Chapter Eight Inventory. Copyright © Houghton Mifflin Company.All rights reserved.8 - 2 Inventory Assets a company holds that will ultimately be sold.

Chapter Eight

Inventory

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


The Purchasing Cycle


Shipping Terms

FOB shipping point:FOB shipping point:• Buyer pays the

transportation costs • Purchase is recorded

by the buyer when the inventory is shipped by the vendor

FOBFOB destination: destination:

• Seller pays the transportation costs

• Purchase is recorded by the buyer when the inventory is received


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


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


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 15Cost of Sales 10 Inventory 10


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.


Costing Inventory

Cost-Flow Methods: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?


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


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


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.


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) $1,500Purchase (100 x $70) 7,000

$8,500 125 = $68

Continue


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


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


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


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


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


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

LIFO FIFO


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.


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.


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.


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


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).


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.


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.


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.


Value Price Balance

in Base-Year Index Sheet Value

Layer 1: Base-year $35,000 100% $35,000Layer 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


Reported Amt Correct Amt Effect of ErrorSales $105,000 $105,000Cost 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 overstatedGross Profit 45,000 47,000 $2,000 understatedOther expenses (25,000) (25,000)Income before taxes 20,000 22,000 $2,000 understatedTax expense (7,000) (7,700) $700 understatedNet income $13,000 $14,300 $1,300 understated

The Effect of Inventory Errors


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 inventorydetermined?

Continue


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

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.


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 Inventory Inventory Yield


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


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


Check Your Understanding

Q If you purchase goods FOB shipping point, are you responsible for shipping charges?

A FOB shipping point requires the buyer to pay the shipping charges.



Q If 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?

A Under the perpetual inventory system, the Inventory account is adjusted each time inventory is purchased or sold.



Q Must a company employ the same cost-flow assumption for all its inventory items?

A No. Companies may employ different assumptions for various products.



Q Which inventory method is based on the assumption that each inventory item bought and sold can be matched with its actual cost?

A Specific identification method



Q If your company seeks to lower its externally reported net income, would it use FIFO or LIFO to accomplish this goal?

A LIFO



Q What situation causes a LIFO liquidation?

A A LIFO liquidation occurs if a period’s ending inventory is lower than its beginning inventory.



Q If a company makes an error in counting inventory and it overstates inventory, how will net income be affected in the current year?

A Net income will be overstated

Chapter Eight Inventory. Copyright © Houghton Mifflin Company.All rights reserved.8 - 2 Inventory Assets a company holds that will ultimately be sold.

Documents

inventory slide

inventory item

value of inventory

inventory assets

sale inventory account

cost of sales

purchase cost

physical count of inventory