Chapter 6 1 CHAPTER 6 INVENTORIES Accounting Principles

Chapter 6 -1

CHAPTER 6 INVENTORIES Accounting Principles, Eighth Edition Chapter 6 -2

Study Objectives 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. Chapter 6 -3

Reporting and Analyzing Inventory Classifying Inventory Finished goods Work in process Raw materials Chapter 6 -4 Determining Inventory Quantities Taking a physical inventory Determining ownership of goods Inventory Costing Specific identification Cost flow assumptions Financial statement and tax effects Consistent use Lower-of-cost -or-market Inventory Errors Income statement effects Balance sheet effects Statement Presentation and Analysis Presentation Analysis

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

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 -6 LO 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 -7 LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities Determining Ownership of 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 LO 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 -9 LO 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 -10 LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities Determining Ownership of Goods Consigned Goods held for sale by one party (the consignee) although ownership of the goods is retained by another party (the consignor). Chapter 6 -11 LO 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) Cost Flow Assumptions Average cost Chapter 6 -12 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing Example Young & Crazy Company makes the following purchases: 1. One item on 2/2/07 for $10 2. One item on 2/15/07 for $15 3. One item on 2/25/07 for $20 Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the Specific Identification method to cost inventories? Assume a tax rate of 30%. Chapter 6 -13 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing “Specific Identification” Inventory Balance = $ 45 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15 Purchase on 2/2/07 for $10 Chapter 6 -14 Young & Crazy Company Income Statement For the Month Feb. is 2007 Depends whichof one sold 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 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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 -15 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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 -16 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions Example Young & Crazy Company makes the following purchases: 1. One item on 2/2/07 for $10 2. One item on 2/15/07 for $15 3. One item on 2/25/07 for $20 Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO, LIFO, and Average cost flow assumptions? Assume a tax rate of 30%. Chapter 6 -17 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “First-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 -18 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “First-In-First-Out (FIFO)” Inventory Balance = $ 45 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15 Purchase on 2/2/07 for $10 Chapter 6 -19 Young & Crazy Company Income Statement For the Month of Feb. 2007 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 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “First-In-First-Out (FIFO)” Inventory Balance = $ 35 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15 Purchase on 2/2/07 for $10 Chapter 6 -20 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Cost of goods sold Gross profit Expenses: Administrative Selling Interest Total expenses Income before tax Taxes Net Income $ 90 10 80 14 12 7 33 47 14 $ 33 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “Last-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 -21 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “Last-In-First-Out (LIFO)” Inventory Balance = $ 45 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15 Purchase on 2/2/07 for $10 Chapter 6 -22 Young & Crazy Company Income Statement For the Month of Feb. 2007 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 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “Last-In-First-Out (LIFO)” Inventory Balance = $ 25 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15 Purchase on 2/2/07 for $10 Chapter 6 -23 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Cost of goods sold Gross profit Expenses: Administrative Selling Interest Total expenses Income before tax Taxes Net Income $ 90 20 70 14 12 7 33 37 11 $ 26 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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 -24 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “Average Cost” Inventory Balance = $ 45 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15 Purchase on 2/2/07 for $10 Chapter 6 -25 Young & Crazy Company Income Statement For the Month of Feb. 2007 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 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions “Average Cost” Inventory Balance = $ 30 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15 Purchase on 2/2/07 for $10 Chapter 6 -26 Young & Crazy Company Income Statement For the Month of Feb. 2007 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 12 $ 30 LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions Comparative Financial Statement Summary FIFO Chapter 6 -27 Average LIFO Sales $90 Cost of goods sold 10 Gross profit 80 Admin. & selling expense 33 Income before taxes 47 Income tax expense 14 Net income $33 $90 15 75 33 42 12 $30 $90 20 70 33 37 11 $26 Inventory balance $30 $25 $35 LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions In Period of Rising Prices, FIFO Reports: FIFO Lowest Highest Chapter 6 -28 Average LIFO Sales $90 Cost of goods sold 10 Gross profit 80 Admin. & selling expense 33 Income before taxes 47 Income tax expense 14 Net income $33 $90 15 75 33 42 12 $30 $90 20 70 33 37 11 $26 Inventory balance $30 $25 $35 LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions In Period of Rising Prices, LIFO Reports: FIFO Highest Lowest Chapter 6 -29 Average LIFO Sales $90 Cost of goods sold 10 Gross profit 80 Admin. & selling expense 33 Income before taxes 47 Income tax expense 14 Net income $33 $90 15 75 33 42 12 $30 $90 20 70 33 37 11 $26 Inventory balance $30 $25 $35 LO 3 Explain the financial effects 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 -30 LO 3 Explain the financial effects 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 -31 LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions Discussion Question Q 6 -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? See notes page for discussion Chapter 6 -32 LO 3 Explain the financial effects of the inventory cost flow assumptions.

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 -33 LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing Lower-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 -34 LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Costing Lower-of-Cost-or-Market BE 6 -7 Alou Appliance Center accumulates the following cost and market data at December 31. $ 12, 000 9, 000 12, 800 $ 33, 800 Compute the lower-of-cost-or-market valuation for the company’s total inventory. Chapter 6 -35 LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

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. Chapter 6 -36 LO 5 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 -16 Illustration 6 -17 Chapter 6 -37 LO 5 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 -38 LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors Illustration 6 -18 Combined income for 2 year period is correct. Chapter 6 -39 ($3, 000) Net Income understated $3, 000 Net Income overstated LO 5 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 -40 LO 5 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 -16 Illustration 6 -19 Chapter 6 -41 LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis 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 -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. Chapter 6 -43 LO 6 Compute and interpret the inventory turnover ratio.

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 Average Inventory Days in inventory measures the average number of days inventory is held. Days in Year (365) Days in = Inventory Turnover Chapter 6 -44 LO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis BE 6 -9 At December 31, 2008, 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. Inventory Turnover Days in Inventory Chapter 6 -45 $270, 000 ($60, 000 + 40, 000) / 2 365 5. 4 = 67. 59 days LO 6 Compute and interpret the inventory turnover ratio.

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