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Financial

Accounting -Kimmel, 7th Chapter 6 1

Chapter 6 - Study

ObjectivesAfter studying this chapter, you should be able to:1. etermine ho! to classify in"entory and in"entory

#uantities.$. %&plain the basis of accounting for in"entories and

apply the in"entory cost 'o! methods under aperiodic in"entory system.

(. %&plain the )nancial statement and ta& e*ects of eachof the in"entory cost 'o! assumptions.

+. %&plain the lo!er-of-cost-or-maret basis of accountingfor in"entories.

. Compute and interpret the in"entory turno"er ratio.6. escribe the /F0 reser"e and e&plain its importance

for comparing results of di*erent companies.

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One Classification:

Merchandise

Inventory

Three Classifications:

Raw Materials

Work in Process

Finished Goods

Merchandising

Comany

Man!fact!ring

Comany

"elf!l "int Regardless of theclassification# comanies reort

all inventories !nder C!rrent

$ssets on the %alance sheet&

Classifying Inventory

Financial

Accounting -Kimmel, 7th $Chapter 6

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Financial

Accounting -Kimmel, 7th Chapter 6 (

Determining Inventory

Quantities/n a periodic system, no attempt is

made on date of sale to record

the cost of merchandise sold. Aphysical count of in"entory istaen at end of period to

determine: Cost of merchandise on hand Cost of goods sold.

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+

Inventory CostingFor the year-end F23, you must determine ho! much of your total

in"entory cost should be assigned to Cost of 4oods 3old5%&pense and ho! much should remain in /n"entory 5Asset.ote the follo!ing:

C43 8 %nding /n"entory 9 otal Cost of /n"entory A"ailable for3ale

Potential Problem etermining the cost per unit of thein"entory you sold 5or ha"e left is a ma;or problem if youbought identical in"entory units at di*erent cost prices. Fore&ample, if you buy ( lamps for the follo!ing costs:

amp

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Financial

Accounting -Kimmel, 7th Chapter 6

rocess se oDetermine C"S and

#nding Inventory Determine the !$I%S remaining &or sold'( @nder both in"entory systems 5perpetual and periodic, a

physical count must be taen. /n a perpetual system, aphysical in"entory is taen to ad;ust in"entory records for

shrinage losses. /n a periodic system, a physical in"entory isthe basis for determining the cost of ending in"entory and costof goods sold.

Potential Problem he e*ect of goods in transit at the endof the period.

)ey Point - the company that o!ns goods during transit

should add them to the physical in"entory they counted. odetermine !ho o!ns the goods in transit, remember thefollo!ing shipping terms: *O+ Shipping Point - title of goods passes at shipping point

buyer o!ns during transit. *O+ Destination Point - title of goods passes at destination

point seller o!ns during transit.

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6

#6-, p( .,6Columbia an and rust is gi"ing 4allup Company a loan. efore doing so, they

decide that further discussions !ith 4allupBs accountant may be desirable.0ne area of particular concern is the in"entory account, !hich has a year-endbalance of =$7,>>>. etermine the correct in"entory amount at ec (1based on the follo!ing information:

1. 4allup sold goods costing =,>>> to aDil Company F0 shipping point on ec$E. he goods are not e&pected to reach aDil until an1$. he goods !ere notincluded in the physical in"entory because they !ere not in the !arehouse.

$. he physical count of the in"entory did not include goods costing =G,>>> that!ere shipped to 4allup F0 destination on ec $7 and !ere still in transit atyear-end.

(. 4allup recei"ed goods costing =$,>>> on an $. he goods !ere shipped F0shipping point on ec $6 by ynch Co. he goods !ere not included in thephysical count.

+. 4allup sold goods costing =1,>>> to amey of Canada F0 destination on ec(>. he goods !ere recei"ed in Canada on an E. hey !ere not included in4allupHs physical in"entory.

. 4allup recei"ed goods costing =+$,>>> on an $ that !ere shipped F0destination on ec $G. he shipment !as a rush order that !as supposed to

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7

#6-, p( .,6etermine the correct in"entory amount at ecember (1.

