Accounting principles 10e by kieso chapter 06

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 Fl

6-1

CHAPTER 6

Inventories

6-3

Manufacturing Company

Regardless of the classification, companies report all inventories under

Current Assets on the balance sheet

Classifying Inventory

6-5

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

Determining Inventory Quantities

Involves counting, weighing, or measuring each kind of

inventory on hand.

Taken,

Taking a Physical Inventory

SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

Goods in Transit

Determining Ownership of Goods

SO 1 Describe the steps in determining 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.

Determining Inventory Quantities

Illustration 6-1

Terms of sale

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

Goods in Transit

Determining Inventory Quantities

Goods in transit should be included in the inventory of the

buyer when the:

Question

SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

Consigned Goods

party.

Determining Inventory Quantities

Determining Ownership of Goods

6-13

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

Inventory Costing

Illustration: Assume that 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.

Illustration 6-2

Inventory Costing

SO 2 Explain the basis of accounting for inventories

and apply the inventory cost flow methods.

Specific Identification

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

Inventory Costing

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.

Inventory Costing

Specific Identification

SO 2 Explain the basis of accounting for inventories

and apply the inventory cost flow methods.

Illustration 6-11

Use of cost flow methods in major U.S companies

Cost Flow Assumptions

do not need to match the

physical movement of

goods

Inventory Costing

SO 2 Explain the basis of accounting for inventories

and apply the inventory cost flow methods.

 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)

Inventory Costing

Illustration 6-5

Inventory Costing

First-In-First-Out (FIFO)

 Latest goods purchased are first to be sold

 Seldom coincides with actual physical flow of

merchandise.

 Includes goods stored in piles, such as coal or hay.

Inventory Costing

Last-In-First-Out (FIFO)

SO 2 Explain the basis of accounting for inventories

and apply the inventory cost flow methods.

Illustration 6-7

Inventory Costing

Last-In-First-Out (FIFO)

Illustration 6-7

Inventory Costing

Last-In-First-Out (FIFO)

SO 2 Explain the basis of accounting for inventories

and apply the inventory cost flow methods.

 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.

Inventory Costing

Average Cost

Illustration 6-10

Inventory Costing

Average Cost

SO 2 Explain the basis of accounting for inventories

and apply the inventory cost flow methods.

Illustration 6-10

Inventory Costing

Average Cost

6-29 SO 3 Explain the financial effects of the inventory cost flow assumptions.

Financial Statement and Tax Effects

Illustration 6-12

Inventory Costing

The cost flow method that often parallels the actual

physical flow of merchandise is the:

Question

Inventory Costing

In a period of inflation, the cost flow method that results

in the lowest income taxes is the:

Question

Inventory Costing

SO 3 Explain the financial effects of the inventory cost flow assumptions.

Using Cost Flow Methods Consistently

 Method should be used consistently, enhances

comparability.

 Although consistency is preferred, a company may

change its inventory costing method.

Illustration 6-14

Disclosure of change in cost flow method

Inventory Costing

SO 3 Explain the financial effects of the inventory cost flow assumptions.

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

Inventory Costing

Illustration: Assume that Ken Tuckie TV has the following

lines of merchandise with costs and market values as

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.

Inventory Errors

Inventory errors affect the computation of cost of goods

sold and net income.

Illustration 6-17 Illustration 6-16

SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing

Income Statement Effects

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

Inventory Costing

Income Statement Effects

($3,000)

Net Income understated

$3,000 Net Income overstated

Combined income for

2-year period is correct

Illustration 6-18

SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing

Understating ending inventory will overstate:

6-41 SO 5 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 - 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).

Statement Presentation and Analysis

Presentation

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

SO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis

Analysis

Inventory turnover measures the number of times on

average the inventory is sold during the period.

Cost of Goods Sold Average Inventory

Days in

Statement Presentation and Analysis

Illustration: Wal-Mart reported in its 2010 annual report a beginning

inventory of $34,511 million, an ending inventory of $33,160 million, and

cost of goods sold for the year ended January 31, 2010, of $304,657

million The inventory turnover formula and computation for Wal-Mart are

shown below.

SO 6 Compute and interpret the inventory turnover ratio.

Illustration 6-21

Days in Inventory: Inventory turnover of 9 times divided into 365 is

approximately 40.6 days This is the approximate time that it takes a

company to sell the inventory.

Statement Presentation and Analysis

SO 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 6A

Perpetual Inventory Systems

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

Perpetual Inventory System

Illustration 6A-4

Cost of Goods

Sold Ending Inventory

Perpetual Inventory System

Estimates the cost of ending inventory by applying a gross profit

rate to net sales

Gross Profit Method

SO 8 Describe the two methods of estimating inventories.

Illustration 6B-1

APPENDIX 6B

Estimating Inventories

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

Estimating Inventories

Company applies the cost-to-retail percentage to ending

inventory at retail prices to determine inventory at cost

SO 8 Describe the two methods of estimating inventories.

Illustration 6B-3

Estimating Inventories

Retail Inventory Method

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:

Estimating Inventories

 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 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).

held-for-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

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.

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 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

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.

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.

Key Points

One convergence issue relates to the use of the LIFO cost flow assumption IFRS specifically prohibits its use Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages 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.

Looking to the Future

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.

IFRS Self-Test Questions

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.

IFRS Self-Test Questions

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