financial accounting: tools for business decision making, 3rd ed. kimmel, weygandt, kieso els

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  • Financial Accounting:Tools for Business Decision Making, 3rd Ed.Kimmel, Weygandt, Kieso

  • Chapter 6

  • Chapter 6Reporting and Analyzing InventoryAfter studying Chapter 6, you should be able to: Describe the steps in determining inventory quantities.Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Explain the financial statement and tax effects of each of the inventory cost flow assumptions.Explain the lower of cost or market basis of accounting for inventories. Compute and interpret the inventory turnover ratio.Describe the LIFO reserve and explain its importance for comparing results of different companies.


  • Merchandise InventoryOwned by the companyIn form ready to sale to customers in ordinary course of business


  • Manufacturing InventoryFinished goods inventoryWork in processRaw materials


  • Finished Goods InventoryManufactured items that are complete and ready for sale.


  • Work in Process Manufactured inventory that has been placed into production but is not yet complete.


  • Raw MaterialsThe basic goods that will be used in production, but have not been placed in production.


  • Key difference between periodic and perpetual inventoryis the point at which the costs of goods sold is computed.

  • Companies that use perpetual inventory take a physical count to... 32check the accuracy of their perpetual inventory records to determine the amount of inventory lost due to:wasted raw materialsshopliftingemployee theft

  • No attempt is made on date of sale to record the cost of merchandise sold...A physical count of inventory is taken at end of period to determine: Cost of merchandise on hand;Cost of goods sold.Periodic Inventory

  • Questions Concerning OwnershipDo all the goods included in the count belong to the company?Does the company own any goods not included in the count? 34

  • Inventory Involved in Many Frauds The Great Salad Oil ScandalLeslie FayeCraig Consumer Electronics34

  • Record Revenue and Cost of Goods SoldCompute Cost of Goods SoldPerpetual PeriodicPerpetual Item Sold End of Period Comparing Periodic and Perpetual Inventory SystemsInventory PurchasedRecord Purchase of InventoryEnd of Period No EntryRecord Purchase of InventoryRecord Revenue Only Inventory PurchasedItem Sold

  • Businesses that use the periodic method generally do not have sophisticated computer systems required to compute cost of goods sold when sale is made.

  • Goods in TransitThese are goods on board a truck, train, ship, or plane at the end of the period.35

  • Goods in Transit36 Who includes these in inventory?Buyer?Seller? The Company with Legal Title

  • Shipping TermsFOB (free on board) shipping point- ownership of goods passes to buyer when public carrier accepts the goods from the sellerFOB (free on board) destination- ownership of goods remains with the seller until the goods reach the buyer38

  • Ownership passes to owner hereOwnership passes to buyer herePublicCarrierCoPublicCarrierCoSellerSellerBuyerBuyerFOB Shipping PointFOB Destination Point

  • Take a Physical InventoryDetermine inventory quantities by counting, weighting or measuring each type of inventory.Determine ownership of goods, including goods in transit, consigned goods.Quantity of each kind of inventory is listed on inventory summary sheets where unit costs are applied.33

  • Consigned GoodsGoods of others you hold that you dont pay for until they sell The company does not take ownership.39

  • Specific IdentificationAn actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of ending inventory.Cost of goods sold = $700 + $800

  • What Wrong with Specific Identification? 45COST BENEFIT - EXPENSIVE TO SET-UP ANDMAINTAIN

  • What Is a Cost Flow Assumption? To presume the order in which goods are sold.45

  • What Makes Cost Flow Assumptions Necessary?45

  • Inventory CostingSpecific Identification methodCost Flow AssumptionsFIFO- First-in, First-Out- earliest goods purchased are the first to be soldLIFO- Last-in,First-Out- latest goods purchased are the first to be soldAverage Cost Method- costs are charged on the basis of weighted average unit cost44

  • The FIFO method assumes the earliest goods purchased are the first to be sold.

  • The LIFO method assumes the latest goods purchased are the first to be sold.

  • The average cost method assumes that goods available for sale are the same. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred.

  • The average cost method assumes that goods available for sale are homogeneous.Illustration 6-10

  • 51Factors Used in Selecting an Inventory Cost MethodIncome statement effectsBalance sheet effectsTax effects

  • Income Statement EffectsIn periods of increasing pricesFIFO reports the highest net income LIFO the lowestaverage cost falls in the middle. In periods of decreasing prices FIFO will report the lowest net incomeLIFO the highestaverage cost falls in the middle.52

  • Balance Sheet EffectsIn a period of increasing prices costs allocated to ending inventory using: FIFO will approximate current costs LIFO will be understated53

  • Tax EffectsWhy do companies use lifo?


    Higher cost of goods soldLower net income

  • Consistency54Whatever cost flow method a company chooses, it must use it consistently ORDisclose the change and its effects on net income in the financial statement.

  • The Lower of Cost or Market Basis of Accounting for InventoriesWhen the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline occurs.55

  • Lower of Cost or Market (LCM)departure from cost principlefollows conservatism conceptcan be used only after one of the cost flow methods ( Specific Identification FIFO, LIFO, or Average Cost)56


  • How Much Inventory Should a Company Have?Only enough for sales needsExcess inventory costs:storage costsinterest costsobsolescence - technology, fashion 58

  • Inventory Turnover Ratio =An indication of how quickly a company sells its goods.

  • Inventory Turnover Ratio =Cost of Goods SoldAverage Inventory

  • Days in Inventory =An indication of how quickly a company sells its goods.

  • Days in Inventory =365 daysInventory Turnover Ratio

  • Lifo Reserve And Its Importance For Comparing Results Of Different CompaniesAccounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO. This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods.61

  • COPYRIGHT Copyright 2004, John Wiley & Sons, Inc. All rights reserved.Reproduction or translation of this work beyond that permitted inSection 117 of the 1976 United States Copyright Act without theexpress written permission of the copyright owner is unlawful.Request for further information should be addressed to thePermissions Department, John Wiley & Sons, Inc. The purchasermay make back-up copies for his/her own use only and not fordistribution or resale. The Publisher assumes no responsibilityfor errors, omissions, or damages, caused by the use of theseprograms or from the use of the information contained herein.


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