Slide 6-1. Slide 6-2 Chapter 6 Inventories Financial Accounting, Seventh Edition.

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Slide 6-2

Chapter 6

InventoriesInventories

Financial Accounting, Seventh Edition

Slide 6-3

1. Describe the steps in determining inventory quantities.

2. Explain the accounting for inventories and apply the inventory cost flow methods.

3. Explain the financial effects of the inventory cost flow assumptions.

4. Explain the lower-of-cost-or-market basis of accounting for inventories.

5. Indicate the effects of inventory errors on the financial statements.

6. Compute and interpret the inventory turnover ratio.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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Statement Statement Presentation Presentation and Analysisand Analysis

Statement Statement Presentation Presentation and Analysisand Analysis

Reporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing Inventory

Taking a Taking a physical physical inventoryinventory

Determining Determining ownership of ownership of goodsgoods

Classifying Classifying InventoryInventory

Classifying Classifying InventoryInventory

Determining Determining Inventory Inventory QuantitiesQuantities

Determining Determining Inventory Inventory QuantitiesQuantities

Inventory Inventory CostingCosting

Inventory Inventory CostingCosting

Inventory Inventory ErrorsErrors

Inventory Inventory ErrorsErrors

Finished Finished goodsgoods

Work in Work in processprocess

Raw materialsRaw materials

Specific Specific identificationidentification

Cost flow Cost flow assumptionsassumptions

Financial Financial statement statement and tax and tax effectseffects

Consistent Consistent useuse

Lower-of-Lower-of-cost-or-cost-or-marketmarket

Income Income statement statement effectseffects

Balance sheet Balance sheet effectseffects

PresentationPresentation

Analysis using Analysis using inventory inventory turnoverturnover

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Classifying InventoryClassifying InventoryClassifying InventoryClassifying 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.

Slide 6-6

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 QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

SO 1 Describe the steps in determining inventory quantities.SO 1 Describe the steps in determining inventory quantities.

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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



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Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.

Determining Ownership of Goods



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.

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Illustration 6-1

Ownership of the goods passes to the buyer

when the public carrier accepts the goods from

the seller.

Ownership of the goods remains with the seller

until the goods reach the buyer.

Goods in Transit

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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



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58

How Much Inventory Should a How Much Inventory Should a Company Have?Company Have?

Only enough for Only enough for salessales needs needs Excess inventory costs: Excess inventory costs:

storage costsstorage costs interest costsinterest costs obsolescence - technology, fashion obsolescence - technology, fashion

Slide 6-12

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 CostingInventory CostingInventory CostingInventory Costing

Cost Flow Assumptio

ns

SO 2 Explain the accounting for inventories SO 2 Explain the accounting for inventories and apply the inventory cost flow and apply the inventory cost flow methods.methods.

Slide 6-13

Suppose you own a bike shopSuppose you own a bike shop

With ONLY With ONLY oneone model of bike model of bike That you buy in large quantities…That you buy in large quantities… At different timesAt different times What do you use for cost?What do you use for cost?

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45

What Makes What Makes Cost Flow Cost Flow AssumptionsAssumptions Necessary? Necessary?

Changing Prices

You probably did NOT purchase the bikes (even the

same models) at the same price levels. . . . .

Slide 6-15

An actual physical flow costing method in

which items still in inventory are specifically

costed to arrive at the total cost of the ending

inventory.

Practice is relatively rare.

Most companies make assumptions (Cost

Flow Assumptions) about which units were

sold.

Specific Identification Method



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Illustration: Assume that Crivitz TV Company purchases three identical 46-inch TVs on different dates at costs of $700, $750, and $800. During the year Crivitz sold two sets at $1,200 each.


Illustration 6-2


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Illustration: If Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 $800), and its ending inventory is $750.


Illustration 6-3


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Specific Identification Method Specific Identification Method

Is appropriate for firms with a small number of items that are generally large, luxury items such as custom jewelry,

yachts or luxury cars.

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Specific Identification Method Specific Identification Method

Would not be appropriate for firms with many identical items with relatively low costs such as sneakers, soup or

candy bars.

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Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptions

Illustration 6-11Use of cost flow methods in major U.S. companies

Cost Flow

Assumption

does not need to

equal

Physical Movement

of Goods


Slide 6-21


What should you use for Cost???


Date Explanation Units Unit Cost Total Cost

2-JunBeg. Inv 500 $ 100 $ 50,000

8-JunPurchase 400 $ 125 $ 50,000

25-JunPurchase 350 $ 130 $ 45,500

Total 1,250 $ 145,500

Ending Inventory 250

Units Sold 1,000 ???

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Earliest goods purchased are first to be sold.

Often parallels actual physical flow of merchandise.

Generally good business practice to sell oldest units first.

