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John Wiley & Sons, Inc. © 2005 Chapter 6 Inventories Prepared by Naomi Karolinski Monroe Community College and Marianne Bradford Bryant College Accounting Principles, 7 th Edition Weygandt • Kieso • Kimmel

Describe steps in determining inventory quantities Explain the basis of accounting for inventories and describe the inventory cost flow methods Explain the financial statements and the tax effects of each inventory cost flow method Explain the lower of cost or market basis of accounting for inventories Indicate the effects of inventory errors on the financial statements Compute and interpret inventory turnover CHAPTER 6 INVENTORIES After studying this chapter, you should be able to:

Balance sheet of merchandising and manufacturing companies inventory significant current asset Income statement inventory is vital in determining results Gross profit (net sales - cost of goods sold) watched by management, owners, and others INVENTORY BASICS

Merchandise inventory 1 Owned by the company 2 In a form ready for sale MERCHANDISE INVENTORY CHARACTERISTICS

Manufacturing inventories may not yet be ready for sale Classified into three categories: 1 Finished goods ready for sale 2 Work in process various stages of production (not completed) 3 Raw materials co mponents on hand w aiting to be used CLASSIFYING INVENTORY IN A MANUFACTURING ENVIRONMENT

To prepare financial statements determine the number of units in inventory by taking a physical inventory of goods on hand physical inventory by counting, weighing or measuring The ownership of goods DETERMINING INVENTORY QUANTITIES STUDY OBJECTIVE 1

DETERMINING COST OF GOODS ON HAND 3. apply unit costs to the total units on hand for each item total the cost of each item of inventory to determine total cost of goods on hand

Internal control principles for inventory: 1 Segregation of duties counting by employees not having custodial responsibility for the inventory 2 Establishment of responsibility e ach counter should establish the authenticity of each inventory item TAKING A PHYSICAL INVENTORY

3 Independent internal verification second count by another employee 4 Documentation procedures pre-numbered inventory tags 5 Independent internal verification designat ed supervisor checks all inventory items tags, no items have more than one tag TAKING A PHYSICAL INVENTORY

Goods in transit : included in the inventory of the party that has legal title to the goods FOB (Free on Board) shipping point : ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller FOB destination point: legal title to the goods remains with the seller until the goods reach the buyer OWNERSHIP OF GOODS IN TRANSIT

Consignment: the holder of the goods ( consignee ) does not own the goods ownership remains with the consignor of the goods until the goods are sold consigned goods should be included in the consignor’s inventory, not the consignee’s inventory Consignee Company CONSIGNED GOODS Owned by a consignor; do not count in consignee inventory

INVENTORY ACCOUNTING SYSTEMS 1 Perpetual detailed records cost of each item maintained cost of each item sold is determined when sale occurs 2 Periodic cost of goods sold is determined at the end of accounting period

Basis of Accounting for Inventories Periodic Cost Flow Methods STUDY OBJECTIVE 2 Revenues from the sale of merchandise are recorded when sales are made in the same way as in a perpetual system. No calculation of cost of goods sold is made at the time of sale of the merchandise. Physical inventories are taken at end of period to determine: the cost of merchandise on hand the cost of the goods sold during the period

Inventory costs- periodic inventory system allocated between ending inventory and cost of goods sold allocation is made at the end of the accounting period 1 the costs assignable to the ending inventory are determined 2 the cost of the ending inventory is subtracted from the cost of goods available for sale to determine the cost of goods sold 3 cost of goods sold is then deducted from sales revenues in accordance with the matching principle to get gross profit ALLOCATING INVENTORIABLE COSTS

COST OF GOODS SOLD Cost of Goods Sold –Review Periodic inventory system Three steps are required: record purchases of merchandise, determine the cost of goods purchased, determine the cost of goods on hand at the beginning and end of the accounting period

To determine Cost of Goods Purchased: 1 subtract contra purchase accounts of Purchases Discounts and Purchases Returns and Allowances from Purchases to get Net Purchases 2 add Freight-in to Net Purchases DETERMINING COST OF GOODS PURCHASED

$15,000 $105,000 ALLOCATION (MATCHING) OF POOL OF COSTS STUDY OBJECTIVE 5 $ 120,000

The cost of goods available for sale is allocated between a. beginning inventory and ending inventory. b. beginning inventory and cost of goods on hand. c. cost of goods purchased and cost of goods sold. d. beginning inventory and cost of goods purchased.

