Accounting Chapter 6 Inventory Cost Flow Methods

Companies can determine the effect of ending inventory errors on the balance sheet by using the basic accounting equation:

Assets = Liabilities + Stockholders' Equity.

Work in process

That portion of manufactured inventory that has begun the production process but is not yet complete.

Regardless of whether prices are rising or falling, average-cost produces

net income between FIFO and LIFO.

Lower-of-Cost-or-Net Realizable Value Typically inventory is recorded at cost, UNLESS the value of that inventory is lower than its cost. In these situations, companies must

"write down" inventory to its net realizable value. The net realizable value refers to the net amount that a company expects to realize (receive) from the sale of inventory

Which of the following companies is most likely to have lost sales due to an inventory shortage? Company 1 has an inventory turnover of 46.3. Company 2 has an average days in inventory of 18.9 days. Company 3 has an inventory turnover of 5.4. Company 4 has an average days in inventory of 32.7.

#1 The shorter the average days in inventory (i.e., the higher the inventory turnover), the more likely the company will have lost sales due to inventory shortage. Company 1 has days in inventory of 365/46.3 = 7.9 days. Company 2 has days in inventory of 18.9 days. Company 3 has days in inventory of 365/5.4 = 67.6 days. Company 4 has days in inventory of 32.7 days. Therefore, the company with the lowest days in inventory is Company 1.

LIFO has the highest quality of earnings ratio for two reasons.

(1) It has the highest net cash provided by operating activities, which increases the ratio's numerator. (2) It reports a conservative measure of net income, which decreases the ratio's denominator.

In FIFO the sequencing of the allocation:

(1) compute ending inventory, and (2) determine cost of goods sold. Beginning Inventory + Cost of Goods Purchesed - Ending Inventroy = COGS

Typcial reasons companies adopt different inventory cost flow methods involve one of three factors:

(1) income statement effects, (2) balance sheet effects, or (3) tax effects

In a multiple-step income statement, cost of goods sold is subtracted from net sales. There also should be disclosure of (1) the major inventory classifications, (2) the basis of accounting (cost, or lower-of-cost-or-net realizable value), and (3) the cost method

(FIFO, LIFO, or average-cost).

There are three assumed cost flow methods:

1. First-in, first-out (FIFO). 2. Last-in, first-out (LIFO). 3. Average-cost.

perpetual system, companies take a physical inventory for the following reasons:

1. To check the accuracy of their perpetual inventory records. 2. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.

Days in Inventory =

365 days / Inventory Turnover --Tells us how quickly inventory "turns over" (is sold) during the year indicates liquidity of inventory Tells us the average number of days inventory is held

Inventory turnover

A ratio that indicates the liquidity of inventory by measuring the number of times average inventory is sold during the year; computed by dividing cost of goods sold by the average inventory.

Specific identification method

An actual physical-flow costing method in which particular items sold and items still in inventory are specifically costed to arrive at cost of goods sold and ending inventory. --need to positively identify which particular units it sold and which are still in ending inventory

First-in, first-out (FIFO) method

An inventory costing method that assumes that the earliest goods purchased are the first to be sold. --parallels the actual physical flow of merchandise --the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold. (This does not necessarily mean that the oldest units are sold first, but that the costs of the oldest units are recognized first

Last-in, first-out (LIFO) method

An inventory costing method that assumes that the latest goods purchased are the first to be sold. --seldom coincides with the actual physical flow of inventory --the costs of the latest goods purchased are the first to be recognized in determining cost of goods sold

Average-cost method

An inventory costing method that uses the weighted-average unit cost to allocate the cost of goods available for sale to ending inventory and cost of goods sold. - uses Weighted-average unit cost

Inventory Ratio is

Analysis Managing inventory levels is a critical task for companies that sell goods. Inventory ratios and data analytics help with this analysis.

Under perpetual FIFO, the company charges to cost of goods sold the cost of the earliest goods on hand prior to each sale. Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and

August 24 ---FIFO in a perpetual system are the same as in a periodic system

Weighted-average unit cost

Average cost that is weighted by the number of units purchased at each unit cost. --Cost of goods avaiable for sale/ total unites available for sale = Weighted-Average Unit cost --verify the cost of goods sold under this method by multiplying the units sold times the weighted-average unit cost (550 × $12 = $6,600). Note that this method does not use the average of the unit costs. That average is $11.50 ($10 + $11 + $12 + $13 = $46; $46 ÷ 4). The average-cost method instead uses the average weighted by the quantities purchased at each unit cost.

Raw materials

Basic goods that will be used in production but have not yet been placed in production.

Companies that use LIFO rather than FIFO as an inventory system must report which value on their financial statements? FIFO reserve LCNRV reserve LIFO reserve

Companies that use Last In First Out (LIFO) rather than First In First Out (FIFO) as an inventory valuation method must also disclose the difference between inventory reported using LIFO vs. using FIFO or the overall LIFO reserve.

