Accounting principles 9e willey kieso chapter 06

Statement Presentation and AnalysisStatement Presentation and Analysis Reporting and Analyzing Inventory Reporting and Analyzing Inventory Taking a physical inventoryDetermining ownershi

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Chapter 6

Inventories

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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.

Study Objectives Study Objectives

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Statement Presentation and Analysis

Reporting and Analyzing Inventory

Taking a physical inventoryDetermining ownership of goods

Determining Inventory Quantities

Inventory Costing

Inventory Costing Inventory Errors

Inventory Errors Errors

Income statement effectsBalance sheet effects

PresentationAnalysis

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Merchandising

Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

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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.

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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.

Taking a Physical Inventory

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Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.

Determining Ownership of Goods

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.

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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.

Terms of Sale

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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.

Review Question

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Consigned Goods

In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods.

These are called consigned goods.

Determining Ownership of Goods

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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) Average-cost

Cost Flow Assumptions

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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.

Specific Identification Method

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Illustration: Assume that Crivitz TV Company purchases

three identical 46-inch TVs on different dates at costs

of $700, $750, and $800 During the year Crivitz sold

two sets at $1,200 each.

Illustration 6-2

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Illustration: 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.

Illustration 6-3

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Inventory Costing – Cost Flow Assumptions

Illustration 6-11

Use of cost flow methods in

major U.S companies

Cost Flow Assumption

does not need to equal

Physical Movement of

Goods

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Illustration: Assume that Houston Electronics uses a

A physical inventory at the end of the year determined that

during the year Houston sold 550 units and had 450 units in

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Earliest goods purchased are first to be sold

Often parallels actual physical flow of merchandise.

Generally good business practice to sell oldest units first.

“First-In-First-Out (FIFO)”

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Illustration 6-5

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Illustration 6-5

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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.

“Last-In-First-Out (LIFO)”

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Illustration 6-7

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Illustration 6-7

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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.

“Average-Cost”

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“Average Cost”

Illustration 6-10

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“Average Cost” Illustration 6-10

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Financial Statement and Tax Effects

Illustration 6-12

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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

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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.

Review Question

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Q6-12 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?

Discussion Question

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Using Cost Flow Methods Consistently

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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

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Illustration: Assume that Ken Tuckie TV has the

following lines of merchandise with costs and market

values as indicated.

Illustration 6-15

Lower-of-Cost-or-Market

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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.

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Inventory errors affect the computation of cost of

goods sold and net income.

Income Statement Effects

Illustration 6-17 Illustration 6-16

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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.

Income Statement Effects

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Understating ending inventory will overstate:

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Effect of inventory errors on the balance sheet is

determined by using the basic accounting equation:.

Balance Sheet Effects

Illustration 6-16

Illustration 6-19

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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).

Presentation

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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.

Analysis

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Inventory turnover measures the number of times

on average the inventory is sold during the period.

Cost of Goods Sold Average Inventory

Inventory

Days in inventory measures the average number of

days inventory is held.

Days in Year (365) Inventory Turnover

Days in

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Illustration: Wal-Mart reported in its 2008 annual

report a beginning inventory of $33,685 million, an ending

inventory of $35,180 million, and cost of goods sold for the

year ended January 31, 2008, of $286,515 million The

inventory turnover formula and computation for Wal-Mart

are shown below.

Illustration 6-21

Days in Inventory: Inventory turnover of 8.3 times divided

into 365 is approximately 44 days This is the approximate

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Cost Flow Methods in Perpetual Systems

Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.

Appendix 6A

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“First-In-First-Out (FIFO)” Illustration 6A-2

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Cost of Goods Sold

“Last-In-First-Out (LIFO)” Illustration 6A-3

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“Average Cost” (Moving-Average System)

Illustration 6A-4

Cost of Goods Sold Ending Inventory

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Estimating Inventories

The gross profit method estimates the cost of ending

inventory by applying a gross profit rate to net sales.

Gross Profit Method

Illustration 6B-1

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Illustration: Kishwaukee Company’s records for January show

net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000 The company expects to earn a 30% gross profit rate Compute the estimated cost of the ending

inventory at January 31 under the gross profit method.

Illustration 6B-2

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Company applies the cost-to-retail percentage to ending

inventory at retail prices to determine inventory at cost.

Retail Inventory Method

Illustration 6B-3

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Note that it is not necessary to take a physical inventory to

determine the estimated cost of goods on hand at any given time.

Illustration 6B-4

Illustration:

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