Accounting Ch. 6: Reporting and Analyzing Inventory
Current Ratio
Current Assets --------------------- Current Liabilities
Merchandising Company
inventory consists of many different items. - the items in a merchandising company have two common characteristics 1) The item are owned by the company 2) they are in a form ready for sale to customers in the ordinary course of business Merchandise inventory- is the only classification merchandisers needs to describe the many different items that make up the total inventory.
Finished goods Inventory
is manufactured items that are completed and ready for sale.
Work in Process
is the portion of the manufactured inventory that has begun the production process, but is not yet complete
Why current replacement cost is used
it is used because a decline in the replacement cost of an item usually leads to a decline in the selling price of the item.
Beginning Inventory Overstated
Cost of goods sold- Overstated Net Income- Over stated
Ending inventory Understated
Cost of goods sold- Overstated Net income- Understated
Beginning inventory understated
Cost of goods sold- Understated Net income- Overstated
Ending inventory overstated
Cost of goods sold- understated Net income- Overstated
Determining Inventory quantities (2 steps)
1) Taking a physical inventory of goods on hand 2) determining the ownership of goods
Days in Inventory
365 --------------------- Inventory Turnover
Balance Sheet Effects
An advantage of the FIFO method is: - Under a period of inflation, the cost allocate to the ending inventory will approximate their current cost. - Under LIFO however, the cost allocated to ending inventory may be significantly understated in terms of current cost. Ex. Caterpillar has used LIFO for over 50 years. Their net income showed 14.5 billion. However, because we're not under a recession, the company could have had a net income of 17 billion had they used FIFO.
Phantom Gains and Example
A company buys the following Jan 10- 200 units at $20 per unit Dec 31- 200 units at $24 per unit. Assume the company sells 200 units at $30 per unit. This would mean the company sold the units for $6,000. Under the assumptions, FIFO - would produce a cost of goods sold of $4,000 and a gross profit of $2,000 LIFO - would produce a cost of goods sold of $4,800 and a gross profit of $1,200. Even though FIFO produced a higher net income, $800 of that still has to be reinvested to cover the units that would be purchased on Dec 31. LIFO however, would produce a cost of goods sold of $4,800 and a gross profit of $1,200. With the cost of goods on Dec 31 being $24 per unit, LIFO fully recouped the amount for purchase of the new goods. Therefore, the extra $800 claimed under FIFO is considered phantom because it's not actually profit.
Specific Identification
A company can use this if it can identify which particular units were sold and which are still in inventory. - specific identification is rarely used because of bar coding and other inventory track methods.
LIFO Example
A company has 450 units at the end of its inventory. It had 1000 units to start with at a total overall unit cost of $12,000. The breakdown is as follows - Jan 1- 100 Units- $10 unit cost- $1,000 total cost - April 150- 200 units- $11 unit cost- $2,200 total cost - Aug 24- 300 units- $12 unit cost- $3,600 total cost Nov 27- 400 units- $13 unit cost- $5,200 total cost Under LIFO, the company would take the 450 units from the breakdown of the oldest goods purchased. 100 units from Jan 1 at a cost of $10 per unit= $1,000 200 unit from Apr 15 at a cost of $11 per unit= $2,200 150 units from Aug 24 at $12 per unit= $1,800 Total =$5,000. Subtract this from the overall total of $12,000= $7,000. This means that the first 550 units sold were sold at a total cost of $7,000.
Example of FIFO
A company has 450 units at the end of its inventory. It had 1000 units to start with at a total overall unit cost of $12,000. The breakdown is as follows - Jan 1- 100 Units- $10 unit cost- $1,000 total cost - April 150- 200 units- $11 unit cost- $2,200 total cost - Aug 24- 300 units- $12 unit cost- $3,600 total cost Nov 27- 400 units- $13 unit cost- $5,200 total cost Under FIFO, you would determine the ending cost by taking the 450 units remaining from the most recent purchased. That means 400 from the Nov 27 date at $13 per unit for $5,200 and the remaining 50 units from the Aug 24 inventory at $12 per unit for a cost of $600. This gives you a total of $5,800. Now you subtract this from the total $12,000 and get $6,200. This means that the cost of the first 550 units was $6,200, under FIFO.
Average-Cost
Allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. Under the average cost, you would take the total cost and divide it by the total units to get the average cost. Then take the amount of units left and multiply it by the average cost. Following that, subtract that by the total cost and that's your average cost of goods sold. Average cost uses the average weighted by the quantities purchased at each unit cost.
First-In, First Out
Assume that the earliest goods purchased are the first to be sold. - Good business practice to sell the oldest units first. - FIFO is the best method because the cost of the earliest foods purchased are the first to be recognized in determining the cost of goods sold, regardless of which are actually sold first. ---- It does not mean that the oldest units are sold first, but that the costs of the oldest units are recognized first.
