Download - Inventories Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University Chapter 10
Inventories
Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University
Chapter 10
Copyright © Houghton Mifflin Company. All rights reserved. 10–2
Learning Objectives
1. Identify and explain the management issues associated with accounting for inventories.
2. Define inventory cost and relate it to goods flow and cost flow.
3. Calculate the pricing of inventory, using the cost basis under the periodic inventory system.
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Learning Objectives (cont’d)
4. Apply the perpetual inventory system to the pricing of inventories at cost.
5. State the effects of inventory methods and misstatements of inventory on income determination, income taxes, and cash flows.
6. Apply the lower-of-cost-or-market (LCM) rule to inventory valuation.
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Supplemental Objective
7. Estimate the cost of ending inventory using the retail method and gross profit method.
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Management Issues Associated with Accounting for Inventories
• Objective 1– Identify and explain the management
issues associated with accounting for inventories
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Inventory
… is considered a current asset because it will normally be sold within a year’s time or within
a company’s operating cycle
• Merchandising entities– Merchandise inventory consists of all goods owned and held
for sale in the regular course of business
• Manufacturing entities – Maintain other types of inventories
• Raw Materials
• Work in Process
• Finished Goods
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Management Issues Associated with Accounting for Inventories
• Applying the matching rule to inventories
• Assessing the impact of inventory decisions
• Evaluating the level of inventory
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Applying the Matching Rule to Inventories
• A major objective of accounting for inventories is the proper determination of income (not to determine the most realistic inventory value)
• This is achieved through the process of matching appropriate costs against revenues
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Net Sales – Cost of Goods Sold Gross Margin – Operating Expenses Net Income
Beginning Inventory + Net Cost of Purchases Goods Available for Sale − Ending Inventory Cost of Goods Sold
Recall that cost of goods sold is dependent upon the cost assigned to ending inventory, or goods not sold
The higher the cost of ending inventory
The lower the cost of goods sold
And, the lower the cost of goods sold, the higher the gross margin
Gross margin has a direct effect on the amount of net income so the higher the amount of gross margin, the higher the amount of net income reported on the income statement
Effect of Inventory Accounting on Income
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Net Sales – Cost of Goods Sold Gross Margin – Operating Expenses Net Income
Beginning Inventory + Net Cost of Purchases Goods Available for Sale − Ending Inventory Cost of Goods Sold
The reverse is also true
The lower the cost of ending inventory
The higher the cost of goods sold
And the higher the cost of goods sold, the lower the gross margin
Gross margin has a direct effect on the amount of net income so the lower the amount of gross margin, the lower the amount of net income reported on the income statement
Effect of Inventory Accounting on Income
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Management Choices in Accounting for Inventories
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Assessing the Impact of Inventory Decisions
• Decisions regarding inventory usually result in different amounts of reported income, which affect– External evaluation by investors and creditors
– Internal evaluation, e.g. executive compensation
– Income taxes
• Management must balance– The goal of proper income determination
– The goal of minimizing income taxes
– The effects on the company’s cash flows
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Evaluating the Level of Inventory
• Management issues involving the level of inventory– Balancing the handling and storage costs
of maintaining inventory with the demands of customers
• Costs of high inventory levels can be substantial
• Costs of low inventory levels include disgruntled customers and lost sales
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Evaluating the Level of Inventory (cont’d)
• Measures used in evaluating the level of inventory include– Inventory turnover
– Average days’ inventory on hand
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Inventory Average
Sold Goods ofCost Turnover Inventory
Inventory Turnover
… indicates the number of times a company’s average inventory is sold
during an accounting period
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Inventory Turnover Illustrated
J.C. Penney’s cost of goods sold was $22,573 million at the end of 2002, and its merchandise inventory was $4,945 million at the end of 2002 and $4,930 at the end of 2001
Inventory Average
Sold Goods ofCost Turnover Inventory
2 ,000)$4,930,000 000,000,945,4($
0,000$22,573,00
times4.6 ,000$4,927,500
0,000$22,573,00
This means that J.C. Penney sold its average inventory 4.6 times during the year 2002
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Inventory Turnover for Selected Industries
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TurnoverInventory
Year ain Days ofNumber Handon Inventory Days' Average
Average Days’ Inventory on Hand
… indicates the average number of days required to sell the inventory on hand
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J.C. Penney’s inventory turnover for 2002 was 4.6 times
TurnoverInventory
Year ain Days ofNumber Handon Inventory Days' Average
days 79.3 times4.6
days 365 This means that it took
an average of 79.3 days for J.C. Penney to sell its inventory on hand during the year 2002
Average Days’ Inventory on Hand Illustrated
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Average Days’ Inventory on Hand for Selected Industries
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Managing Inventory Levels
• To reduce inventory levels, many companies use, in conjunction with each other – Supply-chain management
• Managing inventory and purchasing through business-to-business transactions over the Internet
– Just-in-time operating environment• Working closely with suppliers to coordinate and
schedule inventory shipments so they arrive just as they are needed
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Discussion
Q. What are some of the costs
associated with carrying inventory?
