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Slide 6-1
InventoriesInventories
Financial Accounting,
Seventh Edition
Chapter 6
Slide 6-2
MerchandisMerchandise Inventory e Inventory affects . . . affects . . .
The matching The matching principle principle requires requires
matching cost matching cost of goods sold of goods sold
with sales with sales revenue.revenue.
BalancBalance e
SheetSheet
BalancBalance e
SheetSheet
Income Income StatemeStateme
ntnt
Income Income StatemeStateme
ntnt
Why is Inventory Cost Analysis Why is Inventory Cost Analysis Important?Important?Why is Inventory Cost Analysis Why is Inventory Cost Analysis Important?Important?
Slide 6-3
1.1. Gross profit – operating expenses = Gross profit – operating expenses = operating incomeoperating income
2.2. Sales – cost of goods sold – operating Sales – cost of goods sold – operating expenses = operating incomeexpenses = operating income
3.3. Net income + operating expenses = Net income + operating expenses = Gross ProfitGross Profit
4.4. Operating expenses – cost of goods Operating expenses – cost of goods sold = gross profitsold = gross profit
Knowledge Check Question:Knowledge Check Question:
Which of the following expressions is Which of the following expressions is incorrect incorrect ??
Slide 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.
Slide 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
Slide 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 Inventory
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
Slide 6-7 FOB Destination Point
Public Carrier
Seller Buyer
Public Carrier
Seller Buyer
FOB Shipping Point
Ownership passes to the buyer here.
5-7
Determining Ownership of Goods in Determining Ownership of Goods in TransitTransitDetermining Ownership of Goods in Determining Ownership of Goods in TransitTransitGoods 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.
Slide 6-8
1.1. Merchandise in transit sold to Merchandise in transit sold to customers, FOB shipping pointcustomers, FOB shipping point
2.2. Merchandise in transit sold to Merchandise in transit sold to customers, FOB destinationcustomers, FOB destination
3.3. The cost of all inventory The cost of all inventory purchased during the periodpurchased during the period
4.4. Merchandise purchased in transit Merchandise purchased in transit with terms FOB destinationwith terms FOB destination
Knowledge Check Question:Knowledge Check Question:
Ending Inventory is equal to Ending Inventory is equal to inventory on hand plus:inventory on hand plus:
Slide 6-9
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 Goods
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
Slide 6-10
Wally Mart buys and sells toasters and had the following Wally Mart buys and sells toasters and had the following transactions for 2012:transactions for 2012: June 1 Purchased 10 toasters at $6 per unit.June 1 Purchased 10 toasters at $6 per unit. July 1 Purchased 10 toasters at $9 per unit.July 1 Purchased 10 toasters at $9 per unit. Oct 1 Sold 10 toasters at $11 per unitOct 1 Sold 10 toasters at $11 per unit
What was Wally Mart’s Gross Profit in 2012?
Effect of Inventory Cost Flow Effect of Inventory Cost Flow AssumptionAssumptionEffect of Inventory Cost Flow Effect of Inventory Cost Flow AssumptionAssumption
Slide 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
Cost Flow Assumptio
ns
Slide 6-12
Illustration for Bikers’ Bikes CompanyIllustration for Bikers’ Bikes CompanyIllustration for Bikers’ Bikes CompanyIllustration for Bikers’ Bikes Company
Slide 6-13
+
+
Cost of Beginninginventory
Cost of Beginninginventory
Net cost ofpurchasesNet cost ofpurchases
Cost of goodsavailable for sale Cost of goodsavailable for sale
Cost of Ending inventory
Cost of Ending inventory
Cost of goodssold
Cost of goodssold
==
Cost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompanyCost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompany
Slide 6-14
When units When units are sold, the are sold, the specific costspecific cost
of the unit of the unit sold is added sold is added
to to cost of cost of goods soldgoods sold..
When units When units are sold, the are sold, the specific costspecific cost
of the unit of the unit sold is added sold is added
to to cost of cost of goods soldgoods sold..
Specific Identification MethodSpecific Identification MethodSpecific Identification MethodSpecific Identification Method
Slide 6-15
The company keeps track of its inventory using the Specific Identification Method.