%nding in"entory: physical count ............................................. =$7,>>>

1. o e*ectItitle passes to purchaser upon shipment

!hen terms are F0 shipping point..................................................... >

$. o e*ectItitle does not transfer to 4allup until

goods are recei"ed ............................................................................ >

(. Add to in"entory: itle passed to 4allup !hen

goods !ere shipped ................................................................... $,>>>

+. Add to in"entory: itle remains !ith 4allup untilpurchaser recei"es goods............................................................ 1,>>>

. he goods did not arri"e prior to year-end. he goods,

therefore, cannot be included in the in"entory............................ 5+$,>>>

Correct in"entory..................................................................... =(>G,>>>

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Farley Company had beginning in"entory of =1,>>> atJarch 1, $>>7. uring the month, the company madepurchases of =+>,>>>. he in"entory at the end of themonth is =17,(>>. hat is cost of goods sold for the month

of Jarch?

A. =(7,7>>

. =+>,>>>

C. =,>>>

. =7,(>>

Financial

Accounting -Kimmel, 7th Chapter 6 E

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Farley Company had beginning in"entory of =1,>>> atJarch 1, $>>7. uring the month, the company madepurchases of =+>,>>>. he in"entory at the end of themonth is =17,(>>. hat is cost of goods sold for the month

of Jarch?

A. =(7,7>>

. =+>,>>>

C. =,>>>

. =7,(>>

Financial

Accounting -Kimmel, 7th Chapter 6 G

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1>

Process !sed to Determine C"Sand #nding Inventory

&continued' Determine the cost amount to assign to each unit left

&or sold' - by selecting one of the follo!ing /n"entory CostFlo! Jethods:

Speci/c Identi/cation - the actual cost of the speci)c unitssold are transferred from in"entory to cost of goods sold.Lroperly matches costs to re"enues but can be cumbersome!hen in"entory consists of identical units.

0verage-Cost 1ethod - the a"erage cost of all units inin"entory are computed and assigned to ending in"entory andcost of goods sold. /t is the Mmiddle groundN taen and it doesnot properly re'ect current replacement in"entory costs.

*irst-In *irst-Out &*I*O' - the )rst units purchased are the)rst ones sold, and ending in"entory consists of its mostrecent purchases. uring periods of rising prices, in"entory is"alued at its most recent 5current replacement costs, but netincome could be o"erstated.

2ast-In *irst-Out &2I*O' - the most recent units purchasedare the )rst ones sold, and that the older units remain inending in"entory. Lroponents argue that sales re"enue iso*set by the current cost of the items sold. /n"entories canha"e Mla ersN of items urchased man eriods a o.

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/f the unit price of in"entory is increasing duringa period, a company using the /F0 in"entorymethod !ill sho! less gross pro)t for the period,

than if it had used the F/F0 in"entory method.

A. rue

. False

Financial

Accounting -Kimmel, 7th Chapter 6 11

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/f the unit price of in"entory is increasing duringa period, a company using the /F0 in"entorymethod !ill sho! less gross pro)t for the period,

than if it had used the F/F0 in"entory method.

A. rue

. False

FinancialAccounting -Kimmel, 7th Chapter 6 1$

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Ill!stration '()*

+se of cost flow methods in

ma,or +&-& comanies

Cost Flow Assumption

does not need to %e

consistent with the

hysical movement ofgoods

Inventory Costing

FinancialAccounting -Kimmel, 7th 1(Chapter 6

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1+

Inventory Cost *lo3

#4amplesCompute the cost of %nding /n"entory and C43 using

the data belo! assuming the Periodic InventorySystem(

@nits @nits otalLurchased 3old Cost Ler @nit

an 1 - eg /n"entory > =$.>> =1>>

an 1$ - Lurchase $>> =+.>> =E>>

an 1 - 3ale 1>

an 16 - Lurchase 1>> =.>> =>> an 1G - 3ale 1>

0verage Cost 5 =1,+>>2(> 9 =+.>> per unitAmount in %nding /n"entory 9 1G> units O =+.>> 9 =76>Cost of 4oods 3old 9 =1,+>> - =76> 9 =6+> or 16> units O =+.>>

