accounting principles-10th edition-ch06

Chapter 6-1

Chapter 6-2

CHAPTER CHAPTER 66

IINVENTORIESNVENTORIESThe raw materials, work-in-process goods and completely The raw materials, work-in-process goods and completely finished goods that are considered to be the portion of a finished goods that are considered to be the portion of a business’s assets that are ready or will be ready for sale.business’s assets that are ready or will be ready for sale.

Accounting Principles, Eighth 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

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

CostingCostingInventory Inventory

ErrorsErrors

Inventory Inventory

ErrorsErrors

Statement Statement

PresentatioPresentatio

n and n and

AnalysisAnalysis

Statement Statement

PresentatioPresentatio

n and n and

AnalysisAnalysis

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 Balance sheet sheet effectseffects

PresentatioPresentationn

AnalysisAnalysis

Other Method

s of valuing Invento

ry

•Lower of cost and market•Estimating inventories

•Lower of cost and market•Estimating inventories

Chapter 6-5

Inventories affect both the balance sheet and the income Inventories affect both the balance sheet and the income statement. In the balance sheet of merchandising statement. In the balance sheet of merchandising companies, inventory is frequently the most significant companies, inventory is frequently the most significant current asset. Of course, its amount and relative current asset. Of course, its amount and relative importance can vary, even for enterprises in the same importance can vary, even for enterprises in the same industry. industry.

In the income statement, inventory is vital in determining In the income statement, inventory is vital in determining the results of operations for a particular period. the results of operations for a particular period.

Chapter 6-6

Classifying InventoryClassifying InventoryClassifying InventoryClassifying Inventory

One Classification:

Merchandise Inventory (is needed to describe the many different items that make up the total inventory.)

Three Classifications:Raw Materials (that are on hand waiting to be used in production)

Work in Process (that are on the assembly line in various stage of production)

Finished Goods (that are completed and ready for sale)

Merchandising Company

Manufacturing Company

Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

Chapter 6-7

Classification Inventory Classification Inventory Merchandising enterprise, inventory consists of many different items. Canned goods, dairy products, meats, and produce, for example, are just a few of the inventory items on hand in grocery store. These items have two common characteristics. (1) they are owned by the company, and (2) they are in a form ready for sale to customers in the ordinary in the ordinary course of business. course of business.

In a manufacturing enterprise, inventories are also owned by In a manufacturing enterprise, inventories are also owned by the company, but some goods may not yet be ready for sale. the company, but some goods may not yet be ready for sale.

Chapter 6-8

Physical Inventory taken for two reasons:Perpetual System1. Check accuracy of inventory records.2. Determine amount of inventory lost (wasted raw

materials, shoplifting, or employee theft).

Periodic System1. Determine the inventory on hand2. Determine the cost of goods sold for the period.

Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

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

Chapter 6-9

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 6-10

Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.

Determining Ownership of Goods (Determining Ownership of Goods (Goods are Goods are considered to be in transit when they are in the hands of a considered to be in transit when they are in the hands of a public carrier such as railway, airline, or trucking or shipping public carrier such as railway, airline, or trucking or shipping company at the statement date. company at the statement date.



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 6-11



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 6-12

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 6-13

Consigned Goods

Goods held for sale by one party (the consignee) does not own the goods. although ownership of the goods is retained by another party (the consignor) until the goods are actually sold to a customer.

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 the goods is called CG

Determining Ownership of GoodsDetermining Ownership of Goods



Chapter 6-14

Inventory CostInventory Cost

Inventory cost is the purchase price of the goods, not the selling price of the goods.

All expenditures related to acquiring the goods and making them ready for sale are included in the cost of goods available for sale. This expenditures are commonly known as inventoriable cost.

In accordance with the cost principle, the primary basis of accounting for inventories is cost.

under the matching principle, the primary objective in accounting for inventories is the matching of appropriate costs with sales revenue.

Chapter 6-15

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

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

Cost Flow Assumptions

Chapter 6-16

Young & Crazy Company makes the following purchases:1. One item on 2/2/07 for $102. One item on 2/15/07 for $153. One item on 2/25/07 for $20

Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the Specific Identification method to cost inventories? Assume a tax rate of 30%.

Example



Chapter 6-17

Purchase on 2/2/07 for $10



Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40

“Specific Identification”

Depends which one is soldDepends which one is sold



Chapter 6-18

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.•This method tracks the actual physical flow of the cost. Each item of inventory is marked, tagged, or coded with its specific unit cost. Specific identification is possible when a company sell a limited number of high unit cost that can be clearly identified from the time of purchase through the time of sale.

Practice is relatively rare.Most companies make assumptions (Cost Flow Assumptions) about which units were sold.

Specific Identification MethodSpecific Identification Method



Chapter 6-19


Inventory Costing – Cost Flow AssumptionsInventory Costing – Cost Flow AssumptionsInventory Costing – Cost Flow AssumptionsInventory Costing – Cost Flow Assumptions

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

Cost Flow Assumption does not need to equal Physical Movement of Goods.

Because specific identification is often impractical, other cost flow methods are allowed. These differ from specific identification by assuming flows of costs that may be unrelated to the physical flow of goods.

Chapter 6-20

Young & Crazy Company makes the following purchases:1. One item on 2/2/07 for $102. One item on 2/15/07 for $153. One item on 2/25/07 for $20

Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO, LIFO, and Average cost flow assumptions? Assume a tax rate of 30%.

