Chapter 6: Reporting and Analyzing Inventory

Days in Inventory Formula

Days in Inventory = 365 / Inventory Turnover

Inventory Turnover Ratio Formula

Inventory turnover = Cost of goods sold / Average inventory

A company has the following data: Units Cost Inventory, Dec. 1 150 $825 Purchase, Dec. 10 200 $1,120 Purchase, Dec. 15 200 $1,140 Purchase, Dec. 28 150 $885 A physical count of merchandise inventory on December 31 reveals that there are 200 units on hand. Using the average-cost method and a periodic inventory system, the amount allocated to the ending inventory on December 31 is $1,134. $1,100. $1,120. $1,180. $1,220.

$1,134. Solution: Ending inventory equals the average cost per unit times the number of units of inventory in ending inventory. The average cost per unit equals the total cost of all inventory divided by the number of inventory units. Average cost per unit = $3,970/700 units = $5.6714 per unit. Ending inventory = $5.6714/unit x 200 units = $1,134

A company has the following data: Number of units Cost per unit Beg. inventory, Dec. 1 7,000 $11 Purchase, Dec. 19 12,000 $12 Purchase, Dec. 28 4,000 $13 There are 10,000 units of ending inventory on hand at December 31. What is the company's ending inventory under LIFO using a periodic inventory system? $120,000 $108,000 $110,000 $113,000 $100,000

$113,000 Solution: [LIFO periodic ending inventory]Ending inventory under LIFO uses the oldest (i.e., earliest) costs of inventory to compute ending inventory. Ending inventory = (7,000 x $11) + (3,000 x $12) = $113,000

Counting Inventory at Year-End Perpetual Inventory System

- Check the accuracy of accounting records with the amount of inventory on hand - To determine the amount of inventory lost

Inventory Management Risk

- High levels of inventory require high storage and insurance costs - Low levels of inventory lead to lost sales

FIFO during periods of inflation

- Highest ending inventory, lowest cost of goods sold, highest gross profit - Highest income before operations, income tax expense, and net income - Highest retained earnings and stockholders equity

Inventory Costing Methods

- Inventory recorded at cost. Cost of merchandise inventory includes all costs needed to purchase, acquire, and prepare for sale - If every unit has same cost per unit, then ending inventory is: Ending inventory x cost per unit - Cost of goods sold is: Number of units sold x cost per unit

Goods in Transit

- Owned by the seller if the goods are shipped with terms FOB destination - Are owned by the buyer if the goods are shipped with terms FOB shipping point

3 Inventory Accounts

- Raw materials - Work in process - Finished Goods **All three inventory accounts tend to be classified as current assets on the classified balance sheet

Items that increase inventory turnover ratio

- Selling inventory faster - Reducing inventory on hand without reducing sales to customers - Writing-off inventory as a result of lower of cost or market

First-In, First-Out (FIFO)

First unit of inventory into company is assumed to be first one sold, (oldest inventory is sold first)

Deflation

Time periods with decreasing prices are called ________

Inflation

Time periods with increasing prices are called _________

Sales revenue is $1,000,000, cost of goods purchased is $620,000, beginning inventory is $60,000, and cost of goods sold is $550,000. How much is ending inventory? $90,000 $60,000 $0 $130,000 $10,000

$130,000 Solution: Beginning inventory + Purchases - Ending inventory = Cost of goods sold 60,000 + 620,000 - Ending inventory = 550,000 Ending inventory = 60,000 + 620,000 - 550,000 = 130,000

A company has three categories of inventory in stock: Category Cost Market value Pine $57,000 $45,000 Maple 45,000 35,000 Walnut 70,000 82,000 Apply the lower of cost or market rule to determine the company's ending inventory. $162,000. $184,000. $172,000. $160,000. $150,000.

$150,000 Solution: Cost Market LCM Pine $57,000 45,000 45,000 Maple 45,000 35,000 35,000 Walnut 70,000 82,000 70,000 Total lower-of-cost-or-market (LCM) = $150,000

Inventory Errors and Their Effects on Financial Statements

- Counting errors in and end of year physical count of inventory affect the amount of inventory reported on the balance sheet, the cost of goods sold reported on the income statement. An error in cost of goods sold affects several other financial statement amounts (gross margin, income before taxes, taxes, net income, retained earnings, and stockholders' equity) - Overstating inventory overstates assets and understates cost of goods sold - Understating cost of goods sold understates expenses which overstates gross margin, income from operations, income before taxes, tax expense, and net income - Overstating net income means too much income is closed to retained earnings, so overstating inventory overstates retained earnings and stockholders equity

A company uses LIFO. At the beginning of the current year its inventory was $200,000, and at the end of the current year its inventory is $250,000. At the start of the year its LIFO reserve was $30,000 and at the end of the year its LIFO reserve is $40,000. The company operates in an inflationary environment. If the company used FIFO instead of LIFO, its ending inventory would be $210,000. $250,000. $240,000. $290,000. $160,000.