A. Insurance, property tax, and storage
costs. There is also the possibility of
additional spoilage and employee theft.
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Inventory Cost and Goods Flow
• Objective 2– Define inventory cost and relate it to goods
flow and cost flow
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The Primary Basis of Accounting for Inventories
… is cost,
which has been defined generally as the price paid or consideration given
to acquire an asset
• According to the AICPA
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Inventory Cost
• Includes the following costs– Invoice price less purchases discounts
– Freight in, including insurance in transit
– Applicable taxes and tariffs
• Costs of ordering, receiving, and storing– In principle, should be included in inventory cost
– In practice, are usually considered expenses of the period
• Are too difficult to allocate to specific inventory items
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Merchandise in Transit
• The status of merchandise in transit must be examined to determine if it should be included in the inventory count
• Merchandise inventory includes all merchandise owned by the company– Includes
• Outgoing goods shipped FOB destination
• Incoming goods shipped FOB shipping point
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Merchandise In Transit
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Merchandise on HandNot Included in Inventory
• Merchandise sold but not yet shipped
• Goods held on consignment– Title stays with the consignor until
consignee sells the goods
– Must not be included in the physical inventory of the consignee
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Goods Flow Versus Cost Flow
• It is necessary to make assumptions about the order in which items have been sold– When identical items are bought and sold,
it is often impossible to identify which have been sold and which remain in inventory
– Assumption is about cost flows rather than goods flow
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Goods Flow Versus Cost Flow
• Goods flow– Refers to the actual physical movement of
goods in the operations of a company
• Cost flow– Refers to the association of costs with their
assumed flow in the operations of a company
• Several choices of assumed cost flow are available under generally accepted accounting principles
