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CHAPTER6
Inventories

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PreviewofCHAPTER6

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Classifying Inventory
Merchandising Company
One Classification:

Manufacturing Company
Three Classifications:
  

Inventory

Raw Materials Work in Process Finished Goods

Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
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Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records. 2. Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft).

Periodic System
1. Determine the inventory on hand.

2. Determine the cost of goods sold for the period.

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SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of inventory on hand.
Taken,

when the business is closed or business is slow.
at end of the accounting period.

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SO 1 Describe the steps in determining inventory quantities.

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Determining Inventory Quantities
Determining Ownership of Goods
Goods in Transit
 

Purchased goods not yet received. Sold goods not yet delivered.

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 sale.

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SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities
Goods in Transit
Illustration 6-1 Terms of sale

Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

Ownership of the goods remains with the seller until the goods reach the buyer.

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Determining Inventory Quantities Question
Goods in transit should be included in the inventory of the buyer when the:
a. public carrier accepts the goods from the seller.

b. goods reach the buyer.
c. terms of sale are FOB destination. d. terms of sale are FOB shipping point.

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SO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities
Determining Ownership of Goods
Consigned Goods
 

Goods held for sale by one party. Ownership of the goods is retained by another party.

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SO 1 Describe the steps in determining inventory quantities.

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Inventory Costing
Unit costs can be applied to quantities on hand using the following costing methods:
 

Specific Identification First-in, first-out (FIFO)


Last-in, first-out (LIFO)
Average-cost

Cost Flow Assumptions

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Illustration: Assume that Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of $700, $750, and $800. During the year Crivitz sold two sets at $1,200 each. These facts are summarized below.
Illustration 6-2

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Specific Identification
If Crivitz sold the TVs it purchased on February 3 and May 22,

then its cost of goods sold is $1,500 ($700 + $800), and its
ending inventory is $750.
Illustration 6-3

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Specific Identification
Actual physical flow costing method in which items still in
inventory are specifically costed to arrive at the total cost of the ending inventory.
 

Practice is relatively rare. Most companies make assumptions (Cost Flow Assumptions) about which units were sold.

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Cost Flow

Assumptions
do not need to match the physical movement of goods

Illustration 6-11 Use of cost flow methods in major U.S. companies

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Illustration: Data for Houston Electronics’ Astro condensers.
Illustration 6-4

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
First-In-First-Out (FIFO)
 

Earliest goods purchased are first to be sold. Often parallels actual physical flow of merchandise.

Generally good business practice to sell oldest units
first.

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
First-In-First-Out (FIFO)
Illustration 6-5

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SO 2

Inventory Costing
First-In-First-Out (FIFO)
Illustration 6-5

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Last-In-First-Out (FIFO)
 

Latest goods purchased are first to be sold.
Seldom coincides with actual physical flow of merchandise.

Includes goods stored in piles, such as coal or hay.

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Last-In-First-Out (FIFO)
Illustration 6-7

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SO 2

Inventory Costing
Last-In-First-Out (FIFO)
Illustration 6-7

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Average Cost

Allocates cost of goods available for sale on the basis
of weighted-average unit cost incurred.

Assumes goods are similar in nature.

Applies weighted-average unit cost to the units on
hand to determine cost of the ending inventory.

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Average Cost
Illustration 6-10

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Average Cost
Illustration 6-10

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SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Financial Statement and Tax Effects
Illustration 6-12

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SO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing Question
The cost flow method that often parallels the actual physical flow of merchandise is the:
a. FIFO method.

b. LIFO method.
c. average cost method. d. gross profit method.

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SO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing Question
In a period of inflation, the cost flow method that results in the lowest income taxes is the:
a. FIFO method.

b. LIFO method.
c. average cost method. d. gross profit method.

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SO 3 Explain the financial effects of the inventory cost flow assumptions.

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Inventory Costing
Using Cost Flow Methods Consistently

Method should be used consistently, enhances comparability.
Although consistency is preferred, a company may change its inventory costing method.
Illustration 6-14 Disclosure of change in cost flow method

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SO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost

Companies can “write down” the inventory to its market value in the period in which the price decline occurs.


Market value = Replacement Cost
Example of conservatism.

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SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Costing
Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.
Illustration 6-15

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SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Errors
Common Cause:
 

Failure to count or price inventory correctly. Not properly recognizing the transfer of legal title to goods in transit.

Errors affect both the income statement and balance
sheet.

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SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income.
Illustration 6-16

Illustration 6-17

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SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income in two periods.

An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period. Over the two years, the total net income is correct because the errors offset each other. Ending inventory depends entirely on the accuracy of taking and costing the inventory.
SO 5 Indicate the effects of inventory errors on the financial statements.