The sales were made as follows:
August 14: 8 bikes costing $91
12 bikes costing $106
August 31: 2 bikes costing $91
3 bikes costing $106
15 bikes costing $115
3 bikes costing $119
The company keeps track of its inventory using the Specific Identification Method.
The sales were made as follows:
August 14: 8 bikes costing $91
12 bikes costing $106
August 31: 2 bikes costing $91
3 bikes costing $106
15 bikes costing $115
3 bikes costing $119
Specific Identification MethodSpecific Identification MethodSpecific Identification MethodSpecific Identification Method
Slide 6-16
+
+
Cost of Beginninginventory
Cost of Beginninginventory
Net cost ofpurchasesNet cost ofpurchases
Cost of goodsavailable for sale Cost of goodsavailable for sale
Cost of Ending inventory
Cost of Ending inventory
Cost of goodssold
Cost of goodssold
==
Cost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompanyCost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompany
Slide 6-17
Cost of Goods Sold
Cost of Goods Sold
Ending InventoryEnding
Inventory
Oldest Costs
Oldest Costs
Recent Costs
Recent Costs
FIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHOD
Slide 6-18
FIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHODFIRST IN FIRST OUT METHOD
Slide 6-19
+
+
Cost of Beginninginventory
Cost of Beginninginventory
Net cost ofpurchasesNet cost ofpurchases
Cost of goodsavailable for sale Cost of goodsavailable for sale
Cost of Ending inventory
Cost of Ending inventory
Cost of goodssold
Cost of goodssold
==
Cost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompanyCost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompany
Slide 6-20
Cost of Goods Sold
Cost of Goods Sold
Ending InventoryEnding
Inventory
Recent Costs
Recent Costs
Oldest Costs
Oldest Costs
LAST IN FIRST OUT METHODLAST IN FIRST OUT METHODLAST IN FIRST OUT METHODLAST IN FIRST OUT METHOD
Slide 6-21
LAST IN FIRST OUT METHODLAST IN FIRST OUT METHODLAST IN FIRST OUT METHODLAST IN FIRST OUT METHOD
Slide 6-22
+
+
Cost of Beginninginventory
Cost of Beginninginventory
Net cost ofpurchasesNet cost ofpurchases
Cost of goodsavailable for sale Cost of goodsavailable for sale
Cost of Ending inventory
Cost of Ending inventory
Cost of goodssold
Cost of goodssold
==
Cost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompanyCost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompany
Slide 6-23
AVERAGE COST METHODAVERAGE COST METHODAVERAGE COST METHODAVERAGE COST METHOD
Slide 6-24
+
+
Cost of Beginninginventory
Cost of Beginninginventory
Net cost ofpurchasesNet cost ofpurchases
Cost of goodsavailable for sale Cost of goodsavailable for sale
Cost of Ending inventory
Cost of Ending inventory
Cost of goodssold
Cost of goodssold
==
Cost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompanyCost Flow for a Merchandising Cost Flow for a Merchandising CompanyCompany
Slide 6-25
FIFO LIFO AVERAGE COST
Sales Revenue $6,050 $6,050 $6,050
Cost of Goods Sold (4,570) (4,868) (4,683)
Gross Profit $1,480 $1,182 $1,367
Operating Expenses (1,000) (1,000) (1,000)
Income before Income Taxes $480 $182 $367
Income Tax Expense (40%) (192) (73) (147)
NET INCOME $288 $109 $220
Income Statement Effects of Inventory Cost Flow Income Statement Effects of Inventory Cost Flow AssumptionsAssumptions
Income Statement Effects of Inventory Cost Flow Income Statement Effects of Inventory Cost Flow AssumptionsAssumptions
Which method of accounting would the Which method of accounting would the company management choose?company management choose?
Which method of accounting would the Which method of accounting would the company management choose?company management choose?
Slide 6-26
Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptions
Use of cost flow methods in major U.S. companies
Cost Flow
Assumption
does not need to
equal
Physical Movement
of Goods
Slide 6-27
Inventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptionsInventory Costing – Cost Flow Inventory Costing – Cost Flow AssumptionsAssumptions
Tax Effects
Many companies have selected LIFO. Why?