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Discussion
Q. Why can cost flow differ from goods flow?
A. Because cost flow can be based on assumptions about goods flow
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Methods of Pricing Inventory at Cost Under the Periodic System
• Objective 3– Calculate the pricing of inventory, using the
cost basis under the periodic inventory system
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Methods of Pricing Inventory at Cost Under the Periodic System
• The value of ending inventory is the result of two measurements– Quantity
• Determined by taking a physical count
– Price• Based on the assumed cost flow of the goods
as they are bought and sold
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Methods of Pricing Inventory at Cost
• Accountants use one of four generally accepted methods to price inventory– Specific identification method
– Average-cost method
– First-in, first-out (FIFO) method
– Last-in, first-out (LIFO) method
• The choice of method depends on the– Nature of the business
– Financial effects of the method
– Cost of implementing the method
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Inventory Data – June 30 June 1 Inventory 50 units @ $1.00 $ 50 6 Purchase 50 units @ $1.10 55 13 Purchase 150 units @ $1.20 180 20 Purchase 100 units @ $1.30 130 25 Purchase 150 units @ $1.40 210 Goods available for sale 500 units $625
Sales 280 units On hand, June 30 220 units
Illustrative Data for the Four Periodic Inventory Methods
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Specific Identification Method
… identifies the cost of each item in ending inventory as coming from a specific purchase
• May be used for high-priced articles
• Disadvantages– Difficulty and impracticality of keeping track of the purchase
and sale of individual items
– When items are identical but purchased at different costs, deciding which items were sold becomes arbitrary
• Company can raise or lower income by choosing the lower- or higher-cost items
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Assume that the June 30 inventory consisted of
50 units from the June 1 inventory
100 units from the June 13 purchase
and 70 units from the June 25 purchase
Inventory Data – June 30 June 1 Inventory 50 units @ $1.00 $ 50 6 Purchase 50 units @ $1.10 55 13 Purchase 150 units @ $1.20 180 20 Purchase 100 units @ $1.30 130 25 Purchase 150 units @ $1.40 210 Goods available for sale 500 units $625
Sales 280 units On hand, June 30 220 units
Specific Identification Method Illustrated
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The cost assigned to the inventory would be
Periodic Inventory System – Specific Identification Method 50 units @ $1.00 $ 50
100 units @ $1.20 120 Cost of goods available for sale $625
70 units @ $1.40 98 Less June 30 inventory 268 220 units at a cost of $268 Cost of goods sold $357
Notice that the company can raise or lower income by choosing lower- or higher-cost items
Specific Identification Method (cont’d)
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Average-Cost Method
… computes the average cost of all goods available for sale during the period in
order to determine the value of ending inventory
• Tends to level out the effects of cost increases and decreases
• Is criticized by some who believe that recent costs are more relevant for income measurement and decision making
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$275 $1.25 @ units 220
Average-Cost Method Illustrated
Salefor Available Units
Salefor Available Goods ofCost Cost Unit Average
Cost of goods available for sale $625 Less June 30 inventory 275 Cost of goods sold $350
Cost Unit Average Inventory Endingin UnitsInventory Ending
$1.25 units 500
$625
Inventory Data – June 30 June 1 Inventory 50 units @ $1.00 $ 50 6 Purchase 50 units @ $1.10 55 13 Purchase 150 units @ $1.20 180 20 Purchase 100 units @ $1.30 130 25 Purchase 150 units @ $1.40 210 Goods available for sale 500 units $625
Sales 280 units On hand, June 30 220 units
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First-In, First-Out (FIFO) Method
… is based on the assumption that the costs of the first items acquired should
be assigned to the first items sold
• The cost of ending inventory reflects the cost of merchandise from the most recent purchases
• The costs assigned to cost of goods sold are from the earliest purchases
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FIFO Method Illustrated
Under the FIFO method, the first items purchased are assumed to be the first items sold
This leaves the most recently purchased items in ending inventory
Inventory Data – June 30 June 1 Inventory 50 units @ $1.00 $ 50 6 Purchase 50 units @ $1.10 55 13 Purchase 150 units @ $1.20 180 20 Purchase 100 units @ $1.30 130 25 Purchase 150 units @ $1.40 210 Goods available for sale 500 units $625
Sales 280 units On hand, June 30 220 units
