1 Chapter 6 Financial Notes and BE Chapter Outline Study Objective 1 - Describe the Steps in Determining Inventory Quantities In a merchandising company, inventory consists of many different items. These items have two common characteristics: (1) they are owned by the company and (2) they are in a form ready for sale to customers. Only one inventory classification, merchandise inventory, is needed to describe the many different items that make up the total inventory. In a manufacturing company, inventory is usually classified into three categories: Finished goods, Work in process, and Raw materials. Raw materials inventory the basic goods that will be used in production but have not yet been placed into production. Work in process that portion of manufactured inventory that has been placed into the production process but is not yet complete. Finished goods inventory items that are completed and ready for sale. By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management s production plans. No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory at year-end for two purposes: (1) to check the accuracy of their perpetual inventory records and (2) to determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. Companies using a period inventory system must take a physical inventory for two different purposes: (1) to determine the inventory on hand at the balance sheet date, and (2) to determine the cost of goods sold for the period. Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. To determine ownership of goods, two questions must be answered: (1) Do all of the goods included in the count belong to the company? (2) Does the company own any goods that were not included in the count?
2 To arrive at an accurate count, ownership of goods in transit (on board a truck, train, ship, or plane) must be determined. Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale. When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer. In some lines of business, it is customary to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods. Explain that, for a merchandising company, the cost of goods sold is an expense and, traditionally, the largest expense item the company will have. Study Objective 2 - Explain the Basis of Accounting for Inventories and Apply the Inventory Cost Flow Methods under a Periodic Inventory System After a company has determined the quantity of units of ending inventory, it applies unit costs to the quantities to determine the total cost of the ending inventory and the cost of goods sold. Determining ending inventory can be complicated if the units on hand for a specific item of inventory have been purchased at different times and at different prices. Therefore, there are different inventory costing methods available: Specific identification method requires that companies keep records of the original cost of each individual inventory item. A major disadvantage of this method is that management may be able to manipulate net income. Even though computers have made it possible to specifically match goods to the actual sale, specific identification is not a popular method. Refer students to Illustration 6-11 and ask them why specific identification is seldom used.
3 There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. One of the three cost flow assumptions may be used: Ask students to answer this multiple choice question: Which inventory method should a gasoline retailer use? (a) LIFO, (b) FIFO, (c) Average, or (d) any method that its management chooses. Because it is a gasoline retailer, many students think that it must use average. This is a good way to point out that the inventory cost flow method selected does not have to be consistent with the physical movement of the goods. (1) First-in, First-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. Under FIFO, the cost of the ending inventory is obtained by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. FIFO often parallels the actual physical flow of goods. Use the example of a bicycle shop to illustrate FIFO. Beginning inventory Purchases: 6/2 $100 = $ 50,000 6/8 125 = 50,000 6/ = 45,500 Goods available 1,250 $145,500 Ending inventory 130 = 32,500 Cost of goods sold 1,000 $113,000 When using FIFO, one assumes the first units in are the first units sold. Which of the above units were sold? $100 = $ 50, = 50, = 13,000 Cost of goods sold $113,000
4 (2) Last-in, First-out (LIFO) method assumes that the last goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. Under LIFO, the cost of the ending inventory is obtained by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed. Beginning inventory is the earliest cost. Use the example of a bicycle shop to illustrate LIFO. Beginning inventory Purchases: 6/2 $100 = $ 50,000 6/8 125 = 50,000 6/ = 45,500 Goods available 1,250 $145,500 Ending inventory 100 = 25,000 Cost of goods sold 1,000 $120,500 When using LIFO, one assumes the last units in are the first units sold. Which of the above units were sold? $130 = $ 45, = 50, = 25,000 Cost of goods sold $120,500
5 (3) The average-cost method assumes that the goods available for sale are similar in nature and allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. The weighted-average unit cost is then applied to the units on hand to determine the cost of the ending inventory. Use the example of a bicycle shop to illustrate the average-cost method. $100 = $ 50, = 50, = 45,500 Goods available 1,250 $145,500 $145,500 1,250 = $ per unit Beginning inventory Purchases: 6/2 $100 = $ 50,000 6/8 125 = 50,000 6/ = 45,500 Goods available 1,250 $145,500 Ending inventory = 29,100 Cost of goods sold 1,000 $116,400 When using the average-cost method, one assumes the units were similar in nature. Another way to find the cost of the units sold is to multiply the number of units sold by the average cost. Cost of goods sold $ = $116,400 Stress the fact that FIFO and LIFO are simply cost assumptions and are not intended to trace the physical flow of the merchandise through the firm. Emphasize that with FIFO, the first units in are the first units out or sold. Thus, the cost of the first units purchased are the costs to show up in cost of goods sold, not ending inventory. Stress also, that with LIFO, the cost of the last units in are the first assumed to have gone out, or to cost of goods sold, again not ending inventory. Too frequently, students forget what they are trying to find ending inventory or cost of goods sold. Many students compute the weighted-average cost by simply averaging the unit price of each layer of inventory. Stress that they must use the total cost to get the weighted average.
