Chapter 6 PowerPoint

Learning Objectives

• LO 1: Steps in determining inventory quantities

• LO 2: Cost formulas: specific identification, FIFO, average cost

• LO 3: Effects on financial statements of inventory cost formulas

• LO 4: Effects of inventory errors on financial statements

• LO 5: Presentation and analysis of inventory

• LO 6: FIFO and average cost formulas under periodic inventory system

Reporting and Analyzing Inventory

• Determining Inventory Quantities

  • Ownership of goods

  • Physical inventory counting

  • Internal controls

• Inventory Cost Determination Formulas

  • Specific identification, FIFO, Average cost

  • Effects of cost formulas

• Inventory Errors

• Presentation and Analysis of Inventory

• Inventory Cost Formulas in Periodic System

Steps in Determining Inventory Quantities

• Count physical inventory at end of each accounting period to:

  • Check accuracy of records

  • Determine shrinkage/theft

Ownership Considerations

• Goods in transit impact ownership determination:

  • Legal title determines inventory inclusion

  • Freight concepts: FOB shipping vs. destination

• Consigned goods owned by consignor

• Goods taken home "on approval" remain owned by the company

Taking a Physical Inventory

• Strong internal controls necessary:

  • Review and reconciliation processes

  • Inventory counting as a control activity

Cost Formula Applications

• Cost Formulas

  • Must apply unit costs after counting inventory

  • Various costs impact total inventory cost

• Specific Identification

  • Tracks costs of individual items

  • Used only where items can be distinguished easily

• FIFO (First-In, First-Out)

  • Assumes earliest goods purchased are sold first

  • Recent costs affect ending inventory

• Average Cost

  • Computes a moving average of unit costs

Effects on Financial Statements

• Choose inventory formula that:

  • Closely represents physical flow

  • Reports ending inventory at recent cost

  • Consistent application across similar inventories

Summary of Financial Statement Effects

• FIFO vs Average Cost on:

  • Cost of Goods Sold (COGS)

    • FIFO: Lower COGS in rising costs

    • Average Cost: Higher COGS under falling costs

  • Gross Profit & Net Income:

    • FIFO: Higher under rising costs

    • Average Cost: Higher under falling costs

  • Inventory Valuation:

    • Higher under FIFO in rising costs

Inventory Errors

• Common errors:

  • Incorrect counting of ending inventory

  • Recording purchases in the wrong period

• Effects on financial statements:

  • Impact COGS and net income

Effects of Over/Understated Inventory

• Overstated Inventory:

  • Understated COGS

  • Overstated Gross Profit and Income

• Correcting errors in upcoming periods may lead to reverse effects on net income

Presentation and Analysis of Inventory

• Use LCNRV and accounting for inventory reductions.

• Report inventory at lower of cost and NRV in notes to financial statements.

Inventory Ratios

• Inventory turnover ratio: Frequency of inventory sales

• Days in inventory ratio: Average days inventory held

• Optimal performance: Higher turnover, lower days in inventory

Periodic Inventory Systems

• Both FIFO and Average can be applied in periodic systems with cost allocation at the end of the period.