Periodic Inventory System – First-In, First-Out Method 150 units @ $1.40 from purchase of June 25 $210
70 units @ $1.30 from purchase of June 20 91 220 units at a cost of $301
Cost of goods available for sale $625 Less June 30 inventory 301 Cost of goods sold $324
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Effect of FIFO Method
… is to value the ending inventory at the most recent costs and include earlier costs in cost
of goods sold
• During periods of consistently rising prices– FIFO yields the highest possible amount of net income
• Cost of goods sold will show earliest, lower costs incurred
• During periods of consistently falling prices– FIFO yields the lowest possible amount of net income
• Cost of goods sold will show most recent, higher costs incurred
A major criticism of FIFO is that it magnifies the effects of the business cycle on income
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Last-In, First-Out (LIFO) Method
… is based on the assumption that the costs of the last items acquired should
be assigned to the first items sold
• The cost of ending inventory reflects the cost of merchandise purchased earliest
• The costs assigned to cost of goods sold are from the most recent purchases
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Periodic Inventory System – Last-In, First-Out Method 50 units @ $1.00 from June 1 inventory $ 50 50 units @ $1.10 from purchase of June 6 55
120 units @ $1.20 from purchase of June 13 144 220 units at a cost of $249
Inventory Data – June 30 June 1 Inventory 50 units @ $1.00 $ 50 6 Purchase 50 units @ $1.10 55 13 Purchase 150 units @ $1.20 180 20 Purchase 100 units @ $1.30 130 25 Purchase 150 units @ $1.40 210 Goods available for sale 500 units $625
Sales 280 units On hand, June 30 220 units
Cost of goods available for sale $625 Less June 30 inventory 249 Cost of goods sold $376
LIFO Method Illustrated
Under the LIFO method, the last items purchased are assumed to be the first items sold
This leaves the earliest purchased items in ending inventory
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Effect of LIFO Method
… is to value the ending inventory at the earlier costs and include most recent
costs in cost of goods sold• This assumption does not agree with the
actual physical movement of goods in most businesses– Current value of inventory may be unrealistic
– Balance sheet measures (such as working capital and current ratio) may be distorted and must be interpreted carefully
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Effect of LIFO Method (cont’d)
• Strong logical argument for LIFO– Fairest determination of income occurs if
the current costs of merchandise are matched against current sales prices
• Smoothes out fluctuations in the business cycle– As prices move upward or downward, cost
of goods sold will show costs closer to the price level at the time the goods were sold
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Summary of Cost Flow Assumptions’ Impact on Income Statement and Balance Sheet Using
Periodic Inventory System
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Discussion
Q. Do the FIFO and LIFO inventory methods result in different quantities of ending inventory?
A. The quantities of ending inventory are the same under FIFO and LIFO. Thesemethods affect the pricing of theinventory, not the quantities
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Pricing Inventory Under the Perpetual Inventory System
• Objective 4– Apply the perpetual inventory system to the
pricing of inventories at cost
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Pricing Inventory Under the Perpetual Inventory System
• The perpetual system records sales and purchase quantities and costs as they occur– A continuous record of quantities and costs of
merchandise is maintained
– Cost of goods sold is accumulated as sales are made
• Costs are transferred from the Inventory account to the Cost of Goods Sold account
• The cost of ending inventory is the balance in the Inventory account
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Pricing Inventory Under the Perpetual Inventory System
• Accountants use one of three methods to price inventory– Average-cost method
– FIFO method
– LIFO method
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Illustrative Data for the Three Perpetual Inventory Methods
Inventory Data – June 30 June 1 Inventory 50 units @ $1.00 6 Purchase 50 units @ $1.10 10 Sale 70 units 13 Purchase 150 units @ $1.20 20 Purchase 100 units @ $1.30 25 Purchase 150 units @ $1.40 30 Sale 210 units 30 Inventory 220 units
The same data is used as for the periodic system, except specific sales dates and amounts have been added
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Comparison of Periodic and Perpetual Inventory Systems
• Specific identification method– Pricing inventory and cost of goods sold the same
under both the periodic and perpetual systems
– Perpetual system provides more detailed records of purchases and sales