$290,000 Solution: The LIFO reserve is the difference between inventory using LIFO and inventory using FIFO. If the company operates in an inflationary environment (i.e., rising prices), then the LIFO reserve is a positive number, add the LIFO reserve to LIFO inventory to determine the company's FIFO inventory.FIFO ending inventory = LIFO ending inventory + LIFO reserve = $250,000 + 40,000 = $290,000

At December 31, Moore Company's inventory records indicated a balance of $360,000. Upon further investigation it was determined that this amount included the following: (1) $56,000 in inventory purchases made by Moore shipped from the seller December 28 terms FOB shipping point, but not due to be received until January 2. (2) $24,000 in inventory purchases made by Moore shipped from the seller December 28 terms FOB destination, but not due to be received until January 3. (3) $8,000 in goods sold by Moore with terms FOB destination on December 28. The goods are not expected to reach their destination until January 4. (4) $9,000 in goods sold by Moore with terms FOB shipping point on December 28. The goods are not expected to reach their destination until January 5. (5) $13,000 of goods received on consignment from Dollywood Company. What is Moore's correct ending inventory balance at December 31? $334,000 $314,000 $351,000 $325,000 $327,000

$314,000 Solution: Do not include the following in inventory: 1. FOB destination purchases not yet received (i.e., $24,000) 2. FOB shipping point goods sold and shipped (i.e., $9,000) 3. Goods held on consignment (i.e., $13,000). Ending inventory = $360,000 - 24,000 - 9,000 - 13,000 = $314,000

Counting Inventory at Year-End Periodic Inventory System

- Determine amount of inventory on hand because company has not been keeping the inventory account balance up to date - Determine the cost of goods sold for the period

A company has the following: Beginning inventory, $80,000 Ending inventory, $120,000 Cost of goods sold, $560,000 Sales, $800,000 Net income, $50,000. What is its inventory turnover ratio? 4.7 times. 5.6 times. 4.9 times. 8.0 times. 6.7 times.

5.6 times. Solution: Average inventory = (80,000 + 120,000)/2 = 100,000 Inventory turnover = Cost of goods sold/average inventory Inventory turnover = 560,000/100,000 = 5.6

A company has the following inventory data: July 1 Beginning inventory is 30 units at $4.00 per unit July 7 Purchase 120 units for $4.30 per unit July 17 Purchase 60 units at $4.20 per unit July 22 Purchased 90 units at $4.40 per unit A physical count of merchandise inventory on July 31 reveals that there are 100 units on hand. Cost of goods sold under FIFO and a periodic inventory system is $846 $438 $638 $421 $863

$846 Solution: Goods available for sale is 300 units Ending inventory = 100 units Cost of goods sold = goods available for sale - ending inventory = 300 units - 100 units = 200 units Using FIFO & periodic, the cost of goods sold includes the oldest 200 units and ending inventory includes the 100 newest units. Cost of goods sold = 30 units at $4/unit + 120 units x $4.30/unit + 50 units x $4.20 = $120 + 516 + 210 = $846

A company overstated its ending inventory by $1,000 at the end of its first year. It never noticed the error. What is the effect on the error on the company's stockholders equity (i) at the end of the first year and (ii) at the end of the second year, respectively? (i) overstated; (ii) understated (i) understated; (ii) overstated (i) overstated; (ii) overstated (i) understated; (ii) understated (i) overstated; (ii) neither over nor understated

(i) overstated; (ii) neither over nor understated Solution: If the first year's ending inventory is overstated, that same year's cost of goods sold will be understated and stockholders' equity and net income will be overstated (i.e., reported as being higher than it should be reported). If the error is not corrected, the next year's beginning inventory has the error. The second year's net income will be understated by the same amount it was overstated in the first year. The combined total net income for the two periods will be correct (but one is too high and the other is too low) which causes stockholders' equity at the end of the two periods to be correct.

