CHAPTER 6 INVENTORIESforesthillshs.enschool.org/ourpages/auto/2015/2/25/68787876/ch06.pdfFeb 25,...

Copyright © 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor’s Manual (For Instructor Use Only) 6-1

CHAPTER 6

INVENTORIES

LEARNING OBJECTIVES

1. DETERMINE HOW TO CLASSIFY INVENTORY AND 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 TURN-OVER.

*7. APPLY THE INVENTORY COST FLOW METHODS TO PERPETUAL INVENTORY RECORDS.

*8. DESCRIBE THE TWO METHODS OF ESTIMATING INVENTORIES.

6-2 Copyright © 2013 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 11/e, Instructor’s Manual (For Instructor Use Only)

CHAPTER REVIEW

Classifying Inventory 1. (L.O. 1) Merchandise inventory has two common characteristics: (a) it is owned by the company

and (b) it is in a form ready for sale in the ordinary course of business. 2. A manufacturer’s inventory is usually classified into three categories:

a. Finished goods that are completed and ready for sale. b. Work in process that is in various stages of production but not yet completed. c. Raw materials that are on hand waiting to be used in production.

Determination of Inventory Quantities 3. The determination of inventory quantities involves (a) taking a physical inventory of goods on

hand and (b) determining the ownership of goods. 4. Taking a physical inventory involves counting, weighing or measuring each kind of inventory on

hand. Internal control procedures should be followed in taking the inventory in order to minimize errors.

5. For goods in transit, legal title is determined by the terms of sale. When the terms are:

a. FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

b. FOB destination, legal title to the goods remains with the seller until the goods reach the buyer.

6. Under a consignment arrangement, the holder of the goods (called the consignee) does not own

the goods. Ownership remains with the shipper of the goods (consignor) until the goods are actually sold to a customer. Consigned goods should be included in the consignor’s inventory not the consignee’s inventory.

Inventory Costing 7. (L.O. 2) Inventory is accounted for at cost which includes all expenditures necessary to acquire

goods and place them in a condition ready for sale. After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to determine the total cost of the inventory and the cost of goods sold.

Specific Identification 8. The specific identification method identifies the particular units sold so that the cost of the

specific unit sold is charged to the cost of goods sold. This method is possible when a company sells a limited variety of high unit-cost items that can be clearly identified from the time of purchase through the time of sale.

9. The allocation of inventoriable costs may be made under any of the following assumptions as to

the flow of costs (a) first-in, first-out (FIFO), (b) last-in, first-out (LIFO), or (c) average-cost. FIFO 10. The FIFO method assumes that the costs of the earliest goods purchased are the first to be sold.

a. This method often parallels the actual physical flow of the merchandise. b. Under this method, the ending inventory is based on the latest units purchased.


LIFO 11. The LIFO method assumes that the costs of the latest units purchased are the first to be sold.

a. This method seldom coincides with the actual physical flow of inventory. b. Under this method, all goods purchased during the period are assumed to be available for

the first sale, regardless of the date of purchase. c. The ending inventory is found by taking the unit cost of the oldest goods and working forward

until all units of inventory are costed.

Average-Cost 12. The average-cost method assumes that the goods available for sale are similar in nature.

a. Under this method, the cost of goods available for sale is allocated on the basis of weighted-average unit cost.

b. The formula for determining the weighted-average unit cost is: Cost of goods available for sale divided by total units available for sale.

Financial Statement Effects 13. (L.O. 3) In periods of rising prices, FIFO produces a higher net income, LIFO the lowest, and

average cost falls in the middle. The reverse is true when prices are falling. 14. Companies adopt different inventory costing methods because of:

a. Balance sheet effects: the inventory costs are closer to current costs under FIFO than under LIFO.

b. Income statement effects: in addition to the effects on net income in (13) above, LIFO enables the company to avoid reporting paper or phantom profit as economic gain.

c. Tax effects: in a period of inflation LIFO results in the lowest income taxes. Lower-of-Cost-or-Market 15. (L.O. 4) The value of inventory for companies in certain industries can drop due to changes in

technology or fashions. This situation requires valuing inventory at the lower-of-cost-or-market (LCM) in the period in which the price decline occurs.

16. Market is defined as the current replacement cost of the goods, not selling price. Effects of Inventory Errors 17. (L.O. 5) The effects of inventory errors on the current year’s income statement are: Cost of Inventory Error Goods Sold Net Income Beginning inventory understated Understated Overstated Beginning inventory overstated Overstated Understated Ending inventory understated Overstated Understated Ending inventory overstated Understated Overstated 18. The effects of ending inventory errors on the balance sheet are: Ending Inventory Assets Liabilities Owner’s Equity Overstated Overstated No effect Overstated Understated Understated No effect Understated


19. In the financial statements: a. Inventory is usually classified as a current asset after receivables in the balance sheet, and

cost of goods sold is subtracted from sales in the income statement. b. There should be disclosure of (1) the major inventory classifications, (2) the basis of accounting,

and (3) the costing method. Inventory Turnover 20. (L.O. 6) The inventory turnover measures the number of times on average the inventory is

sold during the period.