• Average-cost method– Periodic system
• Average cost is computed for all goods available for sale during the period
– Perpetual system• Average is computed after each purchase or series of
purchases
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The ending inventory is the balance, or $282.70
The sum of the costs applied to sales becomes the cost of goods sold, $342.30
Inventory Data – June 30 June 1 Inventory 50 units @ $1.00 $ 50.00 6 Purchase 50 units @ $1.10 55.00 6 Balance 100 units @ $1.05 $105.00 10 Sale 70 units @ $1.05 (73.50) 10 Balance 30 units @ $1.05 $31.50 13 Purchase 150 units @ $1.20 180.00 20 Purchase 100 units @ $1.30 130.00 25 Purchase 150 units @ $1.40 210.00 25 Balance 430 units @ $1.28* $551.50 30 Sale 210 Units @ $1.28 (268.80) 30 Inventory 220 Units @ $1.29* $282.70
Cost of goods sold $342.30
*Rounded
Average-Cost Method
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FIFO and LIFO Methods
• It is necessary to keep track of the components of inventory at each step– As sales are made, the costs must be
assigned in the proper order
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Note that the ending inventory and cost of goods sold are the same as those computed under the FIFO periodic inventory system
This will always occur because the ending inventory under both systems consists of the last items purchased
FIFO Method
Perpetual Inventory System – FIFO Method June 1 Inventory 50 units @ $1.00 $ 50.00 6 Purchase 50 units @ $1.10 55.00 10 Sale 50 units @ $1.00 ($50.00) 20 units @ $1.10 (22.00) (72.00) 10 Balance 30 units @ $1.10 $ 33.00 13 Purchase 150 units @ $1.20 180.00 20 Purchase 100 units @ $1.30 130.00 25 Purchase 150 units @ $1.40 210.00 30 Sale 30 units @ $1.10 ($33.00) 150 units @ $1.20 (180.00) 30 units @ $1.30 (39.00) (252.00) 30 Inventory 70 units @ $1.30 $91.00 150 units @ $1.40 210.00 $301.00
Cost of Goods Sold $324.00
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Note that the ending inventory includes 30 units from beginning inventory, all the units from the June 13 purchase, and 40 units from the June 20 purchase
Perpetual Inventory System – LIFO Method June 1 Inventory 50 units @ $1.00 $ 50.00 6 Purchase 50 units @ $1.10 55.00 10 Sale 50 units @ $1.10 ($55.00) 20 units @ $1.00 (20.00) (75.00) 10 Balance 30 units @ $1.00 $ 30.00 13 Purchase 150 units @ $1.20 180.00 20 Purchase 100 units @ $1.30 130.00 25 Purchase 150 units @ $1.40 210.00 30 Sale 150 units @ $1.40 ($210.00) 60 units @ $1.30 (78.00) (288.00) 30 Inventory 30 units @ $1.00 $ 30.00 150 units @ $1.20 180.00 40 units @ $1.30 52.00 $262.00
Cost of Goods Sold $363.00
LIFO Method
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Summary of Cost Flow Assumptions’ Impact on Income Statement and Balance Sheet Using
Perpetual Inventory System
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Discussion
Q. Why do you think it is more expensive to maintain a perpetual inventory system?
A. A perpetual inventory system is more expensive to maintain because detailed records must be kept as transactions occur. Also, businesses may need to purchase special equipment to assist in their perpetual recordkeeping efforts
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Comparison and Impact of Inventory Decisions and Misstatements
• Objective 5– State the effects of inventory methods and
misstatements of inventory on income determination, income taxes, and cash flows
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• During periods of rising prices– LIFO charges the most recent and highest prices to cost of goods sold
resulting in the lowest gross margin under both systems
– FIFO charges the earliest and lowest prices to cost of goods sold resulting in the highest gross margin under both systems
– Average-cost gross margin is between that using FIFO and LIFO• Has a less pronounced effect on gross margin
• During periods of declining prices– The reverse would occur
Effects of Inventory Systems and Methods on Gross Margin Periodic Inventory
System Perpetual Inventory
System Average-Cost $150 $158
FIFO 176 176
LIFO 124 137 Note that gross margin under
FIFO is the same under both the periodic and perpetual systems
Effects of Inventory Systems and Methods
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Effects on the Financial Statements
• Each of the four methods of inventory pricing is acceptable for use in published financial statements
• Factors to consider when choosing a method– The trend of prices
– The effects on the financial statements
– Income taxes and management decisions
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The LIFO Method
… is best suited for the income statement because it matches revenues and cost
of goods sold
• Not the best measure of the current balance sheet value of inventory– Particularly during a prolonged period of
price increases and decreases
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The FIFO Method
