Accounting I

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FinMan15e_IEPPT_Ch06.pptx

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Financial & Managerial Accounting

Fifteenth Edition

Chapter 6

Inventories

Learning Objectives (1 of 2)

Obj. 1: Describe the importance of control over inventory.

Obj. 2: Describe three inventory cost flow assumptions and how they impact the income statement and balance sheet.

Obj. 3: Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and weighted average cost methods.

Obj. 4: Determine the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and weighted average cost methods.

Learning Objectives (2 of 2)

Obj. 5: Compare and contrast the use of the three inventory costing methods.

Obj. 6: Describe and illustrate the reporting of inventory in the financial statements.

Obj. 7: Describe and illustrate the inventory turnover and the number of days’ sales in inventory in analyzing the efficiency and effectiveness of inventory management.

Obj. App: Describe and illustrate the estimation of inventory using the retail inventory and gross profit methods of inventory costing.

Control of Inventory

Two primary objectives of control over inventory are as follows:

Safeguarding the inventory from damage or theft.

Reporting inventory in the financial statements.

Safeguarding Inventory (1 of 3)

Controls for safeguarding inventory begin as soon as the inventory is ordered.

The following documents are often used for inventory control:

Purchase order

Receiving report

Vendor’s invoice

Safeguarding Inventory (2 of 3)

The purchase order authorizes the purchase of the inventory from an approved vendor.

The receiving report establishes an initial record of the receipt of the inventory.

To make sure the inventory received is what was ordered, the receiving report is compared with the purchase order.

The price, quantity, and description of the item on the purchase order and receiving report are compared to the vendor’s invoice before the inventory is recorded in the accounting records.

Safeguarding Inventory (3 of 3)

Recording inventory using a perpetual inventory system is also an effective means of control. The amount of inventory is always available in the subsidiary inventory ledger.

Controls for safeguarding inventory should include security measures to prevent damage and customer or employee theft. Some examples of security measures include:

Storing inventory in areas that are restricted to only authorized employees

Locking high-priced inventory in cabinets

Using two-way mirrors, cameras, security tags, and guards

Reporting Inventory

A physical inventory or count of inventory should be taken near year-end to make sure that the quantity of inventory reported in the financial statements is accurate.

After the quantity of inventory on hand is determined, the cost of the inventory is assigned for reporting in the financial statements.

Most companies assign costs to inventory using one of three inventory cost flow assumptions.

Cost Flow Assumptions

Inventory Cost Flow Assumptions (1 of 4)

Assume that three identical units of merchandise are purchased during May, as follows:

Inventory Cost Flow Assumptions (2 of 4)

Assume that one unit is sold on May 30 for $20. Depending upon which unit was sold, the gross profit varies from $11 to $6 and the ending inventory value varies from $27 to $22, computed as follows:

	May 10 Unit Sold	May 18 Unit Sold	May 24 Unit Sold
Sales	$ 20	$ 20	$ 20
Costs of goods sold	(9)	(13)	(14)
Gross profit	$ 11	$ 7	$ 6
Ending inventory	$ 27	$ 23	$ 22
	($13+$14)	($9+$14)	($9+$13)

Inventory Cost Flow Assumptions (3 of 4)

Under the specific identification inventory cost flow method, the unit sold is identified with a specific purchase and the ending inventory is made up of the remaining units on hand.

Because the specific identification inventory cost method requires each inventory unit to be separately identified, it is not practical for most businesses to use.

Under the first-in, first-out (FIFO) inventory cost flow method, the first units purchased are assumed to be sold and the ending inventory is made up of the most recent purchases.

Inventory Cost Flow Assumptions (4 of 4)

Under the last-in, first out (LIFO) inventory cost flow method, the last units purchased are assumed to be sold and the ending inventory is made up of the first purchases.

Under the weighted average inventory cost flow method, sometimes called the average cost flow method, the cost of the units sold and in ending inventory is a weighted average of the purchase costs.