Inventory Turnover =

Cost of Goods Sold / Average Inventory Average inventory is:Beginning Inventory + Ending Inventory / 2

Beginning Inventory + Cost of Goods Purchesed - Ending Inventroy =

Cost of Goods Sold formula in a periodic system

Regardless of the classification, companies report all inventories under

Current Assets on the balance sheet.

Order of liquidity

Current assets: (1) cash, (2) investments (such as short-term U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Long term investments Plant, property, equipment Intangible assets Then, current liabilities, long term liabilities, SE

higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer

FIFO because it results in higher net income.

Balance Sheet Effects:

FIFO ending inventory will approximate current costs/LIFO ending inventory understated/Average Cost in between -- A major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost

Income Statement Effects:

FIFO produces higher net income/LIFO produces lower net income/Average Cost in between --The use of LIFO enables companies to avoid reporting paper profit as economic gain.

FIFO

First In, First Out. Rotation system that uses the oldest products first. inventory accounting in which the oldest items (those first acquired) are assumed to be the first sold; creates a higher ending inventory and lower cost of goods sold, higher gross profit and higher taxable income.

Lower-of-cost-or-net realizable value (LCNRV)

General rule (applied by companies that do not use LIFO or retail methods) that dictates that a company value inventory at the lower-of-cost-or-net realizable value, with net realizable value being the net amount that a company expects to realize from the sale of inventory. A departure from cost is justified because inventories should not be reported at amounts higher than their expected realization from sale or use. --Ford's inventory was then worth $1 billion less than its original cost, need to "write down"

error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period.

Illustration 6B.3 shows this effect. Note that the understatement of ending inventory in 2021 results in an understatement of beginning inventory in 2022 and an overstatement of net income in 2022 However, Over the two years, though, total net income is correct because the errors offset each other.

Just-in-time (JIT) inventory

Inventory system in which companies manufacture or purchase goods only when needed. --companies have significantly lowered inventory levels and costs using this system --depends on reliable suppliers.

International accounting standards do not allow the use of

LIFO

The LIFO reserve is the difference between the inventory reported on the balance sheet and what inventory would be if reported on a FIFO basis. The amount of taxes deferred by choosing LIFO can be learned from this amount.

LIFO Reserve Formula = FIFO Inventory-LIFO Inventory

The ________ requires that if companies use ________ for tax purposes, they must also use it for financial reporting purposes. tax accounting principle; MACRS LIFO conformity rule; LIFO consistency principle; the average-cost method FIFO conformity rule; FIFO

LIFO conformity rule; LIFO

Tax Effects:

LIFO results in the lowest income taxes (because of lower net income)/FIFO - higher LIFO conformity rule - IRS says must use LIFO for financial reporting purposes if LIFO is being used for income tax purposes to save on taxes, they must be the same --Both inventory and net income are higher when companies use FIFO in a period of inflation. LIFO results in the lowest income taxes (because of lower net income) during times of rising prices.

LIFO

Last In, First Out. Rotation system that uses the newest products first. inventory accounting in which the most recently acquired items are assumed to be the first sold; method is supposed to create the lowest ending inventory in a period of rising prices. Also create a lower taxable income, lower gross profit.

When do you adjust NRV

Lower-of-Cost-or-Net Realizable Value: Inventory only written down if the value of that inventory is lower than its cost to meet the inventory's net realizable value (what company will sell it for). --DO NOT AJUST IF INVENTORY IS ABOVE COST, ONLY IF LOWER

Finished goods inventory

Manufactured items that are completed and ready for sale.

Days in inventory

Measure of the average number of days inventory is held; calculated as 365 divided / by inventory turnover. (need calculate inventory turnover first)

White Incorporated employs a just-in-time (JIT) inventory system. Which inventory issues are mitigated by this inventory system? Obsolescence and Spoilage Labor Costs and Spoilage Cost of Goods Sold and Obsolescence Spoilage and Cost of Goods Sold

Obsolescence and Spoilage

Moving-average method

Perpetual inventory method where the company computes a new average cost after each purchase by dividing the cost of goods available for sale by the units on hand. -is the average-cost method in a perpetual inventory system -

The formula for Total Inventory is: Total Inventory (TI) =

Raw Materials(RM) + Work-in-Process (WIP) + Finished Goods (FG)

Manufacturing company: Three categories of invintory-

Raw materials, work in process, finished goods inventory

What inventory cost flow methods can companies employ if they use a perpetual inventory system?

