Kimmel 6
Financial Accounting:
Tools for Business Decision Making, 3rd Ed.
Kimmel, Weygandt, Kieso
Chapter 6
Chapter 6
Reporting and Analyzing
Inventory
After 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.
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Merchandise Inventory
Owned by the company
In form ready to sale to customers in ordinary course of business
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Manufacturing Inventory
Finished goods inventory
Work in process
Raw materials
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Finished Goods Inventory
Manufactured items that are complete and ready for sale.
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Work in Process
Manufactured inventory that has been placed into production but is not yet complete.
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Raw Materials
The basic goods that will be used in production, but have not been placed in production.
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Key difference between periodic and perpetual inventory… is the point at which the costs of goods sold is computed.
Companies that use perpetual inventory take a physical count to...
check the accuracy of their perpetual inventory records
to determine the amount of inventory lost due to:
wasted raw materials
shoplifting
employee theft
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Periodic Inventory
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 determine: to
Cost of merchandise on hand;
Cost of goods sold.
Questions Concerning
Ownership
Do all the goods included in the count belong to the company?
Does the company own any goods not included in the count?
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Inventory Involved in Many
Frauds
The Great Salad Oil Scandal
Leslie Faye
Craig Consumer Electronics
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Comparing Periodic and
Perpetual Inventory Systems
Inventory Purchased
Record Purchase of Inventory
Inventory Purchased
Item Sold
End of
Period
No Entry
Record Revenue and
Cost of Goods Sold
Item Sold
End of
Period
Periodic
Record Purchase of Inventory
Record Revenue Only
Compute Cost of Goods 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 Transit
These are goods on board a truck, train, ship, or plane at the end of the period.
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Goods in Transit
Who includes these in inventory?
Buyer?
Seller?
The
Company with Legal
Title
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Shipping Terms
FOB (free on board) shipping pointownership of goods passes to buyer when public carrier accepts the goods from the seller
FOB (free on board) destinationownership of goods remains with the seller until the goods reach the buyer
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Seller
Ownership passes to owner here
FOB Shipping Point
Public
Carrier
Co
Buyer
FOB Destination Point
Ownership passes to buyer here
Public
Carrier
Co
Seller Buyer
Take a Physical Inventory
Determine 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.
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Consigned Goods
Goods of others you hold that you don’t pay for until they sell…
The company does not take ownership.
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Specific Identification
Cost of goods sold = $700 + $800
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 Wrong with Specific
Identification?
COST BENEFIT -
EXPENSIVE TO SET-UP AND
MAINTAIN
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What Is a Cost Flow Assumption?
To presume the order in which goods are sold.
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What Makes Cost Flow
Assumptions Necessary?
Changing Prices
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Inventory Costing
Specific Identification method
Cost Flow Assumptions
FIFO- First-in, First-Outearliest goods purchased are the first to be sold
LIFO- Last-in,First-Outlatest goods purchased are the first to be sold
Average Cost Methodcosts are charged on the basis of weighted average unit cost
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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
Illustration 6-10 average cost method assumes that goods available for sale are similar in nature.
Factors Used in Selecting an
Inventory Cost Method
Income statement effects
Balance sheet effects
Tax 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 falls 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 understated
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Tax Effects
Why do companies use lifo?
Higher cost of goods sold
Lower net income
Lower Income Taxes
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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.
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The Lower of Cost or Market Basis of Accounting for Inventories
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.
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Lower of Cost or Market
(LCM)
departure from cost principle
follows conservatism concept
can be used only after one of the cost flow methods ( Specific Identification
FIFO, LIFO, or Average Cost)
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Market Is...
CURRENT REPLACEMENT
COST
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How Much Inventory
Should a Company Have?
Only enough for sales needs
Excess inventory costs:
storage costs
interest costs
obsolescence - technology, fashion
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Inventory
Turnover Ratio =
An indication of how quickly a company sells its goods.
Higher is better.
Inventory
Turnover Ratio =
Cost of Goods Sold
Average Inventory
Days in Inventory =
An indication of how quickly a company sells its goods.
Lower is better.
Days in Inventory =
365 days
Inventory Turnover Ratio
Lifo Reserve And Its Importance For
Comparing Results Of Different Companies
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.
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