Kimmel Weygandt Kieso Financial Accounting Eighth Edition 6 CHAPTER OUTLINE Discuss how to classify and determine inventory 1 Apply inventory cost flow methods and discuss their ID: 543469
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Financial Accounting: Tools for Business Decision Making
Eighth Edition
Kimmel ● Weygandt ● Kieso
Chapter 6
Reporting and Analyzing Inventory
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.Slide2
Financial Accounting: Tools for Business Decision
Making
2
Copyright ©2017 John Wiley & Sons, Inc. Slide3
Chapter Outline:
Learning ObjectivesDiscuss how to classify and determine inventory.
Apply inventory cost flow methods and discuss their financial effects. Explain the statement presentation and analysis of inventory.
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LO 1:
Discuss How to Classify and Determine 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.
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Accounting Across the Organization
(1 of 2)
A Big Hiccup
JIT 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).
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Determining Inventory Quantities
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.
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Taking a Physical Inventory
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.
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Ethics Insight Leslie Fay
Falsifying Inventory to Boost Income
Managers 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.
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Determining Ownership of Goods
(1 of 5)
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.
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Determining Ownership of Goods
(2 of 5)
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.
Freight costs incurred by the seller are an
operating expense
.
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Determining Ownership of Goods
(3 of 5)
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 F
O
B destination.
d.
terms of sale are F
O
B shipping point.
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Determining Ownership of Goods
(4 of 5)
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 F
O
B destination.
d.
terms of sale are F
O
B shipping point.
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Determining Ownership of Goods
(5 of 5)
Consigned GoodsTo hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods.
Many car, boat, and antique dealers sell goods on consignment. Why?
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Anatomy of a Fraud
Ted Nickerson, C E O of clock manufacturer Dally Industries, had expensive tastes. To support this habit, Ted took out large loans, which he collateralized with his shares of Dally Industries stock. If the price of Daily's stock fell, he was required to provide the bank with more shares of stock. To achieve target net income figures and thus maintain the stock price, Ted coerced employees in the company to alter inventory figures. Inventory quantities were manipulated by changing the amounts on inventory control tags after the year-end physical inventory count. For example, if a tag said there were 20 units of a particular item, the tag was changed to 220. Similarly, the unit costs that were used to determine the value of ending inventory were increased from, for example, S125 per unit to $1,250. Both of these fraudulent changes had the effect of increasing the amount of reported ending inventory. This reduced cost of goods sold and increased net income.
Total take: $245,000
The Missing Control
Independent internal verification. The company should have spot-checked its inventory records periodically, verifying that the number of units in the records agreed with the amount on hand and that the unit costs agreed with vendor price sheets.
Source:
Adapted from Welts, Fraud Casebook (2007), pp. 502-509.
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Do It! 1: Rules of Ownership
(1 of 2)
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.
Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000.
The company did not include in the count purchased goods of $10,000, which were in transit (terms: F
O
B
shipping point).
The company did not include in the count inventory that had been sold with a cost of $12,000, which was in transit (terms:
F
O
B
shipping point).
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Do It! 1: Rules of Ownership
(2 of 2)
Solution
Goods of $15,000 held on consignment should be deducted from the inventory count
The goods of $10,000 purchased
F
O
B
shipping point should be added to the inventory count.
Item 3 was treated correctly
Inventory should be $
195,000
($
200,000
−
$15,000 + $10,000).
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L
O 2: Apply Inventory Cost Flow Methods and Discuss Their Financial Effects
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 identification
Cost Flow Assumptions
First-in, first-out (
F
I
F
O
)
Last-in, first-out (
L
I
F
O
)
Average-cost
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Specific Identification
(1 of 3)
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.
Purchases
Blank
February 3
1 TV at $700
March 5
1 TV at $750
May 22
1 TV at $800
Sales
Blank
June 1
2 TVs for $2,400 ($1,200 × 2)
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Specific Identification
(2 of 3)
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.
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Specific Identification
(3 of 3)
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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Cost Flow Assumptions
(1 of 2)
Cost flow assumption does not need to be consistent with the physical movement of goods
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Cost Flow Assumptions
(2 of 2)
Illustration: Data for Houston Electronics’ Astro condensers.
(Beginning Inventory + Purchases)
−
Ending Inventory =
Cost of Goods Sold
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First-In, First-Out (
F I
F
O) (1 of 3)
Costs of the earliest goods purchased
are the first to be recognized in determining cost of goods 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.
