Intermediate accounting 19th by stice stice chapter 09

Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine Inventory and Cost of Goods Sold Chapter 9 19 th Edition... • While the net method tracks discou

Intermediate

Accounting

James D Stice Earl K Stice

PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine

Inventory and Cost of Goods Sold

Chapter 9

19 th

Edition

What Is Inventory?

• Inventory designates goods held for sale in

the normal course of business or, for a

manufacturer, also includes goods in

production or to be placed into production.

most active element in business operations.

and finished goods refer to the inventories of

a manufacturing enterprise.

Raw Materials

• Raw Materials are goods acquired to use in the production process.

to refer to materials that will be physically

incorporated in the products being

manufactured.

refer to auxiliary materials, that is, materials that are necessary in the production process but not directly incorporated into the product.

Work in Process

• Work in Process (WIP) consists of

materials partly processed and

requiring further work before they can

Finished Goods

• Finished goods are the manufactured

products awaiting sale.

• As products are completed, the costs

accumulated in the production process are transferred from Work in Process to the Finished Goods Inventory account.

Inventory Systems

Two types of inventory systems that keep track

of how much inventory has been sold and at

what price are:

• Periodic inventory system—requires a

physical count of the inventory periodically, and at the point of sale only records the

sale price.

• Perpetual inventory system—at point of

sale records selling price and type of item

sold are recorded Example: a bar code

scanning system.

Whose Inventory Is It?

• As a general rule, goods should be

included in the inventory of the business holding legal title.

• The passing of title is a legal term

designating the point at which ownership changes.

• Issues that develop:

• Goods in transit

• Goods on consignment

Goods on Consignment

• Shipper retains title and includes the

goods in inventory until their sale or use

by the dealer or customer.

• Consigned goods are properly reported

by the shipper at the sum of their costs, and the shipping and handling costs

incurred transfer to the dealer or

customer.

Conditional Sales, Installment Sales,

and Repurchase Agreements

• Conditional sales and installment sales

contracts may provide a retention of title by the seller until the sales price is fully

recovered

• As a creative way to obtain cash on a

short-term basis, firms sometimes sell

inventory to another company but at the

same time agree to repurchase the

inventory at a future date

Inventory costs consist of all

expenditures, both direct and indirect,

relating to acquisition, preparation, and placement for sale.

• Expenditures that are relatively small and difficult to allocate are period

costs These are recognized as

expenses in the current period.

Items Included in Inventory Cost

(continued)

• Costs that can be identified with the

product being manufactured are

called product or inventoriable

costs

• Costs arising from idle capacity,

excessive spoilage, and reprocessing are usually considered abnormal and are expensed in the current period.

Items Included in Inventory Cost

(continued)

• Traditionally, manufacturing overhead

costs have been allocated to products

based on the amount of direct labor

required in production

• Activity-based cost (ABC) systems

strive to allocate overhead based on

clearly identified cost drivers—

characteristics of the production process that are known to create overhead costs

Items Included in Inventory Cost

Discounts as Reductions in Cost

• Discounts associated with the purchase of inventory should be treated as a reduction in the cost assigned to the inventory

• Trade discounts refer to the difference

between a catalog price and the price

actually charged to a buyer

• Cost is defined as the list price less the

trade discount

(continued)

Discounts as Reductions in Cost

• Cash discounts are discounts granted for payment of invoices within a limited time period

for payment on a 2/10, n/30 basis If the

buyer pays by the 10th day, $9,800 settles the invoice After that, the full $10,000 is

required

(continued)

Discounts as Reductions in Cost

• The net method records inventory at this discounted amount (i.e., the gross invoice prices less the allowable discount)

• The net method reflects that discounts not taken are in effect a finance charge

incurred for failure to pay within the

discount period

Discounts as Reductions in Cost

• Under the gross method, cash discounts are booked only when they are taken

• While the net method tracks discounts not taken, the gross method provides no such information, and inventory records are

maintained at the gross unit price

• The net method of accounting for

purchases is strongly preferred

Purchases Reported Using

the Net Method

To record the purchase of merchandise priced at

$10,000 with a cash discount of 2%:

