Reporting and Analyzing Inventory
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Reporting and Analyzing Inventory

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Reporting and Analyzing Inventory




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Reporting and Analyzing Inventory

Kimmel ● Weygandt ● KiesoFinancial Accounting, Eighth Edition

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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 Objectives

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Classifying and Determining Inventory

One Classification:Merchandise Inventory

Three Classifications:Raw MaterialsWork in ProcessFinished Goods

Merchandising Company

Manufacturing Company

HELPFUL HINT Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

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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 ORGANIZATION

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Physical Inventory taken for two reasons:

Perpetual SystemCheck accuracy of inventory records.Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.Periodic SystemDetermine the inventory on hand.Determine the cost of goods sold for the period.

Determining Inventory Quantities

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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

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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 INSIGHT

Leslie Fay

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Goods in TransitPurchased 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.

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Illustration 6-2 Terms of sale

Determining 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.

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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

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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

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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).

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Inventory Costing

Inventory is accounted for at cost.

Cost includes all expenditures necessary to acquire 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 identificationFirst-in, first-out (FIFO)Last-in, first-out (LIFO)Average-cost

Cost Flow Assumptions

Actual Flow

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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

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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

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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.

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Inventory Costing

Illustration 6-12Use of cost flow methods in major U.S. companies

Cost Flow Assumptiondoes not need to match the physical movement of goods

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Illustration: Data for Houston Electronics’ Astro condensers.

Cost Flow Assumptions

Illustration 6-5

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

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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)

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Cost Flow Assumptions

Illustration 6-6

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First-In, First-Out (FIFO)

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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.

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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)

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Illustration 6-8

Cost Flow Assumptions

Last-In, First-Out (LIFO)

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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.

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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

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Illustration 6-11

Cost Flow Assumptions

Average-Cost

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Cost Flow Assumptions

Average-Cost

Illustration 6-11

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Comparative effects of cost flow methods

Financial Statement and Tax Effects

Illustration 6-13

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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 LIFOconformity rule, requires thatif companies use LIFO for taxpurposes, they must also use itfor 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.

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INTERNATIONAL INSIGHT

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 Oil’s Accounting Methods Fuel Criticism,” Wall Street Journal (August 8, 2006), p. C1.

ExxonMobil

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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 6-14

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Lower-of-Cost-or-Market

Inventory Costing

When the value of inventory is lower than its costCompanies have to “write down” the inventory to its market value in the period in which the price decline occurs. Market value = Replacement Cost (effective 2017, net realizable value)Example of conservatism.

International Note

UnderU.S. GAAP, companies cannotreverse inventory write-downsif inventory increases invalue in subsequent periods.IFRS permits companies toreverse write-downs in somecircumstances.

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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

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Statement Presentation & Analysis of Inventory

Statement PresentationInventory 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).

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Statement Presentation & Analysis of Inventory

Statement Presentation

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Illustration 6-

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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.

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Statement Presentation & Analysis of Inventory

Inventory Turnover Ratio

Illustration 6-17

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Illustration: Data available for Wal-Mart.

Statement Presentation & Analysis of Inventory

Illustration 6-17

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Too Many TVs or Too Few?Financial analysts closely monitor the inventory management practices of companies. For example, some analysts following Sony expressed concern because the company built up its inventory of televisions in an attempt to sell 25 million liquid crystal display (LCD) TVs—a 60% increase over the prior year. A year earlier, Sony had cut its inventory levels so that its quarterly days in inventory was down to 38 days, compared to 61 days for the same quarter a year before that. But in the next year, as a result of its inventory build-up, days in inventory rose to 59 days. Management said that it didn’t think that Sony’s inventory levels were too high. However, analysts were concerned that the company would have to engage in very heavy discounting in order to sell off its inventory. Analysts noted that the losses from discounting can be “punishing.” Source: Daisuke Wakabayashi, “Sony Pledges to Corral Inventory,” Wall Street Journal Online (November 2, 2010).

ACCOUNTING ACROSS THE ORGANIZATION

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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

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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

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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 System

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First-In, First-Out (FIFO)

Cost of Goods Sold

Ending Inventory

Illustration 6A-2

Appendix 6A

Perpetual Inventory System

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Last-In, First-Out (LIFO)

Cost of Goods Sold

Ending Inventory

Illustration 6A-3

Appendix 6A

Perpetual Inventory System

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Average-Cost

Illustration 6A-4

Cost of Goods Sold

Ending Inventory

Appendix 6A

Perpetual Inventory System

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Inventory Errors

Common Cause: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 Errors

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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 Errors

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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 Errors

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($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 Cancel

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Understating ending inventory will overstate: assets. cost of goods sold. net income. owner's equity.

Review Question

Appendix 6B

Inventory Errors

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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 Errors

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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.

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Key Points

In the lower-of-cost-or-market test for inventory valuation, IFRS defines 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. GAAP, on the other hand, defines market as essentially replacement cost.Note: The definition under GAAP will change to net realizable value for fiscal years beginning after December 15, 2016.

Compare

the procedures for the merchandising under GAAP and IFRS.

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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.

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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.

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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.

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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.

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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).

Takeaways

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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 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.In an inflationary period, LIFO results in higher cost of goods sold and lower income, and reduces the tax liability.

Takeaways

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LIFO reserve can be used to adjust FIFO inventory to LIFO.When the value of inventory is lower than its cost, companies can “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.

Takeaways

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“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

Copyright

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