Reporting and Analyzing Inventory

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Reporting and Analyzing Inventory
ACCOUNTING 101

• Chapter 6

Professor Walsh Providence College
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Study Objectives

• Describe the the steps in determining inv
  quantities.
• Explain the basis of accounting for inventories
  apply the inv cost flow methods under a periodic
  inv 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 inv turnover ratio.
• Describe the LIFO reserve explain its
  importance for comparing results of different
  cos.
• Explain Periodic VS Perpetual and how LIFO, FIFO,
  and AVG is related

3
Describe the the steps in determining inventory
quantities

• Is the company a merchandiser or a manufacturer?

4
Inventory Quantities - Merchandiser

• Consists of many different items
• Owned by the company
• In a form ready for sale to customers
• One inventory classification merchandise
  inventory

5
Inventory Quantities - Manufacturer

• Classify inventory into three categories
• Finished goods
• Work in process
• Raw materials

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Finished Goods Inventory

• Manufactured items that are complete and ready
  for sale.

7
Work in Process

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

8
Raw Materials

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

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Determine Inventory Quantities

• All companies must determine inventory quantities
  by
• Taking a physical inventory Determining
  ownership of goods

10
Perpetual Vs Periodic Inv Systems

• Calculation of ENDING INV CGS
• PERIODIC
• calc ENDING INV CGS at end of period
• PERPETUAL
• Calc ENDING INV at EVERY purchase
• Calc ENDING INV CGS EVERY sale

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Physical Inventory - Perpetual

• Checks accuracy of inventory records
• Determines amount of inventory lost
• Waste
• Shoplifting
• Employee theft

12
Physical Inventory - Periodic

• Determines inv on hand
• Calculate CGS

13
Physical Inventory

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

14
Determine Ownership

• Do all the goods included in the count belong to
  the company?

• Does the company own any goods that were not
  included in the count?

15
Goods in Transit

• Goods are shipped on board trucks, trains, ships,
  and airplanes
• To arrive at an accurate count, ownership of
  goods in transit must be determined

• Goods in transit should be included in the inv of
  the co that has legal title to the goods

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Goods in Transit
FOB (free on board) shipping point Ownership
passes to buyer when public carrier accepts goods
from seller
17
Goods in Transit
FOB (free on board) destination Ownership
remains with seller until the goods reach the
buyer
18
Consigned Goods

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

19
Explain the basis of accounting for inventories
and apply the inventory cost flow methods under a
periodic inventory system.
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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 is complicated if units are purchased at
different prices!
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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
What is the cost of goods sold?
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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
1,450?
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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
1,500?
24
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
1,550?
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Specific Identification

• Specific identification is practical when a
  company can positively identify which particular
  units were sold and which are still in ending
  inventory
• Works best with limited variety of high-unit
  items
• Must have records of original cost of each
  individual inventory item

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Cost Flow vs. Physical Flow
There is no accounting requirement that the cost
flow assumption be consistent with the physical
movement of goods! What is meant by cost
flow? What is meant by physical flow?
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Three Cost Flow Assumptions

• When items are indistinguishable from one
  another, management may choose a cost flow method
  . . .
• FIFO - first-in, first-out
• LIFO - last-in, first out
• Average Cost

Lets use the Houston Electronics example
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Houston ElectronicsAstro Condensers
11/27
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Houston Electronics
11/27
Dec. 31 physical inventory shows 450 in ending
inv (on-hand) ? so how many were sold?
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Houston Electronics
11/27
Dec. 31 physical inventory shows 450 in ending
inventory, so how many were sold?
550 units
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FIFO Ending Inventory (then calc CGS) PERIODIC

• Assumes earliest goods purchased are the first
  sold (first costs go to Cost of Goods Sold)

• Ending inventory is based on the prices of the
  most recent purchases

• Under FIFO, take the unit cost of most recent
  purchase and work backward until all units have
  been costed

