chapter 6-1. chapter 6-2 chapter 6 inventories accounting principles, eighth edition

Chapter 6-1

Chapter 6-2

CHAPTER CHAPTER 66

INVENTORIESINVENTORIES

Accounting Principles, Eighth Edition

Chapter 6-3

1. Describe the steps in determining inventory quantities.

2. Explain the accounting for inventories and apply the inventory cost flow methods.

3. Explain the financial effects of the inventory cost flow assumptions.

4. Explain the lower-of-cost-or-market basis of accounting for inventories.

5. Indicate the effects of inventory errors on the financial statements.

6. Compute and interpret the inventory turnover ratio.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter 6-4

Reporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing Inventory

Taking a Taking a physical physical inventoryinventory

Determining Determining ownership of ownership of goodsgoods

Classifying Classifying

InventoryInventory

Classifying Classifying

InventoryInventory

Determining Determining

Inventory Inventory

QuantitiesQuantities

Determining Determining

Inventory Inventory

QuantitiesQuantities

Inventory Inventory

CostingCosting

Inventory Inventory

CostingCostingInventory Inventory

ErrorsErrors

Inventory Inventory

ErrorsErrors

Statement Statement

Presentation Presentation

and Analysisand Analysis

Statement Statement

Presentation Presentation

and Analysisand Analysis

Finished Finished goodsgoods

Work in Work in processprocess

Raw materialsRaw materials

Specific Specific identificationidentification

Cost flow Cost flow assumptionsassumptions

Financial Financial statement statement and tax and tax effectseffects

Consistent Consistent useuse

Lower-of-Lower-of-cost-or-cost-or-marketmarket

Income Income statement statement effectseffects

Balance sheet Balance sheet effectseffects

PresentationPresentation

AnalysisAnalysis

Chapter 6-5

Classifying InventoryClassifying InventoryClassifying InventoryClassifying Inventory

One Classification:

Merchandise Inventory

Three Classifications:

Raw Materials

Work in Process

Finished Goods

Merchandising Company

Manufacturing Company

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

Chapter 6-6

Physical Inventory taken for two reasons:Perpetual System

1. Check accuracy of inventory records.

2. Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft).

Periodic System

1. Determine the inventory on hand

2. Determine the cost of goods sold for the period.

Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

LO 1 Describe the steps in determining inventory quantities.LO 1 Describe the steps in determining inventory quantities.

Chapter 6-7

Involves counting, weighing, or measuring each kind of inventory on hand.

Taken,

when the business is closed or when business is slow.

at end of the accounting period.

Taking a Physical InventoryTaking a Physical Inventory



Chapter 6-8

Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.

Determining Ownership of Determining Ownership of GoodsGoods



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.

Chapter 6-9



Illustration 6-1

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.

Terms of SaleTerms of Sale

Chapter 6-10

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 FOB destination.

d. terms of sale are FOB shipping point.

Review QuestionReview Question



Chapter 6-11

Consigned Goods

•In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods.

•These are called consigned goods.

Determining Ownership of Determining Ownership of GoodsGoods



Chapter 6-12

Unit costs can be applied to quantities on hand using the following costing methods:

Specific Identification

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Average-cost

Inventory CostingInventory CostingInventory CostingInventory Costing

LO 2 Explain the accounting for LO 2 Explain the accounting for inventories and apply the inventory inventories and apply the inventory cost flow methods.cost flow methods.

Cost Flow Assumptio

ns

Chapter 6-13

Young & Crazy Company makes the following purchases:

1. One item on 2/2/08 for $10



Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 28, 2008, assuming the company used the Specific Identification method to cost inventories and the item purchased on 2/15/08 is sold? Assume a tax rate of 30%.

Example



Chapter 6-14

Purchase on 2/15/08 for $15

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2008 Sales $ 90 Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 Taxes 13 Net Income $ 29

“Specific Identification”



Inventory Balance = $ 30



Chapter 6-15

An 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.