Cost of Goods Sold ÷ Average Inventory = Inventory Turnover *Applying Perpetual Inventory *21. (L.O. 7) Each of the inventory cost flow methods may be used in a perpetual inventory system. a. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of

goods sold. b. Under the LIFO method, the most recent purchase prior to sale is allocated to the units sold. c. When the moving-average method is used, a new average is computed after each

purchase by dividing the cost of goods available for sale by the units on hand. Estimating Inventories *22. (L.O. 8) Inventories may have to be estimated when (a) management wants monthly or quarterly

financial statements or (b) a fire or other type of casualty makes it impossible to take a physical inventory.

Gross Profit Method *23. The gross profit method is widely used to estimate the ending inventory. Two steps are involved

in using this method. a. The estimated cost of goods sold is determined by subtracting the estimated gross profit from

net sales. b. The estimated cost of goods sold is subtracted from cost of goods available for sale to

determine the estimated cost of the ending inventory.

Retail Inventory Method *24. The retail inventory method is used by retail companies to estimate the cost of the inventory.

The steps in using this method are: a. b. c.

Goods Available for Sale at Cost ÷

Goods Availablefor Sale at Retail =

Cost-to-Retail Ratio

Ending Inventory X at Retail

Cost-to- Retail = Ratio

Estimated Cost of Ending Inventory

Goods Available for Sale at Retail –

Net Sales

Ending Inventory at Retail

=


LECTURE OUTLINE

A. Classifying and Determining Inventory.

1. Inventory of a merchandising company has two common characteristics:

a. It is owned by the company.

b. It is in a form ready for sale to customers in the ordinary course of business.

2. In a manufacturing company, some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories:

a. Finished goods; manufactured items that are completed and ready for sale.

b. Work in process; the portion of manufactured inventory that has been placed into the production process but is not yet complete.

c. Raw materials; the basic goods that will be used in production but have not yet been placed into production.

ACCOUNTING ACROSS THE ORGANIZATION

JIT can save a company a lot of money, but it isn’t without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese automakers experienced such a disruption when an earthquake damaged a company that supplies 50% of the automaker’s piston rings.

What steps might companies take to avoid such a serious disruption in the future?

Answer: The manufacturer of the piston rings should spread its manufacturing facilities across a few locations that are far enough apart that they would not all be at risk at once. In addition, the automakers might consider becoming less dependent on a single supplier as well as having weather contingency plans.


B. Determining Inventory Quantities.

1. All companies need to determine inventory quantities at the end of the accounting period. Companies using a perpetual system take a physical inventory for the following reasons:

a. To check the accuracy of their perpetual inventory records.

b. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.

2. Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.

a. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand.

b. Determining the ownership of goods.

(1) Goods in transit should be included in the inventory of the com-pany that has legal title to the goods. Legal title is determined by the terms of the sale:

(a) When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

(b) When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.

(2) Consigned goods are goods held by one party although ownership of the goods is retained by another party. If an inventory count is taken, the goods would not be included in the holding party’s inventory.

C. Inventory Costing.

1. Inventory is accounted for at cost.

2. Cost includes all expenditures necessary to acquire goods and place them in condition ready for sale.


3. Cost of goods available for sale includes:

a. The cost of beginning inventory.

b. The cost of goods purchased.

4. Cost of goods available for sale is allocated to either ending inventory or to cost of goods sold.

D. Specific Identification.

1. Specific identification requires that companies keep records of the original cost of each individual inventory item.

2. Bar coding, electronic product codes, and radio frequency identification make it theoretically possible to do specific identification with nearly any type of product.

3. This method, however, may enable management to manipulate net income.

E. Cost Flow Assumptions—FIFO, LIFO, and Average-Cost.

1. The FIFO (first-in, first-out) method assumes that the earliest goods pur-chased are the first to be recognized in determining cost of goods sold.

a. FIFO often parallels the actual physical flow of merchandise because it generally is good business practice to sell the oldest units first.

b. Under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.

2. The LIFO (last-in, first-out) method assumes that the latest goods pur-chased are the first to be recognized in determining cost of goods sold.

a. LIFO seldom coincides with the actual physical flow of inventory. All goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.


b. Under LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed.

