Slide 6-1 Inventories Financial Accounting, Seventh Edition Chapter 6.

Slide 6-1

InventoriesInventories

Financial Accounting,

Seventh Edition

Chapter 6

Slide 6-2

MerchandisMerchandise Inventory e Inventory affects . . . affects . . .

The matching The matching principle principle requires requires

matching cost matching cost of goods sold of goods sold

with sales with sales revenue.revenue.

BalancBalance e

SheetSheet

BalancBalance e

SheetSheet

Income Income StatemeStateme

ntnt

Income Income StatemeStateme

ntnt

Why is Inventory Cost Analysis Why is Inventory Cost Analysis Important?Important?Why is Inventory Cost Analysis Why is Inventory Cost Analysis Important?Important?

Slide 6-3

1.1. Gross profit – operating expenses = Gross profit – operating expenses = operating incomeoperating income

2.2. Sales – cost of goods sold – operating Sales – cost of goods sold – operating expenses = operating incomeexpenses = operating income

3.3. Net income + operating expenses = Net income + operating expenses = Gross ProfitGross Profit

4.4. Operating expenses – cost of goods Operating expenses – cost of goods sold = gross profitsold = gross profit

Knowledge Check Question:Knowledge Check Question:

Which of the following expressions is Which of the following expressions is incorrect incorrect ??

Slide 6-4

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.

Slide 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 QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

Slide 6-6

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 Inventory


Slide 6-7 FOB Destination Point

Public Carrier

Seller Buyer

Public Carrier

Seller Buyer

FOB Shipping Point

Ownership passes to the buyer here.

5-7

Determining Ownership of Goods in Determining Ownership of Goods in TransitTransitDetermining Ownership of Goods in Determining Ownership of Goods in TransitTransitGoods 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.

Slide 6-8

1.1. Merchandise in transit sold to Merchandise in transit sold to customers, FOB shipping pointcustomers, FOB shipping point

2.2. Merchandise in transit sold to Merchandise in transit sold to customers, FOB destinationcustomers, FOB destination

3.3. The cost of all inventory The cost of all inventory purchased during the periodpurchased during the period

4.4. Merchandise purchased in transit Merchandise purchased in transit with terms FOB destinationwith terms FOB destination


Ending Inventory is equal to Ending Inventory is equal to inventory on hand plus:inventory on hand plus:

Slide 6-9

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 Goods


Slide 6-10

Wally Mart buys and sells toasters and had the following Wally Mart buys and sells toasters and had the following transactions for 2012:transactions for 2012: June 1 Purchased 10 toasters at $6 per unit.June 1 Purchased 10 toasters at $6 per unit. July 1 Purchased 10 toasters at $9 per unit.July 1 Purchased 10 toasters at $9 per unit. Oct 1 Sold 10 toasters at $11 per unitOct 1 Sold 10 toasters at $11 per unit

What was Wally Mart’s Gross Profit in 2012?

Effect of Inventory Cost Flow Effect of Inventory Cost Flow AssumptionAssumptionEffect of Inventory Cost Flow Effect of Inventory Cost Flow AssumptionAssumption

Slide 6-11

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

Cost Flow Assumptio

ns

Slide 6-12

Illustration for Bikers’ Bikes CompanyIllustration for Bikers’ Bikes CompanyIllustration for Bikers’ Bikes CompanyIllustration for Bikers’ Bikes Company

Slide 6-13

+

+

Cost of Beginninginventory


Net cost ofpurchasesNet cost ofpurchases

Cost of goodsavailable for sale Cost of goodsavailable for sale

Cost of Ending inventory


Cost of goodssold

Cost of goodssold

==

Cost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompanyCost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompany

Slide 6-14

When units When units are sold, the are sold, the specific costspecific cost

of the unit of the unit sold is added sold is added

to to cost of cost of goods soldgoods sold..

When units When units are sold, the are sold, the specific costspecific cost

of the unit of the unit sold is added sold is added

to to cost of cost of goods soldgoods sold..

Specific Identification MethodSpecific Identification MethodSpecific Identification MethodSpecific Identification Method

Slide 6-15

The company keeps track of its inventory using the Specific Identification Method.

The sales were made as follows:

August 14: 8 bikes costing $91

12 bikes costing $106





The company keeps track of its inventory using the Specific Identification Method.