Simple—they can use any of the inventory cost flow methods described in the chapter. --three assumed cost flow methods (FIFO, LIFO, and average-cost)

Specific Identification:

The cost of the unit that the customer received would be the cost of goods sold (cogs)

If beginning inventory is understated, cost of goods sold will be understated. If ending inventory is understated, cost of goods sold will be overstated

The effects on cost of goods sold can be computed by first entering incorrect data in the formula in Illustration 6B.1 and then substituting the correct data. beginning inventory + Cost of goods purchased - ending inventory = Cost of Goods Sold

Inventory Methods

Three factors companies consider when adopting different cost flow methods: In periods of inflation: Income Statement Effects, Balance Sheet Effects, Tax Effects

Assuming that the cost the company pays for inventory is increasing (inflation), which method will: Explain the financial statement effect of inventory cost flow assumptions. a. provide the highest net income? b. provide the highest ending inventory? c. result in the lowest income tax expense? d. result in the most stable earnings over a number of years?

a. FIFO, First in, First out b. FIFO, First in, First out c. LIFO, Last in, First out d. Average Cost

The factor which determines whether or not goods should be included in a physical count of inventory is: a. legal title. b. whether or not the purchase price has been paid. c. management's judgment. d. physical possession.

a. legal title

major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will

approximate their current cost

Average cost:

assume all units cots the same, total cost $60/3 = $20 cogs -allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred -assuming every unit cost the same

Under a periodic inventory system, all goods purchased during the period are assumed to be

available for the first sale, regardless of the date of purchase.

cost of goods available for sale

beginning inventory + cost of goods purchased Ie. 1,000 units available to sell during the period --To determine the cost of the units that were sold (the cost of goods sold), we assign a cost to the ending inventory and subtract that value from the cost of goods available for sale. --The value assigned to the ending inventory depends on which cost flow method we use. No matter which cost flow assumption we use, though, the sum of cost of goods sold plus the cost of the ending inventory must equal the cost of goods available for sale—in this case, $12,000.

LCNRV is an example of the accounting concept of conservatism, which means that the

best choice among accounting alternatives is the method that is least likely to overstate assets and net income

Analyzing financial statement and tax effects helps users determine which inventory costing method

best meets the company's objectives.

Cost of goods sold would be in the chart of accounts for merchandisers only. both merchandisers and manufacturers. manufacturers only. neither merchandisers nor manufacturers.

both merchandisers and manufacturers.

under LIFO, companies obtain the cost of the ending inventory

by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed Beginning Inventory + Cost of Goods Purchesed - Ending Inventroy (earliest prices) = COGS -- FISH assumption—first in still here.

errors are caused by failure to count or price the inventory correctly. In other cases, errors occur because

companies do not properly recognize the transfer of legal title to goods that are in transit. When errors occur, they affect both the income statement and the balance sheet.

There is no accounting requirement that the cost flow assumption be

consistent with the physical movement of the goods. Company management selects the appropriate cost flow method.

Taking a physical inventory involves actually

counting, weighing, or measuring each kind of inventory on hand

If goods in transit are shipped FOB destination: a. the buyer has legal title to the goods until they are delivered. b. the transportation company has legal title to the goods while the goods are in transit. c. no one has legal title to the goods until they are delivered. d. the seller has legal title to the goods until they are delivered.

d. the seller has legal title to the goods until they are delivered.

Some believe that LIFO presents a more realistic net income number. That is, LIFO matches the more recent costs against current revenues to provide a better measure of net income. During periods of inflation, many challenge the quality of non-LIFO earnings, noting that failing to match current costs against current revenues leads to an understatement of cost of goods sold and an overstatement of net income. As some indicate, net income computed using FIFO creates "paper or phantom profits"—that is,

earnings that do not really exist.

Inventory is accounted for at cost. Cost includes all

expenditures necessary to acquire goods and place them in a condition ready for sale. For example, freight costs incurred to acquire inventory are added to the cost of inventory, but the cost of shipping goods to a customer is a selling expense.

A tax rule, often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes they must also use it for

financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.

a company may also use more than one cost flow method at the same time. Stanley Black & Decker Manufacturing Company, for example, uses LIFO for domestic inventories and FIFO for

foreign inventories.

To determine ownership of goods, two questions must be answered: Do all of the

goods included in the count belong to the company? Does the company own any goods that were not included in the count?

In a period of inflation, FIFO produces a

higher net income because lower unit costs of the first units purchased are matched against revenue.

Inventory turnover and days in inventory help users determine

how long an item is in inventory. --High inventory turnover (low days in inventory) indicates the company has minimal funds tied up in inventory—that it has a minimal amount of inventory on hand at any one time. Although minimizing the funds tied up in inventory is efficient, too high an inventory turnover may indicate that the company is losing sales opportunities because of inventory shortages.