Specific Identification MethodSpecific Identification Method



Chapter 6-16


Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptions

Illustration 6-11Use of cost flow methods in major U.S. companies

Cost Flow

Assumption

does not need to

equal

Physical Movement

of Goods

Chapter 6-17

Young & Crazy Company makes the following purchases:




Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 2008, assuming the company used the FIFO, LIFO, and Average-cost flow assumptions? Assume a tax rate of 30%.

Example



Chapter 6-18

Earliest goods purchased are first to be sold.

Often parallels actual physical flow of merchandise.

Generally good business practice to sell oldest units first.

““First-In-First-Out (FIFO)”First-In-First-Out (FIFO)”



Chapter 6-19






For the Month of Feb. 2008 Sales $ 90 Cost of goods sold 10 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 4747 Taxes 14 14 Net Income $ 33 $ 33

“First-In-First-Out (FIFO)”



Chapter 6-20

Latest goods purchased are first to be sold.

Seldom coincides with actual physical flow of merchandise.

Exceptions include goods stored in piles, such as coal or hay.

““Last-In-First-Out (LIFO)”Last-In-First-Out (LIFO)”



Chapter 6-21






For the Month of Feb. 2008 Sales $ 90 Cost of goods sold 20 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 37 37 Taxes 11 11 Net Income $ 26$ 26

“Last-In-First-Out (LIFO)”



Chapter 6-22

Allocates cost of goods available for sale on the basis of weighted average unit cost incurred.

Assumes goods are similar in nature.

Applies weighted average unit cost to the units on hand to determine cost of the ending inventory.

““Average-Cost”Average-Cost”



Chapter 6-23






For the Month of Feb. 2008 Sales $ 90 Cost of goods sold 15 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 42 Taxes 13 13 Net Income $ 29$ 29

“Average Cost”



Chapter 6-24

FIFO

LO 3 Explain the financial effects of the inventory cost flow LO 3 Explain the financial effects of the inventory cost flow assumptions.assumptions.


Sales $90 $90 $90

Cost of goods sold 10 15 20

Gross profit 80 75 70

Admin. & selling expense 33 33 33

Income before taxes 47 42 37

Income tax expense 14 13 11

Net income $33 $29 $26

Inventory balance $35 $30 $25

LIFOAverage

Comparative Financial Statement SummaryComparative Financial Statement Summary

Chapter 6-25

In Period of Rising Prices,In Period of Rising Prices, FIFO Reports: FIFO Reports:

FIFO


Highest

Lowest

Sales $90 $90 $90








LIFOAverage


Chapter 6-26

In Period of Rising Prices,In Period of Rising Prices, LIFO Reports: LIFO Reports:

FIFO


Highest

Lowest

Sales $90 $90 $90








LIFOAverage


Chapter 6-27

The cost flow method that often parallels the actual physical flow of merchandise is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.




Chapter 6-28

In a period of inflation, the cost flow method that results in the lowest income taxes is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.




Chapter 6-29

Q6-12 Casey Company has been using the

FIFO cost flow method during a prolonged

period of rising prices. During the same

time period, Casey has been paying out all

of its net income as dividends. What

adverse effects may result from this

policy?

Discussion QuestionDiscussion Question

See notes page for discussion



Chapter 6-30

Using Cost Flow Methods Using Cost Flow Methods ConsistentlyConsistently


Method should be used consistently, enhances comparability.

Although consistency is preferred, a company may change its inventory costing method.

Illustration 6-14Disclosure of change in cost flow method


Chapter 6-31

Lower-of-Cost-or-MarketLower-of-Cost-or-Market


LO 4 Explain the lower-of-cost-or-LO 4 Explain the lower-of-cost-or-market basis of accounting for market basis of accounting for inventories.inventories.

When the value of inventory is lower than its 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.

Chapter 6-32

Lower-of-Cost-or-MarketLower-of-Cost-or-Market


LO 4 Explain the lower-of-cost-or-LO 4 Explain the lower-of-cost-or-market basis of accounting for market basis of accounting for inventories.inventories.