The sales were made as follows:







Specific Identification MethodSpecific Identification MethodSpecific Identification MethodSpecific Identification Method

Slide 6-16

+

+







Cost of goodssold

Cost of goodssold

==


Slide 6-17

Cost of Goods Sold

Cost of Goods Sold

Ending InventoryEnding

Inventory

Oldest Costs

Oldest Costs

Recent Costs

Recent Costs

FIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHOD

Slide 6-18

FIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHOD

Slide 6-19

+

+







Cost of goodssold

Cost of goodssold

==


Slide 6-20

Cost of Goods Sold

Cost of Goods Sold

Ending InventoryEnding

Inventory

Recent Costs

Recent Costs

Oldest Costs

Oldest Costs

LAST IN FIRST OUT METHODLAST IN FIRST OUT METHODLAST IN FIRST OUT METHODLAST IN FIRST OUT METHOD

Slide 6-21

LAST IN FIRST OUT METHODLAST IN FIRST OUT METHODLAST IN FIRST OUT METHODLAST IN FIRST OUT METHOD

Slide 6-22

+

+







Cost of goodssold

Cost of goodssold

==


Slide 6-23

AVERAGE COST METHODAVERAGE COST METHODAVERAGE COST METHODAVERAGE COST METHOD

Slide 6-24

+

+







Cost of goodssold

Cost of goodssold

==


Slide 6-25

FIFO LIFO AVERAGE COST

Sales Revenue $6,050 $6,050 $6,050

Cost of Goods Sold (4,570) (4,868) (4,683)

Gross Profit $1,480 $1,182 $1,367

Operating Expenses (1,000) (1,000) (1,000)

Income before Income Taxes $480 $182 $367

Income Tax Expense (40%) (192) (73) (147)

NET INCOME $288 $109 $220

Income Statement Effects of Inventory Cost Flow Income Statement Effects of Inventory Cost Flow AssumptionsAssumptions

Income Statement Effects of Inventory Cost Flow Income Statement Effects of Inventory Cost Flow AssumptionsAssumptions

Which method of accounting would the Which method of accounting would the company management choose?company management choose?

Which method of accounting would the Which method of accounting would the company management choose?company management choose?

Slide 6-26

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

Use of cost flow methods in major U.S. companies

Cost Flow

Assumption

does not need to

equal

Physical Movement

of Goods

Slide 6-27

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

Tax Effects

Many companies have selected LIFO. Why?

The reason is that LIFO results in the lowest income

taxes (because of lower net income) during times

of rising prices.

If LIFO is used for tax If LIFO is used for tax purposes, the IRS requires it purposes, the IRS requires it

be used in financial be used in financial statements (LIFO conformity statements (LIFO conformity

rule).rule).

If LIFO is used for tax If LIFO is used for tax purposes, the IRS requires it purposes, the IRS requires it

be used in financial be used in financial statements (LIFO conformity statements (LIFO conformity

rule).rule).

Slide 6-28

Scenario 1: When Prices are increasingDec 31, 2007 Dec 31, 2006

Inventories valued at LIFO $ 1,150 million $ 1,219 million

Inventories adjusted to FIFO $ 5,018 million $ 3,492 million

Taxable Income using LIFO $1,371 million

Taxable Income using FIFO $2,966 million

Scenario 2: When Prices are decreasingDec 31, 2008 Dec 31, 2007

Inventories valued at LIFO $821 million $1,150 million

Inventories adjusted to FIFO $2,221 million $5,018 million

Taxable Income using LIFO $1,194 million

Taxable Income using FIFO ($1,274 million)

LIFO RESERVE EXAMPLE – SUNOCO

Slide 6-29

1.1. The flow of inventory costs should match the The flow of inventory costs should match the physical flow of the merchandise.physical flow of the merchandise.

2.2. Accounting standards require that merchandise Accounting standards require that merchandise costs be specifically traced to units left in costs be specifically traced to units left in inventory and to units that have been soldinventory and to units that have been sold

3.3. Accountants have developed methods which Accountants have developed methods which make assumptions concerning how costs should make assumptions concerning how costs should be assigned to inventory and cost of goods be assigned to inventory and cost of goods sold.sold.

4.4. Alternative inventory cost flow assumptions Alternative inventory cost flow assumptions have the same effect on the amount of net have the same effect on the amount of net income reported.income reported.

Knowledge Check:Knowledge Check:Which of the following Which of the following statements is true?statements is true?

Slide 6-30

1.1. lower ending inventory value than under lower ending inventory value than under FIFOFIFO

2.2. lower income tax expense than under FIFOlower income tax expense than under FIFO

3.3. lower cost of goods sold than under FIFOlower cost of goods sold than under FIFO

4.4. lower net income than under FIFOlower net income than under FIFO

Knowledge Check:Knowledge Check:When inventory prices are When inventory prices are falling, using the LIFO falling, using the LIFO costing method will costing method will generally result in a:generally result in a:

Slide 6-31

Knowledge Check:Knowledge Check:

The first-in, first-out (FIFO) method of The first-in, first-out (FIFO) method of inventory valuation is characterized by:inventory valuation is characterized by:

1.1. lower (compared to the last-in-first-out lower (compared to the last-in-first-out method) income taxes when prices are method) income taxes when prices are risingrising

2.2. lower (compared to the last-in-first-out lower (compared to the last-in-first-out method) income taxes when prices are method) income taxes when prices are decliningdeclining

3.3. no correlation between cost of goods sold no correlation between cost of goods sold and current cost.and current cost.

