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Transcript of Inventory analysis
6-1
REPORTING AND ANALYZING INVENTORY
Financial Accounting, Seventh Edition
6
6-2
After studying this chapter, you should be able to:
1. Determine how to classify inventory and inventory quantities.
2. Explain the basis of accounting for inventories and apply the inventory
cost flow methods under a periodic inventory system.
3. Explain the financial statement and tax effects of each of the inventory
cost flow assumptions.
4. Explain the lower-of-cost-or-market basis of accounting for
inventories.
5. Compute and interpret the inventory turnover.
6. Describe the LIFO reserve and explain its importance for comparing
results of different companies.
Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives
6-3
Preview of Chapter 6
Financial AccountingSeventh Edition
Kimmel Weygandt Kieso
6-4
Classifying and Determining InventoryClassifying and Determining InventoryClassifying and Determining InventoryClassifying and Determining Inventory
One Classification:
Merchandise
Inventory
Three Classifications:
Raw Materials
Work in Process
Finished Goods
Merchandising Company
Manufacturing Company
LO 1 Determine how to classify inventory and inventory quantities.
Helpful Hint Regardless of theclassification, companies reportall inventories under CurrentAssets on the balance sheet.
6-5
6-6
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to 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
LO 1 Determine how to classify inventory and inventory quantities.
6-7
Involves counting, weighing, or measuring each kind of
inventory on hand.
Taken,
when the business is closed or business is slow.
at the end of the accounting period.
Taking a Physical Inventory
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
LO 1 Determine how to classify inventory and inventory quantities.
6-8
6-9
Goods in Transit
Purchased goods not yet received.
Sold goods not yet delivered.
Determining Ownership of Goods
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
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.
LO 1 Determine how to classify inventory and inventory quantities.
6-10
Illustration 6-2 Terms of sale
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
LO 1 Determine how to classify inventory and inventory quantities.
Goods in Transit
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.
6-11
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.
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
LO 1 Determine how to classify inventory and inventory quantities.
Review Question
6-12
Consigned Goods
To hold the goods of other parties and try to sell the goods
for them for a fee, but without taking ownership of the
goods.
Many car, boat, and antique dealers sell goods on
consignment, why?
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
LO 1 Determine how to classify inventory and inventory quantities.
Determining Ownership of Goods
6-13
Hasbeen Company completed its inventory count. It arrived at a total inventory value of $200,000. You have been given the information listed below. Discuss how this information affects the reported cost of inventory.
1. Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000.
2. The company did not include in the count purchased goods of $10,000, which were in transit (terms: FOB shipping point).
3. The company did not include in the count inventory that had been sold with a cost of $12,000, which was in transit (terms: FOB shipping point).
Solution
1. Goods of $15,000 held on consignment should be deducted from the inventory count.
2. The goods of $10,000 purchased FOB shipping point should be added to the inventory count.
3. Item 3 was treated correctly. Inventory should be $195,000 ($200,000 - $15,000 + $10,000).
LO 1 Determine how to classify inventory and inventory quantities.
6-14
$
LO 1 Determine how to classify inventory and inventory quantities.
6-15
Inventory CostingInventory CostingInventory CostingInventory Costing
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Inventory is accounted for at cost.
Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale.
Unit costs are applied to quantities to determine the total cost of the inventory and the cost of goods sold using the following costing methods:
► Specific identification
► First-in, first-out (FIFO)
► Last-in, first-out (LIFO)
► Average-cost
Cost Flow Assumptions
6-16
Illustration: Crivitz TV Company purchases three identical 50-
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.
Inventory CostingInventory CostingInventory CostingInventory Costing
Illustration 6-3
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
6-17
Specific Identification
Inventory CostingInventory CostingInventory CostingInventory Costing
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.
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Illustration 6-4
6-18
Inventory CostingInventory CostingInventory CostingInventory Costing
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Specific Identification
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.
6-19
Inventory CostingInventory CostingInventory CostingInventory Costing
Illustration 6-12Use of cost flow methods in
major U.S. companies
Cost Flow
Assumption
does not need to be
consistent with the
physical movement of
goods
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
6-20
Illustration: Data for Houston Electronics’ Astro condensers.
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
Illustration 6-5
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
6-21
Costs of the earliest goods purchased are the first to
be recognized in determining cost of goods sold.
Often parallels actual physical flow of merchandise.
Companies determine 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.
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
First-In, First-Out (FIFO)
6-22
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
Illustration 6-6
LO 2
First-In, First-Out (FIFO)
6-23
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
Illustration 6-6
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
First-In, First-Out (FIFO)
Helpful Hint Another way ofthinking about the calculationof FIFO ending inventory is theLISH assumption—last in still here.
6-24
Costs of the latest goods purchased are the first to be
recognized in determining cost of goods sold.
Seldom coincides with actual physical flow of
merchandise.
Exceptions include goods stored in piles, such as coal or
hay.
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Last-In, First-Out (LIFO)
6-25
Illustration 6-8
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
Last-In, First-Out (LIFO)
LO 2
6-26 LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
Last-In, First-Out (LIFO)
Illustration 6-8
Helpful Hint Another way ofthinking about the calculationof LIFO ending inventory is theFISH assumption—first in still here.
6-27
Allocates cost of goods available for sale on the basis of
weighted-average unit cost incurred.
Applies weighted-average unit cost to the units on
hand to determine cost of the ending inventory.
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Average-Cost
6-28
Illustration 6-11
LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
Average-Cost
6-29 LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions
Average-CostIllustration 6-11
6-30
Comparative effects of cost flow methods
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
Financial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax Effects
Illustration 6-13
6-31
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
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
6-32
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.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
Review Question
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
Helpful Hint A tax rule,often referred to as the LIFOconformity rule, requires thatif companies use LIFO for taxpurposes, they must also use itfor financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.
