Accounting 2000 Chapter 6 Notes 1 Describe the steps in determining inventory quantities 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions 4 Explain the lower of cost or market basis of accounting for inventories 5 Compute and interpret the inventory turnover ratio 6 Describe the LIFO reserve and explain its importance for comparing results of different companies Classifying Inventory Physical inventory taken for 2 reasons Perpetual System 1 Check accuracy of inventory records 2 Determine amount of inventory lost wasted raw materials shoplifting or employee theft Periodic System 1 Determine the inventory on hand 2 Determine the COGS for the period Taking a Physical Inventory 1 Accounting 2000 Chapter 6 Notes Involves weight measuring or counting each kind of inventory on hand Taken when the business is closed or business is slow at end of the accounting period Determining Ownership of Goods Goods in Transit Purchased goods not yet received Sold goods not yet delivered Legal title is determined by the terms of sale Free on board FOB Consigned Goods Goods held for sale by one party although title owner of the goods is retained by another party Inventory Costing 2 Accounting 2000 Chapter 6 Notes Unit costs can be applied to quantities on hand using the following costing methods Illustration Assume that Crivitz TV Company purchases three identical 50 inch TVs on different dates at costs of 700 750 and 800 During the year Crivitz sold two sets at 1 200 each These facts are summarized below 1 Specific Identification If Crivitz sold the TVs it purchased on February 3 and May 22 then its cost of goods sold is 1 500 700 800 and its ending inventory is 750 Illustration Data for Houston Electronics Astro condensers 3 Accounting 2000 Chapter 6 Notes Beginning Inventory Purchases Ending Inventory Cost of Goods Sold 2 First In First Out FIFO Earliest goods purchased are first to be sold Often parallels actual physical flow of merchandise Generally good business practice to sell oldest units first First In First Out FIFO cont 4 Accounting 2000 Chapter 6 Notes 3 Last In First Out LIFO Latest goods purchased are first to be sold Seldom coincides with actual physical flow of merchandise Exceptions include goods stored in pile such as coal or hay Last In First Out LIFO cont 5 Accounting 2000 Chapter 6 Notes 4 Average Cost a Allocates cost of goods available for sale on the basis of weighted average unit cost incurred b Assumes goods are similar in nature c Applies weighted average unit cost to the units on hand to determine cost of the ending inventory Average Cost cont 6 Financial Statement Effects 1 2 3 4 In periods of rising prices FIFO reports lowest COGS In periods of rising prices FIFO reports highest Ending Inventory Net Income Gross Profit In periods of rising prices LIFO reports lowest Ending Inventory Net Income Gross Profit In periods of rising prices LIFO reports highest COGS Accounting 2000 Chapter 6 Notes 7 Accounting 2000 Chapter 6 Notes Using Cost Flow Methods Consistently Method should be used consistently enhances comparability Although consistency is preferred a company may change its costing method Lower of Cost or Market When the value of inventory is lower than its cost Companies can write down the inventory to its market value in the period in which the price decline occurs Market value Replacement Cost Example of conservatism Inventory management is a double edged sword 1 High Inventory Levels may incur high carrying cost 2 Low Inventory Levels may lead to stockouts and lost sales 8 Accounting 2000 Chapter 6 Notes Inventory Ratios Illustration Data available for Wal Mart LIFO Reserve Companies using LIFO are required to report the amount that inventory would increase or occasionally decrease if the company had instead been using FIFO Inventory Errors Failure to count or price inventory correctly Not properly recognizing the of legal title to goods in transit affect both the income statement and balance sheet Income Statement Effects Inventory errors affect the computation of cost of goods sold and net income 9 Accounting 2000 Chapter 6 Notes Inventory errors affect the computation of COGS and net income in periods An error in ending inventory of the current period will have a effect on net income of the next accounting period Over the two years the total net income is correct because the errors each other Income Statement Effects cont 2011 2012 Incorrect Correct Incorrect Correct Sales 80 000 80 000 90 000 90 000 Beginning inventory 20 000 20 000 12 000 15 000 Cost of goods purchased 40 000 40 000 68 000 68 000 Cost of goods available 60 000 60 000 80 000 83 000 Ending inventory 12 000 15 000 23 000 23 000 Cost of good sold 48 000 45 000 57 000 60 000 Gross profit 32 000 35 000 33 000 30 000 Operating expenses 10 000 10 000 20 000 20 000 Net income 22 000 25 000 13 000 10 000 10 Accounting 2000 Chapter 6 Notes Balance Sheet Effects Effect of inventory errors on the balance sheet is determined by the equation International Financial Reporting Standards Accounting standards for inventories are more in IFRS IFRS prohibits the use of In Class Exercises E6 5 and P 2A 11