INVENTORY VALUATION THE SIGNIFICANCE OF INVENTORY

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1 THE SIGNIFICANCE OF INVENTORY INVENTORY VALUATION In the balance sheet inventory is frequently the most significant current asset. In the income statement, inventory is vital in determining the results of operations for a particular period (COGS). There are two areas of concern with inventory as far as operating income goes: o Revenue recognition (F.O.B. status) o Ending inventory valuation ENDING INVENTORY VALUATION In order to prepare financial statements, you must determine: o The number of units of inventory owned, and o Value them. The determination of inventory quantities involves: o Counting goods on hand, and o Determining the ownership of goods. Items in Merchandise Inventory Goods in transit if ownership has been transferred to the owner, included in inventory Goods on consignment: goods shipped by owner (consignor) to a party (consignee) who sells good for owner. Reported in consignors inventory Goods damaged or obsolete: not counted in inventory if unsaleable, if saleable at reduced price, included at their net realizable value (NRV) which is the sales price minus the cost of making the sale. Costs of Merchandise Inventory Expenditures necessary, directly or indirectly, in bringing an item to a saleable condition and location Includes invoice price minus discount plus added or incidental costs (shipping, storage, insurance etc.) METHODS OF VALUING INVENTORY Method 1: Specific Identification The specific identification method tracks the actual physical flow of the goods. Each item of inventory is marked, tagged, or coded with its specific unit cost. It is most frequently used when the company sells a limited variety of high unit-cost items. Method 2: Cost Flow Methods Other cost flow methods are allowed since specific identification is often impractical. These methods assume flows of costs that may be unrelated to the actual physical flow of goods. Cost flow assumptions: 1. First-in, first-out (FIFO). 2. Last-in, first-out (LIFO). 3. Weighted Average Cost. Page 1 of 7

2 EXAMPLE To illustrate the methods use the following inventory schedule: Number of Units Cost Per Unit Total Value Beginning inventory 30 $52,500 May 2, purchase 20 $2,000 $40,000 May 9, purchase 10 $4,500 $45,000 May 18, purchase 10 $6,000 $60,000 Available for sale 70 $197,500 Sales May 7 25 May May Total Sold 52 Ending inventory 18 Specific Identification Best method suited to inventories of high priced, low volume items. custom jewelry, paintings, and estates. The items in inventory are matched to their purchase price. This method is not practical for large volumes of identical units. 22 units purchased from beginning $1750 $38, units purchased from May $2,000 $30,000 7 units purchased from May $4,500 31,500 8 units purchased from May $6,000 48,000 $148,000 Cost of goods available: $197,500 Less: Cost of goods sold: $148,000 Ending Inventory $ 49,500 Page 2 of 7

3 Weighted Average Cost Total the cost of all purchases and divide by the number of all units for sale. This calculation gives the weighted average cost, which is then multiplied by the actual number of units in ending inventory. May 7 th Sale $ = 1850 per unit COGS, May 7 th 1850 = $46, May 11 th Sale = per unit COGS, May 11 th = $31, May 19 th Sale = per unit COGS, May 19 th = $54, Cost of Goods Sold = 46, , , = 132, Cost of goods available: $197, Less: Cost of goods sold $132, Ending Inventory $ 65, First In, First Out This method is based on the assumption that the first merchandise purchased is the first merchandise sold; sales are made from the oldest inventory. This method reflects recent costs. This often reflects the actual physical flow of merchandise May 7 th : 25 units from beginning inventory 1750 = 43,750 43,750 May 11 th : 5 units from beginning inventory 1750 = 8,750 7 units from May = 14,000 22,750 May 19 th : 13 units from May = 26,000 2 units from May = 9,000 35,000 Total Cost of Goods Sold = 43, , ,000 = 101,500 Cost of goods available: $197, Less: Cost of goods sold 101, Ending Inventory $ 96, Page 3 of 7