To record payment of the invoice after the

Purchases Reported Using

the Net Method

To record the purchase of merchandise priced at

$10,000 with a cash discount of 2%:

Purchases Reported Using

the Gross Method

(continued)

period has lapsed:

Purchases Reported Using

the Gross Method

Purchase Returns and Allowances

and Allowances 400

Periodic Inventory System

Perpetual Inventory System

Accounts Payable 400 Inventory

400

Inventory Valuation Methods

Specific Identification

Last-in, out (LIFO)

Specific Identification Method

• This specific identification method

requires a way to identify the historical cost

of each individual unit of inventory

• From a theoretical standpoint, the specific identification method is very attractive,

especially when each inventory item is

unique and has a high cost

• This method opens the door to possible

profit manipulation

Average Cost Method

• The average cost method assigns the same average cost to each unit.

• This method is based on the assumption that goods sold should be charged at an average cost.

• For periodic inventory, the unit cost is the

weighted average for the entire period.

• The First-in, first out (FIFO) method is

based on the assumption that the units sold are the oldest units on hand

• FIFO assumes a cost flow closely paralleling the usual physical flow of goods sold

• With FIFO, the units remaining in ending

inventory are the most recently purchased

units, so their reported cost would most

closely match end-of-year replacement costs

First-In, First-Out (FIFO) Method

Last-In, First-Out (LIFO) Method

• The last-in, first-out (LIFO) method is

based on the assumption that the newest units are sold first

• There is no required connection between the actual physical flow of goods and the

inventory valuation method used

• LIFO is the best method of matching

current inventory costs with current

revenues

• Each year in which the number of units

purchased exceeds the number of units

sold, a new LIFO layer is created in ending inventory

• Many companies that use LIFO report

the amount of their LIFO reserve , either

as a parenthetical note in the balance or the notes to the financial statements.

LIFO Layers

LIFO and Income Taxes

• The LIFO inventory method was developed

in the United States during the late 1930s as

a method of reducing income taxes during periods of rising prices

• The LIFO conformity rule specifies that

only those taxpayers who use LIFO for

financial reporting purposes may use it for tax purposes The rule has been relaxed

(continued)

LIFO and Income Taxes

• As a means of simplifying the valuation

process and extending the applicability to more items, the IRS developed the

technique of establishing LIFO inventory pools of substantially identical goods

• To further simplify the recordkeeping

associated with LIFO and to eliminate the issues associated with new products

replacing old products, the dollar-value

LIFO inventory method was developed

Income Tax Effects

• If a company has large inventory levels, is experiencing significant inventory cost

increases, and does not anticipate

reducing inventory levels in the future,

LIFO gives substantial cash flow benefits

in terms of tax deferrals

• This is the primary reason for LIFO

adoption by most firms

Bookkeeping Costs

• The bookkeeping associated with LIFO is

a bit more complicated than with FIFO or average cost

• In dollars and cents, a LIFO system costs more to operate

• With information technology and with the simplification of LIFO pools and dollar-

value LIFO, the incremental bookkeeping costs can be minimized

Impact on Financial Statements

• While LIFO gives tax benefits, it also

gives reduced reported income and

reduced reported inventory

• These negative financial statement

effects can harm a company by scaring

off stockholders, potential investors, and banks

• Supplement disclosure using FIFO or

average cost might offset this problem

International Accounting and

Inventory Valuation

• In 1992, the IASB decided to officially endorse FIFO and average cost, to kill the base stock method, and to let LIFO live on as a second-class “allowed

alternative treatment.”

• In 2003, the IASB adopted a revised

version of IAS 2 and did away with

LIFO once and for all.

Inventory Accounting Change

When a company changes its method of

valuing inventory, the change is accounted for

as a change in accounting principle

Report the effect of changing methods

on the financial statements.