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First-In, First-Out (
F I
F
O) (2 of 3)
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First-In, First-Out (
F I
F
O) (3 of 3)
▼
Helpful Hint
Another way of thinking about the calculation of F
I
F
O
ending inventory
is the L
I
S H assumption—last in still here.
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Last-In, First-Out (
L I
F
O) (1 of 3)
Costs of the latest goods purchased
are the first to be recognized in determining cost of goods sold.
Seldom coincides with actual physical flow of merchandise.
Exceptions include goods stored in piles, such as coal or hay.
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Last-In, First-Out (
L
I F
O) (2 of 3)
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Last-In, First-Out (
L I
F
O) (3 of 3)
▼ Helpful Hint
Another way of thinking about the calculation of L
I
F
O ending inventory is the F
I
S
H assumption—first in still here.
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Average-Cost
(1 of 3)
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.
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Average-Cost
(2 of 3)
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Average-Cost
(3 of 3)
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Financial Statement and Tax Effects
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Income Statement Effects
In periods of changing prices, the cost flow assumption can have significant impacts both on income and on evaluations of income, such as the following.
In a period of inflation, F
I
F
O produces a higher net income because lower unit costs of the first units purchased are matched against revenue.
In a period of inflation, L
I
F
O produces a lower net income because higher unit costs of the last goods purchased are matched against revenue.
If prices are falling, the results from the use of F
I
F
O and L
I
F
O are reversed F
I
F
O will report the lowest net income and LIFO the highest.
Regardless of whether prices are rising or falling, average-cost produces net income between F
I
F
O and L
I
F
O.
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Cost Flow Assumptions
(1 of 4)
Review Question
The cost flow method that often parallels the actual physical flow of merchandise is the:
a.
F
I
F
O
method.
b.
L
I
F
O method.c.
average cost method.
d.
gross profit method.
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Cost Flow Assumptions
(2 of 4)
Review Question
The cost flow method that often parallels the actual physical flow of merchandise is the:
a.
F
I
F
O
method.
b.
L
I
F
O method.
c. average cost method.
d.
gross profit method.
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Cost Flow Assumptions (3 of 4)
Review Question
In a period of inflation, the cost flow method that results in the lowest income taxes is the:
a.
F
I
F
O
method.
b.
L
I
F
O method.
c. average cost method.
d.
gross profit method.
▼ Helpful Hint
A tax rule, often referred to as the
L
I
F
O conformity rule,
requires that if companies use L
I
F
O for tax purposes, they must also use it for financial reporting purposes. This means that if a company chooses the L
I
F
O method to reduce its tax bills, it will also have to report lower net income in its financial statements.
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Cost Flow Assumptions (4 of 4)
Review Question
In a period of inflation, the cost flow method that results in the lowest income taxes is the:
a.
F
I
F
O
method.
b.
L
I
F
O
method.c.
average cost method.
d.
gross profit method.
▼ Helpful Hint
A tax rule, often referred to as the
L
I
F
O conformity rule,
requires that if companies use L
I
F
O for tax purposes, they must also use it for financial reporting purposes. This means that if a company chooses the L
I
F
O 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 ExxonMobil
Is L
I F O Fair?
ExxonMobil Corporation, like many U.S. companies, uses L
I F
O
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
F
I
F
O
. By increasing cost of goods sold, ExxonMobil reduces net income, which reduces taxes. Critics say that
L
I F
O provides an unfair “tax dodge.” As Congress looks for more sources of tax revenue, some lawmakers favor the elimination of L
I
F
O
. Supporters of
L
I
F
O
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
L
I
F
O
. Because of this, the net income of foreign oil companies such as
B
P
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.
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Using Inventory Cost Flow Methods Consistently
Method should be used consistently, enhances comparability.
Although consistency is preferred, a company may change its inventory costing method.
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Do It! 2: Cost Flow Methods
(1 of 3)
The accounting records of Shumway Ag Implement show the following data.
Beginning inventory
4,000 units at $3
Purchases
6,000 units at $4
Sales
7,000 units at $12
Determine the cost of goods sold during the period under a periodic system using
F
I
F
O
.
Solution
4,000 units × $3 =
$12,000
3,000 units × $4 =
12,000
Blank
$24,000
double underline
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Do It!
