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- 2. <ul><li>Reporting and Analyzing Inventory </li></ul>Accounting, Third Edition
- 3. <ul><li>Describe the steps in determining inventory quantities. </li></ul><ul><li>Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. </li></ul><ul><li>Explain the financial statement and tax effects of each of the inventory cost flow assumptions. </li></ul><ul><li>Explain the lower-of-cost-or-market basis of accounting for inventories. </li></ul><ul><li>Compute and interpret the inventory turnover ratio. </li></ul><ul><li>Describe the LIFO reserve and explain its importance for comparing results of different companies. </li></ul><ul><li>Apply the inventory cost flow methods to perpetual inventory records. </li></ul><ul><li>Indicate the effects of inventory errors on the financial statements. </li></ul>Study Objectives
- 4. Classifying Inventory <ul><li>Finished goods </li></ul><ul><li>Work in process </li></ul><ul><li>Raw materials </li></ul><ul><li>Inventory turnover ratio </li></ul><ul><li>LIFO reserve </li></ul><ul><li>Specific identification </li></ul><ul><li>Cost flow assumptions </li></ul><ul><li>Financial statement and tax effects </li></ul><ul><li>Consistent use </li></ul><ul><li>Lower-of-cost-or-market </li></ul><ul><li>Taking a physical inventory </li></ul><ul><li>Determining ownership of goods </li></ul>Determining Inventory Quantities Inventory Costing Analysis of Inventory Reporting and Analyzing Inventory
- 5. Classifying Inventory <ul><li>One Classification: </li></ul><ul><li>Merchandise Inventory </li></ul><ul><li>Three Classifications: </li></ul><ul><li>Raw Materials </li></ul><ul><li>Work in Process </li></ul><ul><li>Finished Goods </li></ul>Merchandising Company Manufacturing Company Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
- 7. Determining Inventory Quantities Physical Inventory taken for two reasons: <ul><li>Perpetual System </li></ul><ul><li>Check accuracy of inventory records. </li></ul><ul><li>Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft). </li></ul><ul><li>Periodic System </li></ul><ul><li>Determine the inventory on hand </li></ul><ul><li>Determine the cost of goods sold for the period. </li></ul>SO 1 Describe the steps in determining inventory quantities.
- 8. Determining Inventory Quantities <ul><li>Involves counting, weighing, or measuring each kind of inventory on hand. </li></ul><ul><li>Taken, </li></ul><ul><ul><li>when the business is closed or when business is slow. </li></ul></ul><ul><ul><li>at end of the accounting period. </li></ul></ul>Taking a Physical Inventory SO 1 Describe the steps in determining inventory quantities.
- 9. Determining Inventory Quantities <ul><li>Goods in Transit </li></ul><ul><ul><li>Purchased goods not yet received. </li></ul></ul><ul><ul><li>Sold goods not yet delivered. </li></ul></ul>Determining Ownership of Goods SO 1 Describe the steps in determining inventory quantities. 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.
- 10. Determining Inventory Quantities SO 1 Describe the steps in determining inventory quantities. 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 Sale
- 11. Determining Inventory Quantities <ul><li>Goods in transit should be included in the inventory of the buyer when the: </li></ul><ul><ul><li>public carrier accepts the goods from the seller. </li></ul></ul><ul><ul><li>goods reach the buyer. </li></ul></ul><ul><ul><li>terms of sale are FOB destination. </li></ul></ul><ul><ul><li>terms of sale are FOB shipping point. </li></ul></ul>Review Question SO 1 Describe the steps in determining inventory quantities.
- 12. Determining Inventory Quantities Consigned Goods Goods held for sale by one party although ownership of the goods is retained by another party. Determining Ownership of Goods SO 1 Describe the steps in determining inventory quantities.