Costing of the inventory is complicated because specific items of inventory on hand may have been purchased at different prices. The specific identification method t racks the actual physical flow of the goods. Each item of inventory is marked, tagged, or coded with its specific unit cost. Items still in inventory at the end of the year are specifically costed to arrive at the total cost of the ending inventory. USING ACTUAL PHYSICAL FLOW COSTING

SPECIFIC IDENTIFICATION METHOD

Other cost flow methods are allowed since specific identification is often impractical. The se method s assume flows of costs that may be unrelated to the physical flow of goods. For this reason we call them assumed cost flow methods or cost flow assumptions . They are: 1 First-in, first-out ( FIFO ). 2 Last-in, first-out ( LIFO ). 3 Average cost . USING ASSUMED COST FLOW METHODS

The FIFO method earliest goods purchased are the first to be sold. o ften parallels the actual physical flow of merchandise. the costs of the earliest goods purchased are the first to be recognized as cost of goods sold. FIFO

$ 5,800 $ 6,200 ALLOCATION OF COSTS - FIFO METHOD $ 12,000

100 $ 10 $ 1,000 200 11 2,200 250 12 3,000 550 $ 6,200 PROOF OF COST OF GOODS SOLD The accuracy of the cost of goods sold can be verified by recognizing that the first units acquired are the first units sold.

The LIFO method assumes that the latest goods purchased are the first to be sold. LIFO s eldom coincides with the actual physical flow of inventory. Under LIFO, the costs of the latest goods purchased are the first goods to be sold. LIFO

$ 12,000 $ 5,000 $ 7,000 ALLOCATION OF COSTS - LIFO METHOD

400 $ 13 $ 5,200 150 12 1,800 550 $ 7,000 PROOF OF COST OF GOODS SOLD The cost of the last goods in are the first to be assigned to cost of goods sold. Under a periodic inventory system, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase . Unit Total Date Units Cost Cost 11/27 X = X = 08/24 Total

The average cost method assumes goods available for sale are homogeneous. the cost of goods available for sale is allocated on the basis of the weighted average unit cost incurred. weighted average unit cost is applied to the units on hand to determine cost of the ending inventory. AVERAGE COST

$ 12,000 $ 5,400 $ 6,600 ALLOCATION OF COSTS - AVERAGE COST METHOD

USE OF COST FLOW METHODS IN MAJOR U.S. COMPANIES Companies adopt different inventory cost flow methods for various reasons. Usually one of the following factors is involved: 1) income statement effects , 2) balance sheet effects , or 3) tax effects . 44% FIFO 30% LIFO 21% Average Cost 5% Other

A company had the following inventory information for the month of May: Assuming the company is using the Lifo method of inventory: Calculate the value of the ending inventory if there are 100 units in ending inventory on May 31 st . $15,610 Total units 1,100 $ 6,360 $10.60 = @ 600 units Purchase 20 $ 5,250 $10.50 = @ 500 units Purchase 8 $ 4,000 $10.00 = @ 400 units Beg. Inventory May 1

Under LIFO, the ending inventory consists of the oldest 100 units, therefore ending inventory = 100 units X $10 = $1,000.

Cost of goods sold 4,000 (200 x $20) 4,800 (200 x $24) INCOME STATEMENT EFFECTS COMPARED STUDY OBJECTIVE 3 LIFO FIFO Kralik Company buys 200 XR492s at $20 per unit on January 10 and 200 more on December 31 at $24 each. During the year, 200 units are sold at $30 each. Under LIFO, the company recovers the current replacement cost ($4,800) of the units sold. Under FIFO, however, the company recovers only the January 10 cost ($4,000). To replace the units sold, it must invest $800 (200 x $4) of the gross profit. Thus, $800 of the gross profit is said to be phantom or illusory profits . As a result, reported net income is overstated in real terms.