The reason is that LIFO results in the lowest income
taxes (because of lower net income) during times
of rising prices.
If LIFO is used for tax If LIFO is used for tax purposes, the IRS requires it purposes, the IRS requires it
be used in financial be used in financial statements (LIFO conformity statements (LIFO conformity
rule).rule).
If LIFO is used for tax If LIFO is used for tax purposes, the IRS requires it purposes, the IRS requires it
be used in financial be used in financial statements (LIFO conformity statements (LIFO conformity
rule).rule).
Slide 6-28
Scenario 1: When Prices are increasingDec 31, 2007 Dec 31, 2006
Inventories valued at LIFO $ 1,150 million $ 1,219 million
Inventories adjusted to FIFO $ 5,018 million $ 3,492 million
Taxable Income using LIFO $1,371 million
Taxable Income using FIFO $2,966 million
Scenario 2: When Prices are decreasingDec 31, 2008 Dec 31, 2007
Inventories valued at LIFO $821 million $1,150 million
Inventories adjusted to FIFO $2,221 million $5,018 million
Taxable Income using LIFO $1,194 million
Taxable Income using FIFO ($1,274 million)
LIFO RESERVE EXAMPLE – SUNOCO
Slide 6-29
1.1. The flow of inventory costs should match the The flow of inventory costs should match the physical flow of the merchandise.physical flow of the merchandise.
2.2. Accounting standards require that merchandise Accounting standards require that merchandise costs be specifically traced to units left in costs be specifically traced to units left in inventory and to units that have been soldinventory and to units that have been sold
3.3. Accountants have developed methods which Accountants have developed methods which make assumptions concerning how costs should make assumptions concerning how costs should be assigned to inventory and cost of goods be assigned to inventory and cost of goods sold.sold.
4.4. Alternative inventory cost flow assumptions Alternative inventory cost flow assumptions have the same effect on the amount of net have the same effect on the amount of net income reported.income reported.
Knowledge Check:Knowledge Check:Which of the following Which of the following statements is true?statements is true?
Slide 6-30
1.1. lower ending inventory value than under lower ending inventory value than under FIFOFIFO
2.2. lower income tax expense than under FIFOlower income tax expense than under FIFO
3.3. lower cost of goods sold than under FIFOlower cost of goods sold than under FIFO
4.4. lower net income than under FIFOlower net income than under FIFO
Knowledge Check:Knowledge Check:When inventory prices are When inventory prices are falling, using the LIFO falling, using the LIFO costing method will costing method will generally result in a:generally result in a:
Slide 6-31
Knowledge Check:Knowledge Check:
The first-in, first-out (FIFO) method of The first-in, first-out (FIFO) method of inventory valuation is characterized by:inventory valuation is characterized by:
1.1. lower (compared to the last-in-first-out lower (compared to the last-in-first-out method) income taxes when prices are method) income taxes when prices are risingrising
2.2. lower (compared to the last-in-first-out lower (compared to the last-in-first-out method) income taxes when prices are method) income taxes when prices are decliningdeclining
3.3. no correlation between cost of goods sold no correlation between cost of goods sold and current cost.and current cost.
4.4. more (compared to the last-in-first-out more (compared to the last-in-first-out method) complex record keeping.method) complex record keeping.
Slide 6-32
Using Cost Flow Methods Consistently
Inventory CostingInventory CostingInventory CostingInventory Costing
Method should be used consistently, enhances comparability.
Although consistency is preferred, a company may change its inventory costing method.
Slide 6-33
Lower-of-Cost-or-Market
Inventory CostingInventory CostingInventory CostingInventory Costing
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.
Slide 6-34
A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:
Lower of Cost or Market Illustration:Lower of Cost or Market Illustration:Lower of Cost or Market Illustration:Lower of Cost or Market Illustration:
Adjusting entry to apply LCM: (similar to shrinkage):Adjusting entry to apply LCM: (similar to shrinkage):Adjusting entry to apply LCM: (similar to shrinkage):Adjusting entry to apply LCM: (similar to shrinkage):
Slide 6-35
Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors
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.
Slide 6-36
Income Statement Effect of Inventory Income Statement Effect of Inventory ErrorErrorIncome Statement Effect of Inventory Income Statement Effect of Inventory ErrorError
Inventory errors affect the computation of cost of goods sold and net income.
