Chapter 6-1. Chapter 6-2 Chapter 6 Inventories Accounting Principles, Ninth Edition.

Chapter 6-1

Chapter 6-2

Chapter 6

Inventories

Accounting Principles, Ninth Edition

Chapter 6-3

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.

6. Compute and interpret the inventory turnover ratio.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter 6-4

Statement Statement Presentation Presentation and Analysisand Analysis

Statement Statement Presentation Presentation and Analysisand Analysis

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

Taking a Taking a physical physical inventoryinventory

Determining Determining ownership of ownership of goodsgoods

Classifying Classifying InventoryInventory

Classifying Classifying InventoryInventory

Determining Determining Inventory Inventory QuantitiesQuantities

Determining Determining Inventory Inventory QuantitiesQuantities

Inventory Inventory CostingCosting

Inventory Inventory CostingCosting

Inventory Inventory ErrorsErrors

Inventory Inventory ErrorsErrors

Finished Finished goodsgoods

Work in Work in processprocess

Raw materialsRaw materials

Specific Specific identificationidentification

Cost flow Cost flow assumptionsassumptions

Financial Financial statement statement and tax and tax effectseffects

Consistent Consistent useuse

Lower-of-Lower-of-cost-or-cost-or-marketmarket

Income Income statement statement effectseffects

Balance sheet Balance sheet effectseffects

PresentationPresentation

AnalysisAnalysis

Chapter 6-5

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.

Chapter 6-6

Chapter 6-7

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.

Chapter 6-8

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 InventoryTaking a Physical Inventory



Chapter 6-9

Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.

Determining Ownership of Determining Ownership of GoodsGoods



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.

Chapter 6-10



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 SaleTerms of Sale

Chapter 6-11

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 QuestionReview Question



Chapter 6-12

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 Determining Ownership of GoodsGoods



Chapter 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

Inventory CostingInventory CostingInventory CostingInventory Costing

SO 2 Explain the accounting for SO 2 Explain the accounting for inventories and apply the inventory inventories and apply the inventory cost flow methods.cost flow methods.

Cost Flow Assumptio

ns

Chapter 6-14

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 MethodSpecific Identification Method



Chapter 6-15

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

Chapter 6-16

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

Chapter 6-17


Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptions

Illustration 6-11Use of cost flow methods in major U.S. companies

Cost Flow

Assumption

does not need to

equal

Physical Movement

of Goods

Chapter 6-18



Illustration: Assume that Houston Electronics uses a periodic inventory system.

Illustration 6-4

A physical inventory at the end of the year determined that during the year Houston sold 550 units and had 450 units in inventory at December 31.

Chapter 6-19

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)”First-In-First-Out (FIFO)”



Chapter 6-20



““First-In-First-Out (FIFO)”First-In-First-Out (FIFO)”Illustration 6-5

Chapter 6-21



““First-In-First-Out (FIFO)”First-In-First-Out (FIFO)”Illustration 6-5

Chapter 6-22

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)”Last-In-First-Out (LIFO)”



Chapter 6-23

“Last-In-First-Out (LIFO)”



Illustration 6-7

Chapter 6-24



Illustration 6-7

“Last-In-First-Out (LIFO)”

Chapter 6-25

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”Average-Cost”



Chapter 6-26

“Average Cost”



Illustration 6-10

Chapter 6-27



“Average Cost”Illustration 6-10

Chapter 6-28 SO 3 Explain the financial effects of the inventory cost flow SO 3 Explain the financial effects of the inventory cost flow

assumptions.assumptions.

Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsFinancial Statement and Tax EffectsFinancial Statement and Tax Effects

Illustration 6-12

Chapter 6-29

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.




Chapter 6-30

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.



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

Chapter 6-31

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 QuestionDiscussion Question

See notes page for discussion



Chapter 6-32

Using Cost Flow Methods ConsistentlyUsing 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


Chapter 6-33

Chapter 6-34

Lower-of-Cost-or-MarketLower-of-Cost-or-Market


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

Chapter 6-35


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

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-MarketLower-of-Cost-or-Market

Chapter 6-36

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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

Chapter 6-37



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

Income Statement EffectsIncome Statement Effects

Illustration 6-17

Illustration 6-16

Chapter 6-38



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 EffectsIncome Statement Effects

Chapter 6-39



I ncorrect 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$

2010 2011

($3,000)Net Income understated

$3,000Net Income overstated

Combined income for 2-year period is

correct.

Illustration 6-18

Chapter 6-40

Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.




Chapter 6-41



Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.

Balance Sheet EffectsBalance Sheet Effects

Illustration 6-16

Illustration 6-19

Chapter 6-42

Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis

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).

PresentationPresentation

Chapter 6-43


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.

AnalysisAnalysis

SO 6 Compute and interpret the inventory turnover ratio.SO 6 Compute and interpret the inventory turnover ratio.

Chapter 6-44

Inventory turnover measures the number of times on average the inventory is sold during the period.

Cost of Goods Sold

Average Inventory

Inventory Turnover

=


Days in inventory measures the average number of days inventory is held.

Days in Year (365)

Inventory Turnover

Days in Inventory

=


Chapter 6-45

Illustration: Wal-Mart reported in its 2008 annualreport 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-Martare 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 time that it takes a company to sell the inventory.

Chapter 6-46

Example

Cost Flow Methods in Perpetual Cost Flow Methods in Perpetual SystemsSystemsCost Flow Methods in Perpetual Cost Flow Methods in Perpetual SystemsSystems

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

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

Appendix 6AAppendix 6AAppendix 6AAppendix 6A

Chapter 6-47



““First-In-First-Out (FIFO)”First-In-First-Out (FIFO)”

Cost of Goods SoldEnding Inventory

Illustration 6A-2

Chapter 6-48



Cost of Goods SoldEnding Inventory

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

Chapter 6-49



““Average Cost” Average Cost” (Moving-Average (Moving-Average System)System) Illustration 6A-4

Cost of Goods Sold Ending Inventory

Chapter 6-50

Estimating InventoriesEstimating InventoriesEstimating InventoriesEstimating Inventories

The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales.

Gross Profit MethodGross Profit Method

SO 8 Describe the two methods of estimating inventories.SO 8 Describe the two methods of estimating inventories.

Illustration 6B-1

Chapter 6-51


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

Chapter 6-52


Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost.

Retail Inventory MethodRetail Inventory Method


Illustration 6B-3

Chapter 6-53



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:

Chapter 6-54

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Chapter 6-1. Chapter 6-2 Chapter 6 Inventories Accounting Principles, Ninth Edition.

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