Financial Accounting and Accounting Standards

Financial Accounting and Accounting Standards

6 Reporting and Analyzing Inventory 6-1 Kimmel Weygandt Kieso Financial Accounting, Eighth Edition Learning Learning Objectives Objectives After studying this chapter, you should be able to: 1. Determine how to classify and determine (the quantity and cost of) inventory. 2. Apply inventory cost flow methods and discuss their financial effects. 3. Explain the statement presentation and analysis of inventory.

6-2 Classifying Classifying and and Determining Determining Inventory Inventory Merchandising Company One Classification: Merchandise Inventory Manufacturing Company Three Classifications:

Raw Materials Work in Process Finished Goods HELPFUL HINT Regardless of the classification, companies report all inventories under Current Assets on the balance sheet. 6-3 LO 1 Determining Determining Inventory

Inventory Quantities Quantities Physical Inventory taken for two reasons: Perpetual System 1. Check accuracy of inventory records. 2. Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. Periodic System 3. Determine the inventory on hand. 4. Determine the cost of goods sold for the period. 6-4 LO 1 Determining Determining Inventory Inventory Quantities Quantities

Taking a Physical Inventory Involves counting, weighing, or measuring each kind of inventory on hand. Taken, 6-5 when the business is closed or business is slow. at the end of the accounting period. LO 1 Determining Determining Inventory Inventory Quantities

Quantities Determining Ownership of Goods Goods in Transit Purchased goods not yet received. Sold goods not yet delivered. 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. 6-6 LO 1 Determining

Determining Inventory Inventory Quantities Quantities Goods in Transit Illustration 6-2 Terms of sale 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. 6-7 LO 1

Determining Determining Inventory Inventory Quantities Quantities Review Question 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. 6-8 LO 1 Determining Determining Inventory Inventory Quantities

Quantities Determining Ownership of Goods Consigned Goods Goods owned by one party but are held for sale by another party. Many car, boat, and antique dealers sell goods on consignment, why? 6-9 LO 1 Hasbeen Company completed its inventory count. It arrived at a total inventory value of $200,000. You have been given the information listed below. Discuss how this information affects the reported cost of inventory. 1. Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000. 2. The company did not include in the count purchased goods of $10,000, which were in transit (terms: FOB shipping point). 3. The company did not include in the count inventory that had been sold with a

cost of $12,000, which was in transit (terms: FOB shipping point). Solution 1. Goods of $15,000 held on consignment should be deducted from the inventory count. 2. The goods of $10,000 purchased FOB shipping point should be added to the inventory count. Inventory should be $195,000 3. Item 3 was treated correctly. ($200,000 - $15,000 + $10,000). 6-10 LO 1 Inventory InventoryCosting Costing Inventory is accounted for at cost. 6-11

Cost includes all expenditures necessary to acquire (or produce) goods and place them in a condition ready for sale. Unit costs are applied to quantities to determine the total cost of the inventory and the cost of goods sold using the following costing methods: Specific identification First-in, first-out (FIFO) Last-in, first-out (LIFO)

Average-cost Actual Flow Cost Flow Assumptions LO 2 Inventory InventoryCosting Costing Illustration: Crivitz TV Company purchases three identical 50inch 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 6-3 6-12

LO 2 Inventory InventoryCosting 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 6-4 6-13 LO 2 Inventory InventoryCosting Costing Specific Identification

Actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory. 6-14 Practice is relatively rare. Most companies make assumptions (cost flow assumptions) about which units were sold. LO 2 Inventory InventoryCosting Costing

Cost Flow Assumption does not need to match the physical movement of goods Illustration 6-12 Use of cost flow methods in major U.S. companies 6-15 LO 2 Cost CostFlow FlowAssumptions Assumptions Illustration: Data for Houston Electronics Astro condensers. Illustration 6-5 (Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

6-16 Cost CostFlow FlowAssumptions Assumptions First-In, First-Out (FIFO) 6-17 Earliest goods purchased are the first to be sold. Often parallels actual physical flow of merchandise.

Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. LO 2 Cost CostFlow FlowAssumptions Assumptions First-In, First-Out (FIFO) 6-18 Illustration 6-6 LO 2 Cost

CostFlow FlowAssumptions Assumptions First-In, First-Out (FIFO) Illustration 6-6 HELPFUL HINT Another way of thinking about the calculation of FIFO ending inventory is the LISH assumptionlast in still here. 6-19 LO 2 Cost CostFlow FlowAssumptions Assumptions

Last-In, First-Out (LIFO) 6-20 Latest goods purchased are the first to be sold. Seldom coincides with actual physical flow of merchandise. Exceptions include goods stored in piles, such as coal or hay. LO 2

Cost CostFlow FlowAssumptions Assumptions Last-In, First-Out (LIFO) 6-21 Illustration 6-8 LO 2 Cost CostFlow FlowAssumptions Assumptions Last-In, First-Out (LIFO) HELPFUL HINT

Another way of thinking about the calculation of LIFO ending inventory is the FISH assumptionfirst in still here. Illustration 6-8 6-22 LO 2 Cost CostFlow FlowAssumptions Assumptions Average-Cost 6-23

Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred. Applies weighted-average unit cost to the units on hand to determine cost of the ending inventory. LO 2 Cost CostFlow FlowAssumptions Assumptions Average-Cost 6-24 Illustration 6-11

Cost CostFlow FlowAssumptions Assumptions Average-Cost Illustration 6-11 6-25 LO 2 Financial Financial Statement Statement and and Tax TaxEffects Effects Comparative effects of cost flow methods

6-26 Illustration 6-13 Inventory InventoryCost Cost Flow FlowAssumptions Assumptions Review Question 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. 6-27 Helpful Hint A tax rule,

often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes, they must also use it for financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements. LO 2 INTERNATIONAL INSIGHT ExxonMobil Is LIFO Fair? ExxonMobil Corporation, like many U.S. companies, uses LIFO to value its inventory for financial reporting and tax purposes. In one recent year, this resulted in a cost of goods sold figure that was $5.6 billion higher than

under FIFO. By increasing cost of goods sold, ExxonMobil reduces net income, which reduces taxes. Critics say that LIFO provides an unfair tax dodge. As Congress looks for more sources of tax revenue, some lawmakers favor the elimination of LIFO. Supporters of LIFO argue that the method is conceptually sound because it matches current costs with current revenues. In addition, they point out that this matching provides protection against inflation. International accounting standards do not allow the use of LIFO. Because of this, the net income of foreign oil companies such as BP and Royal Dutch Shell are not directly comparable to U.S. companies, which can make analysis difficult. Source: David Reilly, Big Oils Accounting Methods Fuel Criticism, Wall Street Journal (August 8, 2006), p. C1. 6-28 LO 2 Inventory InventoryCosting Costing Using Cost Flow Methods Consistently

Method should be used consistently, enhances comparability. Although consistency is preferred, a company may change its inventory costing method. Illustration 6-14 6-29 Inventory InventoryCosting Costing Lower-of-Cost-or-Market When the value of inventory is lower than its cost 6-30

Companies have to write down the inventory to its market value in the period in which the price decline occurs. Market value = Net realizable value Example of conservatism. International Note Under U.S. GAAP, companies cannot reverse inventory write-downs if inventory increases in value in subsequent periods. IFRS permits companies to reverse write-downs in some

circumstances. LO 2 Inventory InventoryCosting Costing Lower-of-Cost-or-Market Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. Illustration 6-16 6-31 LO 2 Statement Statement Presentation Presentation &&Analysis Analysis of

of Inventory Inventory Statement Presentation Inventory is classified in the balance sheet as a current asset immediately below receivables. There also should be disclosure of 1. the major inventory classifications, 2. the basis of accounting (cost, or lower-ofcost-or-market), and 3. the cost method (FIFO, LIFO, or averagecost). 6-32 LO 3 Statement

