Cost Flow for a Merchandising Company

14. Slide 6-14 When units are sold, the specific cost of the unit sold is added to cost of goods sold. Specific Identification Method

15. Slide 6-15 The company keeps track of its inventory using the Specific Identification Method. The sales were made as follows: August 14: 8 bikes costing $91 12 bikes costing $106 August 31: 2 bikes costing $91 3 bikes costing $106 15 bikes costing $115 3 bikes costing $119 The company keeps track of its inventory using the Specific Identification Method. The sales were made as follows: August 14: 8 bikes costing $91 12 bikes costing $106 August 31: 2 bikes costing $91 3 bikes costing $106 15 bikes costing $115 3 bikes costing $119 Specific Identification Method

16. Slide 6-16 + + Cost of Beginning inventory Net cost of purchases Cost of goods available for sale Cost of Ending inventory Cost of Ending inventory Cost of goods sold = Cost Flow for a Merchandising Company

17. Slide 6-17 Cost of Goods Sold Ending Inventory Oldest Costs Recent Costs FIRST IN FIRST OUT METHOD

18. Slide 6-18 FIRST IN FIRST OUT METHOD

19. Slide 6-19 + + Cost of Beginning inventory Net cost of purchases Cost of goods available for sale Cost of Ending inventory Cost of Ending inventory Cost of goods sold = Cost Flow for a Merchandising Company

20. Slide 6-20 Cost of Goods Sold Ending Inventory Recent Costs Oldest Costs LAST IN FIRST OUT METHOD

21. Slide 6-21 LAST IN FIRST OUT METHOD

22. Slide 6-22 + + Cost of Beginning inventory Net cost of purchases Cost of goods available for sale Cost of Ending inventory Cost of Ending inventory Cost of goods sold = Cost Flow for a Merchandising Company

23. Slide 6-23 AVERAGE COST METHOD

24. Slide 6-24 + + Cost of Beginning inventory Net cost of purchases Cost of goods available for sale Cost of Ending inventory Cost of Ending inventory Cost of goods sold = Cost Flow for a Merchandising Company

25. Slide 6-25 FIFOLIFOAVERAGE COST Sales Revenue$6,050 Cost of Goods Sold(4,570)(4,868)(4,683) Gross Profit$1,480$1,182$1,367 Operating Expenses(1,000) Income before Income Taxes$480$182$367 Income Tax Expense (40%)(192)(73)(147) NET INCOME$288$109$220 Income Statement Effects of Inventory Cost Flow Assumptions Which method of accounting would the company management choose?

26. Slide 6-26 Inventory Costing – Cost Flow Assumptions Use of cost flow methods in major U.S. companies Cost Flow Assumption does not need to equal Physical Movement of Goods

27. Slide 6-27 Inventory Costing – Cost Flow Assumptions Tax Effects Many companies have selected LIFO. Why? The reason is that LIFO results in the lowest income taxes (because of lower net income) during times of rising prices. If LIFO is used for tax purposes, the IRS requires it be used in financial statements (LIFO conformity rule).

28. Slide 6-28 Scenario 1: When Prices are increasing Dec 31, 2007Dec 31, 2006 Inventories valued at LIFO$ 1,150 million$ 1,219 million Inventories adjusted to FIFO$ 5,018 million$ 3,492 million Taxable Income using LIFO$1,371 million Taxable Income using FIFO$2,966 million Scenario 2: When Prices are decreasing Dec 31, 2008Dec 31, 2007 Inventories valued at LIFO$821 million$1,150 million Inventories adjusted to FIFO$2,221 million $5,018 million Taxable Income using LIFO$1,194 million Taxable Income using FIFO($1,274 million) LIFO RESERVE EXAMPLE – SUNOCO

29. Slide 6-29 1. The flow of inventory costs should match the physical flow of the merchandise. 2. Accounting standards require that merchandise costs be specifically traced to units left in inventory and to units that have been sold 3. Accountants have developed methods which make assumptions concerning how costs should be assigned to inventory and cost of goods sold. 4. Alternative inventory cost flow assumptions have the same effect on the amount of net income reported. Knowledge Check: Which of the following statements is true?

30. Slide 6-30 1. lower ending inventory value than under FIFO 2. lower income tax expense than under FIFO 3. lower cost of goods sold than under FIFO 4. lower net income than under FIFO Knowledge Check: When inventory prices are falling, using the LIFO costing method will generally result in a:

31. Slide 6-31 Knowledge Check: The first-in, first-out (FIFO) method of inventory valuation is characterized by: 1. lower (compared to the last-in-first-out method) income taxes when prices are rising 2. lower (compared to the last-in-first-out method) income taxes when prices are declining 3. no correlation between cost of goods sold and current cost. 4. more (compared to the last-in-first-out method) complex record keeping.

