Chapter 6 Inventories

1. Chapter 6 Inventories Financial Accounting, 11e © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

2. Learning Objectives Explain the management decisions related to inventory accounting, evaluation of inventory level, and the effects of inventory misstatements on income measurement. Define inventory cost, contrast goods flow and cost flow, and explain the lower-of-cost-or-market (LCM) rule. Calculate inventory cost under the periodic inventory system using various costing methods. Explain the effects of inventory costing methods on income determination and income taxes. Calculate inventory cost under the perpetual inventory system using various costing methods. Use the retail method and gross profit method to estimate the cost of ending inventory. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

3. Managing Inventories • There are three kinds of inventory: • Raw materials (goods used in making products) • Work in process (partially completed products) • Finished goods ready for sale • Cost components of work in process and finished goods inventories: • Cost of the raw materials that go into the product • Cost of the labor used to convert the raw materials to finished goods • Overhead costs that support the production process © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

4. Inventory Decisions • Management must choose among different processing systems, costing methods, and valuation methods and stay with those methods unless it can justify a change. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

5. Financial Ratios: Inventory Turnover • Inventory turnover:Average number of times a company sells an amount equal to its average level of inventory during an accounting period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

6. Financial Ratios: Days’ Inventory on Hand • Days’ inventory on hand is the average number of days it takes a company to sell an amount equal to its average inventory. • Cisco’s inventory turnover was calculated as 11.1 times: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

7. Inventory Management • Supply-chain management: A company uses the Internet to order and track goods that it needs immediately. • Just-in-time (JIT) operating environment:Goods arrive just at the time they are needed. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

8. Effects of Inventory Misstatements on Income Measurement The relationships between value of inventory, cost of goods sold, and gross margin lead to the following conclusions: The higher the value of ending inventory, the lower the cost of goods sold and the higher the gross margin. The lower the value of ending inventory, the higher the cost of goods sold and lower the gross margin.

9. Inventory Misstatements Illustrated © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

10. Effects of Inventory Misstatements before Taxes © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

11. During 2011, Max’s Sporting Goods had beginning inventory of $500,000, ending inventory of $700,000, and cost of goods sold of $2,100,000. Compute the inventory turnover and days’ inventory on hand. SOLUTION © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

12. Inventory Cost and Valuation • Inventory cost: The primary basis of accounting for inventories. • Includes: • Invoice price less purchases discounts • Freight-in, including insurance in transit • Applicable taxes and tariffs • Other costs—for ordering, receiving, and storing © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

13. Goods Flows and Cost Flows • Goods flow: The actual physical movement of goods in the operations of a company. • Cost flow: The association of costs with their assumed flow in the operations of a company. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

14. Merchandise in Transit Neither the seller nor the buyer has physical possession of merchandise in transit. Ownership is determined by the terms of the shipping agreement, which indicate when title passes. Outgoing goods shipped FOB (free on board) destination are included in the seller’s merchandise inventory, whereas those shipped FOB shipping point are not. Conversely, incoming goods shipped FOB shipping point are included in the buyer’s merchandise inventory, but those shipped FOB destination are not. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

15. Merchandise in Transit © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

16. Merchandise on Hand Not Included in Inventory • Consignment: Merchandise that its owner (the consignor) places on the premises of another company (the consignee) with the understanding that: • Payment is expected only when the merchandise is sold. • Unsold items may be returned to the consignor. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

17. Lower-of-Cost-or-Market (LCM) Rule • If the market value of inventory falls below its historical cost because of physical deterioration, obsolescence, or decline in price level, a loss has occurred. This loss is recognized by writing the inventory down to market. • Market: Current replacement cost. • Lower-of-cost-or-market (LCM) rule: Requires that inventory be written down to the lower value and a loss be recorded. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

18. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

19. Disclosure of Inventory Methods The full disclosure convention requires that companies disclose their inventory methods, including the use of LCM, in the notes to their financial statements.

20. Match the letter of each item on the right with the numbers of the related items on the left: ___ 1. Cost of consigned goods held from suppliers ___ 2. A note to the financial statements explaining inventory policies ___ 3. Application of the LCM rule ___ 4. Goods flow ___ 5. Transportation charge for merchandise shipped FOB shipping point ___ 6. Cost flow ___ 7. Choosing a method and sticking with it ___ 8. Transportation charge for merchandise shipped FOB destination a. An inventory cost b. An assumption used in the valuation of inventory c. Full disclosure convention d. Conservatism convention e. Consistency convention f. Not an inventory cost or assumed flow SOLUTION 1. f; 2. c; 3. d; 4. f; 5. a; 6. b; 7. e; 8. f © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

21. Inventory Cost Under The Periodic Inventory System • Cost is determined by one of the following methods, each based on a different assumption of cost flow: • Specific identification method • Average-cost method • First-in, first-out (FIFO) method • Last-in, first-out (LIFO) method © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

22. Specific Identification Method • Specific identification method:Identifies the cost of each item in ending inventory. • Can be used only when it is possible to identify the units in ending inventory as coming from specific purchases. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

23. Average-Cost Method • Average-cost method(or weighted average method): Inventory priced at the average cost of the goods available for sale during the accounting period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

24. First-In, First-Out (FIFO) Method • First-in, first-out (FIFO)method: Costs of the first items acquired should be assigned to the first items sold. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

25. Last-In, First-Out (LIFO) Method • Last-in, first-out (LIFO) method:Costs of the last items purchased should be assigned to the first items sold and cost of ending inventory should reflect cost of the goods purchased earliest. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