2: Cost Flow Methods (2 of 3)
The accounting records of Shumway Ag Implement show the following data.
Beginning
inventory
4,000 units at $3
Purchases
6,000 units at $4
Sales
7,000 units at $12
Determine the cost of goods sold during the period under a periodic system using
L
I
F
O
.
Solution
6,000 units × $4 =
$12,000
1,000 units × $3 =
3,000
$
27,000 double underline
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Do It! 2: Cost Flow Methods
(3 of 3)The accounting records of Shumway Ag Implement show the following data
.
Determine the cost of goods sold during the period under a periodic system using
average cost
.
Solution
$36,000 ÷ 10,000 units = $3.60 average cost per unit
$36,000 − ($3,000 ending units × $3.60) =
$
25,200
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L
O 3: Explain the Statement Presentation and Analysis of
Inventory
Presentation
Inventory is classified in the balance sheet as a current asset immediately below receivables.
In a multiple-step income statement, cost of goods sold is subtracted from net sales.
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 (F
I
F
O, L
I
F
O, or average-cost).
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Presentation
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Lower-of-Cost-or-Market
(1 of 2)
When the value of inventory is lower than its cost.
Applied to items in inventory after the company has used one of the cost flow methods (specific identification, FIFO, LIFO, or average-cost) to determine cost.
Companies can
“write down”
the inventory to its market value in the period in which the price decline occurs.
Market value
=
Replacement Cost
Example of
conservatism.
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Lower-of-Cost-or-Market
(2 of 2)
Illustration
: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.
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Do It! 3: L
C
M Basis (1 of 2)
Tracy Company sells three different types of home heating stoves (gas, wood, and pellet). The cost and market value of its inventory of stoves are as follows.
Blank
Cost
Market
Gas
$ 84,000
$ 79,000
Wood
250,000
280,000
Pellet
112,000
101,000
Determine the value of the company’s inventory under the lower-of-cost-or-market approach
.
Solution
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Do It! 3: L
C
M Basis (2 of 2)
Tracy Company sells three different types of home heating stoves (gas, wood, and pellet). The cost and market value of its inventory of stoves are as follows.
Cost
Market
Gas
$ 84,000
$ 79,000
Wood
250,000
280,000
Pellet
112,000
101,000
Determine the value of the company’s inventory under the lower-of-cost-or-market approach
.
Solution
The lower value for each inventory type is gas
$79,000
, wood
$250,000
, and pellet
$101,000
. The total inventory value is the sum of these figures,
$430,000
.
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Analysis
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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Inventory Turnover
(1 of 2)
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Inventory Turnover
(2 of 2)
Illustration
: Data available for Wal-Mart
.
(in millions)
2014
2013
Ending inventory
$ 44,858
$43,803
Cost of goods sold
358,069
Blank
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Accounting Across the
Organization (2 of 2)
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 (L C
.D) 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).
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Adjustments for L
I F O Reserve (1 of 3)
Companies using L
I F O are required to report the difference between inventory reported using L I
F O and Inventory using F
I
F
O
. This amount is referred to as the
L
I
F
O
reserve.
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Adjustments for L
I F O Reserve (2 of 3)
If Caterpillar had used
F
I F
O
all along, its inventory would be $14,635 million, rather than $12,205 million.
Blank
(in millions)
2014 inventory using LIFO
$ 12,205
2014 LIFO reserve
2,430
2014 inventory assuming FIFO
$
14,635 double underline
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Adjustments for L
I F O Reserve (3 of 3)
The L
I F O reserve can have a significant effect on ratios analysts commonly use.
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Do It! 3b: Inventory Turnover
Early in 2017, Westmoreland Company switched to a just-in-time inventory system. Its sales, cost of goods sold, and inventory amounts for 2016 and 2017 are shown below
Blank
2016
2017
Sales revenue
$2,000,000
$1,800,000
Cost of goods sold
1,000,000
910,000
Beginning inventory
290,000
210,000
Ending inventory
210,000
50,000
Determine the inventory turnover and days in inventory for 2016 and 2017.
Solution
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L
O *4: Appendix 6A: Apply Inventory Cost Flow Methods to Perpetual Inventory Records
Illustration:
Assuming the
Perpetual
Inventory System, compute Cost of Goods Sold and Ending Inventory under
F
I
F
O
, L
I
F
O , and Average cost.