Example



Chapter 6-21

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 6-22

Perpetual Inventory SystemPerpetual Inventory System

Under perpetual FIFI, the cost of the oldest goods on hand prior to Under perpetual FIFI, the cost of the oldest goods on hand prior to each sale is charged to cost of goods sold. Therefore, the cost of each sale is charged to cost of goods sold. Therefore, the cost of goods sold on May 1 is assumed to consist of all the January 1 goods sold on May 1 is assumed to consist of all the January 1 beginning inventory and 50 units of the items purchased on April 15. beginning inventory and 50 units of the items purchased on April 15. similarly, the cost of goods sold on September 1 is assumed to similarly, the cost of goods sold on September 1 is assumed to consist of the remaining 150 units purchased on April 15, plus 250 consist of the remaining 150 units purchased on April 15, plus 250 of the items purchased on August 24. the ending inventory in this of the items purchased on August 24. the ending inventory in this situation is 5800, and the cost of goods sold is 6200.situation is 5800, and the cost of goods sold is 6200.

Cost of goods available for sale (1000+11000)Cost of goods available for sale (1000+11000) 1200012000

Less ending inventoryLess ending inventory 5800 5800

Cost of goods soldCost of goods sold 6200 6200

Chapter 6-23

Purchased Sold Balance

Date Units Cost Total Units cost Total Units Cost total

1/1 100 10 1000

4/15 200 11 2200 100200

1011

3200

5/1 10050

1011

1550 150 11 1650

8/24 300 12 3600 150300

1112

5250

9/1 150250

1112

4650 50 12 600

11/27

400 13 5200 50400

1213

5800

900 11000 550 6200 450 5800

Chapter 6-24

Periodic Inventory SystemPeriodic Inventory SystemIn the periodic inventory system, we ignore the timing of the dates of each of the sales. Instead, we make the allocation at the end of period and assume that the entire pool of costs is available for allocation at that time.

Pool of CostsCost of goods available for sale

Date Explanation Units Units Cost Total cost

1/1 Beginning Inventory 100 10 1000

4/5 Purchase 200 11 2200

8/24 Purchase 300 12 3600

11/27 Purchase 400 12 5200

Total 1000 12000

Chapter 6-25

Periodic Inventory SystemPeriodic Inventory SystemStep 1

Cost of Goods SoldStep 2

Ending Inventory

Date Units Unit cost Total cost Date Units Unit cost Total cost

1/1 100 10 1000 11/27 400 13 5200

4/15 200 11 2200 8/24 50 12 600

8/24 250 12 3000

550 6200 450 5800

Chapter 6-26







“First-In-First-Out (FIFO)”



Chapter 6-27






For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 10 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 4747 Taxes 14 14 Net Income $ 33 $ 33

“First-In-First-Out (FIFO)”



Chapter 6-28

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 6-29







“Last-In-First-Out (LIFO)”



Chapter 6-30






For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 20 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 37 37 Taxes 11 11 Net Income $ 26$ 26

“Last-In-First-Out (LIFO)”



Chapter 6-31

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 6-32







“Average Cost”



Chapter 6-33






For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 15 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 42 Taxes 12 12 Net Income $ 30$ 30

“Average Cost”



Chapter 6-34

FIFO

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


Sales $90 $90 $90Cost of goods sold 10 15 20 Gross profit 80 75 70Admin. & selling expense 33 33 33Income before taxes 47 42 37Income tax expense 14 12 11Net income $33 $30 $26

Inventory balance $35 $30 $25

LIFOAverage

Comparative Financial Statement SummaryComparative Financial Statement Summary

Chapter 6-35

In Period of Rising Prices,In Period of Rising Prices, FIFO Reports: FIFO Reports:FIFO


Highest

LowestSales $90 $90 $90Cost of goods sold 10 15 20 Gross profit 80 75 70Admin. & selling expense 33 33 33Income before taxes 47 42 37Income tax expense 14 12 11Net income $33 $30 $26


LIFOAverage


Chapter 6-36

In Period of Rising Prices,In Period of Rising Prices, LIFO Reports: LIFO Reports:FIFO


Highest

Lowest

Sales $90 $90 $90Cost of goods sold 10 15 20 Gross profit 80 75 70Admin. & selling expense 33 33 33Income before taxes 47 42 37Income tax expense 14 12 11Net income $33 $30 $26


LIFOAverage


Chapter 6-37

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 6-38

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.




Chapter 6-39

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 6-40

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 6-41

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


LO 4 Explain the lower-of-cost-or-market LO 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.

Chapter 6-42

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


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

BE6-7 Alou Appliance Center accumulates the following cost and market data at December 31.

Inventory Cost Market Lower ofCategories Data Data Cost or MarketCameras 12,000$ 12,100$ Camcorders 9,000 9,700 VCRs 14,000 12,800

Compute the lower-of-cost-or-market valuation for the company’s total inventory.

$ 12,0009,000

12,800$ 33,800

Chapter 6-43

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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

Chapter 6-44



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 6-45



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 6-46



Incorrect Correct Incorrect CorrectSales 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$

2008 2009

($3,000)Net Income understated

$3,000Net Income overstated

Combined income for 2-year period is correct.

Illustration 6-18

Chapter 6-47

Understating ending inventory will overstate: a. assets. b. cost of goods sold. c. net income. d. owner's equity.




Chapter 6-48



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 6-49

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 6-50


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

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

Chapter 6-51

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 6-52

BE6-9 At December 31, 2008, the following information was available for J. Graff Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000. Calculate inventory turnover and days in inventory for J. Graff Company.



$270,000

($60,000 + 40,000) / 2

5.4 =Inventory Turnover

365

5.4 67.59 days

=Days in Inventory

Chapter 6-53

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accounting principles-10th edition-ch06

Education

merchandise inventory

inventory cost flow

effects of inventory

inventory turnover ratio

chapter chapter

income inventories

finished goods

process goods