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FIFO Step 1 Ending Inventory 450 units PERIODIC
11/27
Start with most recent prices and work backward!
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FIFO Step 1 Ending Inventory Work Backward to
450 units PERIODIC
Date
Explanation
Units
Unit Cost
Total Cost
1/1
Beg. Inventory
100
10
1,000
4/15
Purchase
200
11
2,200
8/24
Purchase
300
12
3,600
11/27
Purchase
400
13
5,200
1,000
12,000
Sold from OLDEST layers what is left is from
new layers
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FIFO Step 1 Ending Inventory Work Backward to
450 units PERIODIC
Date
Explanation
Units
Unit Cost
Total Cost
1/1
Beg. Inventory
100
10
1,000
4/15
Purchase
200
11
2,200
8/24
Purchase
300
12
3,600
50 of
11/27
Purchase
400
13
5,200
1,000
12,000
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FIFO Step 1 Ending Inventory 450 units -
PERIODIC
Date
Explanation
Units
Unit Cost
Total Cost
11/27
Purchase
400
13
5,200
8/24
Purchase
50
12
600
450
5,800
Merch Inv Ending Bal
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FIFO Step 2 Cost of Goods Sold PERIODIC
11/27
Recall cost of goods available for sale! CGAS
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CGAS

• Remember
• Beg Inv Purch -Ending Inv CGAS

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FIFO Step 2 Cost of Goods SoldPERIODIC
Cost of goods available for sale
12,000
Less ending inventory
5,800
Cost of Goods Sold
6,200
Total Cost
11/27
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FIFO
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LIFO Ending InventoryPERIODIC

• Assumes first goods sold are the most recent
  purchases (last costs go to Cost of Goods Sold)

• Ending inventory is based on the prices of the
  earliest goods available for sale

• Under LIFO, take the unit cost of earliest
  purchase and work forward until all units have
  been costed

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LIFO Step 1 Ending Inventory 450 units PERIODIC
11/27
Start with earliest prices and work forward!
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LIFO Step 1 Ending Inventory 450 units PERIODIC
11/27
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LIFO Step 1 Ending Inventory 450 units PERIODIC
11/27
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LIFO Step 1 Ending Inventory 450 units PERIODIC
150 of
11/27
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LIFO Step 1 Ending Inventory 450 units PERIODIC
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LIFO Step 2 Cost of Goods PERIODIC
11/27
Recall cost of goods available for sale!
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LIFO Step 2 Cost of Goods SoldPERIODIC
Cost of goods available for sale
12,000
Less ending inventory
5,000
Cost of Goods Sold
7,000
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LIFO
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Average Cost Ending Inventory

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

• Assumes goods are similar in nature

• Calculate weighted average unit cost and apply to
  the units on hand (ending inventory quantity)

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Average Cost Ending Inventory
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Step 1 Average Cost Ending Inventory PERIODIC
450 units in ending inventoryX 12.00
weighted average unit cost5,400 Total Average
Cost Ending Inventory
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Average Cost Step 2 CGS PERIODIC
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Average Cost PERIODIC
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Explain the financial statement and tax effects
of each of the inventory cost flow assumptions
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Use of Cost Flow Methods Major U.S. Companies
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Factors Used in Selecting an Inventory Cost
Method

• Income statement effects
• Balance sheet effects
• Tax effects

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Income Statement Effects
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Income Statement Effects
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Income Statement Effects
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Income Statement Effects
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Income Statement Effects
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Income Statement Effects
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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.

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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

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Why Do Companies Use LIFO?