- 13. Inventory Costing <ul><li>Unit costs can be applied to quantities on hand using the following costing methods: </li></ul><ul><ul><li>Specific Identification </li></ul></ul><ul><ul><li>First-in, first-out (FIFO) </li></ul></ul><ul><ul><li>Last-in, first-out (LIFO) </li></ul></ul><ul><ul><li>Average-cost </li></ul></ul>SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Cost Flow Assumptions
- 14. Inventory Costing 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. These facts are summarized below. Illustration 6-2 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 15. Inventory Costing “ 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 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 16. Inventory Costing <ul><li>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. </li></ul><ul><ul><li>Practice is relatively rare. </li></ul></ul><ul><ul><li>Most companies make assumptions ( Cost Flow Assumptions ) about which units were sold. </li></ul></ul>Specific Identification Method SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 17. Inventory Costing – Cost Flow Assumptions Illustration 6-11 Use of cost flow methods in major U.S. companies Cost Flow Assumption does not need to equal Physical Movement of Goods SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 18. Inventory Costing – Cost Flow Assumptions Illustration: Data for Houston Electronics’ Astro condensers. Illustration 6-4 (Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 19. Inventory Costing – Cost Flow Assumptions <ul><ul><li>Earliest goods purchased are first to be sold. </li></ul></ul><ul><ul><li>Often parallels actual physical flow of merchandise. </li></ul></ul><ul><ul><li>Generally good business practice to sell oldest units first. </li></ul></ul>“ First-In-First-Out (FIFO)” SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 20. Inventory Costing – Cost Flow Assumptions “ First-In-First-Out (FIFO)” Illustration 6-5 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Solution on notes page
- 21. Inventory Costing – Cost Flow Assumptions “ First-In-First-Out (FIFO)” Illustration 6-5 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 22. Inventory Costing – Cost Flow Assumptions <ul><ul><li>Latest goods purchased are first to be sold. </li></ul></ul><ul><ul><li>Seldom coincides with actual physical flow of merchandise. </li></ul></ul><ul><ul><li>Exceptions include goods stored in piles, such as coal or hay. </li></ul></ul>“ Last-In-First-Out (LIFO)” SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 23. Inventory Costing – Cost Flow Assumptions “ Last-In-First-Out (LIFO)” Illustration 6-7 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Solution on notes page
- 24. Inventory Costing – Cost Flow Assumptions “ Last-In-First-Out (LIFO)” Illustration 6-7 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 25. Inventory Costing – Cost Flow Assumptions <ul><ul><li>Allocates cost of goods available for sale on the basis of weighted average unit cost incurred. </li></ul></ul><ul><ul><li>Assumes goods are similar in nature. </li></ul></ul><ul><ul><li>Applies weighted average unit cost to the units on hand to determine cost of the ending inventory. </li></ul></ul>“ Average Cost” SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 26. Inventory Costing – Cost Flow Assumptions “ Average Cost” Illustration 6-10 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Solution on notes page
- 27. Inventory Costing – Cost Flow Assumptions ” Average Cost” Illustration 6-10 SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- 28. Inventory Costing – Cost Flow Assumptions <ul><li>Comparative Financial Statement Summary </li></ul>FIFO LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 LIFO Average
- 29. Inventory Costing – Cost Flow Assumptions <ul><li>In Period of Rising Prices, FIFO Reports: </li></ul>FIFO Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 LIFO Average Highest Lowest LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
- 30. Inventory Costing – Cost Flow Assumptions <ul><li>In Period of Rising Prices, LIFO Reports: </li></ul>FIFO Sales $9,000 $9,000 $9,000 Cost of goods sold 6,200 6,600 7,000 Gross profit 2,800 2,400 2,000 Admin. & selling expense 330 330 330 Income before taxes 2,470 2,070 1,670 Income tax expense 140 120 110 Net income $2,330 $1,950 $1,560 Inventory balance $5,800 $5,400 $5,000 LIFO Average Lowest Highest LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
- 31. Inventory Costing – Cost Flow Assumptions <ul><li>The cost flow method that often parallels the actual physical flow of merchandise is the: </li></ul><ul><ul><li>FIFO method. </li></ul></ul><ul><ul><li>LIFO method. </li></ul></ul><ul><ul><li>average cost method. </li></ul></ul><ul><ul><li>gross profit method. </li></ul></ul>Review Question LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
- 32. Inventory Costing – Cost Flow Assumptions <ul><li>In a period of inflation, the cost flow method that results in the lowest income taxes is the: </li></ul><ul><ul><li>FIFO method. </li></ul></ul><ul><ul><li>LIFO method. </li></ul></ul><ul><ul><li>average cost method. </li></ul></ul><ul><ul><li>gross profit method. </li></ul></ul>Review Question LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
- 34. Inventory Costing Using Cost Flow Methods Consistently <ul><ul><li>Method should be used consistently, enhances comparability. </li></ul></ul><ul><ul><li>Although consistency is preferred, a company may change its inventory costing method. </li></ul></ul>Illustration 6-14 Disclosure of change in cost flow method LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
- 35. Inventory Costing Lower-of-Cost-or-Market SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories. <ul><li>When the value of inventory is lower than its cost </li></ul><ul><ul><li>Companies can “write down” the inventory to its market value in the period in which the price decline occurs. </li></ul></ul><ul><ul><li>Market value = Replacement Cost </li></ul></ul><ul><ul><li>Example of conservatism . </li></ul></ul>
- 36. Inventory Costing Lower-of-Cost-or-Market SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories. Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. $ 55,000 45,000 45,000 12,800 $157,800
- 37. Analysis of Inventory <ul><li>Inventory management is a double-edged sword </li></ul><ul><li>High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). </li></ul><ul><li>Low Inventory Levels – may lead to stockouts and lost sales. </li></ul>Analysis of Inventory SO 5 Compute and interpret the inventory turnover ratio.
