Needles Powers Crosson Principles of Accounting 12e Inventories 7 C H A P T E R © human/iStockphoto

NeedlesPowersCrosson

Principles of Accounting

12e

Inventories7C H A P T E R

© human/iStockphoto

LEARNING OBJECTIVES

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LO1: Explain the concepts underlying inventory accounting.

LO2: Calculate inventory cost under the periodic inventory system using various costing methods.

LO3: Explain the effects of inventory costing methods on income determination and income taxes.

LO4: Calculate inventory cost under the perpetual inventory system using various costing methods.

LO5: Use the retail method and gross profit method to estimate the cost of ending inventory.

LO6: Evaluate inventory level, and demonstrate the effects of inventory misstatements on income measurement.

SECTION 1: CONCEPTS


Accrual accounting (matching rule): recording transactions in the periods in which they occur, rather than in the periods in which cash is received or paid

Valuation: the process of assigning a monetary value to a business transaction and the resulting assets and liabilities

Conservatism: the convention that when faced with two equally acceptable alternatives, the accountant chooses the one least likely to overstate assets and income

Disclosure: presenting all information relevant to users’ understanding of the financial statements

Concepts Underlying Inventory Accounting(slide 1 of 2)

Inventory is considered a current asset because a company normally sells it within a year or within its operating cycle.– For a merchandising company, inventory

consists of goods owned and held for sale in the course of business.

– Manufacturing companies have three kinds of inventory: Raw materials (goods used in making products) Work in process (partially completed products) Finished goods ready for sale


Concepts Underlying Inventory Accounting(slide 2 of 2)

– The work in process and the finished goods have three cost components: Cost of the raw materials that go into the product Cost of the labor used to convert the raw materials

to finished goods Overhead costs that support the production

process. These include:– Costs of indirect materials (such as packing

materials)

– Indirect labor (such as the salaries of supervisors)

– Factory rent

– Depreciation of plant assets

– Utilities

– Insurance


Accrual Accounting and Valuation of Inventories

The primary objective of inventory accounting is to apply accrual accounting to the determination of cost of inventory sold during the accounting period.

Valuation of inventories is usually at cost.

Inventory cost includes the following:– Invoice price less purchases discounts– Freight-in, including insurance in transit– Applicable taxes and tariffs


Accrual Accounting and Valuation of Inventories

Inventory valuation depends on the prices of goods, which usually vary during the year.– A company may have purchased identical lots of

merchandise at different prices.– For identical items, it is often impossible to tell

which have been sold and which are still inventory.

– Thus, it is necessary to make an assumption about the order in which items have been sold. Because the assumed order of sale may or may not be

the same as the actual order of sale, the assumption is really about the flow of costs rather than the flow of physical inventory.


Goods Flows and Cost Flows

Goods flow refers to the actual physical measurement of goods in the operations of a company.

Cost flow refers to the association of costs with their assumed flow.– The assumed cost flow may or may not be

the same as the actual goods flow.– It is sometimes preferable to use an

assumed cost flow that bears no relationship to goods flow because it results in a better estimate of income.


Merchandise in Transit(slide 1 of 2)

Because merchandise inventory includes all items that a company owns and holds for sale, the status of any merchandise in transit, whether the company is buying it or selling it, must be evaluated to see if the merchandise should be included in the inventory count.

As shown on the next slide, ownership is determined by the terms of the shipping agreement, which indicate when title passes.


Merchandise in Transit(slide 2 of 2)

– Outgoing goods shipped FOB destination are included in the seller’s merchandise inventory, whereas those shipped FOB shipping point are not.

– Incoming goods shipped FOB shipping point are included in the buyer’s merchandise inventory, but those shipped FOB destination are not.


Merchandise Not Included in Inventory

At the time a company takes a physical inventory, it may have merchandise to which it does not hold title. Examples include:– Goods sold but not yet delivered to the buyer– Goods held on consignment—merchandise

that its owner (the consignor) places on the premises of another company (the consignee) with the understanding that payment is expected only when the merchandise is sold and that unsold items may be returned to the consignor

Goods to which the company does not hold title should not be included in its physical inventory.


Conservatism and the Lower-of-Cost-or-Market (LCM) Rule

If the market value of inventory falls below its historical cost because of physical deterioration, obsolescence, or decline in the price level, a loss has occurred. This loss is recognized by writing the inventory down to market, or its current replacement cost.