4.4. more (compared to the last-in-first-out more (compared to the last-in-first-out method) complex record keeping.method) complex record keeping.

Slide 6-32

Using Cost Flow Methods Consistently


Method should be used consistently, enhances comparability.

Although consistency is preferred, a company may change its inventory costing method.

Slide 6-33

Lower-of-Cost-or-Market


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.

Slide 6-34

A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:

Lower of Cost or Market Illustration:Lower of Cost or Market Illustration:Lower of Cost or Market Illustration:Lower of Cost or Market Illustration:

Adjusting entry to apply LCM: (similar to shrinkage):Adjusting entry to apply LCM: (similar to shrinkage):Adjusting entry to apply LCM: (similar to shrinkage):Adjusting entry to apply LCM: (similar to shrinkage):

Slide 6-35

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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.

Slide 6-36

Income Statement Effect of Inventory Income Statement Effect of Inventory ErrorErrorIncome Statement Effect of Inventory Income Statement Effect of Inventory ErrorError

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

Slide 6-37

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 Effect of Inventory Income Statement Effect of Inventory ErrorErrorIncome Statement Effect of Inventory Income Statement Effect of Inventory ErrorError

Slide 6-38


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.

Slide 6-39


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

Balance Sheet Effects

Slide 6-40

1.1. $98,000$98,000

2.2. $72,000$72,000

3.3. $95,000$95,000

4.4. $85,000$85,000


In its 2012 income statement, Riley Company reported cost of goods sold of $85,000. Later, they determined that beginning inventory for 2012 was understated by $23,000, and the ending inventory for 2012 was understated by $10,000. What should be the corrected amount for cost of goods sold for 2012?

Slide 6-41

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).

Presentation

Slide 6-42


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.

Analysis Using Inventory Turnover

Slide 6-43

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

=

Slide 6-44

Illustration: In its Balance Sheet dated January 31, 2012, Wal-Mart reported a beginning inventory of $36,437 million, and ending inventory of $40,714 million, and cost of goods sold for the year ended January 31, 2012, of $335,127 million. Determine the inventory turnover for Wal-Mart for 2012.


Slide 6-45

Inventory Turnover Ratios – comparison within industryInventory Turnover Days in Inventory

KROGER 13.3 27

SAFEWAY 11.1 33

KOHL’S 3.9 93

MACY’S 3.1 116

SAKS 2.5 146

AMAZON, INC. 13.6 27

WALMART 8.7 42

TARGET 6.1 60

COSTCO 12.3 30

DELL, INC. 43.8 8

HEWLETT PACKARD 14.5 25

Slide 6-46

On hand, January 1: 10 units @$20 each

Purchases Sales

January 8: 25 units @ $23 each January 4: 8 units @$75 each

January 22: 50 units @$26 each January 15: 20 units @$75 each

January 28: 15 units @ $29 each January 26: 52 units @ $75 each

Calculate the company’s Cost of Goods Sold using FIFO for the month of January:

1.1. $1,930$1,9302.2. $1,945$1,9453.3. $1,966$1,9664.4. $2,080$2,080


Slide 6-47


Purchases Sales




Calculate the company’s Ending Inventory on January 31 using LIFO:

1.1. $430$4302.2. $454$4543.3. $544$5444.4. $565$565


Slide 6-48


Purchases Sales




Calculate the company’s Cost of Goods Sold using Weighted Average for the month of January (round to the nearest cent):

1.1. $1,946$1,9462.2. $1,966$1,9663.3. $1,972$1,9724.4. $2,008$2,008


Slide 6-49

1.1. $450$4502.2. $825$8253.3. $1,275$1,2754.4. $1,150$1,150

Using the information below for a sporting goods store, calculate the amount of inventory adjustment using the Lower of Cost or market method applied to the inventory on an individual item basis:

Units Cost/unit Market value/unit

Football items Helmets 20 $30 $25

Cleats 10 $50 $20

Pads 30 $20 $25

Baseball items: Gloves 40 $10 $15

Jerseys 50 $40 $25


Slide 6-50

END CHAPTER 6END CHAPTER 6

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Slide 6-1 Inventories Financial Accounting, Seventh Edition Chapter 6.

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