The purchase costs are weighted by the quantities purchased at each cost, thus the term weighted average.

Inventory Costing Methods

Inventory Costing Methods Under a Perpetual Inventory System

For purposes of illustration, the data for Item 127B are used, as shown below. We will examine the perpetual inventory system first.

First-In, First-Out Method (1 of 4)

When the FIFO method is used in a perpetual inventory system, costs are included in the cost of goods sold in the order in which they were purchased.

This is often the same as the physical flow of the goods.

For example, grocery stores shelve milk and other perishable products by expiration dates. Products with early expiration dates are stocked in front. In this way, the oldest products (earliest purchases) are sold first.

Entries and Perpetual Inventory Account (FIFO) (1 of 2)

Entries and Perpetual Inventory Account (FIFO) (2 of 2)

The ending balance on January 31 is $18,460. This balance is made up of two layers of inventory as follows:

	Date of Purchase	Quantity	Unit Cost	Total Cost
Layer 1:	Jan. 10	200	$22.40	$ 4,480
Layer 2:	Jan.30	600	23.30	13,980
Total		800		$18,460

Last-In, First-Out Method (1 of 3)

When the LIFO method is used in a perpetual inventory system, the cost of the units sold is the cost of the most recent purchases.

The LIFO method was originally used in those rare cases where the units sold were taken from the most recently purchased units. However, for tax purposes, LIFO is now widely used even when it does not represent the physical flow of units.

Entries and Perpetual Inventory Account (LIFO) (1 of 2)

Entries and Perpetual Inventory Account (LIFO) (2 of 2)

The ending balance on January 31 is $17,980. This balance is made up of two layers of inventory as follows:

	Date of Purchase	Quantity	Unit Cost	Total Cost
Layer 1:	Jan. 10	200	$22.40	$ 4,480
Layer 2:	Jan.30	600	23.30	13,980
		800		$18,460

Check Up Corner: Perpetual Inventory: FIFO and LIFO Methods (1 of 3)

The beginning inventory, purchases, and sales of item QX3 for the month of January are as follows:

The company uses the perpetual inventory system. Determine (1) the cost of goods sold for January and (2) the January 31 inventory balance using the:

first-in, first-out (FIFO) method.

last-in, first-out (LIFO) method.

Check Up Corner: Perpetual Inventory: FIFO and LIFO Methods (2 of 3)

Check Up Corner: Perpetual Inventory: FIFO and LIFO Methods (3 of 3)

Weighted Average Cost Method

When the weighted average cost method is used in a perpetual inventory system, a weighted average unit cost for each item is computed each time a purchase is made.

This unit cost is used to determine the cost of each sale until another purchase is made and a new average is computed.

This technique is called a moving average.

Entries and Perpetual Inventory Account (Weighted Average)

Check Up Corner: Perpetual Inventory: Weighted Average Method (1 of 2)

The beginning inventory, purchases, and sales of Item QX3 for the month of January are as follows:

Jan.	1	Inventory	40 units at $5
	9	Sale	30 units
	18	Purchase	70 units at $7
	22	Sale	36 units

The company uses the perpetual inventory system. Determine (1) the cost of goods sold for January and (2) the January 31 inventory balance using the weighted average cost method.

Check Up Corner: Perpetual Inventory: Weighted Average Method (2 of 2)

Inventory Costing Methods Under a Periodic Inventory System

When the periodic inventory system is used, only revenue is recorded each time a sale is made.

No entry is made at the time of the sale to record the cost of the goods sold.

At the end of the accounting period, a physical inventory is taken to determine the cost of the inventory and the cost of the goods sold.

Like the perpetual inventory system, a cost flow assumption must be made when identical units are acquired at different unit costs during a period.

First-In, First-Out Method (2 of 4)

The beginning inventory and purchases of Item 127B in January are as follows:

First-In, First-Out Method (3 of 4)

The physical count on January 31 shows that 800 units are on hand.

