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REPORTING AND ANALYZING INVENTORY

Financial Accounting, Sixth Edition

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1. Describe the steps in determining inventory quantities.

2. Explain the basis of accounting for inventories and apply the

inventory cost flow methods under a periodic inventory system.

3. Explain the financial statement and tax effects of each of the

inventory cost flow assumptions.

4. Explain the lower-of-cost-or-market basis of accounting for

inventories.

5. Compute and interpret the inventory turnover ratio.

6. Describe the LIFO reserve and explain its importance for

comparing results of different companies.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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Classifying Classifying InventoryInventory

Classifying Classifying InventoryInventory

MerchandisingMerchandising

ManufacturingManufacturing

Just-in-timeJust-in-time

Inventory Inventory turnover ratioturnover ratio

LIFO reserveLIFO reserve

Specific Specific identificationidentification

Cost flow Cost flow assumptionsassumptions

Financial Financial statement and statement and tax effectstax effects

Consistent useConsistent use

Lower-of-cost-Lower-of-cost-or-marketor-market

Taking a Taking a physical physical inventoryinventory

Determining Determining ownership of ownership of goodsgoods

Determining Determining Inventory Inventory QuantitiesQuantities

Determining Determining Inventory Inventory QuantitiesQuantities

Inventory Inventory CostingCosting

Inventory Inventory CostingCosting

Analysis of Analysis of InventoryInventory

Analysis of Analysis of InventoryInventory

Reporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing Inventory

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Classifying InventoryClassifying InventoryClassifying InventoryClassifying Inventory

One Classification:

Merchandise

Inventory

Three Classifications:

Raw Materials

Work in Process

Finished Goods

Merchandising Company

Manufacturing Company

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.

Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

SO 1 Describe the steps in determining inventory quantities.SO 1 Describe the steps in determining inventory quantities.

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Involves counting, weighing, or measuring each kind of inventory on hand.

Taken,

when the business is closed or 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 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


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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

Goods held for sale by one party although ownership of the goods is retained by another party.



Determining Ownership of Goods

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$

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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

Inventory CostingInventory CostingInventory CostingInventory Costing

SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.

Cost Flow Assumptions

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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


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“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


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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”

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Illustration 6-11Use 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: Data for Houston Electronics’ Astro condensers.

Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions

Illustration 6-4

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold


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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

SO 2 SO 2


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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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Illustration 6-10



“Average-Cost”

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Illustration 6-10



“Average-Cost”

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FIFO

Sales $9,000 $9,000$9,000

Cost of goods sold 6,200 6,6007,000

Gross profit 2,800 2,4002,000

Admin. & selling expense 330 330330

Income before taxes 2,470 2,0701,670

Income tax expense 140 120110

Net income $2,330 $1,950$1,560

Inventory balance $5,800 $5,400$5,000

LIFOAverage

Comparative Financial Statement Summary

LO 3 LO 3 Explain the financial statement and tax effects of Explain the financial statement and tax effects of each of the inventory cost flow assumptions.each of the inventory cost flow assumptions.

Financial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax Effects

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FIFO

Sales $9,000 $9,000$9,000


Gross profit 2,800 2,4002,000




Net income $2,330 $1,950$1,560


LIFOAverage

In Period of Rising Prices, FIFO Reports:

Highest

Lowest



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FIFO

Sales $9,000 $9,000$9,000


Gross profit 2,800 2,4002,000




Net income $2,330 $1,950$1,560


LIFOAverage

In Period of Rising Prices, LIFO Reports:

Lowest

Highest



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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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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 6-14Disclosure of change in cost flow method


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Lower-of-Cost-or-Market


SO 4 Explain the lower-of-cost-or-market SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.basis of accounting for inventories.

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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SO 4 Explain the lower-of-cost-or-market SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.basis of accounting for inventories.

Illustration: Assume that Ken Tuckie TV has the following

lines of merchandise with costs and market values as

indicated.

Lower-of-Cost-or-Market

Illustration 6-15

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Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory

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 5 Compute and interpret the inventory turnover ratio.SO 5 Compute and interpret the inventory turnover ratio.

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Inventory Turnover RatioIllustration 6-16

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Illustration: Data available for Wal-Mart.



Illustration 6-16

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Companies using LIFO are required to report the amount that inventory would increase (or occasionally decrease) if the company had instead been using FIFO. This amount is referred to as the LIFO reserve.

Analysts’ Adjustments for LIFO Reserve

SO 6 SO 6 Describe the LIFO reserve and explain its importance Describe the LIFO reserve and explain its importance for comparing results of different companies.for comparing results of different companies.

Illustration 6-17

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The LIFO reserve can have a significant effect on ratios analysts commonly use.

SO 6 SO 6 Describe the LIFO reserve and explain its importance Describe the LIFO reserve and explain its importance for comparing results of different companies.for comparing results of different companies.

Illustration 6-19

Analysts’ Adjustments for LIFO Reserve

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Illustration:

SO 7 Apply the inventory cost flow methods to perpetual inventory records.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 6APerpetual Inventory System

6-46SO 7 Apply the inventory cost flow methods to perpetual inventory records.SO 7 Apply the inventory cost flow methods to perpetual inventory records.


Cost of Goods Sold

Ending Inventory

Illustration 6A-2


6-47SO 7 Apply the inventory cost flow methods to perpetual inventory records.SO 7 Apply the inventory cost flow methods to perpetual inventory records.


Cost of Goods Sold

Ending Inventory

Illustration 6A-3


6-48 SO 7 Apply the inventory cost flow methods to perpetual inventory records.SO 7 Apply the inventory cost flow methods to perpetual inventory records.

“Average-Cost”Illustration 6A-4

Cost of Goods Sold

Ending Inventory


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Inventory Errors

SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 Indicate the effects of inventory errors on the financial statements.

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.

appendix 6B Inventory Errors

6-50 SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory errors affect the computation of cost of goods sold and net income.

Income Statement Effects

Illustration 6-B2

Illustration 6-B1



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.

Income Statement Effects



Incorrect Correct Incorrect Correct

Sales 80,000$ 80,000$ 90,000$ 90,000$

Beginning inventory 20,000 20,000 12,000 15,000

Cost of goods purchased 40,000 40,000 68,000 68,000

Cost of goods available 60,000 60,000 80,000 83,000

Ending inventory 12,000 15,000 23,000 23,000

Cost of good sold 48,000 45,000 57,000 60,000

Gross profit 32,000 35,000 33,000 30,000

Operating expenses 10,000 10,000 20,000 20,000

Net income 22,000$ 25,000$ 13,000$ 10,000$

2011 2012

($3,000)Net Income understated

$3,000Net Income overstated

Combined income for 2-year period is correct.

Illustration 6-B3


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Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.

Review QuestionReview Question

SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 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 Effects

Illustration 6-B1

Illustration 6-B4


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Key Points

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 held-for-

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).

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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 in

which specific identification must be used.

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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.

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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.

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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.

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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.

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Looking into the Future

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.

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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.

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Which method of inventory costing is prohibited under

IFRS?

a) Specific identification.

b) FIFO.

c) LIFO.

d) Average-cost.

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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.

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“Copyright © 2011 John Wiley & Sons, Inc. All rights reserved.

Reproduction or translation of this work beyond that permitted in

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Request for further information should be addressed to the

Permissions Department, John Wiley & Sons, Inc. The purchaser

may make back-up copies for his/her own use only and not for

distribution or resale. The Publisher assumes no responsibility for

errors, omissions, or damages, caused by the use of these

programs or from the use of the information contained herein.”

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