Chapter 6-1

Reporting and Analyzing Inventory

Chapter 6-2

Financial Accounting, Fifth Edition

Study Objectives
1. 2. 3. 4. 5. 6. 7. 8.
Chapter 6-3

Describe the steps in determining inventory quantities. Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Explain the lower-of-cost-or-market basis of accounting for inventories. Compute and interpret the inventory turnover ratio. Describe the LIFO reserve and explain its importance for comparing results of different companies. Apply the inventory cost flow methods to perpetual inventory records. Indicate the effects of inventory errors on the financial statements.

Reporting and Analyzing Inventory

Classifying Inventory

Determining Inventory Quantities Taking a physical inventory Determining ownership of goods

Inventory Costing

Analysis of Inventory

Finished goods Work in process Raw materials

Specific identification Cost flow assumptions Financial statement and tax effects Consistent use Lower-of-costLower-of-costor-market or-

Inventory turnover ratio LIFO reserve

Chapter 6-4

Classifying Inventory
Merchandising Company
One Classification: Merchandise Inventory

Manufacturing Company
Three Classifications: Raw Materials Work in Process Finished Goods

Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
Chapter 6-5

Chapter 6-6

Determining Inventory Quantities

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.

Chapter 6-7

SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

Taking a Physical Inventory

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.

Chapter 6-8

SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

Determining Ownership of Goods

Goods in Transit Purchased goods not yet received. Sold goods not yet delivered.
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.
Chapter 6-9

SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

Terms of Sale
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.
Chapter 6-10

SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

Review Question
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.

Chapter 6-11

SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

Determining Ownership of Goods

Consigned Goods Goods held for sale by one party although ownership of the goods is retained by another party.

Chapter 6-12

SO 1 Describe the steps in determining inventory quantities.

Inventory Costing
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
Cost Flow Assumptions

Chapter 6-13

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing
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. These facts are summarized below.
Illustration 6-2

Chapter 6-14

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing
Specific Identification
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

Chapter 6-15

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing

Specific Identification Method

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.

Chapter 6-16

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

Cost Flow Assumption

does not need to equal Physical Movement of Goods
Illustration 6-11 Use of cost flow methods in major U.S. companies
Chapter 6-17

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

Illustration: Data for Houston Electronics Astro condensers.
Illustration 6-4

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

Chapter 6-18

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

First-In-FirstFirst-In-First-Out (FIFO)
Earliest goods purchased are first to be sold. Often parallels actual physical flow of merchandise. Generally good business practice to sell oldest units first.

Chapter 6-19

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

First-In-First-Out (FIFO)
Illustration 6-5

Solution on notes page

Chapter 6-20

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

First-In-First-Out (FIFO)
Illustration 6-5

Chapter 6-21

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

Last-In-FirstLast-In-First-Out (LIFO)
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.

Chapter 6-22

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

Last-In-FirstLast-In-First-Out (LIFO)

Illustration 6-7

Solution on notes page

Chapter 6-23

SO 2 Explain the basis of accounting for inventories and apply the cost flow methods under a periodic inventory system.

inventory

Inventory Costing Cost Flow Assumptions

Last-In-FirstLast-In-First-Out (LIFO)
Illustration 6-7

Chapter 6-24

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

Average Cost
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.
Chapter 6-25

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

Average Cost

Illustration 6-10

Solution on notes page

Chapter 6-26

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

Average Cost
Illustration 6-10

Chapter 6-27

SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing Cost Flow Assumptions

Comparative Financial Statement Summary
FIFO Average LIFO

Sales Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense Net income Inventory balance
Chapter 6-28

$9,000 $9,000 6,200 2,800 330 2,470 140 $2,330 6,600 2,400 330 2,070 120 $1,950

$9,000 7,000 2,000 330 1,670 110 $1,560 $5,000

$5,800 $5,400

LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing Cost Flow Assumptions

In Period of Rising Prices, FIFO Reports:
FIFO Average LIFO

Sales

$9,000 $9,000 6,200 2,800 330 2,470 140 $2,330 6,600 2,400 330 2,070 120 $1,950

$9,000 7,000 2,000 330 1,670 110 $1,560 $5,000

Lowest

Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense

Highest

Net income Inventory balance

$5,800 $5,400

Chapter 6-29

LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing Cost Flow Assumptions

In Period of Rising Prices, LIFO Reports:
FIFO Average LIFO

Sales

$9,000 $9,000 6,200 2,800 330 2,470 140 $2,330 6,600 2,400 330 2,070 120 $1,950

$9,000 7,000 2,000 330 1,670 110 $1,560 $5,000

Highest

Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense

Lowest

Net income Inventory balance

$5,800 $5,400

Chapter 6-30

LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing Cost Flow Assumptions

Review Question
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.

Chapter 6-31

LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing Cost Flow Assumptions

Review Question
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.

Chapter 6-32

LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Chapter 6-33

Inventory Costing

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 6-14 Disclosure of change in cost flow method

Chapter 6-34

LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing

Lower-of-Cost-orLower-of-Cost-or-Market
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.