When the replacement cost of inventory falls below its historical cost, the lower-of-cost-or-market (LCM) rule requires that the inventory be written down to the lower value and that a loss be recorded.


Disclosure of Inventory Methods

The disclosure concept requires that companies disclose their inventory methods, including the use of LCM, in the notes to their financial statements.


Summary of Inventory Decisions

In accounting for inventory, management must choose among different processing systems, costing methods, and valuation methods.

– These choices affect investors’ and creditors’ evaluations of a company, as well as the internal performance reviews on which bonuses and compensation are based.

– The consistency concept requires that once a company has decided on the accounting systems and methods it will use, it must use them from one period to the next.

– Federal income tax regulations are specific about the valuation methods a company may use, which can have a large impact on the income taxes a company pays.


Management Choices in Accounting for Inventories



SECTION 2 ACCOUNTING APPLICATIONS

Calculate inventory cost under the periodic inventory system using the specific identification, average-cost, first-in, first-out (FIFO), and last-in, first-out (LIFO) methods.

Calculate inventory cost under the perpetual inventory system using the specific identification, average-cost, first-in, first-out (FIFO), and last-in, first-out (LIFO) methods.

Use the retail method to estimate the cost of ending inventory.

Use the gross profit method to estimate the cost of ending inventory.


Inventory Cost Under the Periodic Inventory System

The value assigned to the ending inventory is the result of two measurements: quantity and cost.– Under the periodic inventory system, quantity is

determined by taking a physical inventory.– Cost is determined by using one of the following

methods: specific identification, average-cost, first-in, first-out (FIFO), or last-in, first-out (LIFO).

– The choice of method depends on the nature of the business, the financial effects, and the cost of implementation.


Inventory Cost Under the Periodic Inventory System

To illustrate how each method is used under the periodic inventory system, we use Boilen Company, whose data for April is given below.


Specific Identification Method

The specific identification method identifies the cost of each item in the ending inventory.– It can be used only when it is possible to identify

the units as coming from specific purchases.– Although this method may appear logical, most

companies do not use it for the following reasons: It is usually impractical, if not impossible, to keep track

of the purchase and sale of individual items. When a company deals in items that are identical but

bought at different prices, deciding which items were sold becomes arbitrary.



If Boilen’s April 30 inventory consisted of 100 units from the April 1 inventory, 200 units from the April 6 purchase, and 140 units from the April 25 purchase, the specific identification method would assign the costs as follows.


Average Cost Method

Under the average-cost method (or weighted average method), inventory is priced at the average cost of the goods available for sale during the period. Average cost is computed as follows:Average Cost = Total Cost of Goods Available for Sale

Total Units Available for Sale

- The average cost method tends to level out the effects of cost increases and decreases because the cost of the ending inventory is influenced by all the prices paid during the year and the cost of the beginning inventory.


Average Cost Method

For Boilen, the ending inventory under the average-cost method would be $5,588, or $12.70 per unit, determined as follows.


First-In, First-Out (FIFO) Method

The first-in, first-out (FIFO) method assumes that the costs of the first items acquired should be assigned to the first items sold. – The costs of the goods on hand at the end of a

period are assumed to be from the most recent purchases, and the costs assigned to goods that have been sold are assumed to be from the earliest purchases.

– Thus, the FIFO method values the ending inventory at the most recent costs and includes earlier costs in the cost of goods sold.



For Boilen, the FIFO method would result in an ending inventory of $6,100, computed as follows.




Last-In, First-Out (LIFO) Method

The last-in, first-out (LIFO) method of costing inventories assumes that the costs of the last items purchased should be assigned to the first items sold and that the cost of the ending inventory should reflect the cost of the goods purchased earliest.– The effect of LIFO is to value inventory at the

earliest prices and to include the cost of the most recently purchased goods in the cost of goods sold.



– The supporters of LIFO reason that the fairest determination of income occurs if the current costs of merchandise are matched against current sales prices. When prices are moving up or down, the cost of goods

sold will, under LIFO, show costs closer to the price level at the time the goods are sold.

Thus, the LIFO method tends to show a smaller net income during inflationary times and a larger net income during deflationary times than other methods of inventory valuation, which tends to smooth out the peaks and valleys of the business cycle.

