Chapter 7: Merchandise Inventory Learning Objective List the four important issues that must be addressed when accounting for inventory, and briefly describe how inventory valuation affects earnings Merchandise Inventory • What is inventory? • Items held for resale to customers • Who has inventory? • Wholesaler or Retailer • Merchandise Inventory • Manufacturer • Raw Materials • Work in Process • Finished Goods The Relative Size of Inventories Four Important Inventory Issues Acquiring inventory: What costs to capitalize? Carrying Inventory: Perpetual vs Periodic? Selling inventory: Which cost flow assumption? Ending inventory: Lower-of-cost-or-market valuation Figure 7-2 Accounting for Inventory: Four Important Issues Items should be included in the company’s inventory if they are: a being used in the production of income b held in anticipation of an increase in value c being held for sale d sold during the period Which one of the following companies would likely carry the largest percentage of inventory as compared to its other assets? a Ernst and Young, CPAs b Merrill Lynch investment brokers c The Magic Kingdom as Disney World d DJ’s Ford Dealership Learning Objective Describe how to decide which costs to capitalize in the inventory account Effects on Financials/Taxes In an inflationary period (rising prices) which most periods are: FIFO has the highest inventory balance, lowest COGS, and highest income LIFO has the lowest inventory balance, highest COGS, and lowest income • This means that LIFO pays the least taxes Cost Flows – Effects on Financial Statements Figure 7-6 Financial statement effects of the three inventory cost flow assumptions Cost Flows – Effects on Federal Income Taxes Choosing an Inventory Cost Flow Assumption: Trade-Offs •Income and Asset Measurement • • FIFO provides the best representation of the ending inventory balance LIFO better matches recent revenues with expenses •Economic Consequences • • • Income Taxes and Liquidity Bookkeeping Costs LIFO Liquidation and Inventory Purchasing Practices • Debt and Compensation Practices • The Capital Market The LIFO Reserve: A User Perspective •The LIFO reserve is the difference between the inventory value recorded at FIFO and LIFO for those organizations that use LIFO valuation This can be used to: • • • Revalue inventory for comparison purchases Calculate additional potential tax liability Recalculate net income During a period of rising prices and inventories, a company whose current ratio is dangerously close to the minimum specified by agreement with a major creditor would prefer which cost flow assumption? a FIFO b LIFO c Averaging d The company would be indifferent as to which cost flow assumption is adopted Learning Objective Explain the lower-of-cost-or-market rule and how it is applied to inventory accounting Ending Inventory: Applying the Lowerof-Cost-or-Market Rule • Applying the lower-of-cost-or-market rule to ending inventory is accomplished by comparing the cost allocated to ending inventory with the market value of the inventory If the market value exceeds the cost, no adjustment is made and the inventory remains at cost If the market value is less than the cost, the inventories are written down to market value with an adjusting journal entry The Lower-of-Cost-or-Market Rule and Hidden Reserves • Based on conservatism, ending inventory is valued at cost or market value, whichever is lower • Recognizes price decreases immediately • Defers price increase recognition until sold • Problem: can create hidden reserves Under the lower-of-cost-or-market rule, market is: a the selling price of inventory items b the original cost paid for inventory c used to value inventory if it is less than its recorded cost d the amount of cash the company expects to collect from the sale of an inventory item If the market value of inventory is less than its cost, then application of the lower-of-cost-ormarket rule would: a increase earnings and decrease the current ratio b decrease earnings and increase the current ratio c decrease earnings and decrease the current ratio d cause no change to earnings or the current ratio Learning Objective Describe why the economic trade-offs faced by Japanese managers may be smaller than those faced by U.S managers when considering different inventory flow assumptions International Perspective: Japanese Business and Inventory Accounting • Just-in-time (JIT) inventory systems, which reduce the costs of carrying large amounts of inventory without jeopardizing customer service, have long been a characteristic of this Japanese system and have given the Japanese a definite advantage when competing against U.S industry • Japan has adopted international reporting standards (IFRS), which does not allow the use of LIFO Concept Practice Wiley © 2018 .. .Chapter 7: Merchandise Inventory Learning Objective List the four important issues that must be addressed when accounting for inventory, and briefly describe... requires expertise, and impacts important financial numbers and ratios Concept Practice Learning Objective Compare the perpetual method to the periodic method when accounting for inventory carried on... This would change the Cost of goods sold to $1,427 - 354 $ = $1 ,073 which would then increase the Gross profit to $597 ($1,670 - $1 ,073 ) E7-6 b Compute the impact of these errors on cost of goods