… is best suited to the balance sheet because the ending inventory is closest
to current values
• Gives a more realistic view of the current financial assets of a business
• Does not provide as good a matching of current costs and revenues for income statement purposes
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Effects on Income Taxes
• The inventory valuation method chosen must be used consistently from year to year
– May change if there is a good reason
• If a company uses LIFO for tax purposes, the IRS requires the same method for financial reporting
• IRS will not allow lower-of-cost-or-market inventory valuation if LIFO is used
• If inventory at year end is less than at the beginning, LIFO liquidation results in higher income taxes
• A business wants to avoid paying income taxes on inventory profits
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Effects on Income Taxes
• In periods of rising prices – Using the FIFO and average-cost methods
• May cause a business to report more than its true profit and pay more income taxes
– Using LIFO• For balance sheet purposes, inventory may be valued at
a cost far below current prices for the same items
• Management must monitor this situation carefully because a LIFO liquidation might occur
– The inventory quantity at year end falls below the beginning-of-the-year level
– The company will pay higher income taxes
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Inventory Costing Methods Used by 600 Large Companies
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Effects of Misstatements in Inventory Measurement
• The figures for ending inventory and gross margin are related– A misstatement in the inventory figure will
create misstatements of an equal amount on the financial statements
• On the income statement, gross margin and income before income taxes will be misstated
• On the balance sheet, assets and owner’s equity will be misstated
Effects of Misstatements Illustrated
Income before income taxes overstated $6,000
Gross margin overstated $6,000
Cost of goods sold understated $6,000
Ending inventory overstated $6,000
Ending Inventory Stated Correctly at $10,000 Cost of Goods Sold for the Year Income Statement for the Year
Beginning inventory $12,000 Net sales $100,000 Net cost of purchases 58,000 Cost of goods sold 60,000 Cost of goods available for sale
$70,000
Gross margin
$ 40,000
Ending inventory 10,000 Operating expenses 32,000 Cost of goods sold
$60,000
Income before income taxes
$ 8,000
Ending Inventory Overstated by $6,000 Cost of Goods Sold for the Year Income Statement for the Year
Beginning inventory $12,000 Net sales $100,000 Net cost of purchases 58,000 Cost of goods sold 54,000 Cost of goods available for sale
$70,000
Gross margin
$ 46,000
Ending inventory 16,000 Operating expenses 32,000 Cost of goods sold
$54,000
Income before income taxes
$ 14,000
Ending Inventory Understated by $6,000 Cost of Goods Sold for the Year Income Statement for the Year
Beginning inventory $12,000 Net sales $100,000 Net cost of purchases 58,000 Cost of goods sold 66,000 Cost of goods available for sale
$70,000
Gross margin
$ 34,000
Ending inventory 4,000 Operating expenses 32,000 Cost of goods sold
$66,000
Income before income taxes
$ 2,000
Effects of Misstatements Illustrated
Income before income taxes understated $6,000
Gross margin understated $6,000
Cost of goods sold overstated $6,000
Ending inventory understated $6,000
Ending Inventory Stated Correctly at $10,000 Cost of Goods Sold for the Year Income Statement for the Year
Beginning inventory $12,000 Net sales $100,000 Net cost of purchases 58,000 Cost of goods sold 60,000 Cost of goods available for sale
$70,000
Gross margin
$ 40,000
Ending inventory 10,000 Operating expenses 32,000 Cost of goods sold
$60,000
Income before income taxes
$ 8,000
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Year 1 Ending inventory overstated Cost of goods sold understated Income before income taxes overstated
Year 2 Ending inventory understated Cost of goods sold overstated Income before income taxes understated
Ending inventory understated Cost of goods sold overstated Income before income taxes understated
Ending inventory overstated Cost of goods sold understated Income before income taxes overstated
• Total income for the two years is the same but the misstatements violate the matching rule
• Decisions are based on net income for a period and the company has an obligation to present as useful a figure as possible
Effects of Misstatements from One Accounting Period to the Next
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Inventory Measurement and Cash Flows
• Inventory methods affect– Reported profitability
– Reported liquidity and cash flows
• In the case of large companies, the effects can be complex and material
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Discussion
Q. If merchandise inventory is mistakenly overstated at the end of 20x4, what is the effect on the
(a) 20x4 net income?