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Inventory Costing
Illustration 6-18

2011 Incorrect Correct $ 80,000 20,000 40,000 60,000 12,000 48,000 32,000 10,000 $ 22,000 $ $ 80,000 20,000 40,000 60,000 15,000 45,000 35,000 10,000 25,000

2012 Incorrect Correct $ 90,000 12,000 68,000 80,000 23,000 57,000 33,000 20,000 $ 13,000 $ $ 90,000 15,000 68,000 83,000 23,000 60,000 30,000 20,000 10,000

Sales Beginning inventory Cost of goods purchased Cost of goods available Ending inventory Cost of good sold Gross profit Operating expenses Net income

Combined income for 2-year period is correct.
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($3,000) Net Income understated

$3,000 Net Income overstated

SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing Question
Understating ending inventory will overstate:
a. assets. b. cost of goods sold. c. net income. d. owner's equity.

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SO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Costing
Balance Sheet Effects
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Illustration 6-16

Illustration 6-19

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SO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis
Presentation
Balance Sheet - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted from
sales.

There also should be disclosure of
1) major inventory classifications, 2) basis of accounting (cost or LCM), and 3) costing method (FIFO, LIFO, or average).

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Statement Presentation and Analysis
Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying costs

(e.g., investment, storage, insurance, obsolescence, and damage).
2. Low Inventory Levels – may lead to stockouts and lost

sales.

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SO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis
Inventory turnover measures the number of times on average the inventory is sold during the period.
Inventory Turnover Cost of Goods Sold
=

Average Inventory

Days in inventory measures the average number of days inventory is held. Days in Inventory
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Days in Year (365)
=

Inventory Turnover
SO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis
Illustration: Wal-Mart reported in its 2010 annual report a beginning inventory of $34,511 million, an ending inventory of $33,160 million, and

cost of goods sold for the year ended January 31, 2010, of $304,657
million. The inventory turnover formula and computation for Wal-Mart are shown below.
Illustration 6-21

Days in Inventory: Inventory turnover of 9 times divided into 365 is approximately 40.6 days. This is the approximate time that it takes a company to sell the inventory.
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SO 6 Compute and interpret the inventory turnover ratio.

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APPENDIX6A
Perpetual Inventory Systems
Illustration 6A-1

Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.
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SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Perpetual Inventory System
First-In-First-Out (FIFO)
Illustration 6A-2

Cost of Goods Sold
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Ending Inventory

SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Perpetual Inventory System
Last-In-First-Out (LIFO)
Illustration 6A-3

Cost of Goods Sold
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Ending Inventory

SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Perpetual Inventory System
Average-Cost
Illustration 6A-4

Cost of Goods Sold

Ending Inventory

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SO 7 Apply the inventory cost flow methods to perpetual inventory records.

APPENDIX6B
Estimating Inventories

Gross Profit Method
Estimates the cost of ending inventory by applying a gross profit rate to net sales.
Illustration 6B-1

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SO 8 Describe the two methods of estimating inventories.

Estimating Inventories
Illustration: Kishwaukee Company’s records for January show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. The company expects to earn a 30% gross profit rate. Compute the estimated cost of the ending inventory at January 31 under the gross profit method.
Illustration 6B-2

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SO 8 Describe the two methods of estimating inventories.

Estimating Inventories
Retail Inventory Method
Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost.
Illustration 6B-3

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SO 8 Describe the two methods of estimating inventories.

Estimating Inventories
Illustration:
Illustration 6B-4

Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time.

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SO 8 Describe the two methods of estimating inventories.

Key Points

The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.
The definitions for inventory are essentially similar under IFRS and GAAP. Both define inventory as assets held-forsale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).

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Key Points

Who owns the goods—goods in transit or consigned goods—as well as the costs to include in inventory, are accounted for the same under IFRS and GAAP.
Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used.

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Key Points

A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS.
IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.

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Key Points

In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. In other words, net realizable value is the best estimate of the net amounts that inventories are expected to realize. GAAP, on the other hand, defines market as essentially replacement cost.

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Key Points

Under GAAP, if inventory is written down under the lower-ofcost-or-market valuation, the new value becomes its cost basis. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement as an expense. An item-by-item approach is generally followed under IFRS.

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Key Points

Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost.
Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.

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Looking to the Future
One convergence issue relates to the use of the LIFO cost flow assumption. IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. With a new conceptual framework being developed, it is highly probable that the use of the concept of conservatism will be eliminated. Similarly, the concept of “prudence” in the IASB literature will also be eliminated. This may ultimately have implications for the application of the lower-of-cost-or-net realizable value.

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IFRS Self-Test Questions
Which of the following should not be included in the inventory of a company using IFRS? a) Goods held on consignment from another company.

b) Goods shipped on consignment to another company. c) Goods in transit from another company shipped FOB shipping point.

d) None of the above.

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IFRS Self-Test Questions
Which method of inventory costing is prohibited under IFRS? a) Specific identification. b) FIFO. c) LIFO. d) Average-cost.

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IFRS Self-Test Questions
Specific identification: a) must be used under IFRS if the inventory items are not interchangeable. b) cannot be used under IFRS. c) cannot be used under GAAP. d) must be used under IFRS if it would result in the most

conservative net income.

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