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First-In, First-Out (
F
I F
O)
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Last-in, First-Out (L
I F O)
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Average Cost
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L
O 5: Appendix 6B: Indicate the Effects of Inventory Errors on the Financial
Statements
Inventory ErrorsCommon 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.
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Income Statement Effects
(1 of 5)
Inventory errors affect the computation of cost of goods sold and net income.
Beginning Inventory + Cost of Goods Purchased − Ending Inventory =
Cost of Goods Sold
Inventory Error
Cost of Goods Sold
Net Income
Beginning inventory understated
Understated
Overstated
Beginning inventory overstated
Overstated
Understated
Ending inventory understated
Overstated
Understated
Ending inventory overstated
Understated
Overstated
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Income Statement Effects
(2 of 5)
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.
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Income Statement Effects
(3 of 5)
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Income Statement Effects
(4 of 5)
Review Question
Understating ending inventory will overstate:
a. assets.
b.
cost of goods sold.
c.
net income.
d.
owner’s
equity.
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Income Statement Effects
(5 of 5)
Review Question
Understating ending inventory will overstate:
a. assets.
b.
cost of goods sold.
c.
net income.
d.
owner’s
equity.
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Balance Sheet Effects
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:
Ending Inventory Error
Assets
Liabilities
Stockholders' Equity
Overstated
Overstated
No effect
Overstated
Understated
Understated
No effect
Understated
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A Look at I
F
R
S-L O-6: Compare the Accounting for Inventories Under G
A A
P and I
F
R
S
Key Points
Similarities
I
F
R
S and G A
A
P account for inventory acquisitions at historical cost and value inventory at the lower-of-cost-or-market subsequent to acquisition.
Who owns the goods—goods in transit or consigned goods—as well as the costs to include in inventory are essentially accounted for the same under I
F
R
S and G
A
A
P.
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A Look at I
F
R S
(1 of 7)
Key PointsDifferences
The requirements for accounting for and reporting inventories are more principles based under I
F
R
S. That is,
G
A
A
P provides more detailed guidelines in inventory accounting. A major difference between I
F R
S and
G
A
A
P
relates to the L
I
F
O cost flow assumption.
G
A
A
P
permits the use of L
I
F
O for inventory valuation. I
F
R
S prohibits its use. F
I
F
O and average-cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.
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A Look at I
F
R S
(2 of 7)
Key Points
Differences
In the lower-of-cost-or-market test for inventory valuation, I
F
R
S defines market as net realizable value.
G
A
A
P, on the other hand, defines market as replacement cost.
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A Look at I
F
R S
(3 of 7)
Looking to the FutureOne convergence issue that will be difficult to resolve relates to the use of the L
I
F
O cost flow assumption. As indicated, I
F
R
S specifically prohibits its use. Conversely, the L
I F
O cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that L I
F
O from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income.
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Copyright ©2017 John Wiley & Sons, Inc. Slide72
A Look at I
F
R S
(4 of 7)
I
F
R
S Practice
Which of the following should not be included in the inventory of a company using
I
F
R
S
?
Goods held on consignment from another company.
Goods shipped on consignment to another company.
Goods in transit from another company shipped F
O
B shipping point.
None of the above.
72
Copyright ©2017 John Wiley & Sons, Inc. Slide73
A Look at I
F
R S
(5 of 7)
I
F
R
S Practice
Which of the following should not be included in the inventory of a company using
I
F
R
S
?
Goods held on consignment from another company.Goods shipped on consignment to another company.
Goods in transit from another company shipped F
O
B shipping point.
None of the above.
73
Copyright ©2017 John Wiley & Sons, Inc. Slide74
A Look at I
F
R S
(6 of 7)
I
F
R
S Practice
Which method of inventory costing is prohibited under
I
F
R
S
?
Specific identification.
F
I
F
O
.
L
I
F
O.
Average-cost
74
Copyright ©2017 John Wiley & Sons, Inc. Slide75
A Look at I
F
R S
(7 of 7)
I
F
R
S Practice
Which method of inventory costing is prohibited under
I
F
R
S
?
Specific identification.F
I
F
O
.
L
I
F
O.
Average-cost
75
Copyright ©2017 John Wiley & Sons, Inc. Slide76
Copyright
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76
Copyright ©2017 John Wiley & Sons, Inc.