Chapter 6-35

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

Inventory Costing

Lower-of-Cost-orLower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.
Invento y ategories TVs Radios DVD recorders DVDs Total inventory
Chapter 6-36

o t Data $ 60,000 45,000 48,000 14,000

Market Data $ 55,000 52,000 45,000 12,800

ower of Cost or Market

$ 55,000 45,000 45,000 12,800 $157,800

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

Analysis of Inventory

Analysis of Inventory
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.

Chapter 6-37

SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory
Inventory turnover measures the number of times on average the inventory is sold during the period. Inventory Turnover Cost of Goods Sold
=

Average Inventory

Days in inventory measures the average number of days inventory is held. Days in Year (365) Days in = Inventory Inventory Turnover
Chapter 6-38

SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory
Illustration: The following data are available for Wal-Mart.

Inventory Turnover 2007 Days in inventory 2007

Chapter 6-39

$264,152 (33,685 + 31,910) / 2 365 Days 8.1

8.1 times

= 45.1 Days

SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory
Illustration: The following data are available for Wal-Mart.

Inventory Turnover 2006 Days in inventory 2006

Chapter 6-40

$237,649 (31,910 + 29,419) / 2 365 Days 7.7

= 7.7 times

= 47.4 Days

SO 5 Compute and interpret the inventory turnover ratio.

Chapter 6-41

Analysis of Inventory
Analysts Adjustments for LIFO Reserve
Companies using LIFO are required to report the amount that inventory would increase (or occasionally decrease) if the company had instead been using FIFO. This amount is referred to as the LIFO reserve.
Illustration 6-17

Chapter 6-42

SO 6

Describe the LIFO reserve and explain its importance for comparing results of different companies.

Analysis of Inventory
Analysts Adjustments for LIFO Reserve
The LIFO reserve can have a significant effect on ratios analysts commonly use.
Illustration 6-19

Chapter 6-43

SO 6

Describe the LIFO reserve and explain its importance for comparing results of different companies.

Cost Flow Methods in Perpetual Systems

Illustration:
Appendix 6A
Illustration 6A-1

Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.
Chapter 6-44

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

Cost Flow Methods in Perpetual Systems

Perpetual Inventory
: Tra a t ate Ja . pr. 5 . 4 ept. N . C t 45 Ca at Be . : U t e t r Ba a e: La er La er La er La er 4 T ta

FIFO Method

(55 ) 4 $ $ C t e t r

( G

( $ $ : -

( 5 ) 5 $ $ 6 $ $ 5 U t $ 4 4 $ 5 ar 45

Solution on notes page Chapter 6-45

r ha e G a a a e e t r C G

(45 ) 55 $

(5 6

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

w Meth

erpet a

tem

Perpetual Inventory
L : Tra a t ate Ja . pr. . 4 ept. N . C t 4 Ca at Be . : U t e t r Ba a e: La er La er

+
La er

LIFO Method

La er 4

T ta

( 4

( -

( $ $ -

) 4 4 $ $ U t $ $ ar 4

$ $ C t e t r G

$ $ :

Solution on notes page Chapter 6-46

r ha e G a a a e e t r C G

(4

) $

( 6

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

Cost Flow Methods in Perpetual Systems

Perpetual Inventory
ra a t ate a pr 4 ept 7 t C t ta

+
t 6 4

Moving Average
aa e C t era e C t 67

6 6 4 4 C t e e t r r ha e a a a e e t r C 767

6 67 767 46

Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase.

ar

4 6

767

Chapter 6-47

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

Cost Flow Methods in Perpetual Systems

Perpetual Inventory
ra a t ate a pr 4 ept 4 4 C t e e t r r ha e a a a e e t r C
Chapter 6-48

+
t 6 4

Moving Average
aa e C t era e C t 6

ta

6 6 6

68 6 6 8

Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase.

ar

4 6

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

Inventory Errors

Common Cause:

Appendix 6B

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.

Chapter 6-49

SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors

Income Statement Effects

Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-B1

Illustration 6-B2

Chapter 6-50

SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors

Income Statement Effects

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.
Chapter 6-51

SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Illustration 6-B3

2009 Incorrect orrect $8 , 20,000 40,000 60,000 15,000 45,000 35,000 10,000 $ 25,000 $8 , $9 ,

2010 Incorrect 2,000 8,000 80,000 23,000 57,000 33,000 20,000 $ 13,000 orrect $9 , ,000 8,000 8 ,000 23,000 60,000 30,000 20,000 $ 10,000

Sales Be innin ost of ost of ndin ost of Gross O eratin inventory oods inventory ood sold rofit ex enses rchased oods available

20,000 40,000 60,000 12,000 48,000 32,000 10,000 $ 22,000

Net income

Combined income for 2-year period is correct.

Chapter 6-52

($3,000) Net Income nderstated

$3,000 Net Income overstated

SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors

Review Question
Understating ending inventory will overstate: a. assets. b. cost of goods sold. c. net income. d. owner's equity.

Chapter 6-53

SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors

Balance Sheet Effects

Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Illustration 6-B1

Illustration 6-B4

Chapter 6-54

SO 8 Indicate the effects of inventory errors on the financial statements.

Copyright
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Chapter 6-55