9 =6+>

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1

Inventory Cost *lo3



@nits @nits otalLurchased 3old Cost Ler @nit

an 1 - eg /n"entory > =$.>> =1>>

an 1$ - Lurchase $>> =+.>> =E>>

an 1 - 3ale 1>


( *irst-In *irst-Out &*I*O'

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16

*irst-In *irst-Out

&*I*O'0mount in #nding Inventory

@nits A"ailable 9 (>

@nits 3old 9 16>

@nits eft 1G>1>> units O =.>> 9 =>>

G> units O =+.>> 9 =(6>

1G> units =E6>

Cost of "oods Sold=1,+>> P =E6> 9 =+> or > units O =$.>> 9 =1>>

11> units O =+.>> 9 =++> 16> units =+>

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17

Inventory Cost *lo3



@nits @nits Cost otalLurchased 3old Ler @nitCost

an 1 - eg /n"entory > =$.>> =1>>

an 1$ - Lurchase $>> =+.>> =E>>

an 1 - 3ale 1>


.( 2ast-In *irst-Out &2I*O'

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1E

2ast-In *irst-Out &2I*O'0mount in #nding Inventory

@nits A"ailable 9 (>

@nits 3old 9 16>

@nits eft 1G> > units O =$.>> 9 =1>>

1+> units O =+.>> 9 =6>

1G> units =66>

Cost of "oods Sold=1,+>> P =66> 9 =7+> or 1>> units O =.>> 9

=>> 6> units O =+.>> 9 =$+> 16> units =7+>

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FinancialAccounting -Kimmel, 7th Chapter 6 1G

#7ects of Inventory 1ethodChoice on *8S assuming In9ation

1. /f a company uses *I*O o!er C43 5oldest, lo!est costs go to /23 Qigher et /ncome %nding /n"entory is close to current

replacement cost.

$. /f a company uses 2I*O Qigher C43 5ne!est costs go to /23 o!er et /ncome %nding /n"entory is lo!er than current

replacement cost on the 23.$ote A"erage Cost and 3peci)c /denti)cation usually

produce numbers bet!een /F0 and F/F0.

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FinancialAccounting -Kimmel, 7th Chapter 6 $>

!nderstanding *8S using*I*O

he M#uality of earningsN is considered lo!er becausesome of the gross margin must be used to replacegoods sold at prices higher than is re'ected in the C43section. For e&ample, you buy t!o lamps for the

follo!ing costs:amp

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FinancialAccounting -Kimmel, 7th Chapter 6 $1

!nderstanding *8S using2I*O

he M#uality of earningsN is considered higher becauseC43 is near replacement cost and "ery little of the grossmargin !ill be needed to replace the sold in"entory atcurrent year-end prices. For e&ample, you buy t!o

lamps for the follo!ing costs:amp

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FinancialAccounting -Kimmel, 7th Chapter 6 $$

Points about 2I*O

uring periods of rising prices, /F0 is considered the mostMconser"ati"eN of the in"entory pricing methodsbecause it results in the lo!est "aluation in endingin"entory and income measurement. Qo!e"er,

companies using /F0 must disclose Mcurrentreplacement costN of the in"entory in the notes.,( 2I*O Conformity :ule - the /R3 re#uires you to use

/F0 on your F23 issued to the public if you use /F0 onyour ta& return.

ote: Sou are allo!ed to chose di*erent methods for

use on your F23 "ersus those you use on your ta&return.$. 4enerally, it is better to use /F0 e"en though your F23

sho! lo!er pro)ts. his is because the only economica*ect of the in"entory method you choose is the ta4out9o3. /F0 !ill reduce your ta&es, thus increasingyour cash 'o!s.

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/f the unit price of in"entory is increasing duringa period, a company using the /F0 in"entorymethod !ill sho! less gross pro)t for the period,than if it had used the F/F0 in"entory method.