A. (a) The 20x4 net income will be overstated
(b) 20x4 year-end balance sheet value?(c) 20x5 net income?(d) 20x5 year-end balance sheet value?
(b) The 20x4 year-end balance sheet value will also be overstated(c) The 20x5 net income will be understated(d) There will be no effect on the 20x5 year-end balance sheet value
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Valuing Inventory at the Lower of Cost or Market (LCM)
• Objective 6– Apply the lower-of-cost-or-market (LCM)
rule to inventory valuation
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The Lower-of-Cost-or-Market (LCM) Rule
… requires that when the replacement cost of inventory falls below historical cost, the
inventory is written down to the lower value and a loss is recorded
• Is an application of conservatism– A loss is recognized before an actual transaction
takes place
• Loss is recognized by writing the inventory down to market, or current replacement cost
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Applying the LCM Rule
• Inventory write-down can be done by two methods– Item-by-item method
• Cost and market values are compared for every item in inventory
• Each item is valued at its lower price
– Major category method• The total cost and total market values for each
category of items are compared
• Each category is valued at its lower amount
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Discussion
Q. In the phrase lower of cost or market, what is meant by the word market?
A. The word market in the phrase lower of cost or market refers to current replacement cost
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Valuing Inventory by Estimation
• Supplemental Objective 7– Estimate the cost of ending inventory using
the retail method and gross profit method
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Retail Method of Inventory Estimation
… estimates the cost of ending inventory by using the ratio of cost to retail price
• Used by retail merchandisers– As a cost and cost saving tool for determining the
cost of inventory for preparing monthly financial statements
– It is common practice to take physical inventory from price tags and convert the total value to cost using the retail method
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Retail Method
Estimated Ending Inventory at Retail
= (Beg. Inv. + Purchases) at Retail – Sales During Period
• The term at retail means the amount of inventory at the marked selling prices
• To use this method, the records must show– Beginning inventory at cost and retail
– Amount of goods purchased during the period at cost and retail
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Retail Method of Inventory Estimation
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Gross Profit Method of Inventory Estimation
… a way of estimating the cost of inventory based on the assumption that the ratio of gross margin for a business
remains relatively stable from year to year
• Also called gross margin method
• Is used to estimate value of inventory lost in cases of fire, theft, or other hazards
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Cost at Inventory Ending Estimated
Margin) Gross Est. - (Sales - Salefor Avail. Goods ofCost
Gross Profit Method
• Is used in place of the retail method when records of the retail prices of beginning inventory and purchases are not kept
• Is acceptable for interim reporting
• Is not acceptable for annual financial statements
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Gross Profit Method of Inventory Estimation
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Discussion
Q. Why is Freight In not placed under the
Retail column when using the retail
method of inventory valuation?
A. Businesses automatically price their
goods high enough to cover freight
charges
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Time for Review
1. Identify and explain the management issues associated with accounting for inventories
2. Define inventory cost and relate it to goods flow and cost flow
3. Calculate the pricing of inventory, using the cost basis under the periodic inventory system
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More Review
4. Apply the perpetual inventory system to the pricing of inventories at cost
5. State the effects of inventory methods and misstatements of inventory on income determination, income taxes, and cash flows
6. Apply the lower-of-cost-or-market (LCM) rule to inventory valuation
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… And Finally
7. Estimate the cost of ending inventory using the retail method and gross profit method