Chapter 6 Inventories How a company classifies its inventory depends on whether the firm is a merchandiser or a manufacturer Merchandising Companies Classifying Inventory Inventory consists of many different items EX Grocery store The items have 2 common characteristics 1 They are owned by the company 2 They are already in a form ready for sale to customers in the ordinary course of business Merchandisers need only one inventory classification merchandise inventory to describe the many different items that make up the total inventory Manufacturing Companies Some inventory may not be ready for sale Usually classify into 3 categories 1 Finished Goods Inventory manufactured items that are completed and are ready for sale 2 Work in Progress is that portion of manufactured inventory that has been placed into the production process but is not yet complete 3 Raw Materials are the basic goods that will be used in production but have not yet been placed into production 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 Ex Low levels of raw materials and high levels of finished goods indicates that managers believe there is enough inventory on hand and production will be slowing down Just in time inventory method companies manufacture or purchase goods just in time for use Depends on reliable suppliers By doing this you can reduce your inventory to nearly zero Valuable when products become obsolete nearly overnight Determining Inventory Quantities All companies need to determine inventory quantities at the end of the accounting period regardless if they are using periodic or perpetual If using perpetual companies take physical inventory for two reasons 1 To check the accuracy of inventory lost due to wasted raw materials shoplifting or employee theft 2 To check the accuracy of their perpetual inventory records If using periodic physical inventory is taken to determine the inventory on hand at the balance sheet date and to determine the cost of goods sold for that period Taking inventory quantities involves two steps 1 Taking physical inventory 2 Determining ownership of goods Involves actually counting weighing or measuring each kind of inventory on hand To determine the ownership of goods two questions must be answered Do all of the goods included in the count belong to the company Goods in Transit Goods in Transit Company may have purchased goods that have not yet been received or it may have sold goods that have not been delivered Company must determine ownership of these goods When terms are FOB shipping point ownership of the goods passes to the buyer when When the terms are FOB destination ownership of the goods remains with the seller until the public carrier accepts the goods from the seller the goods reach the buyer Does the company own any goods that were not included in the count Consigned Goods Consigned Goods holding goods of other parties and selling the goods for them for a fee without taking ownership of the goods Chapter 6 Pg 1 Specific Identification Cost Flow Assumptions Inventory is accounted for at cost Inventory Costing Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale Ex Freight costs incurred to acquire inventory are added to cost of inventory cost of shipping goods to a customer are a selling expense After a company has determined the quantity of units of inventory it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold This can be complicated if a company has purchased inventory items at different times and at different prices The specific identification method is when companies are able to accurately identify which particular units it sold and what they paid for each individual good This way companies can accurately determine ending inventory and cost of goods sold Although possible the process is still relatively difficult and is rare Rather than keep track of the cost of each particular item sold most companies make assumptions called cost flow Cost flow methods differ from specific identification because they assume flows of costs may be unrelated to the physical flow assumptions about which units are sold of goods There are 3 assumed cost flow methods 1 First in first out FIFO 2 Last in first out LIFO Assumes that the earliest goods purchased are the first to be sold FIFO often parallels the actual physical flow of merchandise Ending inventory is based on the prices of the most recent units purchased It is generally good business practice to sell oldest units first Under FIFO the costs of the earliest goods purchased are the first to be recognized in determining COGS This does not necessarily mean that the oldest units are sold first but that the earliest goods purchased are the first to be recognized in determining COGS sale Under FIFO the company charges to cost of goods sold the cost of the earliest goods on hand prior to the 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 You can also calculate COGS by pricing the first units sold using the prices of the first units acquired Assumes that the latest goods purchased are the first to be sold Seldom coincides with the actual physical flow of inventory Ending inventory is based on the prices of the oldest units purchased Under LIFO the costs of the latest goods purchased are the first to be recognized in determining the COGS 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 Companies can also calculate COGS by pricing units sold using the prices of the last units acquired under periodic All goods purchased during the period are assumed to be available for the first sale regardless of the date of purchase The use of LIFO in a perpetual system will usually produce cost allocations that differ from those using LIFO in a periodic system Perpetual Company allocates the latest units purchased prior to each sale to cost of goods sold Periodic 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