A. rue

. False

FinancialAccounting -Kimmel, 7th Chapter 6 $(

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/f the unit price of in"entory is increasing duringa period, a company using the /F0 in"entorymethod !ill sho! less gross pro)t for the period,than if it had used the F/F0 in"entory method.

A. rue

. False

FinancialAccounting -Kimmel, 7th Chapter 6 $+

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/n periods of rising prices, the in"entory method!hich results in the in"entory "alue on thebalance sheet that is closest to current cost isthe

A. F/F0 method.

. /F0 method.

C. a"erage cost method.

. ta& method.

FinancialAccounting -Kimmel, 7th Chapter 6 $

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/n periods of rising prices, the in"entory method!hich results in the in"entory "alue on thebalance sheet that is closest to current cost isthe

A. F/F0 method.

. /F0 method.

C. a"erage cost method.

. ta& method.


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2o3er-of-Cost-or-1ar;et&2C1'

After your McostN of ending in"entory is established, youmust perform one more step - the o!er of Cost orJaret to get the in"entory number for the year-endingbalance sheet.

his analysis is done after an %nding /n"entory at Cost andCost of 4oods 3old ha"e been computed per thein"entory 'o! method used by the company.

Only the #nding Inventory number 5for the 23 isin"ol"ed in CJ. he Cost of 4oods 3old is computedby the in"entory 'o! method and is not a*ected byCJ.

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FinancialAccounting -Kimmel, 7th Chapter 6 $E

2o3er-of-Cost-or-1ar;et&2C1'

2C1 1ethod - at the end of the period you compare%nding /n"entory to Jaret TalueCost of %nding /n"entory

If Cost is 2o3er - ea"e your %nding /n"entory at Cost If 1ar;et

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Ill!stration: $ss!me that .en T!ckie T/ has the following lines

of merchandise with costs and market val!es as indicated&

Lower-of-Cost-or-Market

Ill!stration '()'

Inventory Costing

FinancialAccounting -Kimmel, 7th $GChapter 6

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FinancialAccounting -Kimmel, 7th Chapter 6 (>

0nalysis of Inventory

@sed to monitor the age and siDe of your in"entory andcomputed as follo!s:

Inventory %urnover 5 Cost of 4oods 3old5times A"erage /n"entory

!here a"erage 9 eg /n"entory 8 %nd. /n"entory $

Days in Inventory 5 (6 /n"entory urno"er

ene)ts of #uic in"entory turno"er: ess cash tied up in in"entory and the need for

in"entory )nancing ess chance of in"entory obsolescence or spoilageegati"e side - in"entory stocouts could lead to lost sales.

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Ill!stration: 0ata availa%le for Wal(Mart&

Ill!stration '()1

0nalysis of Inventory

(1

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A lo! number of days in in"entorymay indicate all of the follo!inge&cept:

A. 3ales opportunities may be lostbecause of in"entory shortages.

. here is less chance of ha"ing obsoletein"entory items.

C. he company has fe!er funds tied upin in"entory.

. Janagement has achie"ed the bestbalance bet!een too much and toolittle in"entory le"els.

($

FinancialAccounting -Kimmel, 7th Chapter 6

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A lo! number of days in in"entorymay indicate all of the follo!inge&cept:

A. 3ales opportunities may be lostbecause of in"entory shortages.

. here is less chance of ha"ing obsoletein"entory items.

C. he company has fe!er funds tied upin in"entory.

. Janagement has achie"ed the bestbalance bet!een too much and toolittle in"entory le"els.

((

FinancialAccounting -Kimmel, 7th Chapter 6

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FinancialAccounting -

Kimmel, 7th Chapter 6 (+

2I*O :eserve and:eporting :e=uirements

Accounting standards re#uire )rms using /F0 toreport the amount by !hich in"entory !ouldbe increased2decreased if the )rm had instead

been using F/F0. his amount is referred to as the 2I*O

reserve( Reporting the /F0 reser"e enablesanalysts to mae ad;ustments to comparecompanies that use di*erent cost 'o!

methods. o con"ert in"entory from /F0 to F/F0, the

/F0 reser"e is added to the /F0 in"entory.

