Study Objectives
1. Describe the steps in determining inventory quantities.
Inventories
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.
Chapter 6-1
Chapter 6-2
Reporting and Analyzing Inventory
Classifying Inventory
Merchandising Company
One Classification: Merchandise Inventory
Classifying Inventory
Determining Inventory Quantities
Inventory Costing
Inventory Errors
Statement Presentation and Analysis
Manufacturing Company
Three Classifications: Raw Materials Work in Process Finished Goods
Finished goods Work in process Raw materials
Taking a physical inventory Determining ownership of goods
Specific identification Cost flow assumptions Financial statement and tax effects Consistent use Lower-of Lowerofcostcost -orormarket
Income statement effects Balance sheet effects
Presentation Analysis
Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
Chapter 6-4
Chapter 6-3
Determining Inventory Quantities
All companies need to determine inventory quantities at the end of the accounting period. Steps in determining inventory quantities:
1. taking a physical inventory of goods on hand,
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).
and
2. determining the ownership of goods in transit
Periodic System
1. Determine the inventory on hand 2. Determine the cost of goods sold for the period.
or on consignment.
Chapter 6-5
SO 1 Describe the steps in determining inventory quantities.
Chapter 6-6
SO 1 Describe the steps in determining inventory quantities.
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.
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 6-8
Chapter 6-7
SO 1 Describe the steps in determining inventory quantities.
SO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Terms of Sale
Illustration 6-1
Determining Inventory Quantities
Determining Ownership of Goods
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. Legal title remains with the consignor.
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 6-9
SO 1 Describe the steps in determining inventory quantities.
Chapter 6-10
SO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Determining Inventory Quantities
Review Question
Merchandise inventory is a. reported under the classification of Property, Plant, and Equipment on the balance sheet. b. often reported as a miscellaneous expense on the income statement. c. reported as a current asset on the balance sheet. d. generally valued at the price for which the goods can be sold.
Chapter 6-11
Review Question
The factor which determines whether or not goods should be included in a physical count of inventory is a. physical possession. b. legal title. c. management's judgment. d. whether or not the purchase price has been paid.
Chapter 6-12
SO 1 Describe the steps in determining inventory quantities.
SO 1 Describe the steps in determining inventory quantities.
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.
Review Question
Goods that have been purchased FOB destination but are in transit, should be excluded from a physical count of goods. True False
Chapter 6-13
SO 1 Describe the steps in determining inventory quantities.
Chapter 6-14
SO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Inventory Costing
1. The primary basis of accounting for inventories is cost. 2. Cost includes all expenditures necessary to acquire goods and place them in condition ready for sale.
Review Question
Goods out on consignment should be included in the inventory of the consignor. True False
Chapter 6-15
SO 1 Describe the steps in determining inventory quantities.
Chapter 6-16
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Inventory Costing
Cost of beginning inventory Cost of goods purchased
Inventory Costing
Unit costs can be applied to quantities on hand using the following costing methods: Specific Identification
Cost of goods available for sale
First-in, first-out (FIFO) Last-in, first-out (LIFO) Average-cost
Cost Flow Assumptions
Units sold Cost of goods sold
Chapter 6-17
Units on hand Ending inventory
Chapter 6-18
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Inventory Costing
Inventory Costing
Example
Young & Crazy Company makes the following purchases:
1. 2. 3.
Specific Identification Method
Costs assigned to inventory item when sold is the actual cost paid for item Cost flow through accounting records exactly matches physical flow of goods Practice is relatively rare. Most companies make assumptions (Cost Flow Assumptions) about which units were sold.
Chapter 6-19
One item on 2/2/10 for $10 One item on 2/15/10 for $15 One item on 2/25/10 for $20
Young & Crazy Company sells one item on 2/28/10 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 28, 2010, assuming the company used the Specific Identification method to cost inventories and the item purchased on 2/15/10 is sold?