6 Study Objective 3 - Explain the Financial Statement and Tax Effects of Each of the Inventory Cost Flow Assumptions The reasons companies adopt different inventory cost flow methods are varied, but usually involve one of the following three factors: (1) Income statement effects In periods of increasing prices, FIFO reports the highest net income, LIFO the lowest net income and average-cost falls in the middle. In periods of decreasing prices, the opposite is true. FIFO will report the lowest net income, LIFO the highest, with average-cost in the middle. To management, higher net income is an advantage: (a) It causes external users to view the company more favorable. (b) Management bonuses, if based on net income, will be higher. Thus, when prices are rising, companies tend to prefer FIFO. In a period of increasing prices, the use of LIFO enables the company to avoid reporting paper or phantom profit. (2) Balance sheet effects In a period of inflation, the costs allocated to ending inventory, using FIFO, will approximate current costs. Conversely, during a period of increasing prices, the costs allocated to ending inventory using LIFO will be significantly understated. (3) Tax Effects Both inventory on the balance sheet and net income on the income statement are higher when FIFO is used in a period of inflation. Many companies have switched to LIFO because it yields the lowest net income and therefore, the lowest income tax liability in a period of increasing prices. LIFO Conformity Rule: A tax rule that requires if a company uses LIFO for tax purposes it must also use LIFO for financial reporting purposes. Thus, if a company uses LIFO to reduce its tax bills, it must show the lower net income in its external financial statements. Ask students which method of inventory they would choose to use if they were: CEO of a company just going public or CEO or a company short on cash. Remind students that management chooses the inventory method. The company must follow it consistently, but there are procedures for making a change.
7 Study Objective 4 - Explain the Lower-of-Cost-or-Market Basis of Accounting for Inventories When the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower-of-cost-or-market (LCM) in the period in which the price decline occurs. LCM is an example of conservatism. Under the LCM basis, market is defined as current replacement cost, not selling price. For a merchandising company, market is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. Ask students to think about instances where lower of cost or market may be needed. Why would a company want to use lower of cost or market in valuing the inventory? Study Objective 5 - Compute and Interpret the Inventory Turnover Ratio Inventory turnover ratio is computed by dividing cost of goods sold by average inventory. The ratio indicates how many times the inventory turns over (is sold) during the year. Days in inventory, computed by dividing 365 days by the inventory turnover ratio, indicates the average number of days inventory is held. High inventory turnover (low days in inventory) indicates the company is tying up little of its funds in inventory (has minimal inventory on hand at any one time). Although minimizing the funds tied up in inventory is efficient, it may lead to lost sales due to inventory shortages. Management should closely monitor the inventory turnover ratio to achieve the best balance between too much and too little inventory. Provide examples of merchandise which may have a relatively long shelf life as well as examples of merchandise with extremely short lives. Would a retailer or wholesaler want to turn merchandise over rapidly? Why? Discuss the just-in-time inventory procedures with students. Discuss radio frequency identification (RFID) with students and its role in inventory control. Study Objective 6- Describe the LIFO Reserve and Explain its Importance for
8 Comparing Results of Different Companies Accounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO. This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods. Explain to students that the LIFO reserve adjustment is important in that it allows financial statements to be more comparable. Study Objective 7- (Appendix 6A) Apply the Inventory Cost Flow Methods to Perpetual Inventory Records Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Under LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold. Under the average-cost method, a new average cost is computed after each purchase. Study Objective 8- (Appendix 6B) Indicate the Effects of Inventory Errors on the Financial Statements In the income statement of the current year: (a) An error in beginning inventory will have a reverse effect on net income. For example, an overstatement of inventory would result in an understatement of net income. (b) An error in ending inventory will have a similar effect on net income. For example, an overstatement of inventory results in an overstatement of net income. If ending inventory errors are not corrected in the following period, their effect on net income for that period is reversed, and total net income for the two year period will be correct. In the balance sheet: Ending inventory errors will have the same effect on total assets and total stockholders equity and no effect on liabilities.
