Accounting Chapter 6 (Inventories)

Comparing Inventory Costing Methods

• A different cost flow is assumed for the FIFO, LIFO, and weighted average inventory cost flow methods. As a result, the three methods normally yield different amounts for the following: • Cost of goods sold • Gross profit • Net income • Ending inventory • Note that if costs (prices) remain the same, all three methods would yield the same results. However, costs (prices) normally do change.

Reporting Inventory

• A physical inventory or count of inventory should be taken near year-end to make sure that the quantity of inventory reported in the financial statements is accurate. • After the quantity of inventory on hand is determined, the cost of the inventory is assigned for reporting in the financial statements. • Most companies assign costs to inventory using one of three inventory cost flow assumptions.

Effect of Inventory Errors on the Financial Statements

• Any errors in merchandise inventory will affect the balance sheet and income statement. • If you need the table, it's on page 30 of slides

Safeguarding Inventory

• Controls for safeguarding inventory begin as soon as the inventory is ordered. • The following documents are often used for inventory control: • Purchase order • Receiving report • Vendor's invoice

Reporting Inventory in the Financial Statements

• Cost is the primary basis for valuing and reporting inventories in the financial statements. However, inventory may be valued at other than cost in the following cases: • The cost of replacing items in inventory is below the recorded cost. • The inventory cannot be sold at normal prices due to imperfections, style changes, spoilage, damage, obsolescence, or other causes.

Comparing Inventory Costing Methods Part 2

• FIFO reports higher gross profit and net income than the LIFO method when costs (prices) are increasing. • However, in periods of rapidly rising costs, the inventory that is sold must be replaced at increasingly higher costs. • In such cases, the larger FIFO gross profit and net income are sometimes called inventory profits or illusory profits. • During a period of increasing costs, LIFO matches more recent costs against sales on the income statement. • LIFO also offers an income tax savings during periods of increasing costs. • This is because LIFO reports the lowest amount of gross profit and, thus, lower taxable net income. • However, under LIFO, the ending inventory on the balance sheet may be quite different from its current replacement cost. • The weighted average cost method is, in a sense, a compromise between FIFO and LIFO. • The effect of cost (price) trends is averaged in determining the cost of goods sold and the ending inventory.

Valuation at Lower of Cost or Market

• If the market is lower than the purchase cost, the lower-of-cost-or-market (LCM) method is used to value the inventory. • Market, as used in lower of cost or market, is the net realizable value of the inventory. Net realizable value is determined as follows: Net Realizable Value = Estimated Selling Price −- Direct Costs of Disposal • Direct costs of disposal include selling expenses such as special advertising or sales commissions. • The lower-of-cost-or-market method can be applied in one of three ways. The cost, market price, and any declines could be determined for the following: 1. Each item in the inventory 2. Each major class or category of inventory 3. Total inventory as a whole • The amount of any price decline is included in the cost of goods sold. • This, in turn, reduces gross profit and net income in the period in which the price declines occur. • This matching of price declines to the period in which they occur is the primary advantage of using the lower-of-cost-or-market method.

Inventory on the Balance Sheet

• Inventory is usually reported in the current assets section of the balance sheet. • In addition to this amount, the following are reported on the balance sheet or in the accompanying notes: • The method of determining the cost of the inventory (FIFO, LIFO, or weighted average) • The method of valuing the inventory (cost or the lower of cost or market)

Inventory Turnover

• Inventory turnover measures the relationship between cost of goods sold and the amount of inventory carried during the period. • It measures the number of times inventory is turned into sold goods during the year. • Inventory turnover = Cost of Goods Sold / Average Inventory

Safeguarding Inventory Part 2

• Recording inventory using a perpetual inventory system is also an effective means of control. The amount of inventory is always available in the subsidiary inventory ledger. • Controls for safeguarding inventory should include security measures to prevent damage and customer or employee theft. Some examples of security measures include • storing inventory in areas that are restricted to only authorized employees • locking high-priced inventory in cabinets • using two-way mirrors, cameras, security tags, and guards

Number of Days Sales in Inventory

• The number of days' sales in inventory measures the length of time it takes to acquire, sell, and replace the inventory. • # days sales = average inventory / average daily cost of goods sold

Purchase Order

• The purchase order authorizes the purchase of the inventory from an approved vendor.

Receiving Order

• The receiving report establishes an initial record of the receipt of the inventory.To make sure the inventory received is what was ordered, the receiving report is compared with the purchase order. • The price, quantity, and description of the item on the purchase order and receiving report are compared to the vendor's invoice before the inventory is recorded in the accounting records.

Control of Inventory

• Two primary objectives of control over inventory are as follows: • Safeguarding the inventory from damage or theft. • Reporting inventory in the financial statements.

First In First Out (FIFO)

• When the FIFO method is used in a perpetual inventory system, costs are included in the cost of goods sold in the order in which they were purchased. • This is often the same as the physical flow of the goods. • For example, grocery stores shelve milk and other perishable products by expiration dates. Products with early expiration dates are stocked in front. In this way, the oldest products (earliest purchases) are sold first

Last In First Out (LIFO)

• When the LIFO method is used in a perpetual inventory system, the cost of the units sold is the cost of the most recent purchases. • The LIFO method was originally used in those rare cases where the units sold were taken from the most recently purchased units. However, for tax purposes, LIFO is now widely used even when it does not represent the physical flow of units

Inventory Costing Under a Periodic Inventory System

• When the periodic inventory system is used, only revenue is recorded each time a sale is made. • No entry is made at the time of the sale to record the cost of the goods sold. • At the end of the accounting period, a physical inventory is taken to determine the cost of the inventory and the cost of the goods sold. • Like the perpetual inventory system, a cost flow assumption must be made when identical units are acquired at different unit costs during a period.

Weighted Average Cost Method

• When the weighted average cost method is used in a perpetual inventory system, a weighted average unit cost for each item is computed each time a purchase is made. • This unit cost is used to determine the cost of each sale until another purchase is made and a new average is computed. • This technique is called a moving average • Weighted Average Unit Cost = Total Cost of Units Available for Sale / Units Available for Sale