Taking a physical Inventory
At the end of each accounting period, companies take a physical inventory of the items on hand. Retailers with greater inventory take longer to take inventory and will close the story early to take inventory. It is consequently easier to take inventory with a smaller inventory
The LIFO Method
Because LIFO assumed that the first goods sold were those that were most recently purchased, the ending inventory is based on the prices that were of the oldest units purchased - 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 unit all units of inventory have been costed. Under a periodic system- all goods purchased during the period are assumed to be available for the first sale regardless of the date of purchase.
Example of the categories
Caterpillar classifies it as follows. Finished Goods- would be the earth moving completed tractors. Work in Process- would be tractors on the assembly line Raw Materials- the steel, glass, tires, and other components that are on hand waiting to be used in the production of the tractors.
Classifying inventory
Classification depends on whether the firm is a merchandiser or a manufacturer
LIFO Reserve
Companies using different cost flow assumptions report different incomes. LIFO Reserve- Companies using LIFO are required to report the difference between inventory reported using LIFO and inventory using FIFO. Reporting the LIFO Reserve enables analysts to make adjustments to compare companies that use different cost flow methods. After you have found the inventory cost using LIFO you would then add the lifo reserve to it to estimate the the inventory using LIFO plus the reserve.
Inventory Turnover
Cost of Goods Sold ---------------------- Average Inventoru
Periodic System calculation for cost of goods sold.
Cost of Goods sold = (Beginning inventory + Purchases) - Ending Inventory
Inventory cost flow methods in perpetual inventory systems
Each of the systems used under periodic considerations can also be used under perpetual systems. Consider the following information: Houston Electronics: - Jan 1- Beginning inventory- 100 units- $10 unit cost- $1,000 total cost- Balance in units- 100 units - Apr 15- Purchase- 200 units- $11 unit cost- $2,200 total cost- Balance in units- 300 units - Aug 24- Purchase- 300 units- $12 unit cost- $3,600 total cost- Balance in units- 600 units - Sept 10- Sale- 550 units- balance in units-50 - Nov 27- Purchase- 400 units- $13 unit cost- $5,200 total cost- Balance in units- 450 Units
Errors in the ending inventory have the following effects
Ending inventory error - Overstated Assets - Overstated Liabilities - No effect Stockholders' equity - Overstated Ending inventory error - Understated Assets - Understated Liabilities - No effect Stockholders' equity - Understated
Inventory Errors
Errors can be caused by a few different factors, such as the following: - failure to count or price inventory correctly - when companies do not properly recognize the reenter of legal title to goods that are in transit
In most instances, pricing are rising (Inflation). In a period of inflation:
FIFO - Higher net income - Lower unit costs of first units produced - Subjected to higher taxes LIF0 - Lower net income - Higher first units cost - Lower income taxes Average-Costs - Will fall in between the two assumptions and will be subjected to a median tax.
If prices are falling (Recession) The results of FIFO and LIFO will be reversed.
FIFO under recession - lower net income - higher first unit cost - lower income tax LIFO - Higher net income - Lower first unit cost - higher income tax
Explain the financial statement and tax effects of each of the inventory cost flow assumptions
FIFO- Higher net income, lower cost of goods, higher taxes LIFO- Lower net income, higher cost of goods sold, lower taxes
LIFO, FIFO, and Average Cost Companies
FIFO- companies such as; Reebok, Wendy's international LIFO- Campbells soup, krogers, and walgreens Average-Cost- Bristol-Meyers Squibb, Starbucks, and Motorola
Lower-Of-Cost-Or-Market
If a company purchases an item and the price of that item falls significantly, the company can use the lower of cost of market method to value the inventory in the period in which the price decline occurs. -LCM is a basis whereby inventory is stated at the lower of either its cost or market value as determined by current replacement cost. -LCM is an example of there accounting convention of conservatism. Conservatism means that the approach adopted among accounting alternative is the method that is least likely to overstate assets and net income. Under LCM basis, market is defined as current replacement cost, not selling price.
Indicate the effects of inventory errors on the financial statements
In the income of the current year - an error in the beginning inventory will have a reverse effect on net income (overstatement of inventory results in understatement of net income) - an error in ending inventory will have a similar effect on net income (overstatement of inventory results in overstatement of net income) - if ending inventory error are not correct in the following period, their effect on net income for that period is reversed and total net income for the two years will be correct - in the balance sheet: ending inventory error will have the same effect on total assets and total stockholders' equity, but no effect on liabilities.
Which inventory costing method should be used?