32. Slide 6-32 Using Cost Flow Methods Consistently Inventory Costing Method should be used consistently, enhances comparability. Although consistency is preferred, a company may change its inventory costing method.

33. Slide 6-33 Lower-of-Cost-or-Market Inventory Costing 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.

34. Slide 6-34 A motorsports retailer has the following items in inventory: Lower of Cost or Market Illustration: Adjusting entry to apply LCM: (similar to shrinkage):

35. Slide 6-35 Inventory Errors 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.

36. Slide 6-36 Income Statement Effect of Inventory Error Inventory errors affect the computation of cost of goods sold and net income.

37. Slide 6-37 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. Income Statement Effect of Inventory Error

38. Slide 6-38 Inventory Errors ($3,000) Net Income understated $3,000 Net Income overstated Combined income for 2-year period is correct.

39. Slide 6-39 Inventory Errors Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:. Balance Sheet Effects

40. Slide 6-40 1. $98,000 2. $72,000 3. $95,000 4. $85,000 Knowledge Check Question: Knowledge Check Question: In its 2012 income statement, Riley Company reported cost of goods sold of $85,000. Later, they determined that beginning inventory for 2012 was understated by $23,000, and the ending inventory for 2012 was understated by $10,000. What should be the corrected amount for cost of goods sold for 2012?

41. Slide 6-41 Statement Presentation and Analysis Balance Sheet - Inventory classified as current asset. Income Statement - Cost of goods sold subtracted from sales. There also should be disclosure of 1) major inventory classifications, 2) basis of accounting (cost or LCM), and 3) costing method (FIFO, LIFO, or average). Presentation

42. Slide 6-42 Statement Presentation and Analysis Inventory management is a double-edged sword 1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). 2. Low Inventory Levels – may lead to stockouts and lost sales. Analysis Using Inventory Turnover

43. Slide 6-43 Inventory turnover measures the number of times on average the inventory is sold during the period. Cost of Goods Sold Average Inventory Inventory Turnover = Statement Presentation and Analysis Days in inventory measures the average number of days inventory is held. Days in Year (365) Inventory Turnover Days in Inventory =

44. Slide 6-44 Illustration: In its Balance Sheet dated January 31, 2012, Wal-Mart reported a beginning inventory of $36,437 million, and ending inventory of $40,714 million, and cost of goods sold for the year ended January 31, 2012, of $335,127 million. Determine the inventory turnover for Wal-Mart for 2012. Statement Presentation and Analysis

45. Slide 6-45 Inventory Turnover Ratios – comparison within industry Inventory TurnoverDays in Inventory KROGER13.327 SAFEWAY11.133 KOHL’S3.993 MACY’S3.1116 SAKS2.5146 AMAZON, INC.13.627 WALMART8.742 TARGET6.160 COSTCO12.330 DELL, INC.43.88 HEWLETT PACKARD14.525

46. Slide 6-46 On hand, January 1:10 units @$20 each PurchasesSales January 8: 25 units @ $23 eachJanuary 4: 8 units @$75 each January 22: 50 units @$26 eachJanuary 15: 20 units @$75 each January 28: 15 units @ $29 eachJanuary 26: 52 units @ $75 each Calculate the company’s Cost of Goods Sold using FIFO for the month of January: 1. $1,930 2. $1,945 3. $1,966 4. $2,080 Knowledge Check:

47. Slide 6-47 On hand, January 1:10 units @$20 each PurchasesSales January 8: 25 units @ $23 eachJanuary 4: 8 units @$75 each January 22: 50 units @$26 eachJanuary 15: 20 units @$75 each January 28: 15 units @ $29 eachJanuary 26: 52 units @ $75 each Calculate the company’s Ending Inventory on January 31 using LIFO: 1. $430 2. $454 3. $544 4. $565 Knowledge Check:

48. Slide 6-48 On hand, January 1:10 units @$20 each PurchasesSales January 8: 25 units @ $23 eachJanuary 4: 8 units @$75 each January 22: 50 units @$26 eachJanuary 15: 20 units @$75 each January 28: 15 units @ $29 eachJanuary 26: 52 units @ $75 each Calculate the company’s Cost of Goods Sold using Weighted Average for the month of January (round to the nearest cent): 1. $1,946 2. $1,966 3. $1,972 4. $2,008 Knowledge Check:

49. Slide 6-49 1. $450 2. $825 3. $1,275 4. $1,150 Using the information below for a sporting goods store, calculate the amount of inventory adjustment using the Lower of Cost or market method applied to the inventory on an individual item basis: UnitsCost/unitMarket value/unit Football itemsHelmets20$30$25 Cleats10$50$20 Pads30$20$25 Baseball items:Gloves40$10$15 Jerseys50$40$25 Knowledge Check:

50. Slide 6-50 END CHAPTER 6