Consistency Companies needs to use its chosen cost flow method from one period to another. Consistent application makes financial statements comparable over successive time periods . If a company adopts a different cost flow method: The change and its effects on net income must be disclosed in the financial statements USING INVENTORY COST FLOW METHODS CONSISTENTLY

Value of inventory is lower than its cost The inventory is written down to its market value Known as the lower of cost or market ( LCM ) method LCM basis Market is defined as current replacement cost , not selling price VALUING INVENTORY AT THE LOWER OF COST OR MARKET STUDY OBJECTIVE 4

$ 159,000 COMPUTATION OF LOWER OF COST OR MARKET

both beginning and ending inventories appear on the income statement ending inventory of one period automatically becomes the beginning inventory of the next period inventory errors affect the determination of cost of goods sold and net income INVENTORY ERRORS - INCOME STATEMENT EFFECTS STUDY OBJECTIVE 5

the effects on cost of goods sold can be determined by entering the incorrect data in the above formula and then substituting the correct data FORMULA FOR COST OF GOODS SOLD + = _ Beginning Inventory Cost of Goods Purchased Ending Inventory Cost of Goods Sold

Understate beginning inventory Understated Overstated Overstate beginning inventory Overstated Understated Understate ending inventory Overstated Understated Overstate ending inventory Understated Overstated An error in ending inventory of the current period will have a reverse effect on net income of the next period. EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S INCOME STATEMENT

the effect of ending inventory errors on the balance sheet can be determined by the basic accounting equation : Assets = Liabilities + Owners Equity ENDING INVENTORY ERROR - BALANCE SHEET EFFECTS

Errors in the ending inventory have the following effects on these components: Overstated Overstated None Overstated Understated Understated None Understated ENDING INVENTORY ERROR - BALANCE SHEET EFFECTS

Inventory classified as a current asset after receivables in the balance sheet Cost of goods sold subtracted from sales in the income statement Disclosure either in the balance sheet or in accompanying notes for: 1 major inventory classifications 2 basis of accounting ( cost or lower of cost or market ) 3 costing method ( FIFO , LIFO , or average cost ) Note 1. Summary of accounting policies Inventories The company uses the retail, last-in, first-out (LIFO) method for the Wal-Mart Stores segment, cost LIFO for the SAM’S CLUB segment, and other cost methods, including the retail first-in, first-out (FIFO) and average costs methods, for the International segment. Inventories are not recorded in excess of market value. INVENTORY DISCLOSURES Wal-Mart Stores, Inc Notes to the Financial Statements

The inventory turnover ratio measures the number of times, on average, the inventory is sold during the period – which measures the liquidity of the inventory. It is computed by dividing cost of goods sold by average inventory during the year. Assume that Wal-Mart, Inc. has a beginning inventory of $21,442 million and ending inventory of $21,614 and cost of goods sold for 2002 of $171,562; its inventory turnover formula and computation is shown below: INVENTORY TURNOVER FORMULA AND COMPUTATION STUDY OBJECTIVE 6 COST OF GOODS SOLD INVENTORY TURNOVER = ———————————— AVERAGE INVENTORY 7.97 times = $171,562 ( $21,442 + $21,614 ) /2

To illustrate the application of the 3 assumed cost flow methods ( FIFO , Average Cost , and LIFO ), the data shown below for Bow Valley Electronics’ product Z202 Astro Condenser is used. APPENDIX 6A INVENTORY COST FLOW METHODS IN PERPETUAL INVENTORY SYSTEMS Bow Valley Electronics Z202 Astro Condensers Unit Total Date Explanation Units Cost Cost 01/01 Beginning inventory 100 $10 $ 1,000 04/15 Purchase 200 11 2,200 08/24 Purchase 300 12 3,600 11/27 Purchase 400 13 5,200 Total $ 12,000