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FinancialAccounting -

Kimmel, 7th Chapter 6 (

#6-,, p( .,>-.,?

Deere & Company is a global manufacturer and distributor ofagricultural, construction, and forestry e#uipment. /t reportedthe follo!ing information in its $>1+ annual report 5amounts inmillions:

@,A @,. /n"entories5/F0 = $,(G7 (,>+$

Current assets (>,E7

Current liabilities 1$,7(

/F0 reser"e 1,(67

Cost of goods sold 16,$

a Compute eereBs $>1+ in"entory turno"er ratio and days inin"entory.

b Compute eereBs Current Ratio using $>1+ data as presented,and then again after ad;usting for the /F0 reser"e.

c Comment on ho! ignoring the /F0 reser"e might a*ect your

e"aluation of eereBs li#uidity.

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(6

#6-,, p( .,>-.,?

a /n"entory urno"er 9 =16,$ 2 55=(,>+$ 8 =$,(G7 2 $

9 .GE times

ays in /n"entory 9 (6 2 .GE

9 61 days

b Current ratio as presented 9 =(>,E7 2 =1$,7(

9 $.+$:1

Current ratio after ad;usting for /F0 9 5=(>,E7 8 =1,(67 21$,7(

9 $.(:1

c eereBs li#uidity loos better after the ad;ustment.

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(7

0nother #4ample

he U Company had the follo!ing in"entory data for themonth of anuary $>1>. Compute C43 and %nding/n".

@nits @nits Cost otal

Lurchased 3old Ler @nit Cost

eginning /n"entory 1> =6.>> = 6>

an - Lurchase $> =1.>> =(>>

an 6 - 3ale

an 7 - Lurchase (> =17.> =$

an G - 3ale 1 otals 6> 6 =EE

0( Speci/c Identi/cation 1ethod - the in"entory countre"eals that the + units left !ere from the follo!ing - 1>from eg /n", 1 from the an purchase, and $G from the

an 7 purchase.

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(E

Speci/c Identi/cation1ethod

0mount in #nding Inventory

@nits A"ailable 9 6>

@nits 3old 9 6

@nits eft +1> units O =6.>> 9 =6>.>>

1 units O 1.>> 9 $$.>>

$G units O 17.> 9 >7.>

+ units =7G$.>

Cost of "oods Sold

=EE P =7G$.> 9 =G$.>

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+>

0verage Cost

0verage cost 9 =EE26> 9 =1+.72unit


+ units O =1+.7 9 =7G6.>

Cost of "oods Sold

=EE P =7G6.> 9 =EE.>

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+1

0nother #4ample



Lurchased 3old Ler @nit Cost

eginning /n"entory 1> =6.>> = 6>

an - Lurchase $> =1.>> =(>>

an 6 - 3ale

an 7 - Lurchase (> =17.> =$


C( *irst-In *irst-Out &*I*O'

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+$

*irst-In *irst-Out&*I*O'



@nits 3old 9 6

@nits eft +(> units O =17.> 9 =$.>>

$> units O 1.>> 9 (>>.>>

+ units O 6.>> 9 $+.>>

+ units =E+G.>>

Cost of "oods Sold

=EE P =E+G 9 =(6

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+(

0nother #4ample



Lurchased 3old Ler @nit Costeginning /n"entory 1> =6.>> = 6>

an - Lurchase $> =1.>> =(>>

an 6 - 3ale

an 7 - Lurchase (> =17.> =$


D( 2ast-In *irst-Out &2I*O'

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2ast-In *irst-Out &2I*O'



@nits 3old 9 6

@nits eft +1> units O = 6.>> 9 = 6>.>>

$> units O 1.>> 9 (>>.>>

$+ units O 17.> 9 +$>.>>

+ units =7E>.>>

Cost of "oods Sold

=EE P =7E> 9 =1>

a201 ch6 fall 2013 (1)

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