Accounting MEMO (Writing Assignment)

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Financial & Managerial Accounting

Fifteenth Edition

Chapter 6

Inventories

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 4)

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 4)

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 4)

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

Safeguarding Inventory (4 of 4)

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 2)

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 (2 of 2)

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.

First-In, First-Out Method

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.

Last-In, First-Out Method

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.

Weighted Average Cost Method (1 of 2)

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.

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.

Weighted Average Cost Method (2 of 2)

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:

Comparing Inventory Costing Methods (1 of 4)

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.

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

Comparing Inventory Costing Methods (2 of 4)

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 (3 of 4)

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 (4 of 4)

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 3)

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 3)

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 (3 of 3)

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.

Inventory on the Balance Sheet

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)

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 Current Period’s Balance Sheet

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

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: Number of Days’ Sales in Inventory

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:

Appendix: Estimating Inventory Cost

A business may need to estimate the amount of inventory for the following reasons:

Perpetual inventory records are not maintained.

A disaster such as a fire or flood has destroyed the inventory records and the inventory.

Monthly or quarterly financial statements are needed, but a physical inventory is taken only once a year.

Two widely used methods of estimating inventory cost are the retail inventory method and gross profit method.

Appendix: Retail Method of Inventory Costing (1 of 2)

The retail inventory method of estimating inventory cost requires costs and retail prices to be maintained for the merchandise available for sale.

A ratio of cost to retail price is then used to convert ending inventory at retail to estimate the ending inventory cost.

Appendix: Retail Method of Inventory Costing (2 of 2)

The retail inventory method is applied as follows:

Step 1. Determine the total merchandise available for sale at cost and retail.

Step 2. Determine the ratio of the cost to retail of the merchandise available for sale.

Step 3. Determine the ending inventory at retail by deducting the sales from the merchandise available for sale at retail.

Step 4. Estimate the ending inventory cost by multiplying the ending inventory at retail by the cost to retail ratio.

Appendix: Gross Profit Method of Inventory Costing (1 of 2)

The gross profit method uses the estimated gross profit for the period to estimate the inventory at the end of the period.

The gross profit is estimated from the preceding year, adjusted for any current-period changes in the cost and sales prices.

Appendix: Gross Profit Method of Inventory Costing (2 of 2)

The gross profit method is applied as follows:

Step 1. Determine the merchandise available for sale at cost.

Step 2. Determine the estimated gross profit by multiplying the sales by the gross profit percentage.

Step 3. Determine the estimated cost of goods sold by deducting the estimated gross profit from the sales.

Step 4. Estimate the ending inventory cost by deducting the estimated cost of goods sold from the merchandise available for sale.

Sale

for

Available

Units

Sale

for

Available

Units

Cost

Total

Cost

Unit

Average

Weighted

Inventory

Average

Sold

Goods

Cost

Turnover

Inventory

Sold

Goods

Cost

Daily

Average

Inventory

Average

Inventory

Sales

Days’

Number