Chapter 6. Inventories

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2 Chapter 6 Inventories 2

3 Learning objectives 1. Define and identify the items included in inventory at the reporting date 2. Determine the s to be included in the value of inventory 3. Describe the four inventory ing methods and identify the three inventory ing methods that are based on flow assumptions 4. Determine the of goods sold and ending inventory under the perpetual inventory system for each of the four inventory ing methods 3

4 Learning objectives 5. Compare the financial statement effects of the three inventory flow assumptions 6. Explain the characteristics of each inventory ing method 7. Record returns of merchandise using inventory cards for each of the three inventory flow assumptions (perpetual inventory) 8. Explain the lower of or market (LCM) rule 9. Explain the effect of inventory errors on the financial statements 4

5 Learning objective 1 Define and identify the items included in inventory at the reporting date 5

6 Defining inventory Inventory can represent a significant item in the financial statements Inventory can differ between business types and can include: Business Type Retailer Wholesaler Manufacturer Type of inventory held Merchandise held for sale Merchandise held for sale Raw materials / Supplies Work in process Finished goods (Merchandise held for sale) We focus on merchandise inventory held for sale 6

7 Identifying inventory When inventory is held in the retail store or warehouse of the business it is easy to identify who is to report the goods at the reporting date But what happens when the goods are being delivered from the seller to the buyer at reporting date? Or if the goods are shipped on consignment to an agent to be sold on behalf of the owner? 7

8 Goods in transit Party that owns the goods at the reporting date reports them as part of their inventory Ownership determined by shipping terms FOB shipping point: Buyer owns goods and reports them in inventory FOB destination: Seller owns goods and reports them in inventory 8

9 Goods on consignment Goods owned by one party but held by another party who sells the goods on their behalf Consignor (owner) Consignee (agent) Consignor owns the goods and reports them in inventory, even though the consignee may have physical custody of the goods 9

10 Learning objective 2 Determine the s to be included in the value of inventory 10

11 Determining inventory s Cost of inventory includes any expenditure incurred, directly or indirectly, in bringing the inventory to the condition and location where it is able to be sold. Includes: Purchase price (list price less any trade discount) Less purchase discounts Plus incidental s transportation charges import duties s incurred to insure the goods while in transit. 11

12 Learning objective 3 Describe the four inventory ing methods and identify the three inventory ing methods that are based on flow assumptions 12

13 Inventory flow assumptions Consider the situation where a business has a storage container half full of liquid chocolate Next, they purchased more liquid chocolate to fill up the container, purchased at a higher price During the period one third of the liquid chocolate was sold Because the chocolate at the higher price was mixed in with the lower priced chocolate, how do we determine the to assign to of goods sold (COGS) and ending inventory? 13

14 Inventory ing methods There are four inventory ing methods used to assign the of goods available for sale to of goods sold and ending inventory. specific identification first-in, first-out (FIFO) last-in, first-out (LIFO) average The last three are known as inventory flow assumptions because they assume a flow of s through inventory to COGS 14

15 Specific identification Assigns the actual purchase of the item to COGS and ending inventory As each item is purchased, some form of identification is attached to track the of that item from purchase to sale Uses actual s to calculate: COGS Ending inventory 15

16 First-in, first-out (FIFO) Assumes the first units purchased are the first units sold Assigns: Earliest s to COGS Most recent s to ending inventory 16

17 Last-in, first-out (LIFO) Assumes the last units purchased are the first units sold Assigns: Most recent s to COGS Earliest s to ending inventory 17

18 Average Assigns an average of inventory available for sale to both: COGS Ending inventory The average method is called the Moving average method under perpetual inventory Weighted average method under periodic inventory (Appendix 6A) 18

19 Learning objective 4 Determine the of goods sold and ending inventory under the perpetual inventory system for each of the four inventory ing methods 19

20 Illustration of inventory ing methods We now illustrate how to calculate the of goods sold and ending inventory under the perpetual inventory system for each of the four inventory ing methods using the following data: Date Description Purchases Sales Inventory Selling price Sales revenues Nov. 1 Beginning inventory 50 x $1 = $ Purchases 75 x $2 = $ Purchases 15 x $3 = $ Sales 60 x $5 = $

21 Specific identification - (perpetual) Allocates actual s to COGS & ending inventory Of the 60 units sold on November 27, the business specifically identified the number of units sold at each unit identified as sold, Nov