Info needed: - Are prices increasing, or are they decreasing? Tools used for decision: - Income statement, balance sheet, tax effects How to evaluate results: - In a period of rising prices, income and inventory are higher and cash flow is lower under FIFO - In a period of rising prices, income and inventory are lower and cash flow is higher under LIFO - Average costs can moderate the impact of change.
What is the impact of LIFO on the company's reported inventory?
Info needed: - LIFO reserve, cost of goods sold, ending inventory, current assets, current liabilities Tools to use: - LIFO inventory + LIFO reserve= FIFO inventory How to evaluate: - if these adjustments are material, they can significantly affect such measures as the current ratio and inventory turnover
How long is an item in inventory?
Info needed: - cost of goods sold; beginning and ending inventory Tools to use for decision: - Inventory turnover: Cost of goods sold/ Average inventory or Days in inventory: 365 days/Inventory turnover How to evaluate results: - a higher inventory turnover or lower average days in inventory suggest that management is reducing the amount of inventory on hand, relative to the cost of goods sold
Compute and interpret the inventory turnover
Inventory Turnover= cost of goods sold/ average inventory. It can be converted to average days in inventory by dividing 365 days by the inventory turnover. High inventory turnover or lower average day sin inventory suggest that management is trying to keep inventory levels low relative to its sales level.
Determining ownership of goods
Inventory is accounted at a cost. Meaning, the cost to acquire the goods and make them ready for sale. - If freight was required to get the good to you, that would be included in the cost of ownership - If freight is paid to ship it to a customer, that is seen as a sales expense.
Inventory Turnover
Is calculated as: The cost of goods sold/ the average inventory. - This indicated the liquidity of the inventory by measuring the number of times the average inventory turns over (is sold) during the year. Inventory turnover can be divided into 365 days to compute the days in inventory, which indicated the average number of days inventory is held.
Cost of goods available for sale
Is defined as the beginning value of inventory + cost of goods purchased
Reporting and Analyzing Inventory
Is made up of 3 primary components - Classifying and determining inventory - Inventory costing - Analysis of Inventory
Apply the inventory cost flow methods to perpetual inventory records
LIFO- the cost of the earliest goods on hand prior to each sale is charged to the cost of goods sold. Under LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold. Average-cost- a new average cost is computed after each purchase
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 one time. Too high of an inventory turnover, can indicate a company could be losing sales because of inventory shortages.
Analysis of Inventory
Managing inventory levels is on of the most important tasks for any company that sells goods. Having too much inventory on hand costs the company money in storage costs, interest costs (on funds tied up in inventory), and costs associated with the obsolescence of technical goods (e.g. computer chips, or shifts in fashion (clothes). - Having too little inventory results in the loss of sales.
Tax Effects
Many companies still use LIFO because of the difference in taxes. Many companies see the difference in taxes as money that is available to put back into the business. Because LIFO increases cash flows, you find that it also has the highest "net cash provided by operating activities." This also means that it has the highest quality of earnings ratio (Net cash provided by operating activities divided by net income). 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 conservative measure of net income, which decreases the ratio's denominator.
Determine how to classify inventory and inventory quantities
Merchandisers need only one inventory classification, merchandise inventory, to describe the different items that makeup the total inventory. Manufacturers classify based upon 3 different categories 1) finished goods 2) work in process 3) raw materials Manufacturers determine inventory by 1) Taking a physical inventory of goods on hand 2) determine the ownership of goods in transit or on consignment
How companies view higher net income
Most companies aren't concerned with the higher taxes associated with higher net income. External users will obviously view higher net income more favorably. - Management will also bonus based on net income. Therefore, under inflation, companies tend to prefer FIFO because it results in a higher net income.
Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system
Primary basis of accounting for inventories is cost. - Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. Cost of goods available for sale includes: - The cost of beginning inventory - cost of goods purchased Inventory cost flow methods are done one of three different ways - FIFO - LIFO - Average cost
Determining Inventory Quantities
Regardless of a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of accounting periods. Perpetual inventory systems take a physical inventory for the following reasons: - to check the accuracy of their records - to determine the amount of inventory lost due to raw material, shoplifting, or employee theft. Periodic inventory system takes a physical inventory for two purposes: - determine the inventory on hand at the balance sheet date - determine the cost of goods sold
High levels of raw materials and low levels of finished goods
Signal that management believes it is planning to step up production
Manufacturing Company
Some of the inventory may not be ready for sale. Due to the fact some of the items may not be ready for sale, manufacturers classify their items into 3 categories 1) Finished goods 2) Work in process 3) Raw Materials By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into the management's production plans.
Low levels of Raw Materials and high levels of finished goods
Suggest that mgmt believes it has enough inventory on hand and production will be slowing down. - This also could be anticipation of a recession.