Under FIFO , the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold . Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and August 24. PERPETUAL SYSTEM - FIFO

Under the LIFO method using a perpetual system , the cost of the most recent purchase prior to sale is allocated to the units sold. The cost of the goods sold on September 10 consists entirely of goods from the August 24 and April 15 purchases and 50 of the units in beginning inventory. PERPETUAL SYSTEM - LIFO

The average cost method in a perpetual inventory system is called the moving average method . Under this method a new average is computed after each purchase . The average cost is computed by dividing the cost of goods available for sale by the units on hand. The average cost is then applied to the units sold, to determine the cost of goods sold, and, the remaining units on hand, to determine the ending inventory amount. PERPETUAL SYSTEM - AVERAGE COST

As indicated below, a new average is computed each time a purchase is made. On April 15, after 200 units are purchased for $2,200, a total of 300 units costing $3,200 ($1,000 + $2,200) are on hand. The average cost is $10.667 ($3,200/300). PERPETUAL SYSTEM - AVERAGE COST METHOD

Two circumstances for estimating inventories: 1 management may want monthly or quarterly financial statements, but a physical inventory is usually only taken annually. 2 a casualty such as a fire or flood may make it impossible to take a physical inventory. Two widely used methods of estimating inventories: 1 the gross profit method and 2 the retail inventory method APPENDIX 6B ESTIMATING INVENTORIES

Gross profit method Estimates the cost of ending inventory by applying a gross profit rate to net sales used in preparing monthly financial statements under a periodic system should NOT be used in preparing the company’s financial statements at year-end is assumed to remain constant from one year to the next GROSS PROFIT METHOD

Step 1 Net sales less estimated gross profit equals estimated cost of goods sold. Step 2 Cost of goods available for sale less estimated cost of goods sold ( from Step 1 ) equals the estimated cost of ending inventory. GROSS PROFIT METHOD FORMULAS Net Sales Estimated Gross Profit Cost of Goods Available for Sale Estimated Cost of Goods Sold Estimated Cost of Goods Sold Estimated Cost of Ending Inventory

A store has many different types of merchandise at low unit costs the retail inventory method is often used a company’s records must show both the cost and retail value of the goods available for sale Major disadvantage it is an averaging technique RETAIL INVENTORY METHOD

Ending Inventory at Retail Step 1 Cost to Retail Ratio Step 2 Estimated Cost of Ending Inventory Step 3 RETAIL INVENTORY METHOD FORMULAS Goods Available for Sale at Retail Net Sales Goods Available for Sale at Cost Goods Available for Sale at Retail Ending Inventory at Retail Cost to Retail Ratio

DETERMINING COST OF GOODS ON HAND Under the periodic method, cost of inventory on hand is determined from a physical inventory requiring: 1 counting the units on hand for each item of inventory 2 applying unit costs to the total units on hand for each item 3 totaling the cost of each item of inventory to determine total cost of goods on hand

A company had the following inventory information for the month of May: Assuming the company is using the LIFO method of inventory: Calculate the value of the ending inventory if there are 100 units in ending inventory on May 31. $15,610 Total units and cost 1,500 $ 6,360 $10.60 = @ 600 units Purchase 20 $ 5,250 $10.50 = @ 500 units Purchase 8 $ 4,000 $10.00 = @ 400 units Beg. Inventory May 1

A company had the following inventory information for the month of May: $15,610-$1,000= $14,610 Assume an ending inventory of 100 units, then ending inventory would consist of the oldest layer: 100 units @ $10.00 = $1,000 (Cost of Goods sold would be equal to (Cost of Goods available for Sale - Ending Inventory) $15,610 Total units and cost 1,500 $ 6,360 $10.60 = @ 600 units Purchase 20 $ 5,250 $10.50 = @ 500 units Purchase 8 $ 4,000 $10.00 = @ 400 units Beg. Inventory May 1

Copyright © 2005 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 consent 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. COPYRIGHT

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