A company uses the periodic inventory method. If beginning inventory is overstated by $1,000 because the prior's year's ending inventory was overstated by $1,000. The company's ending inventory for this period is correct. The effect of this error in the current period is that cost of goods sold is (i) _________________ and net Income is (ii) ___________________. (i) overstated; (ii) understated (i) understated; (ii) neither overstated nor understated (i) overstated; (ii) overstated (i) understated; (ii) understated (i) understated; (ii) overstated

(i) overstated; (ii) understated Solution: In the periodic inventory system, cost of goods sold is computed at the end of the period using a formula that includes ending inventory which is determined by taking a physical inventory. Sometimes, the ending inventory is mis-counted (i.e., understated or overstated). An error in ending inventory results in an error in cost of goods sold in the opposite direction. For example, understating ending inventory overstates cost of goods sold. Moreover, an error in cost of goods sold causes an error in gross profit, net income, retained earnings, and stockholders' equity. For example, overstating cost of goods sold understates gross profit, net income, and retained earnings.

LIFO Reserve

- Companies using LIFO are required to report the difference between inventory based on LIFO and inventory based on FIFO - Can help financial statement users compare companies that use LIFO to other companies that use FIFO

Determining Ownership of Inventory

- Company should report on balance sheet all of the merchandise inventory that it owns and only merchandise inventory that it does actually own - A person or company that has ownership can transfer their interest in the property to others

Consigned Goods

- Consigner owns consigned goods even though the goods are being held for sale by the consignee - Consignee does not own the goods holds on consignment. It merely tries to sell goods held on consignment for the owner

LIFO Notes

- Cost of goods available for sale = Cost of goods sold + ending inventory - Measures cost of goods sold using newest inventory, and newest inventory usually reflects current cost of replacing inventory very well

FIFO Notes

- Cost of goods available for sale = Cost of goods sold + ending inventory - Measures ending inventory using newest inventory, and newest inventory usually reflects current cost of replacing inventory very well. - Uses oldest inventory, and oldest inventory is less likely to reflect current cost of replacing inventory

Inventory Errors Affects in Two Consecutive Periods

- Ending inventory from one year becomes the company's beginning inventory in the next year - an error in ending inventory will become an error in beginning inventory in the next year - An error in beginning inventory has opposite effect on cost of goods sold than an error in ending inventory - Net effect of an ending inventory error in one year followed by a beginning error in the next year is zero because one year's effects on net income offsets the next year's effect

Specific Identification

- Tracks the cost of each unit of inventory and if that unit has been sold, then its cost becomes a part of cost of goods sold. If that unit has not been sold then its cost remains in ending inventory - Facilitated by scanners, radio frequency tracking, bar codes, etc. - Rarely used except by companies that sell customized inventory and/or high-cost, low volume inventory

A company has the following: Sales revenue, $1,800,000 Beginning inventory, $160,000 Ending inventory, $240,000 Cost of goods sold, $1,200,000 Net income, $80,000 What is its days in inventory? 52.1 days 121.7 days 146 days 97.3 days 60.8 days

60.8 days Solution: Inventory turnover = cost of goods sold divided by average inventory Inventory turnover = $1,200,000/[(240,000 + 160,000)/2] = 6.00 Days in inventory = 365/inventory turnover Days in inventory = 365/6.00 = 60.8 days in inventory

Lower of Cost or Market (LCM)

A basis whereby inventory is stated at the lower of either its cost or its market value as determined by current replacement cost.

When is a physical inventory is taken, what is included? All of these Raw materials None of these Work in process Finished goods inventory

All of these Solution: Taking a physical inventory involves counting, weighing, or measuring each kind of inventory on hand. The types of inventory include finished goods inventory, work in process, and raw materials. A physical inventory count is usually taken at the end of the company's fiscal year as a step in the preparation of the company's financial statements. For example, every company must report its end-of-period inventory on its balance sheet.

Average Cost in a Periodic Inventory System Formula

Average cost per unit = Cost of goods sold available for sale/Number of units available for sale

Average-Cost

Cost All Units for Sale / Number of Units Available for Sale Multiply that average by number of units sold to determine cost of goods sold, and multiply it by the number of units in ending inventory to determine ending inventory

If ending inventory is incorrectly stated, ____________

Cost of Goods Sold will be overstated

When applying the lower of cost or market rule to inventory valuation, market generally means amount owed. current replacement cost. operating margin. gross margin. original cost.

Current replacement cost Solution: To comply with the concepts of conservatism (e.g., accounting rules should avoid overstating assets, profits, etc.), inventory should be valued at the lower-of-cost-or-market rather than at its cost. When there is a decline in the current replacement cost of inventory and a company had paid more for inventory than similar inventory's current replacement cost, the company's inventory account is considered to be overstated. The amount recorded as inventory should be reduced or lowered from cost to "market". Be careful because "market value" is not the company's sales price to its customers. Rather, "market value" is the current replacement cost or how much the company can buy inventory from its suppliers. For example, a company might purchase $100 of inventory and record it at cost of $100. The company might plan on selling the inventory for $150. Before selling that inventory, the current replacement cost might decline to $95 so the company records a $5 decline in inventory. However, the company might be able to still sell at $150 or perhaps approximately $145. Conservatism simply means that accounting rules are designed to report assets, income, etc. on a conservative basis—that is let's avoid overstating how much a company has as assets, profits, etc. Similarly, let's avoid overstating its inventory and the lower-of-cost-or-market helps us avoid overstating the value of inventory reported on a company's balance sheet.