3. The average-cost method assumes that the goods are similar in nature.

a. Under this method, the cost of goods available for sale is allocated on the basis of the weighted-average unit cost.

b. The weighted-average unit cost is computed by dividing cost of goods available for sale by total units available for sale.

c. The company then applies the weighted-average unit cost to the units on hand to determine the cost of ending inventory.

F. Financial Statement and Tax Effects of Cost Flow Methods.

Point out the financial statement effects of using different assumptions. Also emphasize the impact that rising or declining prices have on the financial statement effects and income taxes.

1. Income statement effects.

a. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes.

b. In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues.

c. Some argue that the use of LIFO in a period of inflation enables the company to avoid reporting paper (or phantom) profit as eco-nomic gain.

TEACHING TIP


2. Balance sheet effects.

a. A major advantage of the FIFO method is that in a period of infla-tion, the costs allocated to ending inventory will approximate their current cost.

b. A major shortcoming of the LIFO method is that in a period of infla-tion, the costs allocated to ending inventory may be significantly understated in terms of current cost.

3. Tax effects. LIFO results in lower income taxes, because of lower net income, than either FIFO or average cost in a period of rising prices.

INTERNATIONAL INSIGHT

ExxonMobil Corporation uses LIFO to value its inventory for financial reporting and tax purposes. International accounting standards do not allow the use of LIFO, which makes the net income of foreign oil companies such as BP not directly comparable to U.S. companies.

What are the arguments for and against the use of LIFO?

Answer: Proponents of LIFO argue that it is conceptually superior because it matches the most recent cost with the most recent selling price. Critics contend that it artificially understates the company’s net income and consequently reduces tax payments. Also, because most foreign com-panies are not allowed to use LIFO, its use by U.S. companies reduces the ability of investors to compare results across companies.

G. Lower-of-Cost-or-Market.

1. The value of inventory for companies in certain industries can drop very quickly due to changes in technology or fashions. This situation requires a departure from the cost basis of accounting. This is done by valuing the inventory at the lower-of-cost-or-market (LCM) in the period in which the price decline occurs.


2. Companies apply LCM to the items in inventory after they have used one of cost flow methods to determine cost. Under LCM, companies recognize the loss in the period in which the price decline occurs.

a. LCM is an example of the accounting convention of conservatism, which means that the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income.

b. Under the LCM basis, market is defined as current replacement cost, not selling price. Current replacement cost is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities.

3. Companies apply LCM to the items in inventory after they have used one of the cost flow methods to determine cost.

H. Inventory Errors.

1. The effects of inventory errors on net income of the current year are:

a. An error in beginning inventory will have a reverse effect on net income (overstatement of inventory results in understatement of net income).

b. An error in ending inventory will have a similar effect on net income (overstatement of inventory results in overstatement of net income).

c. If ending inventory errors are not corrected in the following period, their effect on net income for that period is reversed, and total net income for the two years will be correct.

2. Errors in ending inventory have no effect on liabilities and have the same effect on total assets and total owners’ equity (overstatement of inventory results in overstatement of total assets and owners’ equity).


I. Statement Presentation and Analysis.

1. Inventory is classified as a current asset immediately below receivables in the balance sheet. Cost of goods sold is subtracted from sales revenue in a multiple-step income statement.

2. There should be disclosure in the notes to the financial statements of:

a. the major inventory classifications.

b. the basis of accounting (cost, or lower of cost or market).

c. the costing method (FIFO, LIFO, or average cost).

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

4. A variant of the inventory turnover is to compute the number of days inventory is held. It is computed by dividing 365 days by the inventory turnover.

*J Inventory Cost Flow Methods in Perpetual Inventory Systems.

1. Under FIFO, companies charge to cost of goods sold the cost of the earliest goods on hand prior to each sale. The results under FIFO in a perpetual system are the same as in a periodic system.

2. Under LIFO, companies charge to cost of goods sold the cost of the most recent purchase prior to sale. In a perpetual LIFO system, the company allocates the latest units purchased prior to each sale to cost of goods sold.

3. Under the moving-average (average cost) method and a perpetual system, companies compute a new average cost after each purchase. The aver-age cost is computed by dividing the cost of goods available for sale by the units on hand.


*K Estimating Inventories—Gross Profit and Retail Inventory Methods.

1. Two circumstances explain why companies sometimes estimate inventories:

a. A casualty such as a fire, flood, or earthquake may make it impossible to take a physical inventory.

b. Managers may want monthly or quarterly financial statements, but a physical inventory is taken only annually.

2. There are two widely used methods of estimating inventories:

a. The gross profit method is used in preparing monthly financial state-ments under a periodic system.

(1) Step 1: Net sales less estimated gross profit equals estimated cost of goods sold.

(2) Step 2: Cost of goods available for sale less estimated cost of goods sold (from Step 1) equals the estimated cost of ending inventory.