Slide 6-37
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 Effect of Inventory Income Statement Effect of Inventory ErrorErrorIncome Statement Effect of Inventory Income Statement Effect of Inventory ErrorError
Slide 6-38
Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors
I ncorrect 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$
2010 2011
($3,000)Net Income understated
$3,000Net Income overstated
Combined income for 2-year period is
correct.
Slide 6-39
Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Balance Sheet Effects
Slide 6-40
1.1. $98,000$98,000
2.2. $72,000$72,000
3.3. $95,000$95,000
4.4. $85,000$85,000
Knowledge Check Question:Knowledge Check Question:
In its 2012 income statement, Riley Company reported cost of goods sold of $85,000. Later, they determined that beginning inventory for 2012 was understated by $23,000, and the ending inventory for 2012 was understated by $10,000. What should be the corrected amount for cost of goods sold for 2012?
Slide 6-41
Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis
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).
Presentation
Slide 6-42
Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis
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.
Analysis Using Inventory Turnover
Slide 6-43
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 AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis
Days in inventory measures the average number of days inventory is held.
Days in Year (365)
Inventory Turnover
Days in Inventory
=
Slide 6-44
Illustration: In its Balance Sheet dated January 31, 2012, Wal-Mart reported a beginning inventory of $36,437 million, and ending inventory of $40,714 million, and cost of goods sold for the year ended January 31, 2012, of $335,127 million. Determine the inventory turnover for Wal-Mart for 2012.
Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis
Slide 6-45
Inventory Turnover Ratios – comparison within industryInventory Turnover Days in Inventory
KROGER 13.3 27
SAFEWAY 11.1 33
KOHL’S 3.9 93
MACY’S 3.1 116
SAKS 2.5 146
AMAZON, INC. 13.6 27
WALMART 8.7 42
TARGET 6.1 60
COSTCO 12.3 30
DELL, INC. 43.8 8
HEWLETT PACKARD 14.5 25
Slide 6-46
On hand, January 1: 10 units @$20 each
Purchases Sales
January 8: 25 units @ $23 each January 4: 8 units @$75 each
January 22: 50 units @$26 each January 15: 20 units @$75 each
January 28: 15 units @ $29 each January 26: 52 units @ $75 each
Calculate the company’s Cost of Goods Sold using FIFO for the month of January:
1.1. $1,930$1,9302.2. $1,945$1,9453.3. $1,966$1,9664.4. $2,080$2,080
Knowledge Check:Knowledge Check:
Slide 6-47
On hand, January 1: 10 units @$20 each
Purchases Sales
January 8: 25 units @ $23 each January 4: 8 units @$75 each
January 22: 50 units @$26 each January 15: 20 units @$75 each
January 28: 15 units @ $29 each January 26: 52 units @ $75 each
Calculate the company’s Ending Inventory on January 31 using LIFO:
1.1. $430$4302.2. $454$4543.3. $544$5444.4. $565$565
Knowledge Check:Knowledge Check:
Slide 6-48
On hand, January 1: 10 units @$20 each
Purchases Sales
January 8: 25 units @ $23 each January 4: 8 units @$75 each
January 22: 50 units @$26 each January 15: 20 units @$75 each
January 28: 15 units @ $29 each January 26: 52 units @ $75 each
Calculate the company’s Cost of Goods Sold using Weighted Average for the month of January (round to the nearest cent):
1.1. $1,946$1,9462.2. $1,966$1,9663.3. $1,972$1,9724.4. $2,008$2,008
Knowledge Check:Knowledge Check:
Slide 6-49
1.1. $450$4502.2. $825$8253.3. $1,275$1,2754.4. $1,150$1,150
Using the information below for a sporting goods store, calculate the amount of inventory adjustment using the Lower of Cost or market method applied to the inventory on an individual item basis:
Units Cost/unit Market value/unit
Football items Helmets 20 $30 $25
Cleats 10 $50 $20
Pads 30 $20 $25
Baseball items: Gloves 40 $10 $15
Jerseys 50 $40 $25
Knowledge Check:Knowledge Check:
Slide 6-50
END CHAPTER 6END CHAPTER 6