22 Specific identification - (perpetual) Date Purchases Cost of Goods Sold Inventory Balance Nov

23 Specific identification - (perpetual) COGS = the sum of all items in the of goods sold (total ) column (i.e. all sales) Ending inventory = the sum of the items in the inventory balance (total ) column for the last entry only Cost of Goods Sold Inventory Balance

24 First-in, first-out (FIFO) - (perpetual) Assumes the first units purchased are the first units sold Assigns: Earliest s to COGS Most recent s to end inventory 24

25 First-in, first-out (FIFO) - (perpetual) Date Purchases Cost of Goods Sold Inventory Balance Nov

26 First-in, first-out (FIFO) - (perpetual) COGS = the sum of all items in the of goods sold (total ) column (i.e. all sales) Ending inventory = the sum of the items in the inventory balance (total ) column for the last entry only Cost of Goods Sold Inventory Balance

27 Last-in, first-out (LIFO) - (perpetual) Assumes the last units purchased are the first units sold Assigns: Most recent s to COGS Earliest s to end inventory 27

28 Last-in, first-out (LIFO) - (perpetual) Date Purchases Cost of Goods Sold Inventory Balance Nov

29 Last-in, first-out (LIFO) - (perpetual) COGS = the sum of all items in the of goods sold (total ) column (i.e. all sales) Ending inventory = the sum of the items in the inventory balance (total ) column for the last entry only Cost of Goods Sold Inventory Balance

30 Average - (perpetual) Assigns an average of inventory available for sale to both: COGS Ending inventory The average method is called the moving average method under perpetual inventory because a new average of goods available for sale is calculated after each purchase 30

31 Average - (perpetual) Date Inventory Balance: Purchases Cost of Goods Sold Inventory Balance Nov. 7 = ($50 + $150) ( ) units = $ = $1.60 Nov. 17 = ($200 + $45) ( ) units = $ = $1.75 Nov

32 Average - (perpetual) COGS = the sum of all items in the of goods sold (total ) column (i.e. all sales) Ending inventory = the balance reported in the inventory balance (total ) column for the last entry only Cost of Goods Sold Inventory Balance

33 Learning objective 5 Compare the financial statement effects of the three inventory flow assumptions 33

34 Financial statement effects When prices are constant throughout the period each method yields the same results When prices change throughout the accounting period, each method almost always assigns different s to COGS and ending inventory 34

35 Financial statement effects Specific identification FIFO LIFO Moving average Income statement $ $ $ $ Sales Revenues Cost of goods sold Gross profit Expenses Net income Balance sheet Inventory

36 Financial statement effects When prices are rising we can generalize the effects on the financial statement items FIFO Moving average LIFO Cost of goods sold Lowest Middle Highest Gross profit Highest Middle Lowest Net income Highest Middle Lowest Ending balance of inventory Highest Middle Lowest The opposite effect occurs when prices are falling (The effects of the specific identification method can not be generalized. Therefore this method is excluded from the analysis) 36

37 Learning objective 6 Explain the characteristics of each inventory ing method 37

38 Characteristics of ing methods Specific identification: Accurately matches sales revenues to the actual s incurred to earn those revenues Reports actual gross profit Reports actual of ending inventory Can be ly to implement 38

39 Characteristics of ing methods First-in, first-out (FIFO) Ending inventory is reported in the balance sheet closest to its current replacement When prices rise: Reports lower COGS Reports higher gross profit (and higher net income) So can overstate income 39

40 Characteristics of ing methods Last-in, first-out (LIFO) Matches sales revenues to the current s incurred to earn those revenues Taxation advantages for corporations when prices are rising When prices rise: Inventory not reported at current replacement s 40

41 Characteristics of ing methods Average Tends to smooth out net income and inventory Neither of goods sold or ending inventory are reported at their current s Under perpetual inventory, a new average is calculated each time a purchase is made, which can be time consuming and difficult to track 41

42 Learning objective 7 Record returns of merchandise using inventory cards for each of the three inventory flow assumptions (perpetual inventory) 42

43 Recording returns The perpetual inventory system tracks the movement of inventory at the time it occurs Therefore purchase returns and sales returns must also be tracked at the time of the return But what do we use when recording the return? 43