The cost of the 800 units in the ending inventory on January 31 is determined as follows:

First-In, First-Out Method (4 of 4)

Deducting the cost of the January 31 inventory of $18,460 from the cost of goods available for sale of $45,180 yields the cost of goods sold of $26,720, computed as follows:

The $18,460 cost of the ending inventory on January 31 is made up of the most recent costs.

The $26,720 cost of goods sold is made up of the beginning inventory and the earliest costs.

First-In, First-Out Flow of Costs

Last-In, First-Out Method (2 of 3)

Assume again that the physical count on January 31 shows that 800 units are on hand.

The cost of the 800 units in ending inventory on January 31 is $16,000, which consists of 800 units from the beginning inventory at a cost of $20.00 per unit.

Last-In, First-Out Method (3 of 3)

Deducting the cost of the January 31 inventory of $16,000 from the cost of goods available for sale of $45,180 yields the cost of goods sold of $29,180, computed as follows:

The $16,000 cost of the ending inventory on January 31 is made up of the earliest costs.

The $29,180 cost of goods sold is made up of the most recent costs.

Last-In, First-Out Flow of Costs

Weighted Average Cost Method (1 of 3)

If purchases are relatively uniform during a period, the weighted average cost method produces results that are similar to the physical flow of goods.

The weighted average unit cost is determined as follows:

Weighted Average Cost Method (2 of 3)

What is the average cost per unit and the ending inventory?

Weighted Average Cost Method (3 of 3)

Deducting the cost of the January 31 inventory of $17,208 from the cost of goods available for sale of $45,180 yields the cost of goods sold of $27,972, computed as follows:

Weighted Average Flow of Costs

Check Up Corner: Periodic Inventory (1 of 2)

The beginning inventory, purchases, and sales of item PEAR4 for a recent year are as follows:

There are 16 units of the item in the physical inventory at December 31, the end of the fiscal year. The company uses the periodic inventory system. Determine (1) the December 31 Inventory balance and (2) the cost of goods sold for the year, using the:

first-in, first-out (FIFO) method.

last-in, first-out (LIFO) method.

Weighted average cost method.

Check Up Corner: Periodic Inventory (2 of 2)

Comparing Inventory Costing Methods (1 of 5)

A different cost flow is assumed for the FIFO, LIFO, and weighted average inventory cost flow methods. As a result, the three methods normally yield different amounts for the following:

Cost of goods sold

Gross profit

Net income

Ending inventory

Note that if costs (prices) remain the same, all three methods would yield the same results. However, costs (prices) normally do change.

Comparing Inventory Costing Methods (2 of 5)

Using the perpetual inventory system illustration with sales of $39,000 (1,300 units × $30), the differences in cost of goods sold, gross profit, and ending inventory are illustrated below.

Effects of Changing Costs (Prices): FIFO and LIFO Cost Methods

Comparing Inventory Costing Methods (3 of 5)

FIFO reports higher gross profit and net income than the LIFO method when costs (prices) are increasing.

However, in periods of rapidly rising costs, the inventory that is sold must be replaced at increasingly higher costs.

In such cases, the larger FIFO gross profit and net income are sometimes called inventory profits or illusory profits.

Comparing Inventory Costing Methods (4 of 5)

During a period of increasing costs, LIFO matches more recent costs against sales on the income statement.

LIFO also offers an income tax savings during periods of increasing costs.

This is because LIFO reports the lowest amount of gross profit and, thus, lower taxable net income.

However, under LIFO, the ending inventory on the balance sheet may be quite different from its current replacement cost.

Comparing Inventory Costing Methods (5 of 5)

The weighted average cost method is, in a sense, a compromise between FIFO and LIFO.

The effect of cost (price) trends is averaged in determining the cost of goods sold and the ending inventory.

Reporting Inventory in the Financial Statements

Cost is the primary basis for valuing and reporting inventories in the financial statements. However, inventory may be valued at other than cost in the following cases:

The cost of replacing items in inventory is below the recorded cost.