(3) The gross profit method is based on the assumption that the gross profit rate will remain constant.

(4) Companies should not use the gross profit method to prepare financial statements at the end of the year.

b. When a store has many different types of merchandise at low unit costs, the retail inventory method is often used.

(1) Under the retail inventory method, a company’s records must show both the cost and retail value of the goods available for sale.

(2) Step 1: Goods available for sale at retail less net sales equals ending inventory at retail.

(3) Step 2: Goods available for sale at cost divided by goods avail-able for sale at retail equals the cost-to-retail ratio.


(4) Step 3: Ending inventory at retail multiplied by the cost-to-retail ratio equals the estimated cost of ending inventory.

(5) The major disadvantage of the retail method is that it is an averag-ing technique. This may produce an incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale.


A Look at IFRS The major IFRS requirements related to accounting and reporting for inventories are the same as GAAP. The major differences are that IFRS prohibits the use of the LIFO cost flow assumption and determines market in the lower-of-cost-or-market inventory valuation differently. KEY POINTS

The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guide-lines in inventory accounting.

The definitions for inventory are essentially similar under IFRS and GAAP. Both define inventory as assets held-for-sale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).

Who owns the goods—goods in transit or consigned goods—as well as the costs to include in inventory, are accounted for the same under IFRS and GAAP.

Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used.

A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS.

IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.

In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. In other words, net realizable value is the best estimate of the net amounts that inventories are expected to realize. GAAP, on the other hand, defines market as essentially replacement cost.


Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement as an expense. An item-by-item approach is generally followed under IFRS.

An example of the use of lower-of-cost-or-net realizable value (LCNRV) under IFRS follows.

Mendel Company has the following four items in its ending inventory as of December 31, 2014. The company uses the lower-of-cost-or-net realizable value approach for inventory valuation following IFRS. Item No. Cost Net Realizable Value 1320 $3,600 $3,400 1333 4,000 4,100 1428 2,800 2,100 1510 5,000 4,700 The computation of the ending inventory value to be reported in the financial statements at December 31, 2014, is as follows: Item No. Cost Net Realizable Value Lower-of-Cost-or NRV 1320 $ 3,600 $ 3,400 $ 3,400 1333 4,000 4,100 4,000 1428 2,800 2,100 2,100 1510 5,000 4,700 4,700 Total $15,400 $14,300 $14,200

Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost.

Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.

IFRS allows companies to report inventory at standard cost if it does not differ significantly from actual cost. Standard cost is addressed in managerial accounting courses.


LOOKING TO THE FUTURE One convergence issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income.


20 MINUTE QUIZ

Circle the correct answer. True/False

1. When prices are rising, FIFO results in a higher ending inventory than LIFO.

True False

2. We can use the LIFO inventory method only if we know that the newest units are always sold first.

True False

3. Goods in transit would be included in the ending inventory of the buyer and the seller.

True False

4. Under the LCM basis, market is defined as current replacement cost, not selling price.

True False

5. When beginning inventory is understated, net income will be understated.

True False

6. Cost of goods purchased less the ending inventory equals cost of goods sold.

True False

7. The LIFO method assumes that the earliest goods purchased are the first to be sold.

True False

8. The inventory turnover is computed by dividing the cost of goods sold by the ending inventory.

True False

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

True False

*10. The retail inventory method and the gross profit method are both methods of inventory estimation.

True False


Multiple Choice

1. The cost flow method that results in the lowest income taxes when prices are rising is a. average cost. b. FIFO. c. LIFO. d. specific identification.

2. The data below are for Parrett Enterprises: Beginning inventory 150 units at $2.00 Purchase—August 375 units at $1.50 Purchase—October 150 units at $3.00

A periodic inventory system is used; ending inventory is 330 units. What is the ending inventory under FIFO? a. $570 b. $743 c. $593 d. $720

3. Double-counting an inventory item at year end will result in a. understated tax liability. b. overstated cost of goods sold. c. overstated net income. d. understated beginning inventory for the next period.

*4. A retail company has goods available for sale of $300,000 at retail and $210,000 at cost, and ending inventory of $80,000 at retail. What is the estimated cost of goods sold? a. $220,000 b. $154,000 c. $210,000 d. $56,000

*5. Which method might be used to estimate inventory costs when physical inventories are not taken? a. First-in, first-out b. Last-in, first-out c. Average cost method d. Gross profit method


ANSWERS TO QUIZ

True/False

1. True 6. False 2. False 7. False 3. False 8. False 4. True *9. True 5. False *10. True

Multiple Choice

1. c. 2. d. 3. c. *4. b. *5. d.

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CHAPTER 6 INVENTORIESforesthillshs.enschool.org/ourpages/auto/2015/2/25/68787876/ch06.pdfFeb 25,...

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