Professional Documents
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CH 06
CH 06
6
REPORTING AND ANALYZING INVENTORY
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Study Objectives
1. 2. Describe the steps in determining inventory quantities. Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. Explain the financial statement and tax effects of each of the inventory cost flow assumptions. Explain the lower-of-cost-or-market basis of accounting for inventories. Compute and interpret the inventory turnover ratio. Describe the LIFO reserve and explain its importance for comparing results of different companies.
3.
4.
5. 6.
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Classifying Inventory
Merchandising Manufacturing Just-in-time
Inventory Costing
Specific identification Cost flow assumptions Financial statement and tax effects Consistent use Lower-of-costor-market
Analysis of Inventory
Inventory turnover ratio LIFO reserve
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Classifying Inventory
Merchandising Company
One Classification:
Manufacturing Company
Three Classifications:
Merchandise Inventory
Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
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Periodic System
1. Determine the inventory on hand 2. Determine the cost of goods sold for the period.
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Purchased goods not yet received. Sold goods not yet delivered.
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 sale.
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Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
Ownership of the goods remains with the seller until the goods reach the buyer.
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Inventory Costing
Unit costs can be applied to quantities on hand using the following costing methods:
Specific Identification First-in, first-out (FIFO) Last-in, first-out (LIFO) Average-cost
Cost Flow Assumptions
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Inventory Costing
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.
Illustration 6-2
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Inventory Costing
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 6-3
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Inventory Costing
Specific Identification
Actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory. Practice is relatively rare.
Most companies make assumptions (Cost Flow Assumptions) about which units were sold.
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Inventory Costing
Cost Flow
Assumption
does not need to equal Physical Movement of Goods
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Earliest goods purchased are first to be sold. Often parallels actual physical flow of merchandise. Generally good business practice to sell oldest
units first.
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
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SO 2
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Latest goods purchased are first to be sold. Seldom coincides with actual physical flow of merchandise. Exceptions include goods stored in piles, such as
coal or hay.
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred. Assumes goods are similar in nature. Applies weighted-average unit cost to the units
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Sales
$9,000
$9,000
$9,000
6,200
2,800 330
6,600
2,400 330
7,000
2,000 330
2,470
140 $2,330
2,070
120 $1,950
1,670
110 $1,560
Inventory balance
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$5,800
$5,400
$5,000
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
Sales
$9,000
$9,000
$9,000
Lowest
6,200
2,800 330
6,600
2,400 330
7,000
2,000 330
2,470
140 $2,330
2,070
120 $1,950
1,670
110 $1,560
Highest
Net income
Inventory balance
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$5,800
$5,400
$5,000
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
Sales
$9,000
$9,000
$9,000
Highest
6,200
2,800 330
6,600
2,400 330
7,000
2,000 330
2,470
140 $2,330
2,070
120 $1,950
1,670
110 $1,560
Lowest
Net income
Inventory balance
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$5,800
$5,400
$5,000
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
b. LIFO method.
c. average cost method. d. gross profit method.
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LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
b. LIFO method.
c. average cost method. d. gross profit method.
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LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
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Inventory Costing
Using Cost Flow Methods Consistently
Method should be used consistently, enhances comparability. Although consistency is preferred, a company may change its inventory costing method.
Illustration 6-14 Disclosure of change in cost flow method
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LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
Inventory Costing
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.
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Inventory Costing
Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.
Illustration 6-15
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Analysis of Inventory
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying
lost sales.
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Analysis of Inventory
Inventory Turnover Ratio
Illustration 6-16
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Analysis of Inventory
Illustration: Data available for Wal-Mart.
Illustration 6-16
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Analysis of Inventory
Analysts Adjustments for 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. This amount is referred to as the LIFO reserve.
Illustration 6-17
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SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.
Analysis of Inventory
Analysts Adjustments for LIFO Reserve
The LIFO reserve can have a significant effect on ratios analysts commonly use.
Illustration 6-19
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SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.
appendix 6A
Illustration:
Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.
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appendix 6A
First-In-First-Out (FIFO)
Ending Inventory
appendix 6A
Last-In-First-Out (LIFO)
Ending Inventory
appendix 6A
Average-Cost
Ending Inventory
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appendix 6B
Inventory Errors
Common Cause:
Inventory Errors
Failure to count or price inventory correctly. Not properly recognizing the transfer of legal title to goods in transit. Errors affect both the income statement and balance sheet.
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appendix 6B
Income Statement Effects
Inventory Errors
Inventory errors affect the computation of cost of goods sold and net income.
Illustration 6-B1
Illustration 6-B2
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appendix 6B
Income Statement Effects
Inventory Errors
Inventory errors affect the computation of cost of goods sold and net income in two periods.
An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period. Over the two years, the total net income is correct because the errors offset each other.
Ending inventory depends entirely on the accuracy of taking and costing the inventory.
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appendix 6B
Illustration 6-B3
Inventory Errors
2011 Incorrect Correct $ 80,000 20,000 40,000 60,000 12,000 48,000 32,000 10,000 $ 22,000 $ $ 80,000 20,000 40,000 60,000 15,000 45,000 35,000 10,000 25,000 $ 2012 Incorrect Correct $ 90,000 12,000 68,000 80,000 23,000 57,000 33,000 20,000 13,000 $ $ 90,000 15,000 68,000 83,000 23,000 60,000 30,000 20,000 10,000
Sales Beginning inventory Cost of goods purchased Cost of goods available Ending inventory Cost of good sold Gross profit Operating expenses Net income
appendix 6B
Review Question
Inventory Errors
Understating ending inventory will overstate: a. assets. b. cost of goods sold. c. net income. d. owner's equity.
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appendix 6B
Balance Sheet Effects
Inventory Errors
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:
Illustration 6-B1
Illustration 6-B4
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Key Points
The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting. The definitions for inventory are essentially similar under IFRS and GAAP. Both define inventory as assets held-forsale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).
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Key Points
Who owns the goodsgoods in transit or consigned goodsas well as the costs to include in inventory, are accounted for the same under IFRS and GAAP.
Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used.
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Key Points
A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS. IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.
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Key Points
In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. In other words, net realizable value is the best estimate of the net amounts that inventories are expected to realize. GAAP, on the other hand, defines market as essentially replacement cost.
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Key Points
Under GAAP, if inventory is written down under the lower-ofcost-or-market valuation, the new value becomes its cost basis. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement as an expense. An item-by-item approach is generally followed under IFRS.
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Key Points
Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost. Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.
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Which of the following should not be included in the inventory of a company using IFRS? a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company. c) Goods in transit from another company shipped FOB shipping point.
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Which method of inventory costing is prohibited under IFRS? a) Specific identification. b) FIFO. c) LIFO. d) Average-cost.
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Specific identification: a) must be used under IFRS if the inventory items are not interchangeable. b) cannot be used under IFRS. c) cannot be used under GAAP. d) must be used under IFRS if it would result in the most
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Copyright
Copyright 2011 John Wiley & Sons, Inc. All rights reserved.
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