6-1 REPORTING AND ANALYZING INVENTORY 6-2 Financial Accounting, Seventh Edition Learning Learning Objectives Objectives After studying this chapter, you should be able to: 6-3 Determine how to classify inventory and inventory quantities Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system Explain the financial statement and tax effects of each of the inventory cost flow assumptions Explain the lower-of-cost-or-market basis of accounting for inventories Compute and interpret the inventory turnover Describe the LIFO reserve and explain its importance for comparing results of different companies Preview of Chapter 6-4 Financial Accounting Seventh Edition Kimmel Weygandt Kieso Classifying Classifying and and Determining Determining Inventory Inventory Merchandising Company One Classification: Merchandise Inventory Helpful Hint Regardless of the classification, companies report all inventories under Current Assets on the balance sheet 6-5 Manufacturing Company Three Classifications: Raw Materials Work in Process Finished Goods LO Determine how to classify inventory and inventory quantities 6-6 Determining Determining Inventory Inventory Quantities Quantities Physical Inventory taken for two reasons: Perpetual System Check accuracy of inventory records Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft Periodic System Determine the inventory on hand Determine the cost of goods sold for the period 6-7 LO Determine how to classify inventory and inventory quantities Determining Determining Inventory Inventory Quantities Quantities Taking a Physical Inventory Involves counting, weighing, or measuring each kind of inventory on hand Taken, 6-8 when the business is closed or business is slow at the end of the accounting period LO Determine how to classify inventory and inventory quantities 6-9 Determining Determining Inventory Inventory Quantities 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 6-10 LO Determine how to classify inventory and inventory quantities Appendix Appendix 6B 6B Inventory Errors Income Statement Effects Inventory errors affect the computation of cost of goods sold and net income in two periods 6-50 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 LO Indicate the effects of inventory errors on the financial statements Inventory Errors Appendix Appendix 6B 6B Illustration 6-B3 Combined income for 2year period is correct 6-51 ($3,000) Net Income understated $3,000 Net Income overstated LO Indicate the effects of inventory errors on the financial statements Appendix Appendix 6B 6B Inventory Errors Review Question Understating ending inventory will overstate: a assets b cost of goods sold c net income d owner's equity 6-52 LO Indicate the effects of inventory errors on the financial statements Appendix Appendix 6B 6B Inventory Errors Balance Sheet Effects Effect of inventory errors on the balance sheet is determined by using the basic accounting equation: Illustration 6-B1 Illustration 6-B4 6-53 LO Indicate the effects of inventory errors on the financial statements Key Points 6-54 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-for-sale 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) LO Compare the procedures for the merchandising under GAAP and IFRS Key Points 6-55 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 LO Compare the procedures for the merchandising under GAAP and IFRS Key Points 6-56 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 averagecost 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 LO Compare the procedures for the merchandising under GAAP and IFRS Key Points 6-57 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 GAAP, on the other hand, defines market as essentially replacement cost LO Compare the procedures for the merchandising under GAAP and IFRS Key Points 6-58 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 writedown 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 LO Compare the procedures for the merchandising under GAAP and IFRS Key Points 6-59 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 IFRS allows companies to report inventory at standard cost if it does not differ significantly from actual cost Standard cost is addressed in managerial accounting courses LO Compare the procedures for the merchandising under GAAP and IFRS Looking to the Future IFRS specifically prohibits the use of the LIFO cost flow assumption Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income 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 lowerof-cost-or-net realizable value 6-60 LO Compare the procedures for the merchandising under GAAP and IFRS IFRS Practice 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 6-61 LO Compare the procedures for the merchandising under GAAP and IFRS IFRS Practice Which method of inventory costing is prohibited under IFRS? a) Specific identification b) FIFO c) LIFO d) Average-cost 6-62 LO Compare the procedures for the merchandising under GAAP and IFRS IFRS Practice 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 6-63 LO Compare the procedures for the merchandising under GAAP and IFRS Copyright Copyright “Copyright © 2013 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.” 6-64 [...]... deducted from the inventory count 2 The goods of $10,000 purchased FOB shipping point should be added to the inventory count Inventory should be $195,000 3 Item 3 was treated correctly ($200,000 - $15,000 + $10,000) 6-14 LO 1 Determine how to classify inventory and inventory quantities $ 6-15 LO 1 Determine how to classify inventory and inventory quantities Inventory Inventory Costing Costing Inventory is... the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system Financial Financial Statement Statement and and Tax Tax Effects Effects Comparative effects of cost flow methods 6-31 Illustration 6-13 LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions Inventory Inventory Cost Cost Flow Flow Assumptions... inventory system Inventory Inventory Costing 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 6-4 6-18 LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system Inventory Inventory Costing... Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system Cost Cost Flow Flow Assumptions Assumptions Illustration: Data for Houston Electronics’ Astro condensers Illustration 6-5 (Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold 6-21 LO 2 Explain the basis of accounting for inventories and apply the inventory cost... periodic inventory system Inventory Inventory Costing Costing Illustration: Crivitz TV Company purchases three identical 50inch 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 6-3 6-17 LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory. .. inventories and apply the inventory cost flow methods under a periodic inventory system Cost Cost Flow Flow Assumptions Assumptions Average-Cost Illustration 6-11 6-29 LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system Cost Cost Flow Flow Assumptions Assumptions Average-Cost Illustration 6-11 6-30 LO 2 Explain the basis of accounting. .. method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory 6-19 Practice is relatively rare Most companies make assumptions (cost flow assumptions) about which units were sold LO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system Inventory Inventory Costing Costing Cost... use LIFO for tax purposes, they must also use it for financial reporting purposes This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions 6-34 Inventory Inventory Costing Costing Using Cost Flow Methods Consistently... preferred, a company may change its inventory costing method Illustration 6-15 Disclosure of change in cost flow method 6-35 LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions Inventory Inventory Costing Costing Lower-of-Cost-or-Market When the value of inventory is lower than its cost 6-36 Companies can “write down” the inventory to its market value in... Determining Inventory Inventory Quantities Quantities Goods in Transit Illustration 6-2 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 6-11 LO 1 Determine how to classify inventory and inventory quantities Determining Determining Inventory Inventory Quantities