Statement Presentation Presentation &&Analysis Analysis of of Inventory Inventory Statement Presentation 6-33 Illustration 6-15 LO 3 Statement Statement Presentation Presentation &&Analysis Analysis of of Inventory Inventory Inventory management is a critical task

1. High Inventory Levels storage costs, interest cost (on funds tied up in inventory), and costs associated with the obsolescence of technical goods or shifts in fashion. 2. Low Inventory Levels may lead to lost sales. 6-34 LO 3 ACCOUNTING ACROSS THE ORGANIZATION A Big Hiccup JIT can save a company a lot of money, but it isnt without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese automakers experienced just such a disruption when a 6.8-magnitude earthquake caused major damage to the company that produces 50% of their piston rings. The rings themselves cost only $1.50, but you cannot make a car without them. As a result, the automakers were forced to shut down production for a few daysa loss of tens of thousands of cars. Similarly, a major snowstorm halted production at the Canadian plants of Ford. A Ford spokesperson said, Because the plants run with

just-in-time inventory, we dont have large stockpiles of parts sitting around. When you have a somewhat significant disruption, you can pretty quickly run out of parts. Sources: Amy Chozick, A Key Strategy of Japans Car Makers Backfires, Wall Street Journal (July 20, 2007); and Kate Linebaugh, Canada Military Evacuates Motorists Stranded by Snow, Wall Street Journal (December 15, 2010). 6-35 Statement Statement Presentation Presentation &&Analysis Analysis of of Inventory Inventory Inventory Turnover Ratio Illustration 6-17 6-36 LO 3

Statement Statement Presentation Presentation &&Analysis Analysis of of Inventory Inventory Illustration: Data available for Wal-Mart. 6-37 Illustration 6-17 LO 3 Statement Statement Presentation Presentation &&Analysis Analysis of of Inventory Inventory

Analysts Adjustments for LIFO Reserve 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. Illustration 6-18 6-38 LO 3 Statement Statement Presentation Presentation &&Analysis Analysis of of Inventory Inventory Analysts Adjustments for LIFO Reserve The LIFO reserve can have a significant effect on ratios analysts

commonly use. If Caterpillar had used FIFO all along, its inventory would be $14,635 million, rather than $12,205 million. Illustration 6-19 6-39 LO 3 Appendix Appendix6A 6A Illustration: Perpetual Inventory System Illustration 6A-1 Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. 6-40

Appendix Appendix6A 6A First-In, First-Out (FIFO) Cost of Goods Sold 6-41 Perpetual Inventory System Illustration 6A-2 Ending Inventory Appendix Appendix6A 6A

Last-In, First-Out (LIFO) Cost of Goods Sold 6-42 Perpetual Inventory System Illustration 6A-3 Ending Inventory Appendix Appendix6A 6A Average-Cost Cost of Goods

Sold 6-43 Perpetual Inventory System Illustration 6A-4 Ending Inventory Appendix Appendix 6B 6B Inventory Errors Inventory Fraud and Errors Common Causes:

6-44 Intentionally reporting higher inventory 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. ETHICS INSIGHT

Leslie Fay Falsifying Inventory to Boost Income Managers at womens apparel maker Leslie Fay were convicted of falsifying inventory records to boost net income in an attempt to increase management bonuses. In another case, executives at Craig Consumer Electronics were accused of defrauding lenders by manipulating inventory records. The indictment said the company classified defective goods as new or refurbished and claimed that it owned certain shipments from overseas suppliers when, in fact, Craig either did not own the shipments or the shipments did not exist. 6-45 Appendix Appendix 6B 6B

Inventory Errors Income Statement Effects Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-B1 Illustration 6-B2 6-46 Appendix Appendix 6B 6B Inventory Errors Income Statement Effects Inventory errors affect the computation of cost of goods sold

and net income in two periods. 6-47 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. Ending inventory depends entirely on the accuracy of taking and costing the inventory. Inventory