Chapter 6-20
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Inventory Costing
Assume one item is sold for $90
Inventory Costing
Specific Identification
Inventory Balance = $ 30
Purchase on 2/25/10 for $20 Purchase on 2/15/10 for $15 Purchase on 2/2/10 for $10
Chapter 6-22
Inventory Balance = $ 30
Purchase on 2/25/10 for $20 Purchase on 2/15/10 for $15 Purchase on 2/2/10 for $10
Chapter 6-21
Young & Crazy Company Income Statement For the Month of Feb. 2010 Sales Cost of goods sold Gross profit Expenses: Administrative Selling Interest Total expenses Income before tax Taxes Net Income $ 90 0 90 14 12 7 33 57 17 $ 40
Young & Crazy Company Income Statement For the Month of Feb. 2010 Sales Cost of goods sold Gross profit Expenses: Administrative Selling Interest Total expenses Income before tax Taxes Net Income $ 90 15 75 14 12 7 33 42 13 $ 29
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Inventory Costing Cost Flow Assumptions
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 6-23
FirstFirst -InIn-First First-Out (FIFO)
Assumes earliest goods purchased are first to be sold. Often parallels actual physical flow of merchandise. Generally good business practice to sell oldest units first.
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Chapter 6-24
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Cost Flow Assumptions - FIFO
Beginning inventory = 2 units @$10 each $10 $10 Ending inventory 3 units @ $12 = $36 Company sells 7 units, leaving 3 units in ending inventory Cost of goods sold = $12 $12 $12
Chapter 6-25
Cost Flow Assumptions - FIFO
Date
Units
Purchase
Cost per unit Total Units
Sale
Cost per unit Total Units
Balance
Cost per unit Total
Purchase of 8 units at $12 each $12 $12 $12 $12 $12
Beg. Purch. Sale
2 8
$10 $12
$20 $96 2 5 7 $10 $12 $20 $60 $80
2 8 10
$10 $12
$20 $96 $116
2 units @ $10 = $20 5 units @$12 = $60 $80
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
End.
$12
$36
Chapter 6-26
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Inventory Costing Cost Flow Assumptions
Cost Flow Assumptions - LIFO
Beginning inventory = 2 units @$10 each $10 $10 Ending inventory 2 units @ $10 = $20 1 unit @12 = $12 $32 Company sells 7 units, leaving 3 units in ending inventory Cost of goods sold = $12 $12 $12 $12 $12 $12
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
LastLast -InIn-First First-Out (LIFO)
Assumes 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.
Purchase of 8 units at $12 each $12 $12
7 units @ $12 = $84
Chapter 6-27
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Chapter 6-28
Cost Flow Assumptions - LIFO
Inventory Costing Cost Flow Assumptions
AverageAverage -Cost
Date
Units
Purchase
Cost per unit Total Units
Sale
Cost per unit Total Units
Balance
Cost per unit Total
Beg. Purch. Sale End.
2 8
$10 $12
$20 $96 7 $12 $84
2 8 10 2 1 3
$10 $12
$20 $96 $116
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.
Cost of Inventory Number of Units on Hand on Hand
Chapter 6-30
$10 $12
$20 $12 $32
Average Cost
Chapter 6-29
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Cost Flow Assumptions Average Cost
Beginning inventory = 2 units @$10 each $10 $10 Ending inventory 3 units @ $11.60 = $34.80 Company sells 7 units, leaving 3 units in ending inventory Cost of goods sold =
2 @ $10 @ $12 = = $20 96 116 $11.60
Cost Flow Assumptions Average Cost
Date
Units
Purchase
Cost per unit Total Units
Sale
Cost per unit Total Units
Balance
Cost per unit Total
Purchase of 8 units at $12 each $12 $12 $12 $12
Chapter 6-31
Beg. Purch. Sale
2 8
$10 $12
$20 $96 7 $11.60 $81.20
2 8 10 3
$10 $12 $11.60 $11.60
$20 $96 $116 $34.80
$12 $12 $12 $12
8 10 Average cost =
7 units @ $11.60 = $81.20
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Chapter 6-32
Cost per unit sold is determined by dividing total inventory $ by total units on hand each purchase. SO after 2 Explain the accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing Cost Flow Assumptions
Comparative Financial Statement Summary
FIFO Average LIFO
Inventory Costing Cost Flow Assumptions
In Period of Rising Prices, FIFO Reports:
FIFO Average LIFO
Sales Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense Net income Inventory balance
Chapter 6-33
$140 80 60 33 27 8 $19
$140 81.20 58.80 33 25.80 8 $17.80
$140 84 56 33 23 7 $16 $32
Chapter 6-34
Sales
$140 80 60 33 27 8 $19
$140 81.20 58.80 33 25.80 8 $17.80
$140 84 56 33 23 7 $16 $32
Lowest
Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense
Highest
Net income Inventory balance
$36 $34.80
$36 $34.80
SO 3 Explain the financial effects of the inventory cost flow assumptions.
