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of
6

Classifying Inventory
One Classification:
 Inventory
Three Classifications:
 Raw Materials
 Work in Process
 Finished Goods
6-4
Regardless of the classification, companies report all inventories under
Current Assets on the balance sheet.

6-5

6-6
Determining Inventory Quantities
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.
SO 1 Describe the steps in determining inventory quantities.

6-7
Determining Inventory Quantities
Involves counting, weighing, or measuring each kind of inventory on hand.
Taken,
 when the business is closed or business is slow.
 at end of the accounting period.
SO 1 Describe the steps in determining inventory quantities.

6-8

Determining Inventory Quantities
 Purchased goods not yet received.
 Sold goods not yet delivered.
6-9
Goods 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 .
SO 1 Describe the steps in determining inventory quantities.

6-10
Determining Inventory Quantities
Illustration 6-1
Terms of sale
Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
Ownership of the goods remains with the seller until the goods reach the buyer.

6-11
Determining Inventory Quantities
Question
Goods in transit should be included in the inventory of the buyer when the: a. public carrier accepts the goods from the seller. b. goods reach the buyer. c. terms of sale are FOB destination. d. terms of sale are FOB shipping point.
SO 1 Describe the steps in determining inventory quantities.

6-12
Determining Inventory Quantities
 Goods held for sale by one party.
 Ownership of the goods is retained by another party.
SO 1 Describe the steps in determining inventory quantities.

6-13

6-14
Inventory Costing
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
Cost Flow
Assumptions
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

6-15
Inventory Costing
Illustration: Assume that Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of $700,
$750, and $800. During the year Crivitz sold two sets at $1,200 each. These facts are summarized below.
Illustration 6-2
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

6-16
Inventory Costing
If Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 + $800), and its ending inventory is $750.
Illustration 6-3
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

6-17
Inventory Costing
Actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory.
 Practice is relatively rare.
 Most companies make assumptions ( Cost Flow
Assumptions ) about which units were sold.
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
6-18
Illustration 6-11
Use of cost flow methods in major U.S. companies
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Illustration: Data for Houston Electronics’ Astro condensers.
Illustration 6-4
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
6-19
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

6-20
Inventory Costing
 Earliest goods purchased are first to be sold.
 Often parallels actual physical flow of merchandise.
 Generally good business practice to sell oldest units first .
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

6-21
Inventory Costing
Illustration 6-5
SO 2

Inventory Costing
Illustration 6-5
6-22
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

6-23
Inventory Costing
 Latest goods purchased are first to be sold.
 Seldom coincides with actual physical flow of merchandise.
 Includes goods stored in piles , such as coal or hay.
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

6-24
Inventory Costing
Illustration 6-7
SO 2

Inventory Costing
Illustration 6-7
6-25
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

6-26
Inventory Costing
 Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred.
 Assumes goods are similar in nature.
 Applies weighted-average unit cost to the units on hand to determine cost of the ending inventory.
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Illustration 6-10
6-27
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Illustration 6-10
6-28
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Illustration 6-12
6-29 SO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing
Question
The cost flow method that often parallels the actual physical flow of merchandise is the: a. FIFO method. b. LIFO method. c. average cost method. d. gross profit method.
6-30 SO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing
Question
In a period of inflation, the cost flow method that results in the lowest income taxes is the: a. FIFO method. b. LIFO method. c. average cost method. d. gross profit method.
6-31 SO 3 Explain the financial effects of the inventory cost flow assumptions.

6-32

Inventory Costing
 Method should be used consistently, enhances comparability.
 Although consistency is preferred, a company may change its inventory costing method.
Illustration 6-14
Disclosure of change in cost flow method
6-33 SO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory 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 .
6-34 SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Costing
Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.
Illustration 6-15
6-35 SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory 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.
6-36 SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing
Inventory errors affect the computation of cost of goods sold and net income.
Illustration 6-16
Illustration 6-17
6-37 SO 5 Indicate the effects of inventory errors on the financial statements.