- 38. Analysis of Inventory 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 = SO 5 Compute and interpret the inventory turnover ratio.
- 39. Analysis of Inventory Illustration: The following data are available for Wal-Mart. $264,152 (33,685 + 31,910) / 2 Inventory Turnover 2007 = SO 5 Compute and interpret the inventory turnover ratio. = 8.1 times 365 Days 8.1 Days in inventory 2007 = = 45.1 Days
- 40. Analysis of Inventory Illustration: The following data are available for Wal-Mart. $237,649 (31,910 + 29,419) / 2 Inventory Turnover 2006 = SO 5 Compute and interpret the inventory turnover ratio. = 7.7 times 365 Days 7.7 Days in inventory 2006 = = 47.4 Days
- 42. Analysis of Inventory 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 Describe the LIFO reserve and explain its importance for comparing results of different companies. Illustration 6-17
- 43. Analysis of Inventory The LIFO reserve can have a significant effect on ratios analysts commonly use. Analysts’ Adjustments for LIFO Reserve SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies. Illustration 6-19
- 44. Illustration: Cost Flow Methods in Perpetual Systems 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. Appendix 6A Illustration 6A-1
- 45. Perpetual Inventory FIFO Method + Cost Flow Methods in Perpetual Systems SO 7 Apply the inventory cost flow methods to perpetual inventory records. Solution on notes page
- 46. LIFO Method Cost Flow Methods in Perpetual Systems SO 7 Apply the inventory cost flow methods to perpetual inventory records. Perpetual Inventory + Solution on notes page
- 47. Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. + Cost Flow Methods in Perpetual Systems SO 7 Apply the inventory cost flow methods to perpetual inventory records.
- 48. Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. + Cost Flow Methods in Perpetual Systems SO 7 Apply the inventory cost flow methods to perpetual inventory records.
- 49. Inventory Errors SO 8 Indicate the effects of inventory errors on the financial statements. <ul><li>Common Cause: </li></ul><ul><ul><li>Failure to count or price inventory correctly. </li></ul></ul><ul><ul><li>Not properly recognizing the transfer of legal title to goods in transit. </li></ul></ul><ul><ul><li>Errors affect both the income statement and balance sheet. </li></ul></ul>Appendix 6B
- 50. Inventory Errors 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
- 51. Inventory Errors SO 8 Indicate the effects of inventory errors on the financial statements. <ul><li>Inventory errors affect the computation of cost of goods sold and net income in two periods . </li></ul><ul><ul><li>An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period. </li></ul></ul><ul><ul><li>Over the two years, the total net income is correct because the errors offset each other. </li></ul></ul><ul><ul><li>The ending inventory depends entirely on the accuracy of taking and costing the inventory. </li></ul></ul>Income Statement Effects
- 52. Inventory Errors SO 8 Indicate the effects of inventory errors on the financial statements. ($3,000) Net Income understated $3,000 Net Income overstated Combined income for 2-year period is correct. Illustration 6-B3
- 53. Inventory Errors <ul><li>Understating ending inventory will overstate: </li></ul><ul><ul><li>assets. </li></ul></ul><ul><ul><li>cost of goods sold. </li></ul></ul><ul><ul><li>net income. </li></ul></ul><ul><ul><li>owner's equity. </li></ul></ul>Review Question SO 8 Indicate the effects of inventory errors on the financial statements.
- 54. Inventory Errors 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
- 55. Copyright “ Copyright © 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. 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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