– However, because the inventory valuation on the balance sheet under LIFO reflects earlier prices, it often gives an unrealistic picture of the inventory’s current value.



Under LIFO, Boilen’s April 30 inventory would be $5,100, computed as follows.


Summary of Inventory Costing Methods

The graphic below shows how the four inventory methods affect the cost of goods sold and inventory when a company uses the periodic inventory system.



Effects of Inventory Costing Methods on Gross Margin

Assuming Boilen had April sales of $10,000, the graphic below shows how the specific identification, average-cost, FIFO, and LIFO methods of pricing inventory affect gross margin.


Impact of Inventory Decisions

As the previous slide shows, in a period of rising prices, LIFO, which charges the most recent prices to the cost of goods sold, results in the lowest gross margin.

In a period of rising prices, FIFO, which charges the earliest prices to the cost of goods sold, produces the highest gross margin.

The gross margin under the average-cost method falls between the gross margins produced by LIFO and FIFO.


Inventory Costing Methods Used by 500 Large Companies


Effects on the Financial Statements

Among the factors managers should consider in choosing an inventory costing method are the trend of prices and the effects of each method on financial statements, income taxes, and cash flows.– LIFO is best suited for the income statement

because it matches revenues and the cost of goods sold. But it is not the best method for valuing inventory on the balance sheet, particularly during a prolonged period of price increases.

– FIFO is well suited to the balance sheet because the ending inventory is closer to current values.


Effects on Income Taxes(slide 1 of 2)

The Internal Revenue Service governs how inventories must be valued for federal income tax purposes. – IRS regulations give companies a wide choice of

inventory costing methods, including specific identification, average-cost, FIFO, and LIFO.

– Except when companies use the LIFO method, they may use the lower-of-cost-or-market rule.

– If a company wants to change the valuation method it uses for income tax purposes, it must have advance approval from the IRS.


Effects on Income Taxes(slide 2 of 2)

– Many accountants believe that using the FIFO and average-cost methods in periods of rising prices causes businesses to overstate their profits, resulting in excess income tax.

– During a period of rising prices, if a company that uses LIFO lets the inventory quantity at year end fall below the level at the beginning of the year, the company will pay higher income taxes.

– When sales have reduced inventories below the levels set in prior years, it is called a LIFO liquidation—that is, units sold exceed units purchased for the period.


Effects on Cash Flows

Generally speaking, a company’s choice of average cost, FIFO, or LIFO does not affect cash flows.

However, the choice of inventory method will affect the amount of income tax paid. Choosing a method that results in lower income will result in lower taxes.



Inventory Cost Under the Perpetual Inventory System

Under the perpetual inventory system, inventory is updated as purchases and sales take place.

The cost of goods sold is accumulated as sales are made and costs are transferred from the Inventory account to the Cost of Goods Sold account.

The cost of the ending inventory is the balance of the Inventory account.

Goods are valued using one of these methods: specific identification, average-cost, FIFO, or LIFO.


Inventory Cost Under the Perpetual Inventory System

To illustrate costing methods under the perpetual inventory system, Boilen Company’s data for April is used, as shown below.



If Boilen’s April 30 inventory consisted of 100 units from the April 1 inventory, 200 units from the April 6 purchase, and 140 units from the April 25 purchase, the specific identification method would assign the costs as shown below.


Average-Cost Method

Under the perpetual system, an average is computed after each purchase or series of purchases, as shown below.


FIFO Method

When costing inventory with the FIFO or LIFO methods, it is necessary to keep track of the components of inventory because, as sales are made, the costs must be assigned in the proper order. The FIFO method is applied as shown below.


LIFO Method

The LIFO method is applied as shown below. The ending inventory of $6,000 includes 40 units from the beginning inventory and 400 units from the April 25 purchase.


Summary of Inventory Costing Methods

The graphic below compares the specific identification, average-cost, FIFO, and LIFO methods under the perpetual inventory system for Boilen.



Valuing Inventory by Estimation

It is sometimes necessary or desirable to estimate the value of the ending inventory.

The most commonly used methods for this purpose are:– the retail method, which estimates the cost

of the ending inventory by using the ratio of cost to retail price.

– the gross profit method (or gross margin method), which assumes that the ratio of gross margin for a business remains relatively stable from year to year.


