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©2006 Prentice Hall, Inc.
REPORTING AND
ANALYZING INVENTORY
 Learning
objectives
 Inventory cost flow assumptions
 How inventory cost flow assumptions
affect financial statements
 Lower-of-cost-or-market rule
 Financial statement analysis
 Business risk, control, and ethics
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©2006 Prentice Hall, Inc.
Learning Objectives
(1 of 2)
 Explain
and apply the four cost flow
assumptions for valuing inventory
and cost of goods sold
 Explain the effects of the inventory
cost flow assumption on the financial
statements
 Explain the lower-of-cost-or-market
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rule for valuing inventory
©2006 Prentice Hall, Inc.
Learning Objectives
(2 of 2)
 Evaluate
a firm’s inventory
management using the inventory
turnover ratio.
 Recognize special risks and controls
associated with inventory.
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©2006 Prentice Hall, Inc.
Inventory Cost Flow
Assumptions (1 of 3)
 During
March, Jeremy’s Friendly
Market showed the following results:
Beginning
inventory of Big Q Beans was
400 cans at $0.75 per can
Purchased 1,000 cans of Big Q Beans for
$0.79 per can. Later that month, they
purchased 2,000 more cans of Big Q
Beans for $0.84 per can
It sells 2,400 cans of beans during March
©2006 Prentice Hall, Inc.
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Inventory Cost Flow
Assumptions (2 of 3)
 What
is the cost of the beans sold?
What
is the cost of the beans remaining in
merchandise inventory?
 Cost
flow assumptions allocate goods
available for sale (GAS) to cost of goods
sold and ending inventory (EI)
BI
+ Purch = GAS
GAS – EI + GoGS (GAS = EI + GoGS)
©2006 Prentice Hall, Inc.
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Inventory Cost Flow
Assumptions (3 of 3)
 Alternate
inventory cost flow
assumptions
Specific
identification
Weighted average
First-in, first-out (FIFO)
Last-in, last-out (LIFO)
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©2006 Prentice Hall, Inc.
Specific Identification
 Specific
identification does NOT make
any cost-flow assumptions
The
accounting system tracks the actual
cost of each item in merchandise
inventory and the actual cost of items
sold
 For
what types of goods would a
company use specific identification?
©2006 Prentice Hall, Inc.
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Weighted Average Cost
(1 of 2)
 Same
cost is assigned to all GAS for each
inventory item carried by the business.
 For what types of goods would a
company use weighted average?
 Average cost per unit in GAS:
Total cost of inventory item _
Total # of units of inventory item
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©2006 Prentice Hall, Inc.
Weighted Average Cost
(2 of 2)
 Cost
of goods sold
# of units sold x avg cost per unit
Ending
#
inventory
of units in EI x avg cost per unit
Calculate
GAS,
for Big Q Beans:
CoGS, and EI
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©2006 Prentice Hall, Inc.
FIFO
 Assumes
that FIRST items purchased
are first items sold
Oldest
costs are in CoGS
Most recent costs are in EI
Calculate
GAS,
for Big Q Beans:
CoGS, and EI
Are
your answers different than for
weighted average? Why or why not?
©2006 Prentice Hall, Inc.
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LIFO
(1 of 3)
 Assumes
that LAST items purchased
are first items sold
Most
recent costs are in CoGS
Oldest costs are in EI
Calculate
GAS,
for Big Q Beans:
CoGS, and EI
Are
your answers different than for
FIFO? Why or why not?
©2006 Prentice Hall, Inc.
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LIFO
(2 of 3)
 Use
of LIFO requires extra disclosures in
financial statement footnotes
 What effect would making an extra
purchase of inventory at the end of the
period have on CoGS under LIFO if:
Inventory
costs are rising? Falling?
How would the extra purchase affect
CoGS under FIFO?
©2006 Prentice Hall, Inc.
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LIFO
(3 of 3)
 What
would happen company using
LIFO kept an inventory reserve (never
sold all of its inventory)?
 If a company sells all of its inventory
each period (no BI), would CoGS
change under the different methods?
Why or why not?
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©2006 Prentice Hall, Inc.
Effect of Cost Flow Assumptions
on Financial Statements (1 of 3)
FIFO
LIFO
Sales
$ 3,000 $ 3,000
Cost of G. S.