9 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 6-1 (a) Ownership of the goods belongs to the consignor (Cashin). Thus, these goods should be included in Cashin s inventory. (b) The goods in transit should not be included in the inventory count because ownership by Cashin does not occur until the goods reach the buyer. (c) The goods being held belong to the customer. They should not be included in Cashin s inventory. (d) Ownership of these goods rests with the other company (the consignor). Thus, these goods should not be included in the physical inventory. BRIEF EXERCISE 6-2 (a) The ending inventory under FIFO consists of 200 units at $9 for a total allocation of $1,800. (b) The ending inventory under LIFO consists of 200 units at $6 for a total allocation of $1,200. BRIEF EXERCISE 6-3 Average unit cost is $7.917 computed as follows: 300 X $6 = $1, X $8 = 3, X $9 = 4,500 1,200 $9,500 $9,500 1,200 = $7.917 The cost of the ending inventory is $1,583 (200 X $7.917).
10 BRIEF EXERCISE 6-4 (a) FIFO would result in the highest net income. (b) FIFO would result in the highest ending inventory. (c) LIFO would result in the lowest income tax expense (because it would result in the lowest taxable income). (d) Average cost would result in the most stable income over a number of years because it averages out any big changes in the cost of inventory. BRIEF EXERCISE 6-5 Cost of goods sold under: LIFO FIFO Purchases $6 X 100 $6 X 100 $7 X 200 $7 X 200 $8 X 140 $8 X 140 Cost of goods available for sale $ 3,120 $ 3,120 Less: Ending inventory $ 1,160* $ 1,400** Cost of goods sold $ 1,960 $ 1,720 *(100 X $6) + (80 X $7) **(140 X $8) + (40 X $7) Since the cost of goods sold is $240 ($1,960 $1,720) less under FIFO that is the amount of the phantom profit. It is referred to as phantom profit because FIFO matches current selling prices with old inventory costs. To replace the units sold the company will have to pay the current price of $8 per unit, rather than the $6 per unit which some of the units were priced at under FIFO. Therefore, profit under LIFO is more representative of what the company can expect to earn in future periods.
11 BRIEF EXERCISE 6-6 (a) LIFO results in a higher quality of earnings ratio. (b) FIFO results in higher phantom profits. (c) FIFO results in higher net income. (d) LIFO results in lower taxes. (e) FIFO results in lower net cash provided by operating activities. BRIEF EXERCISE 6-7 Inventory Categories Cost Market LCM Cameras $12,500 $13,400 $12,500 Camcorders 9,000 9,500 9,000 DVDs 13,000 12,200 12,200 Total valuation $33,700 The lower-of-cost-of-market value is $33,700. BRIEF EXERCISE 6-8 Inventory turnover ratio: $349,114 ($119,035+$155,377) 2 = $349,114 =2.54 times $137,206 Days in inventory: 365 =144 days 2.54 BRIEF EXERCISE ending inventory using LIFO... $46,850, LIFO reserve... 30,346, ending inventory assuming FIFO... $77,196,000