BE6-7 Alou Appliance Center accumulates the following cost and market data at December 31.

I nventory Cost Market Lower of

Categories Data Data Cost or Market

Cameras 12,000$ 12,100$

Camcorders 9,500 9,700

VCRs 14,000 12,800

Compute the lower-of-cost-or-market valuation for the company’s total inventory.

$ 12,000

9,000

12,800$ 33,800

Chapter 6-33

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

LO 5 Indicate the effects of inventory errors on the financial LO 5 Indicate the effects of inventory errors on the financial statements.statements.

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.

Chapter 6-34



Inventory errors affect the computation of cost of goods sold and net income.

Income Statement EffectsIncome Statement Effects

Illustration 6-17

Illustration 6-16

Chapter 6-35



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.

The ending inventory depends entirely on the accuracy of taking and costing the inventory.

Income Statement EffectsIncome Statement Effects

Chapter 6-36



Incorrect Correct Incorrect Correct

Sales 80,000$ 80,000$ 90,000$ 90,000$

Beginning inventory 20,000 20,000 12,000 15,000

Cost of goods purchased 40,000 40,000 68,000 68,000

Cost of goods available 60,000 60,000 80,000 83,000

Ending inventory 12,000 15,000 23,000 23,000

Cost of good sold 48,000 45,000 57,000 60,000

Gross profit 32,000 35,000 33,000 30,000

Operating expenses 10,000 10,000 20,000 20,000

Net income 22,000$ 25,000$ 13,000$ 10,000$

2008 2009

($3,000)Net Income understated

$3,000Net Income overstated

Combined income for 2-year period is

correct.

Illustration 6-18

Chapter 6-37

Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.




Chapter 6-38



Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.

Balance Sheet EffectsBalance Sheet Effects

Illustration 6-16

Illustration 6-19

Chapter 6-39

Statement Presentation and Statement Presentation and AnalysisAnalysisStatement Presentation and Statement Presentation and AnalysisAnalysis

Balance Sheet - Inventory classified as current asset.

Income Statement - Cost of goods sold subtracted from sales.

There also should be disclosure of

1) major inventory classifications,

2) basis of accounting (cost or LCM), and

3) costing method (FIFO, LIFO, or average).

PresentationPresentation


Chapter 6-40


Inventory management is a double-edged sword

1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage).

2. Low Inventory Levels – may lead to stockouts and lost sales.

AnalysisAnalysis

LO 6 Compute and interpret the inventory turnover ratio.LO 6 Compute and interpret the inventory turnover ratio.

Chapter 6-41

Inventory turnover measures the number of times on average the inventory is sold during the period.

Cost of Goods Sold

Average Inventory

Inventory Turnover

=


Days in inventory measures the average number of days inventory is held.

Days in Year (365)

Inventory Turnover

Days in Inventory

=


Chapter 6-42

BE6-9 At December 31, 2008, the following information was available for J. Graff Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000. Calculate inventory turnover and days in inventory for J. Graff Company.



$270,000

($60,000 + 40,000) / 2

5.4 =

Inventory

Turnover 365

5.4 67.59 days

=

Days in Inventor

y

Chapter 6-43

Inventory Cost Flow Methods in Perpetual Inventory Systems

Illustration 6A-1

The following data from Houston Electronics will be used to illustrate inventory costing under a perpetual

system.

LO 7 Apply the inventory cost flow methods to perpetual inventory records.

Chapter 6-44


Cost of goods sold

Ending inventory

Computation of cost of goods sold and ending inventory under FIFO for Houston Electronics.


Illustration 6A-2

Chapter 6-45


Ending inventory

Computation of cost of goods sold and ending inventory under LIFO for Houston Electronics.


Illustration 6A-3

Cost of goods sold

Chapter 6-46


Computation of cost of goods sold and ending inventory under moving average for Houston Electronics.


Illustration 6A-4

Cost of goods sold Ending inventory

Chapter 6-47

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chapter 6-1. chapter 6-2 chapter 6 inventories accounting principles, eighth edition

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