Chapter 5 Reporting and Analyzing Inventories Inventory Basics sale Merchandise inventory includes all goods that a company owns and holds for Goods in transit these goods inventory are counted as inventory if there was FOB shipping point aka purchaser took responsibility of the goods when they left the warehouse Goods on consignment are goods shipped by the owner called the consignor to another party the consignee a consignee sells goods for the owners the consignor continues to own the goods and reports them in its inventory Goods damaged or obsolete are not counted in inventory if they cannot be sold if these goods can be sold at a lower price then they are in the inventory at a conservative estimate of their net realizable value is sales price minus the cost of making the sale Invoice cost minus any discounts plus any incidental costs such as import duties freight storage insurance Incidental costs are added to inventory Matching principle states that inventory costs should be recorded against revenue in the period when inventory is sold Materiality constraint cost to benefit constraint avoid assigning some incidental costs of acquiring merchandise to inventory expense them when incurred Inventory account balance can differ from actual inventory available because of theft loss damage and errors therefore all companies take a physical count of inventory aka taking an inventory at least once each year Inventory Costing Under a Perpetual System Accounting for inventory affects the balance sheet and income statement Properly match cost with sales Items included in inventory and their costs costing method inventory system use of market values or other estimates management decisions that affect the reported amounts of inventory cost of goods sold gross profit income current assets and other accounts Important determine the per unit costs assigned to inventory items o Four methods are used to assign costs to inventory and costs of goods sold o 1 Specific identification o 2 First in first out assumes costs flow in the order incurred the earliest cost incurred is sent to the cost of goods sold on the income statement and the other units are reported in inventory on the balance sheet o 3 Last in first out assumes cost flow in the reverse order incurred most recent cost incurred is sent to cost of goods on the income statement and the other units are reported in inventory on the balance sheet o 4 Weighted average assumes costs flow at an average of the costs available the average is sent as cost of goods on the income statement and the remaining units is reported as inventory on the balance sheet Specific identification aka specific invoice inventory pricing when each item in inventory can be identified with a specific purchase and invoice we can use this to assign costs When costs are rising o Managers prefer FIFO when costs are rising and incentives exist to report higher income for reasons such as bonus plans job security and reputation FIFO assigns the lowest amount to cost of goods sold o LIFO assigns the highest amount to cost of goods sol yielding the lowest gross profit and net income and a temporary tax advantage by postponing payment of some income tax o Weighted average yields results between FIFO and LIFO o Specific identification always yields results that depend on which units are sold Opposite when costs are declining Advantages of each method o FIFO assigns an amount to inventory on the balance sheet that approximates its current costs it also mimics the actual flow of goods for most businesses o LIFO assigns an amount to cost of goods sold on the income statement that approximates its current cost it also better matches current costs with revenues in computing gross profit o Weighted average tends to smooth out erratic changes in costs o Specific identification exactly matches the costs of items when the revenues they generate When LIFO is used for tax reporting the IRS requires that it also be used in financial statements LIFO conformity rule Consistency concept prescribes that a company use the same accounting methods period after period so that financial statements are comparable across periods the only exception is when a change from one method to another will improve its financial reporting Full disclosure principle prescribes that the notes to the statements report this type of change its justification and its effect on income Valuing Inventory at LCM and the Effects of Inventory Errors Inventory must be reported at the market value cost of replacing inventory when market value is lower than cost Lower of cost or market LCM merchandise inventory is then said to be reported on the balance sheet as this Market is defined as the current replacement cost of purchasing the same inventory o When the recorded cost of inventory is higher than the replacement o When the recorded cost of inventory is higher than the replacement cost a loss is recognized cost no adjustment is made LCM can be applied to each individual item to major categories of items to the whole of inventory Inventory must be adjusted downward when market is less than cost o Debit costs of goods sold the difference o Credit merchandise inventory Conservatism constraint prescribes the use of the less optimistic amount when more than one estimate of the amount to be received or paid exists and these estimates are about equally likely Effects of inventory errors on the income statement Effects of inventory errors on the balance sheet
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