• During periods of rising prices
• Higher cost of goods sold
• Lower net income

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Income Statement Effects
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Lets Review
Which of the following should be included in the
physical inventory of XYZ Co.?
a. Goods in transit from a supplier shipped FOB
destination
b. Goods in transit to a buyer shipped FOB
shipping point
c. Goods on consignment from another company
d. Goods on consignment to another company
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Lets Review
Which of the following should be included in the
physical inventory of XYZ Co.?
a. Goods in transit from a supplier shipped FOB
destination
b. Goods in transit to a buyer shipped FOB
shipping point
c. Goods on consignment from another company
d. Goods on consignment to another company
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Lets Review
Which inventory cost flow method produces the
highest net income in a period of rising prices?
a. Average cost.
b. LIFO.
c. FIFO.
d. Specific identification.
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Lets Review
Which inventory cost flow method produces the
highest net income in a period of rising prices?
a. Average cost.
b. LIFO.
c. FIFO.
d. Specific identification.
71
Lets Review
Which inventory cost flow method produces the
lowest income taxes in a period of rising prices?
a. Average cost.
b. LIFO.
c. FIFO.
d. Specific identification.
72
Lets Review
Which inventory cost flow method produces the
lowest income taxes in a period of rising prices?
a. Average cost.
b. LIFO.
c. FIFO.
d. Specific identification.
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Lets Review
Using the above data, assume there are 9,000
units on hand at Dec. 31, what is the cost of
ending inventory under FIFO?
a. 99,000
c. 113,000
d. 100,000
b. 108,000
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Lets Review
Using the above data, assume there are 9,000
units on hand at Dec. 31, what is the cost of
ending inventory under FIFO?
a. 99,000
c. 113,000
d. 100,000
b. 108,000
75
Lets Review
Using the above data, assume there are 9,000
units on hand at Dec. 31, what is the cost of
ending inventory under LIFO?
a. 99,000
c. 113,000
d. 100,000
b. 108,000
76
Lets Review
Using the above data, assume there are 9,000
units on hand at Dec. 31, what is the cost of
ending inventory under LIFO?
a. 99,000
c. 113,000
d. 100,000
b. 108,000
77
Explain the lower of cost or market basis of
accounting for inventories.
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The Lower of Cost or Market Basis for Inventories

• When the value of inv is lower than its cost,
  the inv is written down to its market value by
  valuing the inv at the lower of cost or market
  (LCM) in the period in which the price decline
  occurs.

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Lower of Cost or Market (LCM)

• 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

80
Compute and interpret the inventory turnover
ratio.
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Inventory Turnover Ratio
Tells how many times inventory is turning over
during the year
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Days in Inventory
Indicates average age of the inventory
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Illustration 6-15 in Text
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How Much Inventory Do You Think a Co Should Have?

• Only enough for sales needs
• Excess inventory costs resulting from
• storage costs
• interest costs
• obsolescence - technology, taste

85
Describe the LIFO reserve and explain its
importance for comparing results of different co.
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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. (why are the
  chances of inv being INCREASED under FIFO usually
  greater than decreased???)
• This amount is referred to as the LIFO reserve.

87
LIFO Reserve

• Reporting the LIFO reserve enables analysts to
  make adjustments to compare co that use different
  cost flow methods.

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LIFO Reserve
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Appendix 6AApply the inventory cost flow methods
to perpetual inventory records. YES you DO
NEED to know this
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Perpetual Vs Periodic Inv Systems

• Calculation of ENDING INV CGS
• PERIODIC
• calc ENDING INV CGS at end of period
• PERPETUAL
• Calc ENDING INV at EVERY purchase
• Calc ENDING INV CGS EVERY sale

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Perpetual FIFO
New calculation prior to each sale
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Perpetual LIFO
New calculation prior to each sale
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Perpetual Average Cost
New calculation of weighted averageprior to each
sale
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Appendix 6BIndicate the effects of inventory
errors on the financial statements.
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Cost of Goods Sold Formula

• Beginning inventory
• Purchases
• - Ending inventory
• Cost of Good sold

CGAS
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Inventory ErrorsCurrent Income Statement Effects
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Inventory ErrorsImpact Two Years
Error in the ending inventory of the current
period will have a reverse effect on the net
income of the next accounting period!
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(No Transcript)
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Balance Sheet Effects