Chapter 7: Inventory

1. Chapter 7: Inventory

2. Acquisition of inventory: What costs to capitalize? Recording inventory activity: Which method? Selling inventory: Which cost flow assumption? Ending inventory: Lower-of-cost-or market valuation. Chapter 7: Inventory

3. What items or units to include? General rule: (1) held for sale and (2) complete and unrestricted ownership. Consignments: belong to consignor, ownership not based on physical possession. Goods in transit FOB Shipping Point: belongs to the purchaser while in transit (once inventory leaves seller’s facilities). FOB Destination: belongs to seller while in transit (until inventory reaches purchaser’s facilities). 1. Acquiring Inventory

4. Error if Dallas includes in ending inventory at 12/31? 1. FOB Shipping Point (purchase): No error 2. FOB Shipping Point (sale): Yes - inventory overstated. 3. FOB Destination (sale): No error 4. FOB Destination (purchase): No error 5. FOB Destination (purchase): Yes - inventory overstated Class Exercise E7-1

5. Inventory errors are unique in financial reporting because they involve multiple accounts and multiple periods. Because of the carryover nature of inventory, some inventory errors reverse out by the end of the second year involved. To analyze, use basic inventory formula. Inventory Errors

6. Assume that the ending inventory of 2004 was undervalued by $9,000. If the error goes undetected in 2005, what effect would the error have on the balance sheet and income statement accounts for 2004 and 2005. Analyze using the following relationships: BI + P - EI = COGS NI A = L + SE Note that the asset account in inventory error analysis is ending inventory, and the equity effect is retained earnings, specifically the effect on net income. Class Problem

7. Analysis: BI + P - EI = COGS NI A = L + SE Class Problem 04: 9u 9o 9u 9u 9u 05: 9u 9u 9o X X Why no effect on 2005 ending SE? NI 2004 understated by $9,000 NI 2005 overstated by $9,000 Both closed to RE, so no net effect at end.

8. What costs to attach? General rule: all costs associated with purchase or manufacture, including shipping to facility. Freight-in (transportation-in) adds to the cost of inventory. Purchase returns reduce the cost of purchases (contra) for returned inventory. Purchase allowances reduce the cost of purchases (contra) for reduced prices due to damage or errors. Purchase discounts from early cash payments (contra) reduce the cost of purchases. Acquiring inventory - contd.

9. Perpetual Up-to-date record in inventory account. Cost of goods sold computed for each sale. Periodic Inventory purchases are recorded as incurred. Inventory and cost of goods sold determined at the end of each period through physical count. Costs and benefits Perpetual requires more bookkeeping but provides more useful information. General application: Periodic used for external reporting; perpetual used for internal tracking of units. 2. Perpetual or Periodic Method

10. December 10 Purchase of 100 units @ $20: Inventory 2,000 Accts. Pay. 2,000 December 20 Sale of 50 units @ $30: Cash 1,500 Sales 1,500 COGS 1,000 Inventory 1,000 December 30 AJE to recognize loss of 5 units @$20 each (170 on hand, books show 175) Loss 100 Inventory 100 Figure 7.3, Perpetual System

11. December 10 Purchase of 100 units @ $20: Purchases 2,000 Accts. Pay. 2,000 December 20 Sale of 50 units @ $30: Cash 1,500 Sales 1,500 (no COGS entry until the end of the period) December 31 AJE/CJE to recognize EI and COGS: (Note: BI given at $2,500 and EI of 175 units (125 BI + 100 Purchase -50 Sold) valued at $20 per unit, or $3,500) Inventory (end) 3,500 COGS 1,000 Purchases 2,000 Inventory (begin) 2,500 Figure 7.3, Periodic System

12. BI + Purchases (net) - EI = COGS 2,500 + 2,000 - 3,500 = 1,000 Note that Purchases (net) = Purchases + Freight-in - Purchase Discounts (see next slide) - Purchase Returns - Purchase Allowances This AJE under periodic system follows the formula for COGS: (Alternative: BI + P(net) = EI + COGS)

13. Assume purchase of $100 on account on 6/1/05, terms 2/15 (2% discount if paid within15 days), n/30. GJE to record purchase on 6/1/05: Purchases 100 Accounts Payable 100 GJE to record payment, if on or before 6/16/05: Accounts Payable 100 Purchase Discounts 2 Cash 98 GJE to record payment, if after 6/16/05: Accounts Payable 100 Cash 100 (Purch Disc. is contra to Purchases; part of COGS calc.) Purchase Discounts - Gross Method