Describe the LIFO reserve and explain its importance for comparing results of different companies.
The LIFO reserve represents the difference between ending inventory using LIFO and ending inventory if FIFO were employed instead. For some companies the difference can be significant and ignoring it can lead to inappropriate conclusions when using the current ratio or inventory turnover.
Average-Cost under Perpetual Assumptions
The average cost in a perpetual system is much different that under a periodic system because the average is computed after each purchase and is referred to as the moving average method. - The average cost is computed by dividing the cost of goods available for sale by the units on hand. - the average is then applied to the units sold, to determine the cost of goods sold, and the remaining units sold to determine the ending inventory. - Under the periodic system the average is weighted as opposed to moving.
Balance sheet effects of inventory errors
The effects of ending inventory errors on balance sheets can be determined by using the basic accounting equation: Assets= Liabilities + Stockholders equity.
Financial statement and tax effects of cost flow methods
The reason different companies employ different cost flow methods are for one of the three following methods: 1) Income statement effects 2) Balance sheet effect 3) Tax effects
Cost Flow Assumptions
These methods assume flows of costs that may be untreated to the actual physical flow of goods - There is no accounting requirement that the cost flow assumption be consistent with the physical movement of goods. - Cost flow assumptions will, most of the time, use a periodic system vs. perpetual. Periodic systems record - LIFO (Last in, First Out) - FIFO (First in, First out) - Average-Cost Perpetual systems record - assumed cost (standard cost) to record cost of goods sold at the time of sale. - at the end of the period when they count their inventory, they recalculate cost of goods sold using a periodic method.
Explain the lower-of-cost-or-market basis of account for inventories
They use this when the current replacement cost (market) is less than the cost. Under LCM, companies can recognize the loss in the period in which the decline occurs
Last-In, First-Out (LIFO)
This assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. Goods that use LIFO - Goods store in piles, such as coal, hat, or where goods are removed from the top of the pile as they are sold. Under LIFO- The costs of the latest goods purchased are the first to be recognized in determining the cost of goods sold.
Classifying and Determining Inventory
Two important steps in the reporting of inventory at the end of the accounting period are: - the classification of inventory based on its degree of completeness - determination of inventory amounts
The FIFO Method
Under FIFO it is assumed that the first goods purchased were the first goods sold and ending inventory is based on the prices of the most recent units purchased. - Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units have been costed.
FIFO under Perpetual Inventory systems
Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to the cost of goods sold. - Therefore, the cost of goods sold on Sept 10 consists of the units on hand on Jan 1 and the units purchased April 15 and Aug 24. Ending inventory is $5,800 and the cost of goods sold is $6,200 [(100x$10)+(200x$11)+(250x$12). Results under LIFO are the same under both periodic and perpetual assumptions
Income Statement Effects
Under a condensed income statement you find that the a company had the following breakdown Sold-550 unit Price of units sold- $18,500 Expenses- $9,000 Income tax rate- 30% Cost of goods available for sale- $12,000 The ending inventories and the cost of goods sold are different under the three inventory cost flow methods. - Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes. - In periods of changing prices, the cost flow assumptions can have a significant impact on income and cost evaluations based on income.
Income statement effects of inventory errors
Under periodic systems - both the beginning and ending inventories appear in the income statement. - The ending inventory of one period automatically affects the beginning inventory of the next. - Thus, inventory errors affect the computation of cost of goods sold and net income in two periods. Beginning inventory + cost of goods purchased - ending inventory = cost of goods sold. If beginning inventory is understated - cost of goods sold will be understated In ending inventory is understated - cost of goods sold will be overstated
LIFO under the perpetual system
Under perpetual assumptions, LIFO would be the cost of the goods prior to the sale on sept 10, as opposed to being made up of the cost of the goods on Nov 27. Under periodic assumptions, Nov 27 would be used, however under perpetual assumptions, it would be everything prior to the date of the sale, but with the most recent prior to the date of the sale.
An error in the ending inventory of the current period:
Will have a reverse effect on net income of the next accounting period. - Note that the understatement of inventory of one year results in an understatement of the beginning inventory of the next year and an overstatement of net income for the following year as well. However, the total net income over the two years is correct because the understatement from one year balances to the next year and the total two year income would actually be correct
Raw Materials
are the basic goods that will be used in production, but have not
Determining the cost of items that were sold
assign a cost to the ending inventory and subtract is from the cost of goods available for sale
Just-in-time-inventory methods
companies manufacture or purchase goods just in time for use. Dell has figured out how to use this system and is still able to produce a computer tailored to the customer which ships out within 48 hours.
Current Replacement cost for merchandising companies
would be the cost of purchasing the same goods at the presort time from the usual suppliers in the usual quantities.