6-33
6-34
Using Cost Flow Methods Consistently
Inventory CostingInventory CostingInventory CostingInventory Costing
Method should be used consistently, enhances
comparability.
Although consistency is preferred, a company may change
its inventory costing method.Illustration 6-15Disclosure of change in cost flow method
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
6-35
Lower-of-Cost-or-Market
Inventory CostingInventory CostingInventory CostingInventory Costing
LO 4 Explain the lower-of-cost-or-market basis of accounting for 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. International Note UnderU.S. GAAP, companies cannotreverse inventory write-downsif inventory increases invalue in subsequent periods.IFRS permits companies toreverse write-downs in somecircumstances.
6-36
Inventory CostingInventory CostingInventory CostingInventory Costing
LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.
Illustration: Assume that Ken Tuckie TV has the following
lines of merchandise with costs and market values as indicated.
Lower-of-Cost-or-Market
Illustration 6-16
6-37
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
Inventory management is a critical task
1. High Inventory Levels - storage costs, interest cost (on
funds tied up in inventory), and costs associated with the
obsolescence of technical goods or shifts in fashion.
2. Low Inventory Levels – may lead to lost sales.
LO 5 Compute and interpret the inventory turnover ratio.
6-38
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
LO 5 Compute and interpret the inventory turnover ratio.
Inventory Turnover RatioIllustration 6-17
6-39
Illustration: Data available for Wal-Mart.
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
LO 5 Compute and interpret the inventory turnover ratio.
Illustration 6-17
6-40
6-41
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
Companies using LIFO are required to report the difference
between inventory reported using LIFO and Inventory using
FIFO. This amount is referred to as the LIFO reserve.
Analysts’ Adjustments for LIFO Reserve
LO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.
Illustration 6-18
6-42
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
The LIFO reserve can have a significant effect on ratios analysts
commonly use.
LO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.
Illustration 6-20
Analysts’ Adjustments for LIFO Reserve
6-43
Illustration:
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.
Illustration 6A-1
Appendix 6AAppendix 6AAppendix 6AAppendix 6APerpetual Inventory System
6-44LO 7 Apply the inventory cost flow methods to perpetual inventory records.
First-In, First-Out (FIFO)
Cost of Goods Sold
Ending Inventory
Illustration 6A-2
Appendix 6AAppendix 6AAppendix 6AAppendix 6APerpetual Inventory System
6-45LO 7 Apply the inventory cost flow methods to perpetual inventory records.
Last-In, First-Out (LIFO)
Cost of Goods Sold
Ending Inventory
Illustration 6A-3
Appendix 6AAppendix 6AAppendix 6AAppendix 6APerpetual Inventory System
6-46 LO 7 Apply the inventory cost flow methods to perpetual inventory records.
Average-CostIllustration 6A-4
Cost of Goods Sold
Ending Inventory
Appendix 6AAppendix 6AAppendix 6AAppendix 6APerpetual Inventory System
6-47
Inventory Errors
LO 8 Indicate the effects of inventory errors on the financial 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.
Appendix 6BAppendix 6BAppendix 6BAppendix 6B Inventory Errors
6-48 LO 8 Indicate the effects of inventory errors on the financial statements.
Inventory errors affect the computation of cost of goods sold and net income.
Income Statement Effects
Illustration 6-B2
Illustration 6-B1
Appendix 6BAppendix 6BAppendix 6BAppendix 6B Inventory Errors
6-49 LO 8 Indicate the effects of inventory errors on the financial statements.
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.
Ending inventory depends entirely on the accuracy of taking and costing the inventory.
Income Statement Effects
Appendix 6BAppendix 6BAppendix 6BAppendix 6B Inventory Errors
6-50 LO 8 Indicate the effects of inventory errors on the financial statements.
Incorrect 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$
2013 2014
($3,000)Net Income understated
$3,000Net Income overstated
Combined income for 2-year period is correct.
Illustration 6-B3
Appendix 6BAppendix 6BAppendix 6BAppendix 6B Inventory Errors
6-51
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.
Review Question
LO 8 Indicate the effects of inventory errors on the financial statements.
Appendix 6BAppendix 6BAppendix 6BAppendix 6B Inventory Errors
6-52 LO 8 Indicate the effects of inventory errors on the financial statements.
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:
Balance Sheet Effects
Illustration 6-B1
Illustration 6-B4
Appendix 6BAppendix 6BAppendix 6BAppendix 6B Inventory Errors
6-53
Key Points
The requirements for accounting for and reporting inventories
are more principles-based under IFRS. That is, GAAP provides
more detailed guidelines 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).
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
6-54
Key Points
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.
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
6-55
Key Points
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.
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
6-56
Key Points
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. GAAP, on the other hand, defines market as
essentially replacement cost.
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
6-57
Key Points
Under GAAP, if inventory is written down under the lower-of-
cost-or-market valuation, the new value becomes its cost
basis. 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.
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
6-58
Key Points
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.
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
6-59
Looking to the Future
IFRS specifically prohibits the use of the LIFO cost flow assumption.
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. With a new
conceptual framework being developed, it is highly probable that the
use of the concept of conservatism will be eliminated. Similarly, the
concept of “prudence” in the IASB literature will also be eliminated.
This may ultimately have implications for the application of the lower-
of-cost-or-net realizable value.
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
6-60
IFRS Practice
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
Which of the following should not be included in the inventory of a
company using IFRS?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB shipping
point.
d) None of the above.
6-61
IFRS Practice
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
Which method of inventory costing is prohibited under IFRS?
a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.
6-62
IFRS Practice
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
Specific identification:
a) must be used under IFRS if the inventory items are not
interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most
conservative net income.
6-63
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