“First-In-First-Out (FIFO)”



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FIFO calculating COGS

2-Jun 500 $ 100 $ 50,000

8-Jun 400 $ 125 $ 50,000

25-Jun 100 $ 130 $ 13,000

COGS 1,000 $ 113,000

Ending Inventory 250 $ 32,500


2-JunBeg. Inv 500 $ 100 $ 50,000

8-JunPurchase 400 $ 125 $ 50,000

25-JunPurchase 350 $ 130 $ 45,500

Total 1,250 $ 145,500 Ending Inventory 250


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FIFO – First In First Out FIFO – First In First Out

FIFO assumes that the first units purchased are the first units sold

FIFO leaves the most recent purchases in Ending Inventory

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Allocates cost of goods available for sale on the basis of weighted average unit cost incurred.

Assumes goods are similar in nature.

Applies weighted average unit cost to the units on hand to determine cost of the ending inventory.

“(Weighted) Average-Cost”



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“Average Cost”Illustration 6-

10

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(Weighted) Average Cost


Average Cost - calculating COGS

Total Cost $ 145,500

Units Available 1,250 bikes

Avg Cost/bike $116.40

COGS 1,000

$116.40 $ 116,400



2-JunBeg. Inv 500 $ 100 $ 50,000

8-JunPurchase 400 $ 125 $ 50,000

25-JunPurchase 350 $ 130 $ 45,500



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Latest goods purchased are first to be sold.

Seldom coincides with actual physical flow of merchandise.

Exceptions include goods stored in piles, such as coal or hay.

“Last-In-First-Out (LIFO)”



Slide 6-30


“Last-In Last Out (LIFO)”


LIFO calculating COGS

25-Jun 350 $ 130 $ 45,500

8-Jun 400 $ 125 $ 50,000

2-Jun 250 $ 100 $ 25,000

COGS 1,000 $ 120,500



2-JunBeg. Inv 500 $ 100 $ 50,000

8-JunPurchase 400 $ 125 $ 50,000

25-JunPurchase 350 $ 130 $ 45,500



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LIFO – Last In First Out LIFO – Last In First Out

LIFO assumes that the Last units purchased are the first units sold

LIFO leaves the earliest purchases in Ending Inventory

Slide 6-32 SO 3 Explain the financial effects of the inventory cost flow SO 3 Explain the financial effects of the inventory cost flow

assumptions.assumptions.

Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsIncome Statement Effects

George's Bike Shop - using periodic inventory

FIFO Average Cost LIFO

Sales $ 240,000 $ 240,000 $ 240,000

Beginning Inv 50,000 50,000 50,000

Purchases 95,500 95,500 95,500

Cost of Good Available 145,500 145,500 145,500

Ending Inv 32,500 29,100 25,000

COGS 113,000 116,400 120,500

Gross Profit 127,000 123,600 119,500

Operating Exp. 52,800 52,800 52,800

Income before Tax 74,200 70,800 66,700

Tax Exp (30%) 22,260 21,240 20,010

Net Income $ 51,940 $ 49,560 $ 46,690

The costing flow method affects

Net Income, Taxes, and

Ending Inventory costs!

Note: in this

example, prices are increasing = Inflation



Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsBalance Sheet Effects-INFLATION

A major advantage of the FIFO method is that in a

period of inflation, the costs allocated to Ending

Inventory will approximate their current cost.

A major shortcoming of the LIFO method is that in

a period of inflation, the costs allocated to ending

inventory may be significantly understated in

terms of current cost.



Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsBalance Sheet Effects -- DEFLATION

FIFO – during a period of deflation, the costs

allocated to Ending Inventory may be significantly

understated in terms of current cost.

LIFO – during a period of deflation, the costs

allocated to ending inventory will approximate

their current cost.



Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsTax 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.

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Using Cost Flow Methods Consistently


Method should be used consistently, enhances comparability.

Although consistency is preferred, a company may change its inventory costing method.

Illustration 6-14Disclosure of change in cost flow method

SO 3 Explain the financial effects of the inventory cost flow SO 3 Explain the financial effects of the inventory cost flow assumptions.assumptions.

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Lower-of-Cost-or-Market


SO 4 Explain the lower-of-cost-or-SO 4 Explain the lower-of-cost-or-market basis of accounting for market basis of accounting for inventories.inventories.

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.

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SO 4 Explain the lower-of-cost-or-SO 4 Explain the lower-of-cost-or-market basis of accounting for market basis of accounting for inventories.inventories.

Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.

Illustration 6-15

Lower-of-Cost-or-Market

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Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

SO 5 Indicate the effects of inventory errors on the financial SO 5 Indicate the effects of inventory errors on the financial statements.statements.

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.

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Inventory errors affect the computation of cost of goods sold and net income.