6-38
Inventory Costing
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 .
 Ending inventory depends entirely on the accuracy of taking and costing the inventory.
SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing
Illustration 6-18
Sales
Beginning inventory
Cost of goods purchased
Cost of goods available
Ending inventory
Cost of good sold
Gross profit
Operating expenses
Net income
Incorrect
2011
Correct
$ 80,000
20,000
40,000
60,000
12,000
48,000
32,000
10,000
$ 22,000
$ 80,000
20,000
40,000
60,000
15,000
45,000
35,000
10,000
$ 25,000
Incorrect
2012
Correct
$ 90,000
12,000
68,000
80,000
23,000
57,000
33,000
20,000
$ 13,000
$ 90,000
15,000
68,000
83,000
23,000
60,000
30,000
20,000
$ 10,000
6-39
Combined income for
2-year period is correct.
($3,000)
Net Income understated
$3,000
Net Income overstated
SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing
Question
Understating ending inventory will overstate: a. assets. b. cost of goods sold. c. net income. d. owner's equity.
6-40 SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Illustration 6-16
Illustration 6-19
6-41 SO 5 Indicate the effects of inventory errors on the financial statements.

6-42
Statement 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).

6-43
Statement 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.
SO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis
Inventory turnover measures the number of times on average the inventory is sold during the period.
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
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Days in inventory measures the average number of days inventory is held.
Days in Year (365)
Days in
Inventory
=
Inventory Turnover
SO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis
Illustration: Wal-Mart reported in its 2010 annual report a beginning inventory of $34,511 million, an ending inventory of $33,160 million, and cost of goods sold for the year ended January 31, 2010, of $304,657 million. The inventory turnover formula and computation for Wal-Mart are shown below.
Illustration 6-21
6-45
Days in Inventory: Inventory turnover of 9 times divided into 365 is approximately 40.6 days . This is the approximate time that it takes a company to sell the inventory.
SO 6 Compute and interpret the inventory turnover ratio.

6-46

6A
Illustration 6A-1
6-47
Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Perpetual Inventory System
Illustration 6A-2
6-48
Cost of Goods
Sold
Ending Inventory
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Perpetual Inventory System
Illustration 6A-3
6-49
Cost of Goods
Sold
Ending Inventory
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Perpetual Inventory System
Illustration 6A-4
Cost of Goods
Sold
Ending Inventory
6-50 SO 7 Apply the inventory cost flow methods to perpetual inventory records.

6B
Estimates the cost of ending inventory by applying a gross profit rate to net sales.
Illustration 6B-1
6-51 SO 8 Describe the two methods of estimating inventories.

Estimating Inventories
Illustration: Kishwaukee Company’s records for January show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. The company expects to earn a 30% gross profit rate. Compute the estimated cost of the ending inventory at
January 31 under the gross profit method.
Illustration 6B-2
6-52 SO 8 Describe the two methods of estimating inventories.

Estimating Inventories
Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost.
Illustration 6B-3
6-53 SO 8 Describe the two methods of estimating inventories.

Estimating Inventories
Illustration:
Illustration 6B-4
6-54
Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time.
SO 8 Describe the two methods of estimating inventories.

6-55
Key Points
 The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is,
GAAP provides more detailed guidelines in inventory accounting.
 The definitions for inventory are essentially similar under
IFRS and GAAP. Both define inventory as assets held-forsale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).

6-56
Key Points
 Who owns the goods
— goods in transit or consigned goods
— as well as the costs to include in inventory, are accounted for the same under IFRS and GAAP.
 Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used.

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Key Points
 A major difference between IFRS and GAAP relates to the
LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS.
 IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.

6-58
Key Points
 In the lower-of-cost-or-market test for inventory valuation,
IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. In other words, net realizable value is the best estimate of the net amounts that inventories are expected to realize. GAAP, on the other hand, defines market as essentially replacement cost.

6-59
Key Points
 Under GAAP, if inventory is written down under the lower-ofcost-or-market valuation, the new value becomes its cost basis. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement as an expense. An item-by-item approach is generally followed under IFRS.

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Key Points
 Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost.
 Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.

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Looking to the Future
One convergence issue relates to the use of the LIFO cost flow assumption. IFRS specifically prohibits its use. Conversely, the
LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. With a new conceptual framework being developed, it is highly probable that the use of the concept of conservatism will be eliminated. Similarly, the concept of
“ prudence
” in the IASB literature will also be eliminated. This may ultimately have implications for the application of the lower-of-cost-or-net realizable value.

6-62
IFRS Self-Test Questions
Which of the following should not be included in the inventory of a company using IFRS?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB shipping point.
d) None of the above.

6-63
IFRS Self-Test Questions
Which method of inventory costing is prohibited under
IFRS?
a) Specific identification.
b) FIFO.
c) LIFO. d) Average-cost.

6-64
IFRS Self-Test Questions
Specific identification: a) must be used under IFRS if the inventory items are not interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most conservative net income.

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Copyright
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