4 Last in, First out This method assumes the most recently purchased items are sold first. The ending inventory consists of old purchases. May 7 th : 20 units from May = 40,000 5 units from beginning inventory 1750 = 8,750 48,750 May 11 th : 10 units from May = 45,000 2 units from beginning inventory 1750 = 3,500 48,500 May 19 th : 10 units from May = 60,000 5 units from beginning inventory 1750 = 8,750 68,750 Total Cost of Goods Sold = 48, , ,750 = 166,000 Cost of goods available: $197,500 Less: Cost of goods sold 166,000 Ending Inventory $31,500 How do these methods affect inventory costs? When purchase prices are rising or falling, different methods of valuation assign different cost amounts Specific identification exactly matches costs and revenues Average Cost smoothes out price changes FIFO assigns a cost close to approximate current replacement costs LIFO assigns the most recent costs incurred to cost of goods sold, and may likely improve the match of current costs to revenues Effects of Inventory Valuation Methods on Financial Statements Assume all goods were sold for $8000 per unit. Specific Identification Weighted Average Cost FIFO LIFO Sales $416,000 $416, $416,000 $416,000 COGS 148, , , ,000 Gross Profit $268,000 $283, $314,500 $250,000 Page 4 of 7

5 Practice Problem On January 1, Parker Limited had a beginning inventory of 30 toilet seats which had cost the company $11 each. During the year, the following purchase transactions took place: March 21 Purchased 20 units for $11 August 7 Purchased 40 units for $12 September 2 Sold 30 units for $20 November 18 Purchased 10 units for $13 December 2 Sold 20 units for $20 December 23 Purchased 20 units for $13 December 27 Sold 20 units for $20 During the year, the company sold 70 units for $20 per unit. Instructions 1. Determine (1) the cost of goods sold and (2) the cost of the ending inventory under each of three cost flow assumptions (FIFO, weighted average and LIFO). 2. Determine the gross profit for each cost flow assumption. Page 5 of 7

6 Income Statement Effects In periods of rising prices, FIFO reports the highest net income, LIFO the lowest and average cost falls in the middle. The reverse is true when prices are falling. When prices are constant, all cost flow methods will yield the same results. The Consistency GAAP A company needs to use its chosen cost flow method consistently from one accounting period to another. Such consistent application enhances the comparability of financial statements over successive fiscal periods. When a company adopts a different cost flow method, the change and its effects on net income should be disclosed in the financial statements. INVENTORY ERRORS Inventory Errors Income Statement Effects The ending inventory of one period automatically becomes the beginning inventory of the next period. An inventory error in this period, affects: o COGS in this period, and thus o Net income in this period, as well as o Ending inventory in this period, and o Beginning inventory next period Inventory Error Cost of Goods Sold Net Income Inventory Error Cost of Goods Sold Net Income Understate ending inventory Overstated Understated Understate ending inventory Overstated Understated Understate beginning inventory Understated Overstated Understate beginning inventory Understated Overstated Overstate ending inventory Understated Overstated Overstate ending inventory Understated Overstated Overstate beginning inventory Overstated Understated Overstate beginning inventory Overstated Understated Inventory Error Balance Sheet Effects The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation: Assets = Liabilities + Owner s Equity LOWER OF COST OR MARKET When the value of inventory is lower than the cost, the inventory is written down to its market value. Page 6 of 7

7 This is known as the lower of cost and market method. Market is defined as replacement cost or net realizable value. Example of Alternative Lower of Cost or Market Valuations Cost Market LCM Television sets Consoles $ 60,000 $ 55,000 Portables 45,000 52,000 Total 105, ,000 Video equipment Recorders 48,000 45,000 Movies 15,000 14,000 Total 63,000 59,000 Total inventory $ 168,000 $ 166,000 $ 166,000 What is the total value of inventory if you look at the individual products? What is the total value of inventory if you look at the categories? The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation. RATIOS Merchandise Turnover Used to help analyze short-term liquidity. Average inventory = (beginning inventory + ending inventory) / 2 No simple rule high rate is preferable as long as inventory is adequate to meet demand. Day s Sales in Inventory Estimate how many days it will take to convert inventory into receivables or cash Page 7 of 7