Income Statement Effects

Illustration 6-17

Illustration 6-16

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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 Effects

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I ncorrect Correct Incorrect Correct

Sales 80,000$ 80,000$ 90,000$ 90,000$

Beginning inventory 20,000 20,000 12,000 15,000

Cost of goods purchased 40,000 40,000 68,000 68,000

Cost of goods available 60,000 60,000 80,000 83,000

Ending inventory 12,000 15,000 23,000 23,000

Cost of good sold 48,000 45,000 57,000 60,000

Gross profit 32,000 35,000 33,000 30,000

Operating expenses 10,000 10,000 20,000 20,000

Net income 22,000$ 25,000$ 13,000$ 10,000$

2010 2011

($3,000)Net Income understated

$3,000Net Income overstated

Combined income for 2-year period is

correct.

Illustration 6-18

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Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.

Balance Sheet Effects

Illustration 6-16

Illustration 6-19

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Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement 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

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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

SO 6 Compute and interpret the inventory turnover ratio.SO 6 Compute and interpret the inventory turnover ratio.

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Inventory turnover measures the number of times on average the inventory is sold during the period.

Cost of Goods Sold

Average Inventory

Inventory Turnover

=


Days in inventory measures the average number of days inventory is held.

Days in Year (365)

Inventory Turnover

Days in Inventory

=


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Days in Inventory: Inventory turnover of 8.8 times divided into 365 is approximately 41 days. This is the approximate time that it takes a company to sell the inventory.

Illustration: Wal-Mart reported in its 2009 annualreport a beginning inventory of $35,159 million, an ending inventory of $34,511 million, and cost of goods sold for the year ended January 31, 2009, of $306,158 million. The inventory turnover formula and computation for Wal-Martare shown below.



Illustration 6-21

Solution on notes page

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Good Bye and Good Luck!

End of Chapter 6End of Chapter 6End of Chapter 6End of Chapter 6

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The National Food Service Security Council estimates that employee theft costs U.S. restaurants $15 billion to $25 billion annually.

The average supermarket has inventory shrinkage losses of 2.28% of sales, or $224,808 per year. Average net profit is only 1.1% of sales, so inventory shrinkage is twice the level of profits.

Fear of getting caught and being fired ranks among one of the top reasons employees give, in surveys of reasons why they do not steal from their employer.

Employee Theft—An Inside Job

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Tips from customers are the No. 1 way that many stores catch thieving employees.

The average employee caught stealing costs his or her company $1,341, while the average loss from a shoplifting incident is only $207.

Employee Theft—An Inside Job

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Suppose you own a number of wine shops selling mid-level as well as expensive bottled wine. You have been experiencing significant losses from theft at your stores. You suspect that it is a combination of both employee and customer theft. Assuming that it would be cost-effective, would you install video cameras to reduce both employee theft and customer theft? YES: Most employees and customers are honest. However, management has a responsibility to employ reasonable, cost-effective approaches to safeguard company assets.

NO: The use of video technology to monitor employees and customers sends a message of distrust. You run the risk of alienating your employees. Cameras might also reduce the welcoming atmosphere for your customers.

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Illustration

Cost Flow Methods in Perpetual Cost Flow Methods in Perpetual SystemsSystemsCost Flow Methods in Perpetual Cost Flow Methods in Perpetual SystemsSystems

SO 7 Apply the inventory cost flow methods to perpetual inventory SO 7 Apply the inventory cost flow methods to perpetual inventory records.records.

Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.

Appendix 6AAppendix 6A

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Cost of Goods SoldEnding Inventory

Illustration 6A-2


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Cost of Goods SoldEnding Inventory

“Last-In-First-Out (LIFO)” Illustration 6A-3


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““Average Cost”Average Cost” (Moving-Average (Moving-Average System)System) Illustration 6A-

4

Cost of Goods Sold Ending Inventory


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Estimating InventoriesEstimating InventoriesEstimating InventoriesEstimating Inventories

The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales.

Gross Profit Method

SO 8 Describe the two methods of estimating inventories.SO 8 Describe the two methods of estimating inventories.

Illustration 6B-1

Appendix 6BAppendix 6B

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Illustration: Kishwaukee Company’s records for January show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. The company expects to earn a 30% gross profit rate. Compute the estimated cost of the ending inventory at January 31 under the gross profit method.


Illustration 6B-2

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Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost.

Retail Inventory Method


Illustration 6B-3

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Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time.

Illustration 6B-4

Illustration:

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CopyrightCopyrightCopyrightCopyright

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Slide 6-64

Goods in transit should be included in the inventory of the buyer when the:

a. public carrier accepts the goods from the seller.

b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

Review Question



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The cost flow method that often parallels the actual physical flow of merchandise is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

Review Question



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In a period of inflation, the cost flow method that results in the lowest income taxes is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

Review Question


SO 3 Explain the financial effects of the inventory cost flow SO 3 Explain the financial effects of the inventory cost flow assumptions.assumptions.

Slide 6-67

Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.

Review Question



Slide 6-1. Slide 6-2 Chapter 6 Inventories Financial Accounting, Seventh Edition.

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