Chapter 6 REPORTING AND ANALYZING INVENTORY Inventory-Merchandiser vs. Manufacturing MERCHANDISER Consists of many different items Owned by the company In a form ready for sale to customers One inventory classification: Merchandise Inventory MANUFACTURING Three inventory classifications: Finished goods inventory Work in process Raw Materials Inventory - Manufacturing Finished goods inventory: manufactured 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 materials: The basic goods that will be used in production, but have not been placed in production Determine Inventory Quantities Two steps are involved: 1.) Take a physical inventory of goods on hand. This involves counting, weighting or measuring each type of inventory. 2.) Determine ownership of goods, including goods in transit, consigned goods. Goods in Transit - Goods on board a truck, train, ship, or plane at the end of the period Consigned Goods ? Goods of others you hold. You do not pay for the goods until they sell. The company does not take ownership of the goods. 11 1 Goods in Transit 36 Who includes these in inventory? Buyer? Seller? Answer: Company with legal title. Legal Title is determined my the Terms of the Sale ? FOB (free-on-board): FOB Shipping Title or FOB Destination Inventory Costing - Periodic Determine quantity of units of inventory Apply unit costs to the quantities Determine total cost of inventory Determine cost of goods sold Process can be complicated if units are purchased at different times and at different prices! 11 2 Inventory Costing Specific Identification method Cost Flow Assumptions FIFO- First-in, First-Out- earliest goods purchased are the first to be sold LIFO- Last-in,First-Out- latest goods purchased are the first to be sold Average Cost Method- costs are charged on the basis of weighted average unit cost Illustrative Data ? Crivitz TV Co. Purchases February 3 1 set $ 700 March 5 1 set $ 750 May 22 1 set $ 800 Sales June 1 2 sets $2,400 Specific Identification Method An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of ending inventory. What Is a Cost Flow Assumption? To presume the order in which goods are sold even if flow of costs is unrelated to the physical flow of goods. What Makes Cost Flow Assumptions Necessary? Changing Inventory Costs The FIFO method assumes the earliest goods purchased are the first to be sold. FIFO The LIFO method assumes the last goods purchased are the first to be sold. LIFO The average cost method allocates the cost of goods available for sale on the basis of weight-average unit cost incurred. Weighted Average Factors Used in Selecting an Inventory Cost Method Income statement effects Cost of Goods Available for Sale (COGAS) is the same Ending Inventory is different Cost of Goods Sold (COGS) is different Gross Profit is different Net Income is different Balance sheet effects Ending inventory will be affected Tax effects Income Statement Effects Income Statement Effects In periods of increasing prices FIFO reports the highest net income LIFO the lowest average cost falls in the middle. In periods of decreasing prices FIFO will report the lowest net income LIFO the highest average cost in the middle. Balance Sheet Effects In a period of increasing prices, costs allocated to ending inventory using: FIFO will approximate current costs LIFO will be significantly understated Why Do Companies Use LIFO? During periods of rising prices, Higher cost of goods sold Lower net income Lower Income Taxes Income Tax Effects Taxes are different Consistency Whatever cost flow method a company chooses, it must use it consistently? OR Disclose the change and its effects on net income in the financial statement. Lower of Cost or Market (LCM) When 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. 11 4 Under LCM, market is defined as current replacement cost ? NOT selling price Departure from cost principle, but follows conservatism concept LCM applied after costing with one of methods (FIFO, LIFO, average, specific) Apply to individual items or major categories or total inventory 1.) Inventory Turnover Ratio = Cost of Goods Sold Average Inventory*** An indication of how quickly a company sells its goods. Higher is better. 11 5 RELEVANT RATIOS 2.) Days in Inventory = 365 days Inventory Turnover Ratio Measures average number of days inventory is held. Lower is better. ***Average Inventory = (Beginning Inventory + Ending Inventory)/2 LIFO RESERVE Accounting 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. LIFO Inventory +/- LIFO Reserve = FIFO Inventory 11 6 Appendix 6B ? Inventory Errors Income Statement Effects Overstated Understated Overstate end. inv. Understated Overstated Understate end. inv. Understated Overstated Overstate beg. inv. Overstated Understated Understate beg. inv. Net Income Cost of Goods Sold Inventory Error Balance Sheet Effects Understated No effect Understated Understated Overstated No effect Overstated Overstated Stockholders Equity Liabilities Assets End Inventory Error Perpetual System - Inventory Cost Flow Methods All cost flow methods we used for the period inventory system can be used in a perpetual inventory system. Assume the following transactions? FIFO ? Perpetual Inventory System Remember, under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs. Therefore under FIFO, the cost of the earliest good on hand prior to each sale is charged to cost of goods sold. Ending inventory is $5,800 and COGS is $6,200 LIFO ? Perpetual Inventory System Cost of the most recent purchase price is allocated to the units sold Ending inventory is $5,700 and COGS is $6,300 Average Cost ? Perpetual Inventory System Under the average cost method, a new average must be calculated after each purchase (thus, moving average method) Ending inventory is $5,767 and COGS is $6,233 [(100x$10) + (200x$11) ]/300 = $10.667 [(300x$10.667) + (300x$12)]/600 = $11.333 [(50x$11.333) + (400x$13)]/450 = $12.816
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