The inventory cannot be sold at normal prices due to imperfections, style changes, spoilage, damage, obsolescence, or other causes.

Valuation at Lower of Cost or Market (1 of 6)

If the market is lower than the purchase cost, the lower-of-cost-or-market (LCM) method is used to value the inventory.

Market, as used in lower of cost or market, is the net realizable value of the inventory. Net realizable value is determined as follows:

Net Realizable Value = Estimated Selling Price −– Direct Costs of Disposal

Direct costs of disposal include selling expenses such as special advertising or sales commissions.

Valuation at Lower of Cost or Market (2 of 6)

Assume the following data about an item of damaged inventory:

In applying LCM, the market value of the inventory is $650, computed as follows:

Thus, the inventory would be valued at $650, which is the lower of its cost of $1,000 and its market value of $650.

Valuation at Lower of Cost or Market (3 of 6)

The lower-of-cost-or-market method can be applied in one of three ways. The cost, market price, and any declines could be determined for the following:

Each item in the inventory

Each major class or category of inventory

Total inventory as a whole

Valuation at Lower of Cost or Market (4 of 6)

The amount of any price decline is included in the cost of goods sold.

This, in turn, reduces gross profit and net income in the period in which the price declines occur.

This matching of price declines to the period in which they occur is the primary advantage of using the lower-of-cost-or-market method.

Valuation at Lower of Cost or Market (5 of 6)

Assume the following data for 400 identical units of Item A in inventory on December 31:

Cost per unit	$10.25
Market value (net realizable value) per unit	9.50

Since the market value of Item A is $9.50 per unit, $9.50 is used under the lower-of-cost-or-market method.

Valuation at Lower of Cost or Market (6 of 6)

The following exhibit illustrates the application of the lower-of-cost-or-market method to (1) each inventory item, (2) each major class of inventory (Class 1, Class 2), and (3) inventory in total.

The market declines under each approach would be included in cost of goods sold.

Applying the lower-of-cost-or-market method on an item-by-item basis always gives the lowest value for inventory.

Conversely, applying the lower-of-cost-or-market method to the total inventory always gives the highest value for inventory.

Determining Inventory at Lower of Cost or Market (LCM)

Check Up Corner: Lower of Cost or Market (1 of 2)

JJ’s Electronics Company has three products in inventory (PCs, tablets, and smartphones). Each product’s quantity, cost per unit, and market value per unit are as follows:

Apply the lower-of-cost-or-market method to each inventory item.

Check Up Corner: Lower of Cost or Market (2 of 2)

Inventory on the Balance Sheet (1 of 2)

Inventory is usually reported in the current assets section of the balance sheet.

In addition to this amount, the following are reported on the balance sheet or in the accompanying notes:

The method of determining the cost of the inventory (FIFO, LIFO, or weighted average)

The method of valuing the inventory (cost or the lower of cost or market)

Inventory on the Balance Sheet (2 of 2)

Effect of Inventory Errors on the Financial Statements (1 of 3)

Any errors in merchandise inventory will affect the balance sheet and income statement.

Some reasons that inventory errors may occur include the following:

Physical inventory on hand was miscounted.

Costs were incorrectly assigned to inventory.

Inventory in transit was incorrectly included or excluded from inventory.

Consigned inventory was incorrectly included or excluded from inventory.

Effect of Inventory Errors on the Financial Statements (2 of 3)

Inventory errors often arise from merchandise that is in transit at year-end.

Shipping terms determine when the title to merchandise passes.

When goods are purchased or sold FOB shipping point, title passes to the buyer when the goods are shipped.

When the terms are FOB destination, title passes to the buyer when the goods are received.

Effect of Inventory Errors on the Financial Statements (3 of 3)

Inventory errors often arise from consigned inventory. Manufacturers sometimes ship merchandise to retailers who act as the manufacturer’s selling agent.

The manufacturer, called the consignor, retains title until the goods are sold. Such merchandise is said to be shipped on consignment to the retailer, called the consignee.

