chapter 6-1 chapter 6 inventories financial accounting, sixth edition

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Chapter 6-1 CHAPTER CHAPTER 6 6 Inventories Financial Accounting, Sixth Edition

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Page 1: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-1

CHAPTER CHAPTER 66

InventoriesInventories

Financial Accounting, Sixth Edition

Page 2: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-2

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

Page 3: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-3

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

Merchandising Merchandising inventoryinventory

Manufacturing Manufacturing inventoryinventory

Specific identificationSpecific identification

Cost flow Cost flow assumptionsassumptions

Financial statement Financial statement and tax effectsand tax effects

Consistent useConsistent use

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

Income Income statement statement effectseffects

Balance sheet Balance sheet effectseffects

PresentationPresentation

AnalysisAnalysis

Page 4: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-4

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.

Page 5: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-5

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

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

Page 6: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-6

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

Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

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

Page 7: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-7

Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.

Determining Ownership of Determining Ownership of GoodsGoods

Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

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

Page 8: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-8

Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

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

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

Page 9: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-9

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

Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

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

Page 10: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-10

Consigned Goods

Goods held for sale by one party although ownership of the goods is retained by another party.

Determining Ownership of Determining Ownership of GoodsGoods

Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities

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

Page 11: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-11

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

SO 2 Explain the accounting for SO 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

Page 12: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-12

Young & Crazy Company makes the following purchases:

1. One item on 2/2/07 for $10

2. One item on 2/15/07 for $15

3. One item on 2/25/07 for $20

Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the Specific Identification method to cost inventories? Assume a tax rate of 30%.

Example

Inventory CostingInventory CostingInventory CostingInventory Costing

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

Page 13: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-13

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40

“Specific Identification”

Depends which one is Depends which one is soldsold

Inventory CostingInventory CostingInventory CostingInventory Costing

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

Page 14: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-14

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

Inventory CostingInventory CostingInventory CostingInventory Costing

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

Page 15: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-15

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

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

Page 16: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-16

Young & Crazy Company makes the following purchases:

1. One item on 2/2/07 for $10

2. One item on 2/15/07 for $15

3. One item on 2/25/07 for $20

Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO, LIFO, and Average cost flow assumptions? Assume a tax rate of 30%.

Example

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

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

Page 17: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-17

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)”

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

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

Page 18: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-18

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40

“First-In-First-Out (FIFO)”

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

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

Page 19: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-19

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Inventory Balance = $ 35

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 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)”

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

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

Page 20: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

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)”

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

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

Page 21: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-21

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40

“Last-In-First-Out (LIFO)”

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

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

Page 22: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-22

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Inventory Balance = $ 25

Purchase on 2/25/07 for $20

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 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)”

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

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

Page 23: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-23

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”

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

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

Page 24: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-24

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40

“Average Cost”

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

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

Page 25: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-25

Purchase on 2/2/07 for $10

Purchase on 2/15/07 for $15

Purchase on 2/25/07 for $20

Inventory Balance = $ 30

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 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 12 12 Net Income $ 30$ 30

“Average Cost”

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

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

Page 26: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-26

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.

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

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 12 11

Net income $33 $30 $26

Inventory balance $35 $30 $25

LIFOAverage

Comparative Financial Statement SummaryComparative Financial Statement Summary

Page 27: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-27

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

FIFO

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

Highest

Lowest

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 12 11

Net income $33 $30 $26

Inventory balance $35 $30 $25

LIFOAverage

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

Page 28: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-28

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

FIFO

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

Highest

Lowest

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 12 11

Net income $33 $30 $26

Inventory balance $35 $30 $25

LIFOAverage

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

Page 29: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-29

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.

Review QuestionReview Question

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

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

Page 30: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-30

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.

Review QuestionReview Question

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

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

Page 31: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-31

Using Cost Flow Methods Using Cost Flow Methods ConsistentlyConsistently

Inventory CostingInventory CostingInventory CostingInventory Costing

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

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

Page 32: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-32

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

Inventory CostingInventory CostingInventory CostingInventory Costing

SO 4 Explain the lower-of-cost-or-SO 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.

Page 33: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-33

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

Inventory CostingInventory CostingInventory CostingInventory Costing

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

Exercise: 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 9,000 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

Page 34: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-34

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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

Page 35: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-35

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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

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

Income Statement EffectsIncome Statement Effects

Illustration 6-17

Illustration 6-16

Page 36: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-36

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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

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

Page 37: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-37

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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

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

Page 38: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-38

Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.

Review QuestionReview Question

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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

Page 39: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-39

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

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

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

Page 40: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-40

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

Page 41: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-41

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

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

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

Page 42: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-42

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

Cost of Goods Sold

Average Inventory

Inventory Turnover

=

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

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

Days in Year (365)

Inventory Turnover

Days in Inventory

=

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

Page 43: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-43

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.

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

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

$270,000

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

5.4 =

Inventory

Turnover 365

5.4 67.59 days

=

Days in Inventor

y

Page 44: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-44

Inventory theft is a HUGE problem.

Companies use sophisticated technologies tomonitor their customers and employees

Examples:

Closed-circuit cameras

Radio frequency identification (RFID).

Taking frequent inventory counts

Employees keep belongings in a separate room

Surprise checks of employees’ bags as they leave.

All About YouAll About YouAll About YouAll About You

Employee Theft—An Inside JobEmployee Theft—An Inside Job

Page 45: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-45

Some Facts:

Theft costs U.S. restaurants $15 billion to $25 billion annually.

The average supermarket has inventory shrinkage losses of 2.28% of sales, or $224,808 per year.

Tips from customers are the No. 1 way that many stores catch thieving employees.

The average employee caught stealing costs his or her company $1,341, while the average loss from a shoplifting incident is only $207.

All About YouAll About YouAll About YouAll About You

Employee Theft—An Inside JobEmployee Theft—An Inside Job

Page 46: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-46

All About YouAll About YouAll About YouAll About You

Source: Data from 2003 National Retail Security Survey, University of Florida.

Page 47: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-47

What Do You Think?What Do You Think?

Suppose you own a number of wine shops. Assuming that it would be cost-effective, would you install video cameras to reduce both employee and customer theft?

All About YouAll About YouAll About YouAll About You

YES: Management has a responsibility to employreasonable, cost-effective approaches to safeguard company assets.

NO: The use of video technology to monitor employees and customers sends a message of distrust. Cameras might also reduce the welcoming atmosphere for your customers, who might find the cameras offensive.

Page 48: Chapter 6-1 CHAPTER 6 Inventories Financial Accounting, Sixth Edition

Chapter 6-48

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