26. Impact on the Income Statement and Balance Sheet Under the Periodic Inventory System • In periods of rising prices, FIFO yields the highest inventory valuation, the lowest cost of goods sold and hence a higher net income; LIFO yields the lowest inventory valuation, the highest cost of goods sold, and thus a lower net income. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

27. Match the following inventory costing methods with the related statements. a. Average cost b. FIFO c. LIFO ___ 1. In periods of rising prices, this method results in the highest cost of goods sold. ___ 2. In periods of rising prices, this method results in the highest income. ___ 3. In periods of rising prices, this method results in the lowest ending inventory cost. ___ 4. In periods of decreasing prices, this method results in neither the highest inventory cost nor the lowest income. ___ 5. In periods of decreasing prices, this method results in the lowest income. ___ 6. In periods of decreasing prices, this method results in the highest costof goods sold. SOLUTION 1. c; 2. b; 3. c; 4. a; 5. b; 6. b © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

28. Impact of Inventory Decisions • Effects on the Financial Statements • Effects on Income Taxes • The Internal Revenue Service governs how inventories must be valued for federal income tax purposes. • LIFO liquidation: Sales have reduced inventories below the levels set in prior years. • Effects on Cash Flows • The choice of accounting methods does not affect cash flows. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

29. Effects of Inventory Costing Methods on Gross Margin © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

30. Inventory Costing Methods Used by 500 Large Companies © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

31. Match the inventory costing methods on the right with the descriptions on the left. 1. Matches recent costs with recent revenues 2. Assumes that each item of inventory is identifiable 3. Results in the most realistic balance sheet valuation 4. Results in the lowest net income in periods of deflation 5. Results in the lowest net income in periods of inflation 6. Matches the oldest costs with recent revenues 7. Results in the highest net income in periods of inflation 8. Results in the highest net income in periods of deflation 9. Tends to level out the effects of inflation 10. Is unpredictable as to the effects of inflation a. Specific identification b. Average-cost c. First-in, first-out (FIFO) d. Last-in, first-out (LIFO) SOLUTION 1. d; 2. a; 3. c; 4. c; 5. d; 6. c; 7. c; 8. d; 9. b; 10. a © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

32. Inventory Cost Under the Perpetual Inventory System • Under the perpetual inventory system, cost of goods sold is accumulated as sales are made and costs are transferred from the Inventory account to the Cost of Goods Sold account. • The following data is used to illustrate different costing methods under perpetual inventory: system. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

33. Average-Cost Method Applied © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

34. FIFO Method Applied © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

35. LIFO Method Applied © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

36. Impact on the Income Statement and Balance Sheet Under the Perpetual Inventory System © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

37. Make the calculations asked for below given the following data: Inventory Data—April 30 May 1 Inventory 100 units @ $4.00 5 Purchase 200 units @ $5.00 6 Sale 250 units Using the perpetual inventory system and (a) the average-cost method, (b) the FIFO method, and (c) the LIFO method, determine the cost of goods sold associated with the sale on May 6. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

38. SOLUTION a. Average-cost method: 100 units × $4.00 $ 400 200 units × $5.00 1,000 300 units $1,400 $1,400 ÷ 300 = $4.67 per unit Cost of goods sold = 250 units × $4.67 = $1,168* *Rounded. b. FIFO method: 100 units × $4.00 $ 400 150 units × $5.00 750 Cost of goods sold = $1,150 c. LIFO method: 200 units × $5.00 $1,000 50 units × $4.00 200 Cost of goods sold = $1,200 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

39. Retail Method • Retail method:Estimating the cost of ending inventory using the ratio of cost to retail price. • At retail: The amount of the inventory at the marked selling prices of the inventory items • Use the company’s records to find • The beginning inventory at cost and at retail. • The amount of goods purchased during the period at cost and at retail. • Net sales at retail: The balance of the Sales account less returns and allowances. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

40. Retail Method of Inventory Estimation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

41. Gross Profit Method • Gross profit method (gross margin method) • Used in place of the retail method when retail prices of beginning inventory and purchase records are not available. • Calculate cost of goods available for sale (add purchases to beginning inventory). • Deduct the estimated gross margin percent from sales. • Deduct the estimated cost of goods sold from the goods available for sale. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

42. Gross Profit Method of Inventory Estimation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

43. Campus Jeans Shop had net retail sales of $195,000 during the current year. The following additional information was obtained from the company’s accounting records: At Cost At Retail Beginning inventory $ 40,000 $ 60,000 Net purchases (excluding freight-in) 130,000 210,000 Freight-in 10,000 Using the retail method, estimate the company’s ending inventory at cost. Assuming that a physical inventory taken at year-end revealed an inventory on hand of $66,000 at retail value, what is the estimated amount of inventory shrinkage (loss due to theft, damage, etc.) at cost using the retail method? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom

44. SOLUTION Cost Retail Beginning inventory $ 40,000 $ 60,000 Net purchases for the period (excluding freight-in) 130,000 210,000 Freight-in 10,000 Goods available for sale $180,000 $270,000 Ratio of cost to retail price: $180,000 ÷ $270,000 = 66.7% Net sales during the period 195,000 Estimated ending inventory at retail $ 75,000 Ratio of cost to retail 66.7% Estimated cost of ending inventory $50,025 Estimated Inventory Loss = Estimated Cost - (Retail Inventory Count × 66.7%) $50,025 - ($66,000 × 66.7%) = $50,025 – $44,022 = $6,003 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom