Kimmel Weygandt Kieso Financial Accounting Eighth Edition 6 After studying this chapter you should be able to Determine how to classify and determine the quantity and cost of ID: 543468
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Slide1
Reporting and Analyzing Inventory
Kimmel ● Weygandt ● KiesoFinancial Accounting, Eighth Edition
6Slide2
After studying this chapter, you should be able to:
Determine how to classify and determine (the quantity and cost of) inventory.Apply inventory cost flow methods and discuss their financial effects.Explain the statement presentation and analysis of inventory.Learning ObjectivesSlide3
Classifying and Determining Inventory
One Classification:Merchandise InventoryThree Classifications:Raw Materials
Work in Process
Finished Goods
Merchandising Company
Manufacturing Company
▼
HELPFUL HINT
Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
LO 1 Slide4
Physical Inventory taken for two reasons:
Perpetual System
Check accuracy of inventory records.
Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.
Periodic System
Determine the inventory on hand.
Determine the cost of goods sold for the period.
Determining Inventory Quantities
LO 1 Slide5
Involves counting, weighing, or measuring each kind of inventory on hand.
Taken,when the business is closed or business is slow.at the end of the accounting period.
Taking a Physical Inventory
Determining Inventory Quantities
LO 1 Slide6
Goods in Transit
Purchased goods not yet received.Sold goods not yet delivered.
Determining Ownership of Goods
Determining Inventory Quantities
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
.
LO 1 Slide7
Illustration 6-2
Terms of saleDetermining Inventory Quantities
Goods in Transit
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.
LO 1 Slide8
Goods in transit should be included in the inventory of the buyer when the:
public carrier accepts the goods from the seller. goods reach the buyer. terms of sale are FOB destination. terms of sale are FOB shipping point.Determining Inventory Quantities
Review Question
LO 1 Slide9
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?
Determining Inventory Quantities
Determining Ownership of Goods
LO 1 Slide10
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.
3. Item 3 was treated correctly.
Inventory should be $195,000
($200,000 - $15,000 + $10,000).
LO 1 Slide11
Inventory Costing
Inventory is accounted for at cost.
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
Cost Flow Assumptions
Actual Flow
LO 2 Slide12
Illustration:
Crivitz TV Company purchases three identical 50-inch 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.
Inventory Costing
Illustration 6-3
LO 2 Slide13
Specific Identification
Inventory Costing
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
LO 2 Slide14
Inventory 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.
Practice is relatively rare.
Most companies make assumptions (
cost flow assumptions
) about which units were sold.
LO 2 Slide15
Inventory Costing
Illustration 6-12Use of cost flow methods in major U.S. companiesCost Flow Assumptiondoes not need to match the physical movement of goods
LO 2 Slide16
Illustration:
Data for Houston Electronics’ Astro condensers.Cost Flow Assumptions
Illustration 6-5
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods SoldSlide17
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.
Cost Flow Assumptions
First-In, First-Out (FIFO)
LO 2 Slide18
Cost Flow Assumptions
Illustration 6-6
LO 2
First-In, First-Out (FIFO)Slide19
Cost Flow Assumptions
Illustration 6-6
First-In, First-Out (FIFO)
▼ HELPFUL HINT
Another way of thinking about the calculation of FIFO
ending inventory
is the
LISH assumption
—last in still here.
LO 2 Slide20
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.
Cost Flow Assumptions
Last-In, First-Out (LIFO)
LO 2 Slide21
Illustration 6-8
Cost Flow Assumptions
Last-In, First-Out (LIFO)
LO 2Slide22
Cost Flow Assumptions
Last-In, First-Out (LIFO)
Illustration 6-8
▼ HELPFUL HINT
Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—first in still here.
LO 2 Slide23
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.
Cost Flow Assumptions
Average-Cost
LO 2 Slide24
Illustration 6-11
Cost Flow Assumptions
Average-CostSlide25
Cost Flow Assumptions
Average-Cost
Illustration 6-11
LO 2 Slide26
Comparative effects of cost flow methods
Financial Statement and Tax EffectsIllustration 6-13Slide27
In a period of inflation, the cost flow method that results in the lowest income taxes is the:
FIFO method. LIFO method. average cost method. gross profit method.
Inventory Cost Flow Assumptions
Review Question
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 Slide28
INTERNATIONAL INSIGHTIs 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 Oil’s Accounting Methods Fuel Criticism,” Wall Street Journal
(August 8, 2006), p. C1.
ExxonMobil
LO 2 Slide29
Using Cost Flow Methods Consistently
Inventory Costing
Method should be used consistently, enhances comparability.
Although consistency is preferred, a company may change its inventory costing method.
Illustration 6-14Slide30
Lower-of-Cost-or-Market
Inventory Costing
When the value of inventory is lower than its cost
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 Slide31
Inventory Costing
Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.
Lower-of-Cost-or-Market
Illustration 6-16
LO 2 Slide32
Statement Presentation & Analysis of Inventory
Statement Presentation
Inventory is classified in the balance sheet as a current asset immediately below receivables.
There also should be disclosure of
the major inventory classifications,
the basis of accounting (cost, or lower-of-cost-or-market), and
the cost method (FIFO, LIFO, or average-cost).
LO 3 Slide33
Statement Presentation & Analysis of Inventory
Statement Presentation
LO 3
Illustration 6-15Slide34
Statement Presentation & Analysis of Inventory
Inventory management is a critical taskHigh 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.
Low Inventory Levels
– may lead to lost sales.
LO 3 Slide35
A Big HiccupJIT can save a company a lot of money, but it isn’t 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 days—a 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 don’t 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 Japan’s 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).ACCOUNTING ACROSS THE ORGANIZATIONSlide36
Statement Presentation & Analysis of Inventory
Inventory Turnover Ratio
Illustration 6-17
LO 3 Slide37
Illustration:
Data available for Wal-Mart.Statement Presentation & Analysis of Inventory
Illustration 6-17
LO 3 Slide38
Statement Presentation & Analysis of Inventory
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.
Analysts
’
Adjustments for LIFO Reserve
Illustration 6-18
LO 3 Slide39
Statement Presentation & Analysis of Inventory
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
Analysts
’
Adjustments for LIFO Reserve
LO 3 Slide40
Illustration:
Assuming the
Perpetual
Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.
Illustration 6A-1
Appendix 6A
Perpetual Inventory SystemSlide41
First-In, First-Out (FIFO)
Cost of Goods Sold
Ending Inventory
Illustration 6A-2
Appendix 6A
Perpetual Inventory SystemSlide42
Last-In, First-Out (LIFO)
Cost of Goods Sold
Ending Inventory
Illustration 6A-3
Appendix 6A
Perpetual Inventory SystemSlide43
Average-Cost
Illustration 6A-4
Cost of Goods Sold
Ending Inventory
Appendix 6A
Perpetual Inventory SystemSlide44
Inventory Fraud and Errors
Common Causes:
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.
Appendix 6B
Inventory ErrorsSlide45
Falsifying Inventory to Boost IncomeManagers at women’s 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.ETHICS INSIGHTLeslie FaySlide46
Inventory errors affect the computation of cost of goods sold and net income.
Income Statement Effects
Illustration 6-B2
Illustration 6-B1
Appendix 6B
Inventory ErrorsSlide47
Inventory errors affect the computation of cost of goods sold and net income
in two periods.An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.Over the two years, the total net income is correct because the errors offset each other.
Ending inventory depends entirely on the accuracy of taking and costing the inventory.
Income Statement Effects
Appendix 6B
Inventory ErrorsSlide48
($3,000)
Net Income understated
$3,000
Net Income overstated
Combined income for 2-year period is correct.
Illustration 6-B3
Appendix 6B
Inventory Errors
Errors CancelSlide49
Understating ending inventory will overstate:
assets. cost of goods sold. net income. owner's equity.Review Question
Appendix 6B
Inventory ErrorsSlide50
Effect of inventory errors on the balance sheet is determined by using the basic
accounting equation:Assets = Liabilities + Stockholders’ EquityErrors in the ending inventory have the effects shown:
Balance Sheet Effects
Illustration 6-B4
Appendix 6B
Inventory ErrorsSlide51
Key Points
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 average-cost 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.Slide52
Key Points
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.Slide53
Key Points
Under GAAP, if inventory is written down under the lower-of-cost-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 write-down 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.Slide54
IFRS Practice
Compare the procedures for the merchandising under GAAP and IFRS.
Which of the following should not be included in the inventory of a company using IFRS?
Goods held on consignment from another company.
Goods shipped on consignment to another company.
Goods in transit from another company shipped FOB shipping point.
None of the above.Slide55
IFRS Practice
Compare the procedures for the merchandising under GAAP and IFRS.
Which method of inventory costing is prohibited under IFRS?
Specific identification.
FIFO.
LIFO.
Average-cost.Slide56
IFRS Practice
Compare the procedures for the merchandising under GAAP and IFRS.
Specific identification:
must be used under IFRS if the inventory items are not interchangeable.
cannot be used under IFRS.
cannot be used under GAAP.
must be used under IFRS if it would result in the most conservative net income.Slide57
Takeaways
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.
Companies take a physical inventory (by
counting, weighing, or measuring each kind of inventory) on hand under both perpetual and periodic systems.
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).Slide58
Takeaways
Under specific identification, items in inventory or sale are specifically costed to arrive at the total cost.
Under FIFO, the cost of earliest goods purchased are assigned to cost of goods sold, and latest goods to inventory.
LIFO works exactly the opposite of FIFO.
Average-cost method a
llocates cost of goods available for sale to cost of goods sold and items in inventory on the basis of
weighted-average unit cost
incurred.
In an inflationary period, LIFO results in higher cost of goods sold and lower income, and reduces the tax liability.Slide59
Takeaways
LIFO reserve can be used to adjust FIFO inventory to LIFO.
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.
Inventory errors affect income statement and balance sheet numbers. Income will be misstated for two periods.
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.Slide60
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