In a period of inflation, the costs allocated to ending inventory will approximate their current cost if the accelerated method is used. LIFO method is used. average cost method is used. FIFO method is used. specific identification method is used.

FIFO method is used Solution: In order for ending inventory to closely correspond to the current cost of inventory, ending inventory should include the most recently purchased inventory. First-in, first-out (FIFO) uses the oldest inventory to compute cost of goods sold and uses the newest inventory to compute ending inventory.

Ownership passes to the buyer when the public carrier accepts the goods if the goods are shipped FOB buyer. FOB transit. FOB shipping point. FOB destination. FOB shipper.

FOB shipping point. Solution: Under FOB shipping point, ownership transfers when the carrier accepts the goods from the seller.

Which of the following should be included in the physical inventory of a company? All of the answer choices are correct. Goods shipped on consignment to another company Goods in transit from another company shipped FOB destination Goods held on consignment from another company None of these choices is correct.

Goods shipped on consignment to another company Solution: Goods shipped on consignment to another company remain owned. Goods held on consignment are owned by company that shipped them. Inventory should include all goods owned by the company regardless of whether the company holds physical possession or not. Goods in transit from another company shipped FOB shipping point should be included in the physical inventory of the firm to whom the goods are being shipped because title (i.e., legal ownership) passes when the goods leave the seller's place of business but goods in transit shipped from another company FOB destination should not because they are not yet received and ownership does not transfer to the recipient until they are received (i.e., they reach their destination).

Which of the following would most likely employ the specific identification method of inventory costing? Gasoline station Grocery store Jewelry store Hardware store All of these are equally likely to use specific identification

Jewelry store Solution: Jewelry stores use the specific identification method because of the high value and uniqueness of many of the inventory items. The average item in the grocery store is low in value and generic in nature. As such, the specific identification method would not be desirable. While numerous items within the store may warrant the specific identification method, the vast majority of items would not warrant the cost of implementing the specific identification method. A gasoline station would be unable to utilize the specific identification method for its fuel sales from a single holding tank. Its product is generic and of relatively low value.

In a period of falling prices, which of the following methods will give the largest net income? Average-cost All of these produce the same net income FIFO Specific identification LIFO

LIFO Solution: The largest net income occurs with the smallest cost of goods sold. In periods with falling prices (i.e., deflation), low cost of goods sold occurs when the last units of inventory purchased are the ones assumed sold. LIFO will provide the highest net income during a period of falling prices. FIFO will not provide the highest net income during a period of falling prices. Specific identification costing will vary depending on which units are sold. Average costing will produce a net income between LIFO and FIFO.

A company started business in December and it made the following purchases of inventory: (1) On December 1, it purchased 100 units for $1,500; (2) On December 12, it purchased 100 units for $1,550; and (3) On December 24, it purchased 100 units for $1,575. A physical count of the inventory on December 31 reveals that there are 500 units on hand. What inventory method produces the lowest gross profit for August? FIFO method LIFO method Perpetual method Periodic method Average cost method

LIFO method Solution: On Dec. 1, it spent $15 per unit; on Dec. 12, it spent $15.50 per unit; and on Dec. 24, it spent $15.750 per unit. This company is experiencing inflation. Low gross profit (i.e., low gross margin) occurs with higher cost of goods sold. During periods of inflation, the inventory costing method that considers the most expensive inventory to be sold is LIFO (i.e., last-in, first-out). The LIFO method will produce the lowest gross profit because LIFO results in the highest cost goods sold in periods of rising prices. The choice of a periodic versus perpetual inventory system does not change whether LIFO or FIFO produces the highest or lowest cost of goods sold or gross profit.

Last-In, First-Out (LIFO)

Last unit of inventory into company is assumed to be first one sold, (newest inventory is sold first)

If the current recorded cost of inventory is greater than the current market cost to replace inventory then the inventory should be recorded at the market cost True False

True

Inventory costing methods place primary reliance on assumptions about the flow of goods. costs. margins. values. resale prices.

costs. Solution: The inventory costing methods, such as first-in first-out, place a primary reliance on assumptions about the costs of inventory to cost of goods sold and ending inventory.