44 Recording returns The specific identification method uses the actual of the items returned for both purchase and sales returns, so will not be illustrated The difficulty is deciding what to record the return under the three inventory flow assumptions FIFO LIFO Moving average Let s start with purchase returns 44

45 Purchase returns Purchase returns are always recorded using the actual value of the refund, regardless of the flow assumption The return is to be recorded as a negative entry into the Purchases column for all inventory flow assumptions 45

46 Purchase returns For example: A business purchased 300 units at $2 each on November 5 The business then returned 100 of these units purchased at $2 on November 8 46

47 FIFO purchase return Date Purchases Cost of Goods Sold Inventory Balance Nov (100) 2 (200)

48 LIFO purchase return Date Purchases Cost of Goods Sold Inventory Balance Nov (100) 2 (200)

49 Moving average purchase return Date Purchases Cost of Goods Sold Inventory Balance Nov (100) 2.00 (200) A new moving average is calculated after each purchase and after each purchase return 49

50 Sales returns Sales returns are recorded following the same inventory flow assumption used in their original sale The return is to be recorded as a negative entry into the Cost of Goods Sold column for all inventory ing methods 50

51 Sales returns For example: A different business sold 195 units on November 13 The customer then returned 100 of these units on November 19 Each flow assumption will record a different value for of goods sold for the sale and for the sales return 51

52 FIFO sales return FIFO assumes that the of the goods returned are the most recent s assigned to inventory when the sale was made 52

53 FIFO sales return Date Purchases Cost of Goods Sold Inventory Balance Nov (75) 4 (300) (25) 3 (75)

54 LIFO sales return LIFO assumes the of the goods returned to be the oldest s assigned to the goods at the time the sale was made 54

55 LIFO sales return Date Purchases Cost of Goods Sold Inventory Balance Nov (15) 3 (45) (85) 4 (340)

56 Moving average sales return The moving average method records the sales return at the moving average of the inventory at the time of the return rather than at the time of the original sale 56

57 Moving average sales return Date Purchases Cost of Goods Sold Inventory Balance Nov (100) 4.70 (470)

58 Learning objective 8 Explain the lower of or market (LCM) rule 58

59 Lower of or market rule Inventories are initially accounted for on a basis Inventories may subsequently be valued at less than if: Purchase price decreases Can not sell goods at normal selling prices Damaged goods Obsolete goods To test if this is the case, businesses are required to apply the lower of or market (LCM) rule 59

60 Lower of or market rule The lower of or market (LCM) rule requires inventories to be reported at current market value when the market value is lower than the recorded for the item 60

61 Lower of or market rule The market value of an item is defined as the current replacement of the inventory item provided that: a) market value is not to be greater than net realizable value b) market value is not to be lower than the net realizable value less an allowance for a normal profit margin The net realizable value of an item is the selling price less s incurred to sell the item 61

62 Lower of or market rule The lower of or market rule can be applied to one of the following: 1. Items 2. Categories 3. Entire balance Each of the three methods results in a different amount to be reported in ending inventory and a different loss recognized in the income statement See your textbook for a detailed example 62

63 Journal entry to adjust inventory to LCM Calculate the amount to be adjusted (Current Market value) Record the journal entry Date 2011 fds Account and explanation Post Ref. Debit Nov. 30 Cost of Goods Sold 2,000 Alternatively, a specific account can be debited, such as Loss on Write-Down of Inventory Credit Inventory 2,000 (To adjust inventory from to market value.) 63

64 Lower of or market The written down value becomes the new of the item for subsequent accounting periods Even if the market value of the goods rises in subsequent accounting periods, the goods are not to be revalued upward to the old higher This is consistent with the lower of or market rule 64

65 Learning objective 9 Explain the effect of inventory errors on the financial statements 65

66 Effects of inventory errors Inventory errors can occur in many ways, e.g. Taking inventory Using an inventory ing method Applying the lower of or market rule Transcription errors Affects both the income statement and the balance sheet 66

67 Effects of inventory errors Income statement: Affects the current period, and has an equal and opposite effect in the following period ending balance of inventory is used in determining COGS ending balance of inventory in one period becomes the opening balance of inventory in the following period Affects: Cost of goods sold Gross profit Net income 67

68 Effects of inventory errors Balance sheet: Affects the current period only Affects: Inventory 68