Errors Appendix Appendix 6B 6B 2013 Incorrect Correct 2014 Incorrect Correct $ $ Illustration 6-B3 Sales

$ 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 $

Combined income for 2-year period is correct. 6-48 80,000 22,000 $ 25,000 $ 13,000 $ 10,000 $3,000

Net Income overstated ($3,000) Net Income understated Errors Cancel Appendix Appendix 6B 6B Inventory Errors Review Question Understating ending inventory will overstate: a. assets. b. cost of goods sold. c. net income. d. owner's equity.

6-49 Appendix Appendix 6B 6B Inventory Errors Balance Sheet Effects Effect of inventory errors on the balance sheet is determined by using the basic accounting equation: Assets = Liabilities + Stockholders Equity Errors in the ending inventory have the effects shown: Illustration 6-B4 6-50 Key Points

6-51 A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and averagecost are the only two acceptable cost flow assumptions permitted under IFRS. Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable. IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area. Compare the procedures for the merchandising under GAAP and IFRS. Key Points

6-52 In the lower-of-cost-or-market test for inventory valuation, both GAAP and IFRS define market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. Compare the procedures for the merchandising under GAAP and IFRS. Key Points 6-53 Under GAAP, if inventory is written down under the lower-ofcost-or-market valuation, the new value becomes its cost basis. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the writedown may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income

statement as an expense. An item-by-item approach is generally followed under IFRS. Compare the procedures for the merchandising under GAAP and IFRS. IFRS Practice Which of the following should not be included in the inventory of a company using IFRS? a) Goods held on consignment from another company. b) Goods shipped on consignment to another company. c) Goods in transit from another company shipped FOB shipping point. d) None of the above. 6-54 Compare the procedures for the merchandising under GAAP and IFRS. IFRS Practice Which method of inventory costing is prohibited under IFRS? a) Specific identification.

b) FIFO. c) LIFO. d) Average-cost. 6-55 Compare the procedures for the merchandising under GAAP and IFRS. IFRS Practice Specific identification: a) must be used under IFRS if the inventory items are not interchangeable. b) cannot be used under IFRS. c) cannot be used under GAAP. d) must be used under IFRS if it would result in the most conservative net income. 6-56 Compare the procedures for the merchandising under GAAP and IFRS.

Takeaways Takeaways 1. Inventory should include all items (materials, work in process, merchandise/finished goods) owned by an entity, regardless of its location. The ownership of goods in transit depends on the terms of sale. 2. Companies take a physical inventory (by counting, weighing, or measuring each kind of inventory) on hand under both perpetual and periodic systems. 3. Companies value the inventory by applying unit costs to quantities on hand using either the actual flow (specific identification) or an assumed flow (e.g., FIFO). 6-57 Takeaways Takeaways 4. Under specific identification, items in inventory or sale are specifically costed to arrive at the total cost. 5. Under FIFO, the cost of earliest goods purchased are assigned to cost of goods sold, and latest goods to

inventory. 6. LIFO works exactly the opposite of FIFO. 7. Average-cost method allocates cost of goods available for sale to cost of goods sold and items in inventory on the basis of weighted-average unit cost incurred. 8. In an inflationary period, LIFO results in higher cost of goods sold and lower income, and reduces the tax liability. 6-58 Takeaways Takeaways 9. LIFO reserve can be used to adjust FIFO inventory to LIFO. 10. When the value of inventory is lower than its cost, companies have to write down the inventory to its market value when the price decline occurs. 11. Inventory errors affect income statement and balance sheet numbers. Income will be misstated for two periods.

12. IFRS does not allow use of LIFO; requires using the same cost flow assumption for goods of a similar nature; defines market value as net realizable value; and allows write up of inventory up to the amount of the previous write-down. 6-59 Copyright Copyright Copyright 2013 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. Note: presentation somewhat modified by Reza Espahbodi 6-60

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