1,930
1,996
Gross Margin
1,070
1,004
Oper. exp.
250
250
Pretax Inc.
820
754
Taxes (30%)
246
226
Net Income
$574
$528
Wt. Avg.
$ 3,000
1,955
1,045
250
795
239
$556
Assumes sales price $1.25/can & op exp $250
©2006 Prentice Hall, Inc.
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Effect of Cost Flow Assumptions
on Financial Statements (2 of 3)
FIFO
LIFO
Wt. Avg.
Inflows:
Sales collected $ 3,000 $ 3,000 $ 3,000
Outflows:
Purch paid for 2,470
2,470 2,470
Op. exp. paid
250
250
250
Taxes paid
246
226
239
Net cash flow
$ 34 $ 54 $
41
Assumes sales price $1.25/can & op exp $250
©2006 Prentice Hall, Inc.
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Effect of Cost Flow Assumptions
on Financial Statements (3 of 3)
 Effect
of reported inventory and CoGS
under different cost flow assumptions
 Income tax effects under LIFO and FIFO
 Choosing an inventory cost flow
method
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©2006 Prentice Hall, Inc.
Effect of Cost Flow Assumptions
on CoGS and EI
 Which
method produces the highest
net income in times of rising
inventory costs? Falling inventory
costs?
 Which method produces the highest
ending inventory under rising
inventory costs? Falling inventory
costs?
©2006 Prentice Hall, Inc.
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Income Tax Effects Under
LIFO and FIFO
 In
times of rising inventory costs,
which inventory method produces
the highest income tax expense?
Does
this affect which method produces
the highest net income?
How does this affect cash flow?
 How
do your answers change if
inventory costs are falling
©2006 Prentice Hall, Inc.
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Choosing an Inventory
Cost Flow Method (1 of 2)
 Factors
that may affect choice of
inventory cost flow assumption
Compatibility
with similar companies
Maximize tax savings and cash flows
Maximize net income
 If
LIFO is used for tax purposes, it
must also be used for financial
statement purposes
©2006 Prentice Hall, Inc.
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Choosing an Inventory
Cost Flow Method (2 of 2)
 How
does choice of cost flow method
affect the following ratios in times of
rising inventory costs? Falling costs?
Current
ratio
Quick ratio
Gross profit ratio
Profit margin ratio
Inventory turnover ratio
©2006 Prentice Hall, Inc.
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Lower-of-cost-or-market Rule
 Which
reporting constraint (see ch 2)
requires inventory to be stated at
lower of cost or market value?
Replacement cost is used to estimate
market value
 If market value is lower than cost
Reduce
the inventory account
Reduce net income
©2006 Prentice Hall, Inc.
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Financial Statement Analysis
(1 of 2)
 Inventory
turnover
Measures
how quickly a firm is selling
its inventory
Cost of goods sold
Average inventory
Average
 Average
365
©2006 Prentice Hall, Inc.
inventory = (BI + EI) / 2
days in inventory
(days in year) / Inventory turnover
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Financial Statement Analysis
(2 of 2)
 In
general, do companies want higher or
lower inventory turnover?
Compared
 What
to what?
happens if inventory turnover is
too high? Too low?
 Which industry would have higher
inventory turnover, a jeweler or grocer?
Who
©2006 Prentice Hall, Inc.
would have a higher profit margin?
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Business Risk, Control, and Ethics
(1 of 2)
 What
is inventory padding?
How
else can a company artificially
inflate its assets?
 Safeguarding
Physical
assets
controls
Includes
ensuring that products don’t spoil
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©2006 Prentice Hall, Inc.
Business Risk, Control, and Ethics
(2 of 2)
 RFID
tags
How
to they help control costs?
What inventory method do they
enable businesses to use that they could
not use previously?
 Controlling
inventory levels and
monitoring product developments to
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prevent inventory obsolescence
©2006 Prentice Hall, Inc.
Comments or questions about PowerPoint Slides?
Contact Dr. Richard Newmark at
University of Northern Colorado’s
Kenneth W. Monfort College of Business
richard.newmark@PhDuh.com
©2006 Prentice Hall, Inc.
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