May select LIFO because LIFO results in the lowest

income taxes (because of lower net income) during times of rising prices

Last-In, First-Out (LIFO): Under the LIFO method using a perpetual system, the company charges to cost of goods sold the cost of the most recent purchase prior to sale. Therefore, the cost of the goods sold on September 10 consists of all the units from the August 24 and April 15 purchases plus 50 of the units in beginning

inventory

merchandising company,

inventory consists of many different items. Ie. in a grocery store, canned goods, dairy products. Items have two common characteristics: (1) they are owned by the company, and (2) they are in a form ready for sale to customers in the ordinary course of business. Thus, merchandisers need only one inventory classification:: merchandise inventory

LIFO reserve For a company using LIFO, the difference between

inventory reported using LIFO and inventory using FIFO. --enables analysts to make adjustments to compare companies that use different cost flow methods

In a period of inflation, LIFO produces a

lower net income because higher unit costs of the last goods purchased are matched against revenue.

rather than keep track of the cost of each particular item sold, most companies

make assumptions, called cost flow assumptions, about which units were sold.

By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into

management's production plans --low levels of raw materials and high levels of finished goods suggest that management believes it has enough inventory on hand and production will be slowing down

A major disadvantage of the specific identification method is that management may be able to

manipulate net income. For example, it can boost net income by selling units purchased at a low cost, or reduce net income by selling units purchased at a high cost.

Merchandising company:

merchandise inventory ( owned by company, ready to sell)

To adjust Caterpillar's inventory balance, we add the LIFO reserve to reported inventory, That is, if Caterpillar had used FIFO all along, its inventory would be $11,112 million, rather than $8,614

million. current ratio:: (current assets ÷ current liabilities)

Under the LCNRV basis, net realizable value refers to

net amount that a company expects to realize (receive) from the sale of inventory --estimated selling price in the normal course of business, less estimated costs to complete and sell.

Quality of earnings ratio

net cash provided by operating activities/net income

With the Moving-average method when is new average calculated?

new average after each purchase, by dividing the cost of goods available for sale by the units on hand. The average cost is then applied to (1) the units sold, to determine the cost of goods sold, and (2) the remaining units on hand, to determine the ending inventory amount.

Companies apply LCNRV to the items in inventory after they have used

one of the inventory costing methods (specific identification, FIFO, or average-cost) to determine cost.

FOB (free on board) shipping point Freight terms indicating that

ownership of goods passes to the buyer when the public carrier accepts the goods from the seller.

FOB destination Freight terms indicating that

ownership of goods remains with the seller until the goods reach the buyer.

ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold and net income in two

periods.

If prices are falling, the results from the use of FIFO and LIFO are

reversed. FIFO will report the lowest net income and LIFO the highest.

The use of LIFO in a perpetual system will usually produce cost allocations that differ from those using LIFO in a periodic system. In a perpetual system, the latest units purchased prior to each sale are allocated to cost of goods sold. In contrast, in a periodic system, the latest units purchased during the period are allocated to cost of goods sold. Thus, when a purchase is made after the last sale, the LIFO periodic system will apply this purchase to the previous

sale

Consigned goods Goods held for

sale by one party although ownership of the goods is retained by another party. --If you take the item to a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is sold. Under this agreement, the dealer would not take ownership of the car, which would still belong to you. Therefore, if an inventory count were taken, the car would not be included in the dealer's inventory because the dealer does not own it.

Consistency concept Companies use the

same accounting principles and methods from year to year. -same cost flow method - FIFO, LIFO, Average --does not mean that a company may never change its inventory costing method. When a company adopts a different method, it should disclose in the financial statements the change and its effects on net income

manufacturing company,

some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories: finished goods, work in process, and raw materials.

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 the sale --goods in transit (on board a truck, train, ship, or plane)

cost flow assumptions

the choice of an inventory costing method is not based on the physical flow of goods on and off the shelves -not related to the actual unit sold, actual unit only matters in specific identificatoin

No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at

the end of the accounting period.

Specific Identification

the inventory costing method that identifies the cost of the specific item that was sold -used in high dollar inventory, (car dealership) not used often

Companies using a periodic inventory system take a physical inventory for two different purposes:

to determine the inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period. --Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.

major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly

understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior accounting periods

Inventory fraud increases during recessions. Such fraud includes pricing inventory at amounts in excess of its actual value, or claiming to have inventory when no inventory exists. Inventory fraud usually overstates ending inventory, thereby

understating cost of goods sold and creating higher income.

under FIFO, companies obtain the cost of the ending inventory by taking the

unit cost of the most recent purchase and working backward until all units of inventory have been costed. --LISH assumption—last in still here

very few companies use perpetual LIFO, FIFO, or average-cost, most companies, Instead, companies that use perpetual systems often

use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they recalculate cost of goods sold using periodic FIFO, LIFO, or average-cost as shown in this chapter and adjust cost of goods sold to this recalculated number