14. March 3 purchase: Purchases 50,000 A/P 50,000 March 10 purchase: Purchases 140,000 A/P 140,000 Class Problem: E7-3 (Periodic)

15. March 20 payment (3% discount taken): A/P 140,000 Purchase discounts 4,200 Cash 135,800 April 25 payment (no discount taken): A/P 50,000 Cash 50,000 Class Problem: E7-3 (Periodic)

16. Note: Cost of goods available for sale = GAS, and GAS = Beginning inventory + Purchases (net) GAS = EI + COGS Class Exercise: Exercise 7-4, Part (a)

17. Find Beginning inventory (2003): BI 2003 = EI 2002 = 1,931 Find GAS (2003): BI + P(n) = GAS 1,931 + 9,170 = GAS 11,101 = GAS Find EI (2003): GAS = EI + COGS 11,101 = EI + 9,285 1,816 = EI Class Exercise: Exercise 7-4, Part (a) for 2003

18. Find Beginning inventory (2002): BI 2002 = EI 2001 = GAS 2001 - COGS 2001 = 10,840 - 8,749 = 2,091 Find GAS (2002): GAS = EI + COGS GAS = 1,931 + 8,496 GAS = 10,427 Find Purchases: BI + P = GAS 2,091 + P = 10,427 P = 8,336 Class Exercise: Exercise 7-4, Part (a) for 2002

19. Given: BI + P (net) = EI + COGS How to assign costs of inflows [BI + P(net)] to EI and COGS? Methods: Specific identification Averagefor both COGS and EI FIFO- (first-in, first-out) for COGS and LISH (last-in, still here) for EI LIFO - (last-in, first-out) for COGS and FISH (first-in, still here) for EI 3. Cost Flow Assumptions

20. Given the following activity for January: Cost Total Units per Unit Cost Begin Inventory 20 $ 9.00 $180 Purchase 1/10 40 10.00 400 Purchase 1/22 30 11.00 330 Total available 90 units $910 Sales -55 units Ending inventory Class Problem - Cost Flows 35 units

21. Note that, for illustrative purposes, only the periodic system is shown here. The perpetual system give similar results, but is more cumbersome to illustrate. In fact, using the FIFO method, the perpetual and periodic systems yield exactly the same results. Class Problem - Cost Flows

22. FIFO for COGS (top down) 55 units 20 @ $9 = $180 35 @ $10 = $350 Total = $530 LISH for EI (bottom up) 35 units 30 @ $11 = $330 5 @ $10 = $ 50 Total $380 FIFO(LISH)

23. LIFO for COGS (bottom up) 55 units 30 @ $11 = $330 25 @ $10 = $250 Total = $580 FISH for EI (top down) 35 units 20 @ $ 9 = $180 15 @ $10 = $150 Total = $330 LIFO(FISH)

24. First calculate average: Goods available cost = $910 Goods available units = 90 units Avg. = $10.11 per unit Now COGS: 55 units x $10.11 per unit = $ 556 Now EI: 35 units x $10.11 per unit = $354 Average

25. In times of rising prices: highest COGS: lowest COGS highest EI lowest EI highest Net Income lowest Net Income Comparison of FIFO, LIFO, and Average LIFO FIFO FIFO LIFO FIFO LIFO

26. LIFO and taxes Why use LIFO for taxes? Why use LIFO for financial statements? LIFO and market valuation Should market value a company higher or lower if they use LIFO? LIFO liquidation What happens to net income with liquidation of an old LIFO layer? LIFO reserve what information is contained in this disclosure? Additional LIFO issues:

27. Based on conservatism, ending inventory is valued at cost or market value, whichever is lower. Problem: can create hidden reserves Recognizes price decreases immediately Defers price increase recognition until sold 4. Ending Inventory:Applying the Lower-of-Cost-or-Market Rule

28. a. AJE (in millions)- reduce EI and recognize loss: Loss on Inventory 12 Inventory 12 b. Sale next year (new basis = 40): Cash (or A/R) 48 Sales 48 COGS 40 Inventory 40 c. Loss of $12 in first year; gain of $8 in second year: - overestimate? - or creating hidden reserve? Class Issues for Discussion: ID7-4