LIFO change to Average Cost or FIFO

(continued)

Any Method change to LIFOLIFO

No adjustment to financial statements for change to LIFO, but special disclosure required.

Inventory Accounting Change

If the change is to LIFO from another method,

a company’s records are generally not

complete enough to reconstruct the prior

years’ inventory layer

Applying the Lower of Cost

or Market Method

ceiling (NRV).

constrained by ceiling and floor limits).

2 above), and select the lower amount.

Lower of Cost or Market

Fezzig Company sells six products identified with the letters A through F For each product, the selling price per unit is $1.00, selling

expenses are $0.20 per unit, and the normal

profit is 25% of sales, or $0.25 per unit.

(continued)

$0.70 Ceiling: $0.80

$0.60 Ceiling: $0.80

$0.50

$0.50 Ceiling: $0.80

$0.45

$0.45 Ceiling: $0.80

Lower of Cost or Market Applied Individually versus as a Whole

The journal entry to record the write-down of the inventory on an individual item basis is usually made as follows:

Loss from Decline in Value

of Inventory 250

Inventory

250

($4,100 ‒ $3,850)

Once an individual item is reduce to a

lower market price, the new market price

is considered to be the item’s cost for

future inventory valuations.

Allowance Method

Rather than reducing the inventory directly, the inventory account can be maintained at cost, and an allowance account can be used

to record the decline in value

Loss from Decline in Value

Gross Profit Method

• The gross profit method is based on the

observation that the relationship between

sales and cost of goods sold is usually fairly stable.

• The gross profit percentage [(Sales – Cost

of goods sold)/Sales] is applied to sales to

estimate cost of goods sold.

be a reliable measure of current experience.

(continued)

Retail Inventory Method

inventory method can be used to generate a reliable estimate of inventory position

whenever desired.

than the gross profit method in that it allows estimates to be based on FIFO, LIFO, or

average cost assumptions.

Effects of Errors in Recording Inventory

Failure to correctly report inventory results in

misstatements on both the balance sheet and the income statement There are three typical inventory errors:

an improper physical count

an improper physical count

delay in recording a purchase until the

following year

Using Inventory Information

for Financial Analysis

Consider the financial information relating to

inventories for Deere & Co provided below.

Inventory Turnover

Appropriateness of inventory size and

position can be measured by calculating the inventory turnover ratio

Cost of Goods Sold

Number of Days’ Sales

Deere’s number of days’ sales in

inventory results mean that, on

average, Deere & Co has enough

inventory to continue operations for 61.0 days using just its existing inventory.

Number of Days’ Sales

in Inventory

Retail Inventory Method

• The retail inventory method is widely

employed by retail firms to arrive at

reliable estimates of inventory position

Retail Inventory Method

$50,000 Purchases in January 30,000 40,000

Goods available for sale $60,000

Retail Inventory Method: Lower

of Cost or Market

Frequently, retail prices change after they are originally set The following terms are used to

describe these changes.

• Original retail—the initial sales price,

including the original increase over cost

• Markups—increases that raise sales prices above original retail.

• Markdowns—decreases that reduce sales prices below original retail.

Dollar-Value LIFO

• Under dollar-value LIFO, LIFO layers are determined based on total dollar changes rather than quantity changes

• With dollar-value LIFO, the unit of

measurement is the dollar

• All goods in the inventory pool to which

dollar-value LIFO is to be applied are

viewed as though they are identical items

Purchase Commitments

purchases can expose a company to

excessive risk.

locks in the inventory purchase price in

• Rollins Oat Company entered into a

purchase commitment on November 1,

2012, for 100,000 bushes of wheat at $3.40 per bushel to be delivered on March 2013

At the end of 2012, the market price for

wheat had dropped to $3.20 per bushel

Purchase Commitments

Foreign Currency Inventory

Transactions

• Only transactions denominated in

currencies other than the U.S dollar are

foreign currency transactions for U.S

companies

• If the transaction contract is written in

terms of U.S dollars, there is no foreign

currency risk whether the other company is based in Azerbaijan or Zimbabwe