SO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing Cost Flow Assumptions
In Period of Rising Prices, LIFO Reports:
FIFO Average LIFO
Inventory Costing Cost Flow Assumptions
Balance sheet effects
84 56 33 23 7 $16 $32
Sales
$140 80 60 33 27 8 $19
$140 81.20 58.80 33 25.80 8 $17.80
$140
Highest
Cost of goods sold Gross profit Admin. & selling expense Income before taxes Income tax expense
1. 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. 2. 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.
Chapter 6-36
Lowest
Net income Inventory balance
$36 $34.80
Chapter 6-35
SO 3 Explain the financial effects of the inventory cost flow assumptions.
SO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing Cost Flow Assumptions
Inventory Costing Cost Flow Assumptions
Discussion Question
Q6-12 Casey Company has been using the FIFO cost flow method during a prolonged period of rising prices. During the same time period, Casey has been paying out all of its net income as dividends. What adverse effects may result from this policy?
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 6-37
SO 3 Explain the financial effects of the inventory cost flow assumptions.
Chapter 6-38
SO 2 Explain the accounting for inventories and apply the inventory cost flow methods.
Inventory Costing Cost Flow Assumptions
Inventory Costing
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.
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 6-39
SO 3 Explain the financial effects of the inventory cost flow assumptions.
Chapter 6-40
SO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing
LowerLower -ofof-Cost Cost-oror-Market
When the value of inventory is lower than its cost Companies can write down the inventory
Record a loss & reduce inventory value to market value
Market value = Replacement Cost If cost market No entry needed
Example of conservatism.
Chapter 6-41 Chapter 6-42
SO 4 Explain the lowerlower-ofof-cost cost-oror-market basis of accounting for inventories.
Inventory Costing
Inventory Errors
LowerLower -ofof-Cost Cost-oror-Market
BE6-7: Alou Appliance Center accumulates the following cost and market data at December 31.
Inventory Categories Cameras Camcorders VCRs Cost Data $ 12,000 9,500 14,000 $ Market Data 12,100 9,700 12,800 Lower of Cost or Market
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.
$ 12,000 9,500 12,800 $ 34,300
$ 35,500
$ 34,600
Compute the lower-of-cost-or-market valuation The market decline based on individual total inventory itemsfor the companys total inventory. ($35,500 $34,300) $34,600) = $1,200 $900
Chapter 6-43
SO 4 Explain the lowerlower-ofof-cost cost-oror-market basis of accounting for inventories.
Chapter 6-44
SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-16
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.
Illustration 6-17
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 6-45
SO 5 Indicate the effects of inventory errors on the financial statements.
Chapter 6-46
SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Illustration 6-18
Inventory Errors
2010 2011 Incorrect $ 90,000 12,000 68,000 80,000 23,000 57,000 33,000 20,000 $ 13,000 Correct $ 90,000 15,000 68,000 83,000 23,000 60,000 30,000 20,000 $ 10,000 Correct $ 80,000 20,000 40,000 60,000 15,000 45,000 35,000 10,000 $ 25,000
Incorrect Sales Beginning inventory Cost of goods purchased Cost of goods available Ending inventory Cost of good sold Gross profit Operating expenses Net income $ 80,000 20,000 40,000 60,000 12,000 48,000 32,000 10,000 $ 22,000
Review Question
Understating ending inventory will overstate: a. assets. b. cost of goods sold. c. net income. d. owner's equity.
Combined income for 2-year period is correct.
Chapter 6-47
($3,000) Net Income understated
$3,000 Net Income overstated
Chapter 6-48
SO 5 Indicate the effects of inventory errors on the financial statements.
SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Statement Presentation and Analysis
Balance Sheet Effects
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Assets = Liabilities + Owners Equity
Illustration 6-19
Presentation
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).
Chapter 6-49
SO 5 Indicate the effects of inventory errors on the financial statements.
Chapter 6-50
Presentation of Merchandise Inventory on the Balance Sheet
MetroMetro -Arts Balance Sheet December 31, 2007
Determining Inventory Quantities
Review Question
Inventories are reported in the current assets section of the balance sheet immediately below receivables.
$19,400
Chapter 6-51
Assets Current assets: Cash Accounts receivable $80,000 Less allowance for doubtful accounts 3,000 Merchandise inventory at lower of cost (first-in, first-out method) or market
True
77,000
False
216,300
Chapter 6-52
SO 1 Describe the steps in determining inventory quantities.
Statement Presentation and Analysis
Statement Presentation and Analysis
Inventory turnover measures the number of times on average the inventory is sold during the period. Inventory Turnover Cost of Goods Sold
=
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
Average Inventory
lost sales.
Days in inventory measures the average number of days inventory is held. Days in Year (365) Days in = Inventory Inventory Turnover
Chapter 6-54
Chapter 6-53
SO 6 Compute and interpret the inventory turnover ratio.
SO 6 Compute and interpret the inventory turnover ratio.
Statement Presentation and Analysis
BE6-9 At December 31, 2011, the following information was available for J. Graff Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000. Calculate inventory turnover and days in inventory for J. Graff Company.
Statement Presentation and Analysis
Review Question
Jenner Company had beginning inventory of $90,000, ending inventory of $110,000, cost of goods sold of 400,000, and sales of 660,000. Jenner's days in inventory is: a. 55.3 days. b. 91.3 days. c. 101.4 days. d. 60.8 days. assets.
Chapter 6-56
Inventory Turnover Days in Inventory
Chapter 6-55
$270,000 ($60,000 + 40,000) / 2 365 5.4
5.4
67.59 days
SO 6 Compute and interpret the inventory turnover ratio.
SO 6 Compute and interpret the inventory turnover ratio.
Estimating Inventories
Two circumstances explain why companies sometimes estimate inventories:
1. A casualty such as a fire, flood, or earthquake may make it impossible to take a physical inventory. 2. Managers may want monthly or quarterly financial statements, but a physical inventory is taken only annually.
Estimating Inventories
Gross Profit Method
The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales.
Illustration 6B-1
Chapter 6-57
SO 8 Describe the two methods of estimating inventories.
Chapter 6-58
SO 8 Describe the two methods of estimating inventories.
Estimating Inventories
*BE6-11 At May 31, Creole Company has net sales of $330,000 and cost of goods available for sale of $230,000. Compute the estimated cost of the ending inventory, assuming the gross profit rate is 35%.
Estimating Inventories
Gross Profit Method assumes that the gross profit rate will remain constant should not use to prepare year-end financial statements
Chapter 6-59
SO 8 Describe the two methods of estimating inventories.
Chapter 6-60
SO 8 Describe the two methods of estimating inventories.
Estimating Inventories
Retail Inventory Method Based on relationship between cost of goods available for sale and the retail price. Retail prices of all goods must be accumulated and totaled.
Estimating Inventories
Retail Inventory Method
Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost.
Illustration 6B-3
Chapter 6-61
SO 8 Describe the two methods of estimating inventories.
Chapter 6-62
SO 8 Describe the two methods of estimating inventories.
Estimating Inventories
*BE6-12 On June 30, Fabre Fabrics has the following data pertaining to the retail inventory method: Goods available for sale: at cost $35,000, at retail $50,000; net sales $40,000, and ending inventory at retail $8,000. Compute the estimated cost of the ending inventory using the retail inventory method.
Review Questions
Which of the following should be included in the physical inventory of a company a. Goods held on consignment from another company. b. Goods in transit to another company shipped FOB shipping point. c. Goods in transit from another company shipped FOB shipping point. d. Both b and c above.
Chapter 6-63
SO 8 Describe the two methods of estimating inventories.
Chapter 6-64
Review Questions
Review Questions
Chapter 6-65
Chapter 6-68
Review Questions
Chapter 6-70