Any unsold merchandise at year-end is part of the manufacturer’s (consignor’s) inventory, even though the merchandise is in the hands of the retailer (consignee).

Effect of Inventory Errors on Current Period’s Income Statement

Effect of Inventory Errors on Two Years’ Income Statements

Effect of Inventory Errors on Current Period’s Balance Sheet

Effect of Inventory Errors on the Financial Statements

Inventory errors reverse themselves within two years on the income statement and the balance sheet.

The effects are summarized as follows:

Check Up Corner: Effects of Inventory Errors (1 of 2)

Zulu Industries incorrectly counted its December 31, 20Y1 inventory at $250,000 instead of the correct amount of $220,000. Indicate the effect of the misstatement on Zulu’s income statement for the current year (20Y1) and the following year (20Y2). What is the net effect of the error for the two years?

Check Up Corner: Effects of Inventory Errors (2 of 2)

Analysis for Decision Making: Inventory Turnover and Number of Days’ Sales in Inventory

A retail business should keep enough inventory on hand to meet its customers’ needs and a failure to do so may result in lost sales.

Too much inventory ties up funds that could be used to improve operations.

Excess inventory increases expenses such as storage and property taxes.

Excess inventory increases the risk of losses due to price decreases, damage, or changes in customer tastes.

Analysis for Decision Making: Inventory Turnover (1 of 2)

Inventory turnover measures the relationship between cost of goods sold and the amount of inventory carried during the period.

It measures the number of times inventory is turned into sold goods during the year.

Inventory turnover is calculated as follows:

Generally, the larger inventory turnover, the more efficient and effective the company is in managing inventory.

Analysis for Decision Making: Inventory Turnover (2 of 2)

To illustrate, inventory turnover for Best Buy is computed from the following data (in millions) from two recent annual reports:

	Year 3	Year 2	Year 1
Cost of goods sold	$30,334	$31,292	$31,212
Inventories:
Beginning of year	$5,174	$5,376	$6,781
End of year	$5,051	$5,174	$5,376
Average inventory:*
($5,174+$5,051)÷2	$5,112.5
($5,376+$5,174)÷2		$5,275.0
($6,781+$5,376)÷2			$6,078.5
Inventory turnover:*
$30,334÷$5,112.5	5.9
$31,292÷$5,275.0		5.9
$31,212÷$6,			5.1

*Rounded to one decimal place.

Analysis for Decision Making: Number of Days’ Sales in Inventory (1 of 2)

The number of days’ sales in inventory measures the length of time it takes to acquire, sell, and replace the inventory.

The number of days’ sales in inventory is computed as follows:

Analysis for Decision Making: Number of Days’ Sales in Inventory (2 of 2)

To illustrate, the number of days’ sales in inventory for Best Buy is computed from the following data (in millions) taken from two recent annual reports:

	Year 3	Year 2	Year 1
Cost of goods sold	$30,334	$31,292	$31,212
Average daily cost of goods sold.*
$30,334÷365 days	83.1
$31,292÷365 days		85.7
$31,212÷365 days			85.5
Average inventory:*
($5,174+$5,051)÷2	$5,112.5
($5,376+$5,174)÷2		$5,275.0
($6,781+$5,376)÷2			$6,078.5
Number of days’ sales in inventory:*
$5,112.5÷$83.1	61.5 days
$5,275.0÷$85.7		61.6 days
$6,078.5÷$85.5			71.1 days

*Rounded to one decimal place.

Analysis for Decision Making

Generally, the lower the number of days’ sales in inventory, the more efficient and effective the company is in managing inventory.

Because food is perishable, it will sell more rapidly than Best Buy’s consumer electronics.

Thus, Whole Foods’ inventory management should be significantly more efficient than Best Buy’s.

For a recent year, this is confirmed as follows:

	Best Buy	Whole Foods
Inventory turnover	5.9	21.2
Number of days’