Principles of financial accounting 12e by needles crosson chapter 07

Specific Identification Method The specific identification method identifies the cost of each item in the ending inventory.. Average Cost Method Under the average-cost method or weigh

Concepts Underlying Inventory Accounting

 Manufacturing companies have three

kinds of inventory:

– Raw materials (goods used in making

products) – Work in process (partially completed

products) – Finished goods ready for sale

 For a merchandising company, inventory consists of all goods owned and held for sale in the regular course of business.

Accrual Accounting and Valuation of

Inventories

 Inventory accounting applies accrual accounting

to the determination of the cost of inventory sold

– Inventory cost includes the following: invoice price less purchases discounts; freight-in, including insurance in transit; applicable taxes and tariffs.

– Inventory valuation depends on the prices of goods, which can vary during the year Thus, it is necessary to make an assumption about the order in which items have been sold.

 Goods flow refers to the actual physical measurement

of goods in the operations of a company.

 Cost flow refers to the association of costs with their

assumed flow.

Merchandise in Transit

 Outgoing goods shipped FOB

destination are included in the seller’s merchandise inventory, whereas those shipped FOB shipping point are not.

 Incoming goods shipped FOB shipping point are included in the buyer’s

merchandise inventory, but those

shipped FOB destination are not.

Merchandise Not Included in Inventory

 Goods to which the company does not

hold title should not be included in its

physical inventory These include:

– Goods sold but not yet delivered to the

buyer – Goods held on consignment —merchandise that its owner (the consignor) places on the premises of another company (the

consignee) with the understanding that payment is expected only when the

merchandise is sold and that unsold items

Conservatism and the

Lower-of-Cost-or-Market (LCM) Rule

 If the market value of inventory falls

below its historical cost because of

physical deterioration, obsolescence, or

decline in the price level, a loss has

occurred This loss is recognized by

writing the inventory down to market , or its current replacement cost.

– When the replacement cost of inventory falls below its historical cost, the lower-of-cost-

inventory be written down to the lower value and that a loss be recorded.

Inventory Cost Under the

Periodic Inventory System

 The value assigned to the ending inventory

is the result of two measurements: quantity and cost.

– Under the periodic inventory system, quantity is determined by taking a physical inventory.

– Cost is determined by using one of the following methods: specific identification, average-cost, first-in, first-out (FIFO), or last-in, first-out (LIFO) – The choice of method depends on the nature of the business, the financial effects, and the cost

of implementation.

Specific Identification Method

 The specific identification method

identifies the cost of each item in the ending inventory.

– It can be used only when it is possible to identify the units as coming from specific purchases.

– Although this method may appear logical, most

companies do not use it for the following reasons:

 It is usually impractical, if not impossible, to keep track of the purchase and sale of individual items.

 When a company deals in items that are identical but bought at different prices, deciding which items were sold becomes arbitrary

Average Cost Method

 Under the average-cost method (or weighted

average method), inventory is priced at the

average cost of the goods available for sale during the period Average cost is computed as follows:

Average Cost = Total Cost of Goods Available for Sale

Total Units Available for Sale

- The average cost method tends to level out the

effects of cost increases and decreases because the cost of the ending inventory is influenced by all the prices paid during the year and the cost of the beginning inventory.

First-In, First-Out (FIFO) Method

assumes that the costs of the first items

acquired should be assigned to the first

items sold

– The costs of the goods on hand at the end of a period are assumed to be from the most recent purchases, and the costs assigned to goods that have been sold are assumed to be from the

earliest purchases.

– Thus, the FIFO method values the ending

inventory at the most recent costs and includes earlier costs in the cost of goods sold.

Last-In, First-Out (LIFO) Method

 The last-in, first-out (LIFO) method of costing inventories assumes that the costs

of the last items purchased should be

assigned to the first items sold and that

the cost of the ending inventory should

reflect the cost of the goods purchased

earliest.

– The effect of LIFO is to value inventory at the earliest prices and to include the cost of the most recently purchased goods in the cost of goods sold.

Impact of Inventory Decisions

 In a period of rising prices, LIFO, which

charges the most recent prices to the cost of goods sold, results in the lowest gross margin.

 In a period of rising prices, FIFO, which

charges the earliest prices to the cost of

goods sold, produces the highest gross

margin.

 The gross margin under the average-cost

method falls between the gross margins

produced by LIFO and FIFO.

Effects on Income Taxes

 The Internal Revenue Service governs how inventories must be valued for federal

income tax purposes

– IRS regulations give companies a wide choice of inventory costing methods, including specific identification, average-cost, FIFO, and LIFO

– During a period of rising prices, a company using LIFO will pay higher income taxes if it lets the

inventory at year end fall below the level at the beginning of the year This is called a LIFO

liquidation —that is, units sold exceed units purchased for the period.

Inventory Cost Under the

Perpetual Inventory System

 Under the perpetual inventory system, inventory

is updated as purchases and sales take place

 The cost of goods sold is accumulated as sales are made and costs are transferred from the

Inventory account to the Cost of Goods Sold

account.

 The cost of the ending inventory is the balance of the Inventory account.

 Goods are valued using one of these methods:

specific identification, average-cost, FIFO, or

LIFO.

Specific Identification Method

 The detailed records of purchases and sales maintained under the perpetual system facilitate the use of the specific identification method.

Average-Cost Method

 Under the perpetual system, an

average is computed after each

purchase or series of purchases.

FIFO Method

 When costing inventory with the FIFO or LIFO methods, it is necessary to keep

track of the components of inventory

because, as sales are made, the costs must be assigned in the proper order

Valuing Inventory by Estimation

 The most commonly used methods for

estimating the value of the ending inventory are:

– the retail method , which estimates the cost of the ending inventory by using the ratio of cost to retail price It can be used to estimate the cost without taking time to determine the cost of each item in the inventory.

– the gross profit method (or gross margin

method), which assumes that the ratio of gross

margin for a business remains relatively stable from year to year.

Gross Profit Method

 The gross profit method is used in place of

the retail method when records of the retail prices of the beginning inventory and

purchases are not available.

 This method is acceptable for estimating the cost of inventory for insurance claims and for interim reports, but it is not acceptable for

valuing inventory in the annual financial

statements.

 The gross profit method involves three steps.

Inventory Turnover

 Inventory turnover is the

average number of times a

company sells an amount equal to its average level of inventory

during a period

Days’ Inventory on Hand

 Day’s inventory on hand is the average number of days it takes a company to sell an amount equal

to its average inventory.

– With supply-chain management , a

company uses the Internet to order and track goods that it needs immediately.

just at the time they are needed.

Inventory Misstatements and Fraud

 Inventory is particularly susceptible to

fraudulent financial reporting.

– It is easy to overstate or understate inventory

by including end-of-the-year purchase and sale transactions in the wrong fiscal year or by

simply misstating inventory by mistake.

– A misstatement can also occur because of

deliberate manipulation of operating results motivated by a desire to enhance the market’s perception of the company, obtain bank

financing, or achieve compensation incentives.

Inventory Misstatements Illustrated

 Because the ending inventory in one

period becomes the beginning

inventory in the following period, a

misstatement in inventory valuation

affects both periods.