Retail Method(slide 1 of 2)

Retail merchandising businesses use the retail method for two main reasons:– To prepare financial statements for each period,

the retail method can be used to estimate the cost without taking time or going to the expense of determining the cost of each item in the inventory.

– Because items in a retail store normally have a price tag or universal product code, it is common practice to take the physical inventory “at retail” from these price tags or codes and to reduce the total value to cost by using the retail method.


Retail Method(slide 1 of 2)

– Goods available for sale is determined at cost and at retail by listing the beginning inventory and net purchases for the period at cost and at their expected selling price, adding freight-in to the Cost column, and totaling.

– The ratio of these two amounts (cost to retail price) provides an estimate of the cost of each dollar of retail sales value. The estimated ending inventory at retail is then determined by deducting sales from the retail price of the goods that were available for sale. The inventory at retail is then converted to cost on the basis of the ratio of cost to retail, as shown on the next slide.


Retail Method of Inventory Estimation


Gross Profit Method

The gross profit method is used in place of the retail method when records of the retail prices of the beginning inventory and purchases are not available.

This method is acceptable for estimating the cost of inventory for insurance claims and for interim reports, but it is not acceptable for valuing inventory in the annual financial statements.


Gross Profit Method

As shown on the next slide, the gross profit method involves the following steps:– 1. Calculate the cost of goods available for

sale in the usual way (add purchases to beginning inventory)

– 2. Estimate the cost of goods sold by deducting the estimated gross margin of 30 percent from sales.

– 3. Deduct the estimated cost of goods sold from the goods available for sale to arrive at the estimated cost of the ending inventory.


Gross Profit Method of Inventory Estimation


Inventory and the Financial Statements

Cost of goods sold is created by transferring from the balance sheet to the income statement the cost of the inventories sold during the period. The amount of the transfer depends on the valuation of inventories.



SECTION 3 BUSINESS APPLICATIONS

Evaluate the level of inventory– Inventory turnover– Days’ inventory on hand

Manage the level of inventory– Supply-chain management– Just-in-time operating environment

Evaluate the effects of inventory misstatements on income measurement


Evaluating the Level of Inventory

The level of inventory a company maintains has important economic consequences, and it involves conflicting goals.– One goal is to have a great variety and quantity of

goods on hand so that customers have a choice and do not have to wait for an item to be restocked.

– This conflicts with the goal of controlling costs, which favors keeping the level of inventory low.

– Managers control inventory by closely observing two ratios: inventory turnover and days’ inventory on hand.


Inventory Turnover

Inventory turnover is the average number of times a company sells an amount equal to its average level of inventory during a period.


Days’ Inventory on Hand

Day’s inventory on hand is the average number of days it takes a company to sell an amount equal to its average inventory.


Inventory Management

To reduce their levels of inventory, many merchandisers and manufacturers use supply-chain management in conjunction with a just-in-time operating environment.– With supply-chain management, a

company uses the Internet to order and track goods that it needs immediately.

– A just-in-time (JIT) operating environment is one in which goods arrive just at the time they are needed.


Effects of Inventory Misstatements on Income Measurement

The reason inventory accounting is so important to income measurement is the way income is measured.

– The higher the value of the ending inventory, the lower the cost of goods sold and the higher the gross margin.

– The lower the value of the ending inventory, the higher the cost of goods sold and the lower the gross margin.

– Because the figures for the ending inventory and the cost of goods sold are related, a misstatement in the inventory figure will cause an equal misstatement in gross margin and income before income taxes.


Inventory Misstatements and Fraud

Inventory is particularly susceptible to fraudulent financial reporting.– It is easy to overstate or understate inventory

by including end-of-the-year purchase and sale transactions in the wrong fiscal year or by simply misstating inventory by mistake.

– A misstatement can also occur because of deliberate manipulation of operating results motivated by a desire to enhance the market’s perception of the company, obtain bank financing, or achieve compensation incentives.


Inventory Misstatements Illustrated(slide 1 of 2)

The examples below illustrate the effects of an overstatement or understatement of inventory.


Inventory Misstatements Illustrated(slide 2 of 2)

Because the ending inventory in one period becomes the beginning inventory in the following period, a misstatement in inventory valuation affects both periods.

Over two periods, the errors in income before income taxes will offset, or counterbalance, each other.



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Needles Powers Crosson Principles of Accounting 12e Inventories 7 C H A P T E R © human/iStockphoto