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Chapter 6 Inventories 2
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
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
Learning objective 1 Define and identify the items included in inventory at the reporting date 5
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
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
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
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
Learning objective 2 Determine the s to be included in the value of inventory 10
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
Learning objective 3 Describe the four inventory ing methods and identify the three inventory ing methods that are based on flow assumptions 12
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
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
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
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
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
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
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
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 = $50 50 7 Purchases 75 x $2 = $150 125 17 Purchases 15 x $3 = $45 140 27 Sales 60 x $5 = $300 80 20
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. 27 35 1 35 20 2 40 5 3 15 60 90 21
Specific identification - (perpetual) Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 50 1 50 7 75 2 150 50 1 50 75 2 150 17 15 3 45 50 1 50 75 2 150 15 3 45 27 35 1 35 15 1 15 20 2 40 55 2 110 5 3 15 10 3 30 22
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 35 1 35 15 1 15 20 2 40 55 2 110 5 3 15 10 3 30 60 90 80 155 23
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
First-in, first-out (FIFO) - (perpetual) Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 50 1 50 7 75 2 150 50 1 50 75 2 150 17 15 3 45 50 1 50 75 2 150 15 3 45 27 50 1 50 65 2 130 10 2 20 15 3 45 25
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 50 1 50 65 2 130 10 2 20 15 3 45 60 70 80 175 26
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
Last-in, first-out (LIFO) - (perpetual) Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 50 1 50 7 75 2 150 50 1 50 75 2 150 17 15 3 45 50 1 50 75 2 150 15 3 45 27 15 3 45 50 1 50 45 2 90 30 2 60 28
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 15 3 45 50 1 50 45 2 90 30 2 60 60 135 80 110 29
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
Average - (perpetual) Date Inventory Balance: Purchases Cost of Goods Sold Inventory Balance Nov. 7 = ($50 + $150) (50 + 75) units = $200 125 = $1.60 Nov. 17 = ($200 + $45) (125 + 15) units = $245 140 = $1.75 Nov. 1 50 1.00 50 7 75 2.00 150 125 1.60 200 17 15 3.00 45 140 1.75 245 27 60 1.75 105 80 1.75 140 31
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 60 1.75 105 80 1.75 140 60 105 80 140 32
Learning objective 5 Compare the financial statement effects of the three inventory flow assumptions 33
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
Financial statement effects Specific identification FIFO LIFO Moving average Income statement $ $ $ $ Sales Revenues 300 300 300 300 Cost of goods sold 90 70 135 105 Gross profit 210 230 165 195 Expenses 100 100 100 100 Net income 110 130 65 95 Balance sheet Inventory 155 175 110 140 35
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
Learning objective 6 Explain the characteristics of each inventory ing method 37
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
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
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
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
Learning objective 7 Record returns of merchandise using inventory cards for each of the three inventory flow assumptions (perpetual inventory) 42
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
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
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
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
FIFO purchase return Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 450 1 450 5 300 2 600 450 1 450 300 2 600 6 150 1 150 300 1 300 300 2 600 8 (100) 2 (200) 300 1 300 200 2 400 47
LIFO purchase return Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 450 1 450 5 300 2 600 450 1 450 300 2 600 6 150 2 300 450 1 450 150 2 300 8 (100) 2 (200) 450 1 450 50 2 100 48
Moving average purchase return Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 450 1.00 450 5 300 2.00 600 750 1.40 1050 6 150 1.40 210 600 1.40 840 8 (100) 2.00 (200) 500 1.28 640 A new moving average is calculated after each purchase and after each purchase return 49
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
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
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
FIFO sales return Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 120 3 360 180 4 720 13 120 3 360 105 4 420 75 4 300 18 385 5 1925 105 4 420 385 5 1925 19 (75) 4 (300) 25 3 75 (25) 3 (75) 180 4 720 385 5 1925 53
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
LIFO sales return Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 120 3 360 180 4 720 13 180 4 720 105 3 315 15 3 45 18 385 5 1925 105 3 315 385 5 1925 19 (15) 3 (45) 120 3 360 (85) 4 (340) 85 4 340 385 5 1925 55
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
Moving average sales return Date Purchases Cost of Goods Sold Inventory Balance Nov. 1 300 3.60 1080 13 195 3.60 702 105 3.60 378 18 385 5.00 1925 490 4.70 2303 19 (100) 4.70 (470) 590 4.70 2773 57
Learning objective 8 Explain the lower of or market (LCM) rule 58
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
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
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
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
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
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
Learning objective 9 Explain the effect of inventory errors on the financial statements 65
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
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
Effects of inventory errors Balance sheet: Affects the current period only Affects: Inventory 68