CHAPTER 9 WHAT IS REPORTED AS INVENTORY? WHAT IS INVENTORY? COST OF GOODS SOLD AND INVENTORY

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1 CHAPTER 9 COST OF GOODS AND INVENTORY 1 WHAT IS REPORTED AS INVENTORY? Inventory represents goods that are either manufactured or purchased for resale in the normal course of business Inventory is classified as an asset on the balance sheet 2 WHAT IS INVENTORY? There are three types of inventory for a manufacturing firm: Raw materials Goods acquired in a raw state that will eventually be finished products Work in process Partially finished products Finished goods Completed products waiting for sale 3 1

2 INVENTORY COST FLOW FOR A MANUFACTURING FIRM Balance Sheet Income Statement Raw Materials Work in Process Finished Goods Cost of Goods Sold Manufacturing Overhead Labor 4 INVENTORY OWNERSHIP Legal title rule Goods should be reported in the balance sheet of the business holding legal title to the goods Goods in transit Legal title depends upon the shipping terms 5 GOODS IN TRANSIT Shipping terms: FOB (free-on-board) destination The seller is paying the shipping cost The seller owns the inventory until it is delivered FOB shipping point The buyer is paying the shipping cost The buyer owns the inventory during transit 6 2

3 GOODS ON CONSIGNMENT The dealer does not pay for the inventory unless it is sold Although the dealer has possession of the inventory, the supplier still owns the inventory at the balance sheet date 7 THE COST OF INVENTORY The cost of inventory includes all costs of acquisition and preparation for sale price Freight Receiving and storage costs 8 THE COST OF INVENTORY The cost of work in process and finished goods inventory includes Raw materials Production labor Some allocation of factory overhead Activity-based cost (ABC) systems allocate overhead based on some clearly identified cost drivers 9 3

4 COST OF GOODS Beginning Inventory Add: Inventory s = Goods Available for Sale Less: Ending Inventory = Cost of Goods Sold 10 OVERVIEW OF PERPETUAL AND PERIODIC SYSTEMS Perpetual system Inventory records are updated whenever a purchase or a sale is made Advances in information technology have made the cost of using this system practical Periodic system Inventory records are not updated when a sale is made 11 TAKING A PHYSICAL COUNT OF INVENTORY The actual quantity on hand is determined by taking a physical count A cost is attached to the quantity counted With a perpetual system, a physical count can reveal inventory shrinkage 12 4

5 ENDING INVENTORY ERRORS When inventory is overstated Cost of good sold is understated Net income is overstated When inventory is understated Cost of good sold is overstated Net income is understated 13 INVENTORY VALUATION METHODS Where specific identification is not possible, an assumption must be made about which cost is associated with the units remaining Three assumptions are generally accepted: FIFO (first-in, first-out) LIFO (last-in, first-out) Average cost 14 SPECIFIC IDENTIFICATION Requires no assumption about the flow of inventory units Inventory items are specifically identified and valued The actual cost of goods sold can be computed as inventory is sold 15 5

6 INVENTORY VALUATION METHODS Assume the following data: Unit Total Units Cost Cost January $10 $2,000 March $12 3,600 July $11 5,500 November $13 1,300 1,100 $12,400 Sales: 700 $15 16 AVERAGE COST METHOD Cost of Goods Available for Sale Units Available for Sale $12,400 1,100 units Ending Inventory = 400 Units x $11.27 Cost of Goods Sold = 700 Units x $11.27 Cost of Goods Available for Sale = Average Cost/Unit = $11.27 Average Cost/Unit = $4,510 = 7,890 $12, FIFO Goods Available for Sale 1,100 units = Ending Inventory 400 units + Goods Sold 700 units Nov. 6 July 15 March 23 Jan $13/unit 500 $11/unit 300 $12/unit 200 $10/unit $1,300 $3, $13/unit $11/unit $2,200 $3,600 $2, $11/unit 300 $12/unit 200 $10/unit $12,400 = $4,600 + $7,

7 LIFO Goods Available for Sale 1,100 units = Ending Inventory 400 units + Goods Sold 700 units Nov. 6 July 15 March 23 Jan $13/unit 500 $11/unit 300 $12/unit 200 $10/unit $2,400 $2, $12/unit $10/unit $1,300 $5,500 $1, $13/unit 500 $11/unit 100 $12/unit $12,400 = $4,400 + $8, COMPARISON OF METHODS FIFO Advantages: Inventories are reported on the balance sheet near current costs Cost flow often matches the physical flow of goods in a business Disadvantages: Current costs are not matched with current revenues Choosing FIFO for financial reporting prohibits the use of LIFO on the tax 20 return (LIFO conformity rule) COMPARISON OF METHODS LIFO Advantages: Current costs are matched with current revenues (matching principle) Income taxes are minimized during periods of rising prices Disadvantages: Inventory is valued at old prices Cost flow may not match the physical flow of goods in the business 21 7

8 MORE LIFO ISSUES Any year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending inventory The creation of LIFO layers results in ending inventory at very old prices 22 INVENTORY ESTIMATION AND VALUATION The gross profit method is used to estimate inventory without actually taking a physical count The gross profit percentage is applied to estimate cost of goods sold, and ultimately gross profit 23 GROSS PROFIT METHOD Gross Profit % = (Sales - Cost of Goods Sold) / Sales Assume the following data: Beginning inventory, January 1 $25,000 s, January 1 through January 31 40,000 Sales, January 1 through January 31 50,000 Historical gross profit percentage 40% 24 8

9 GROSS PROFIT METHOD Sales (actual) $50, % Gross profit (estimate) 20,000 40% Cost of goods sold (estimate) $30,000 60% Beginning inventory (actual) $25,000 + s (actual) 40,000 = Cost of goods available for sale (actual) $65,000 - Cost of goods sold (estimate) $30,000 = Ending inventory (estimate) $35, INVENTORY ESTIMATION AND VALUATION The lower of cost or market method recognizes inventory price declines, but not price increases until the inventory is sold Market value is defined as Replacement cost or Net realizable value 26 INVENTORY ESTIMATION AND VALUATION Replacement cost is the cost to buy equivalent new inventory items Net realizable value is the amount expected to be received when the inventory is sold Rule of thumb: Inventory is valued on the balance sheet at the lowest of (1) historical cost, (2) replacement cost, or (3) net realizable value 27 9

10 INVENTORY ESTIMATION AND VALUATION An inventory write-down when market value is lower than cost recognizes the economic loss when it happens rather than when the inventory is sold This is another example of the principle of conservatism 28 EVALUATING THE LEVEL OF INVENTORY Two widely used measurements: Inventory turnover Measures how many times a company turns over its inventory during the year Number of days sales in inventory Measures the number of days sales represented in the inventory value 29 EVALUATING THE LEVEL OF INVENTORY Inventory Turnover = Cost of Goods Sold Average Inventory Number of Days Sales = 365 / Inventory Turnover in Inventory These ratios are compared with those of other firms in the same industry and with comparable ratios for the same firm in previous years

11 EVALUATING THE LEVEL OF INVENTORY The number of days purchases in accounts payable indicates how long it takes for a company to pay its suppliers Number of Days 365 days s in = Accounts Payable s/average Accounts Payable 31 11