Chapter Eight Inventory Inventory • Assets a company holds that will ultimately be sold to its customers • Often the largest current asset that a firm holds • Can take the form of finished goods, raw materials, or work in process Copyright © Houghton Mifflin Company.All rights reserved. 8-2 The Purchasing Cycle Copyright © Houghton Mifflin Company.All rights reserved. 8-3 Shipping Terms FOB shipping point: FOB destination: • Buyer pays the • Seller pays the transportation costs transportation costs • Purchase is recorded • Purchase is recorded by the buyer when the by the buyer when inventory is shipped by the inventory is the vendor received Copyright © Houghton Mifflin Company.All rights reserved. 8-4 The Sales Cycle Customer purchase Record sale and cost of sale Increase Cash or A/R Increase Sales Copyright © Houghton Mifflin Company.All rights reserved. Credit payment received by firm Decrease Inventory Increase Cost of Goods Sold 8-5 Accounting for Inventory Initially record at full cost (purchase price plus shipping, handling, shipping insurance, and taxes) Perpetual Inventory System Periodic Inventory System Inventory account adjusted for every purchase or sale Inventory account adjusted only at end of accounting period Copyright © Houghton Mifflin Company.All rights reserved. 8-6 Perpetual Inventory System Illustration When Vanya Co. purchases an inventory item on account for $10, the following entry is made: Inventory Accounts Payable 10 10 When the item is sold for $15 to a customer on account, the following entries are made: Accounts Receivable Sales Cost of Sales Inventory Copyright © Houghton Mifflin Company.All rights reserved. 15 15 10 10 8-7 Periodic Inventory System Illustration Vanya Co. purchases an inventory item on account for $10 and the following entry is made: Purchases Accounts Payable 10 10 When the item is sold for $15 to a customer on account, the following entry is made: Accounts Receivable Sales 15 15 The Inventory account is not updated until the end of the period by performing a physical count of inventory. Copyright © Houghton Mifflin Company.All rights reserved. 8-8 Costing Inventory As inventories turn over, with items rapidly entering and exiting the pool of items, how should the value of inventory be determined? Cost-Flow Methods: • Specific Identification • Average Cost • First-in, first-out (FIFO) • Last-in, first-out (LIFO) Copyright © Houghton Mifflin Company.All rights reserved. 8-9 Specific Identification Method Each item bought and sold is matched with its actual cost • • • Inventory account reflects the physical flow of goods Ideal for a firm that has low sales volume and can easily track its goods When an item is sold, its actual cost is used to increase Cost of Sales and decrease Inventory Copyright © Houghton Mifflin Company.All rights reserved. 8 - 10 Average-Cost Method Cost of an inventory item is the average of the costs of all goods available for sale at that point in time • • Suited for firms that carry homogeneous items, such as grocery and office supply stores A new average cost must be computed after each purchase Copyright © Houghton Mifflin Company.All rights reserved. 8 - 11 Average-Cost Method: Computing the Average Cost 1. Add the cost of new purchases to any previous inventory balance. 2. Divide this total by the number of units on hand. 3. Yields new average cost of units of inventory. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 12 Average-Cost Method: Illustration Shoe Warehouse has a beginning inventory that consists of 25 pairs of shoes at $60 per pair. SW purchases 100 pairs at $70 per pair and makes the following entry: Inventory Cash 7,000 7,000 Compute the average unit cost after the purchase: Beg. Inventory (25 x $60) $1,500 Purchase (100 x $70) 7,000 $8,500 125 = $68 Continue Copyright © Houghton Mifflin Company.All rights reserved. 8 - 13 Average-Cost Method: Illustration Shoe Warehouse sells 80 pairs of shoes at $125 per pair. When recording the cost of sales, use the newly computed average unit cost of $68. Cash (80 x $125) Sales Cost of Sales (80 x $68) Inventory 10,000 10,000 5,440 5,440 Remember: After each purchase, the new average cost per unit must be computed Copyright © Houghton Mifflin Company.All rights reserved. 8 - 14 First-in, First-Out (FIFO) Method Assumes that the first item into inventory is the first item sold to the customer • • Inventory is carried at more current costs and cost of sales consists of older costs Under a perpetual system, the Inventory and Cost of Sales accounts are updated after each purchase and sale. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 15 FIFO: Illustration Shoe Warehouse inventory activity: • Jan. 1, purchased 25 pairs of shoes at $60 per pair. • Jan. 3, purchased 100 pairs at $70 per pair. • Jan. 8, sold 80 pairs at $125 per pair. • Using the FIFO method, how will the sale and cost of the sale on Jan. 8 be recorded? Cash Sales Cost of Sales [(25 x $60) + (55 x $70)] Inventory Copyright © Houghton Mifflin Company.All rights reserved. 10,000 10,000 5,350 5,350 8 - 16 Last-in, First-Out (LIFO) Method Assumes that the last item into inventory is the first item sold to the customer • • Inventory is carried at older costs and cost of sales consists of recent costs Under a perpetual system, the Inventory and Cost of Sales accounts are updated after each purchase and sale. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 17 LIFO: Illustration • Shoe Warehouse inventory activity: • Jan. 1, purchased 25 pairs of shoes at $60 per pair. • Jan. 3, purchased 100 pairs at $70 per pair. • Jan. 8, sold 80 pairs at $125 per pair. • Using the LIFO method, how will the sale on Jan. 8 as well as the cost of the sale be recorded? Cash Sales 10,000 Cost of Sales (80 x $70) Inventory 5,600 Copyright © Houghton Mifflin Company.All rights reserved. 10,000 5,600 8 - 18 Comparing LIFO and FIFO LIFO • Results in lower pretax earnings and tax payments • Closer match between earnings and current-cost income • Requires more complex record keeping • Risk of LIFO liquidation Copyright © Houghton Mifflin Company.All rights reserved. FIFO • Results in higher pretax earnings and tax payments • Stronger correlation between inventory amount and current replacement cost • Easier record keeping 8 - 19 Critical Thinking • Discussion: What factors do you think businesses consider when choosing one inventory method over another? • When businesses choose inventory methods, they consider the flow of merchandise, type of merchandise, how each method will impact net income and income tax, and what method competitors use. Some methods are more suitable to distinct goods while others are more suitable to homogeneous goods. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 20 Choosing an Inventory Method Four Key Questions: 1. What cost-flow assumption will be used for tax purposes? • If firms use LIFO for tax purposes, they must use FIFO for reporting purposes. 2. Which cost-flow assumption will result in the most cash flow? • In times of rising prices, LIFO results in lower income and lower tax payments, which means that the firm will have more cash left after paying taxes. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 21 Choosing an Inventory Method (continued) Four Key Questions: 3. What cost-flow assumptions are competitors using? • Choose a method equivalent to competitors so that financial results and ratios will be comparable. 4. Which cost-flow assumption is easiest to implement? • The FIFO method requires less record keeping as compared to the other methods. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 22 Special LIFO Issues • Use of LIFO causes older, less current values to be reported as inventory amounts Current costs - Inventory valued using LIFO = LIFO Reserve Disclose in notes to the financial statements • Change in the LIFO reserve from one period to another is called the LIFO effect Copyright © Houghton Mifflin Company.All rights reserved. 8 - 23 LIFO Liquidation • If a period’s ending inventory is ever lower than its beginning inventory, it is assumed that older, less costly inventory has been sold = LIFO liquidation • Effect: Cost of sales does not reflect current costs and gross profit is inflated. Thus higher earnings are reported (not the intended effect of the LIFO method). Copyright © Houghton Mifflin Company.All rights reserved. 8 - 24 Inventory Pools • Tracking entire inventory as a whole or in pools of like items reduces the danger of LIFO liquidation. • A reduction in one inventory item within the pool is likely to be offset by an increase in another item in the pool. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 25 Dollar-Value LIFO • Based on the assumption that inventory is a quantity of value rather than a quantity of physical goods. • Increases and decreases in inventory are measured in dollar amounts, not numbers of items. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 26 Dollar-Value LIFO Illustration Komanda Co. begins using FIFO on Jan. 1, 2004 and has a beginning inventory of $35,000. At year end 2004, ending inventory is $42,000. 