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

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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.


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.


Supplemental Objective

7. Estimate the cost of ending inventory using the retail method and gross profit method.


Management Issues Associated with Accounting for Inventories

• Objective 1– Identify and explain the management

issues associated with accounting for inventories


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


Management Issues Associated with Accounting for Inventories

• Applying the matching rule to inventories

• Assessing the impact of inventory decisions

• Evaluating the level of inventory


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


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


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


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


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


Evaluating the Level of Inventory (cont’d)

• Measures used in evaluating the level of inventory include– Inventory turnover

– Average days’ inventory on hand


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


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


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


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


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


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.


Inventory Cost and Goods Flow

• Objective 2– Define inventory cost and relate it to goods

flow and cost flow


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


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


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


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


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


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


Discussion

Q. Why can cost flow differ from goods flow?

A. Because cost flow can be based on assumptions about goods flow


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


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


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


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


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


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



Specific Identification Method Illustrated


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)


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


$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




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


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



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



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


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


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




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


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


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


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


Pricing Inventory Under the Perpetual Inventory System

• Objective 4– Apply the perpetual inventory system to the

pricing of inventories at cost



• 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



• Accountants use one of three methods to price inventory– Average-cost method

– FIFO method

– LIFO method


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


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


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


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


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


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


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


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


• 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


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


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


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


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


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


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


$70,000

Gross margin

$ 46,000


$54,000


$ 14,000

Ending Inventory Understated by $6,000 Cost of Goods Sold for the Year Income Statement for the Year


$70,000

Gross margin

$ 34,000


$66,000


$ 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


$70,000

Gross margin

$ 40,000


$60,000


$ 8,000


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


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


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


Valuing Inventory at the Lower of Cost or Market (LCM)

• Objective 6– Apply the lower-of-cost-or-market (LCM)

rule to inventory valuation


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


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


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


Valuing Inventory by Estimation

• Supplemental Objective 7– Estimate the cost of ending inventory using

the retail method and gross profit method


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


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


Retail Method of Inventory Estimation


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


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


Gross Profit Method of Inventory Estimation


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


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


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


… And Finally

7. Estimate the cost of ending inventory using the retail method and gross profit method

inventories multimedia slides by: gail a. mestas, macc, new mexico state university chapter 10

Documents

inventory cost

pricing of inventory

misstatements of inventory

cost flow

cost of goods soldand

cost basis

periodic inventory system

perpetual inventory