I. Learning Objectives FINANCIAL ACCOUNTING WEEK 6 Merchandise Inventory A. Define inventory, and describe how the methods used to account for it affect the financial statements. B. Describe the general rules for including items in inventory and attaching costs to these items. C. Explain the differences between the perpetual and periodic methods and the trade-offs involved in choosing between them. D. Identify the four primary cost flow assumptions and the measurement and economic trade-offs that concern both managers and users. E. Explain how the lower-of-cost-or-market rule is applied to ending inventories and why it is often criticized. F. Understand the meaning of inventory turnover and how it relates to inventory holding period. II. Inventory A. Definition - Merchandise Inventory are items held for sale in the ordinary course of business. B. Statement Presentation 1. Inventories - Raw Materials * Work-in-Process * Finished Goods * * Or disclosed in a footnote 2. St. Jude, Note 1, page 47 (see website for copy) C. Effect of Inventory on Net Income (NI) 1. Inventory affects NI through Cost of Goods Sold (CGS) 2. Effect of inventory on current period's NI and subsequent period's NI. III. Accounting for Inventory A. Items to include in inventory 1
1. General rule: Items held for sale and over which the company has complete and unrestricted ownership should be included in inventory. Purchases should be recorded when legal title to the items passes from the seller to the buyer. 2. Problem areas a. Goods on consignment (1) Definition: Goods owned by one party (consignor), but held for sale by another party (consignee). (2) Goods on consignment should be included in the inventory of the consignor, not the consignee, since the consignor retains legal title to the goods. b. Goods in transit - items not in the physical possession of either buyer or seller as of a point in time because the goods are in transit from the seller to the buyer. (1) Free on Board (FOB) shipping point: legal title to the inventory passes from the seller to the buyer when the seller delivers the goods to the shipping point. (2) FOB destination: Legal title to the inventory passes from the seller to the buyer when the goods reach their destination. (3) E7-1. B. Costs to attach to inventory (Costs to Capitalize) 1. General rule: All costs associated with manufacturing, acquiring, storing, and preparing inventory should be included in the cost of that inventory. 2. Manufacturing firms must cost their inventory with direct costs like labor and raw materials as well as an allocated portion of overhead. C. Methods to account for inventory 1. Periodic (Although not covered in book, still used by small business.) a. The balance in the inventory account remains unchanged throughout the accounting period. Inflows of inventory increase the "Purchases" 2
account, while outflows of inventory are not recorded until the end of the accounting period. b. The sum of Beginning Inventory and Purchases is - Cost of Goods Available. These costs are allocated to one of two accounts: (1) Ending Inventory (2) Cost of Goods Sold c. Query - Which of these accounts is computed and which is a remainder? d. E7-4 2. Perpetual a. Inventory account is directly increased for every inflow of inventory. b. Inventory account is decreased for every out flow of inventory. 3. Comparison of Accounting using Periodic or Perpetual Event Periodic Perpetual BUY + Purchases + Inventory + Accounts Payable + Accounts Payable SALE + Accounts Rec. + Accounts Rec. + Sales + Sales + Cost of Goods Sold - Inventory End of Period CGS = + Beg. Inv Compare Account + Purchases Balance with Actual - End. Inv. Count a. Which method provides better information? b. Which is more expensive? 4. Tradeoffs between Perpetual and Periodic a. Perpetual provides information throughout the period on the inventory levels that should be on hand. 3
b. Perpetual can reveal inventory shrinkage. c. Perpetual increases bookkeeping costs. 5. Inventory Errors a. Inventory counts are made under both the perpetual and periodic methods and sometimes may be in error. (1) An overstatement of inventory overstates net income by the same amount, and an understatement of inventory understates net income by the same amount. (2) Net income for the next period is misstated by the same amount in the opposite direction. b. Inventory errors are not unusual, often quite significant, and sometimes made intentionally by management to manipulate reported income. c. E7-6. D. Methods to allocate inventory costs to CGS 1. Specific ID - the cost of the actual inventory item sold is allocated to CGS a. Practical for companies that sell largeticket, easily-tracked items b. Allows manipulation of NI and inventory c. E7-8. 2. Cost flow assumptions a. Used to determine the inventory cost allocated to cost of goods sold and inventory. Does not refer to the PHYSICAL FLOW of inventory. b. Averaging assumption (1) A weighted average of all units available is used to allocate inventory costs (2) May be applied using either periodic or perpetual (moving average) 4
c. FIFO (What numbers are on Income Statement) (1) Oldest inventory costs are assumed to be the first inventory costs sold. (2) May be applied using either periodic or perpetual method. EI and CGS are the same using either method! d. LIFO (What numbers are on Income Statement) (1) Most recent costs are assumed to be the first inventory costs sold. (2) May be applied using either periodic or perpetual method 3. Tradeoffs among cost flow assumptions a. Income and Asset measure tradeoffs Assumptions CGS - IS EI - BS LIFO Most current costs Older costs FIFO Older costs Most current costs Averaging Mixture of costs Mixture of costs b. Economic tradeoffs (1) Taxes (a) LIFO conformity rule (p. 289) (b) In times of rising inventory costs, LIFO results in lower NI than FIFO. This lower NI results in lower current income taxes. The tax effect has cash flow implications and could affect liquidity. (2) LIFO requires more detailed accounting records than FIFO - more costly (3) Unexpected increases in sales or unexpected decreases in purchases can deplete LIFO layers, which can cause: (a) Substantially increased taxes, if 5
layers contain "old" costs (b) (c) (d) (e) Poor inventory purchasing practices P7-10. E7-10 (Do FIFO and LIFO only.) ID7-3. (4) If debt covenants specify a minimum debt/equity ratio or minimum working capital requirements, management can minimize the probability of violating the covenant by maximizing inventory cost and NI with FIFO (rising prices). (5) If a manager's bonus is based on NI, FIFO will maximize bonus, if prices are rising. (6) Managers who believe that investors cannot "see through" accounting methods, may choose FIFO because larger NI will be shown. Research in accounting and finance generally supports the view that investors can see through accounting methods and value a company based on its underlying cash flows. (7) Financial statements of companies using LIFO include footnote disclosure of "LIFO reserves," which reflect the difference between inventories computed using LIFO and FIFO. This disclosure is helpful to financial statement users in assessing the tax and income effects of using LIFO versus FIFO, and for making more valid comparisons with other companies that use FIFO. E. Lower-of-cost-or-market rule (LCM) 1. LCM recognizes decreases in inventory value to the I/S but not increases. This makes it inconsistent. However LCM rule makes economic sense due to conservatism. 2. E7-13. F. Inventory Turnover (p. 194) 1. Formula - Cost of Goods Sold / Average Inventory 6
2. Meaning - The speed with which inventories move through operations. 3. Inventory Holding Period - Formula: 365 (360) / Inventory Turnover Ratio = Inventory Holding Period (in days) 4. Low vs. high turnover. Implications of each - a. Too low - Carrying costs b. Too high - Stock outs 5. Effects of LIFO vs FIFO: a. LIFO b. FIFO IV. Review Learning Objectives V. Introduce Group Project 7