1. Determine whether inventory has increased or decreased in real dollars. (Prices in the firm’s industry have risen such that the price index is 107 percent at year end.) • $42,000 107% = $39,252 2. Compare beginning inventory to computed amount. • $39,252 - $35,000 = $4,252 Copyright © Houghton Mifflin Company.All rights reserved. Continue 8 - 27 Dollar-Value LIFO Illustration 3. To determine how the inventory should be valued on the balance sheet, group inventories into layers: Layer 1: Base-year Layer 2: Inventory increase for 2004 in terms of price index Dollar-value LIFO inventory at 12/31/04 Value in Base-Year Price Index Balance Sheet Value $35,000 100% $35,000 4,252 107% $39,252 4,550 $39,550 Record on the balance sheet Copyright © Houghton Mifflin Company.All rights reserved. 8 - 28 The Effect of Inventory Errors Sales Cost of Sales: Beg. Inv. Purchases Available Less End. Inv. Cost of sales Gross Profit Other expenses Income before taxes Tax expense Net income Reported Amt $105,000 25,000 60,000 85,000 (25,000) 60,000 45,000 (25,000) 20,000 (7,000) $13,000 Copyright © Houghton Mifflin Company.All rights reserved. Correct Amt $105,000 25,000 60,000 85,000 (27,000) 58,000 47,000 (25,000) 22,000 (7,700) $14,300 Effect of Error $2,000 understated $2,000 overstated $2,000 understated $2,000 understated $700 understated $1,300 understated 8 - 29 Lower-of-Cost-or-Market Rule for Valuing Inventory If market value of inventory < original cost Write down inventory to the lower value and record the loss How is the market value of the inventory determined? Continue Copyright © Houghton Mifflin Company.All rights reserved. 8 - 30 Lower-of-Cost-or-Market Rule Illustration • Rockwood Co. purchases inventory at a cost of $100. This inventory sells for $125, yielding a 20 percent gross profit. At the end of period, the replacement cost has fallen to $80. Under the LCM rule, in most cases, the inventory is reflected at its replacement cost, the more conservative value. Accounting Research Bulletin No. 43 Inventory’s current replacement cost should not exceed the net realizable value and should not be less than the net realizable value less gross margin. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 31 Analyzing Inventory • How well is inventory being managed? • Are items in inventory turned (sold) quickly? • Does a firm have too much inventory? • Is the inventory profitable? Inventory Turnover Analysis Ratios Days in Inventory Inventory Yield Copyright © Houghton Mifflin Company.All rights reserved. 8 - 32 Inventory Turnover Ratio Cost of Sales Average Inventory • Measures how quickly inventory flows through a business • The higher the ratio, the more effectively management is controlling inventory Copyright © Houghton Mifflin Company.All rights reserved. 8 - 33 Days in Inventory 365 Inventory Turnover Ratio • Measures how many days, on average, a firm holds inventory before selling it • If a firm has a 3.76 inventory ratio, it would hold inventory, on the average, for 97 days Copyright © Houghton Mifflin Company.All rights reserved. 8 - 34 Check Your Understanding Q If you purchase goods FOB shipping point, are you responsible for shipping charges? A FOB shipping point requires the buyer to pay the shipping charges. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 35 Check Your Understanding Q If you want your accounting records (Inventory account) to reflect an accurate count of inventory at all times, which system of accounting for inventory purchases and sales would you use? A Under the perpetual inventory system, the Inventory account is adjusted each time inventory is purchased or sold. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 36 Check Your Understanding Q Must a company employ the same costflow assumption for all its inventory items? A No. Companies may employ different assumptions for various products. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 37 Check Your Understanding Q Which inventory method is based on the assumption that each inventory item bought and sold can be matched with its actual cost? A Specific identification method Copyright © Houghton Mifflin Company.All rights reserved. 8 - 38 Check Your Understanding Q If your company seeks to lower its externally reported net income, would it use FIFO or LIFO to accomplish this goal? A LIFO Copyright © Houghton Mifflin Company.All rights reserved. 8 - 39 Check Your Understanding Q What situation causes a LIFO liquidation? A A LIFO liquidation occurs if a period’s ending inventory is lower than its beginning inventory. Copyright © Houghton Mifflin Company.All rights reserved. 8 - 40 Check Your Understanding Q If a company makes an error in counting inventory and it overstates inventory, how will net income be affected in the current year? A Net income will be overstated Copyright © Houghton Mifflin Company.All rights reserved. 8 - 41