CHAPTER 6 INVENTORIES

Chapter 6: Inventories

1. Overview of Inventory Accounting

• Inventory: Goods and materials a business holds for the purpose of resale. It serves not only as a key asset but is also essential for measuring profitability and financial position, affecting both operational efficiency and financial reporting.

2. Table of Contents

• Classification and determination of inventory

• Inventory cost flow methods and their financial effects

• Effects of inventory errors on financial statements

• Statement presentation and analysis of inventory

• Appendices:

  • Appendix 6A: Inventory cost flow methods

  • Appendix 6B: Estimating inventories

• Comparison of inventory accounting under GAAP and IFRS

3. Classifying and Determining Inventory

• Three Classifications of Inventory:

  • Raw Materials: Inputs used in production.

  • Work in Process (WIP): Goods that are in the manufacturing process but not yet complete.

  • Finished Goods: Products ready for sale.

• Merchandising Company vs. Manufacturing Company: Regardless of the type, both report all inventories under Current Assets on the balance sheet, affecting liquidity ratios and working capital assessments.

4. Physical Inventory Procedures

• Conducted for accuracy in financial records and for loss prevention purposes.

• Perpetual System: Involves continuous updates to inventory records as purchases and sales occur, allowing for real-time inventory tracking and assessment.

• Periodic System: Involves inventory counted at specified intervals which helps to assess the on-hand quantity, often chosen for businesses with fewer transactions.

• Reasons for Taking Physical Inventory:

  • Verify inventory counts to ensure records are accurate.

  • Assess losses due to spoilage, shrinkage, or theft, enabling improved loss prevention strategies.

• Example of Fraud: In a significant case, a salad oil company deceived auditors by filling their tanks with water, misrepresenting the actual amount of oil held.

5. Goods in Transit and Ownership

• Goods in transit must be included in the inventory count of the owner of the legal title, ensuring that financial records accurately reflect ownership.

• Legal title is determined based on specific sales terms, such as FOB shipping point (ownership transfers when the goods leave the seller's location) vs. FOB destination (ownership transfers only when goods reach the buyer).

6. Consigned Goods

• Definition: Consigned goods involve holding and selling another party's inventory without taking on ownership, allowing for a unique selling scenario. Common in industries such as car and antique dealerships, where items can be sold on behalf of others without capital investment.

7. Inventory Valuation Methods

• Cost includes all expenditures necessary to acquire and prepare goods for sale, ensuring accurate financial reporting.

• Valuation Methods:

  • Specific Identification: Assigning specific costs to unique items.

  • First-in, First-out (FIFO): Assumes the first goods purchased are the first sold, reflecting older costs in COGS.

  • Last-in, First-out (LIFO): Assumes the last goods purchased are the first sold, matching current costs with revenues in inflationary periods.

  • Average-cost: Calculates an average cost for goods available for sale.

• Example: Crivitz TV Company purchased TVs at $700, $750, and $800, sold at $1,200 each. Proper accounting of inventory cost is crucial for accurate profit reporting.

8. Cost Flow Assumptions

• Assumptions about inventory flow do not need to correspond with the actual physical flow of goods, allowing flexibility in accounting.

• FIFO recognizes oldest costs first, typically resulting in higher reported profits during times of rising prices.

• LIFO recognizes the most recent costs first, often leading to reduced taxes due to lower reported profits.

• Average cost divides total cost of goods by units available for sale to determine COGS.

9. Financial Statement Effects

• Income Statement Comparison under FIFO, LIFO, and Average Cost: This affects the Cost of Goods Sold (COGS) reported and, consequently, the net income, influencing stakeholders' perceptions of profitability.

• Balance Sheet Effects: During inflationary periods, FIFO will show higher asset values when compared to LIFO, impacting financial ratios and assessments of overall company value.

10. Inventory Errors

• Common causes of inventory errors include inaccuracies in counting or pricing, which can lead to significant discrepancies in financial statements.

• Effects of Errors: Errors affect both the income statement and balance sheet, especially COGS and net income observed through various reporting periods, possibly leading to misstate income guidance.

• Example: Incorrect beginning and ending inventory valuations can misrepresent the actual financial health of a business.

11. Statement Presentation & Analysis of Inventory

• Required disclosures involve clear reporting of inventory classifications, the accounting basis employed, and the chosen costing method present in financial reports.

• Inventory must always be classified as a current asset, signifying its liquidity.

• Low-of-Cost-or-Net Realizable Value (LCNRV): This rule dictates that if the net realizable value (the estimated selling price less costs to complete and sell) drops below the cost, then a write-down is necessary.

12. Inventory Management Analysis

• Inventory turnover ratio: Measures how efficiently a company sells its inventory, providing insights into operational efficiency. A higher turnover ratio suggests better performance.

• Days in inventory: Indicates the average number of days items remain unsold, assisting in cash flow analysis and operational planning.

13. Appendices

• Appendix 6A: Details on applying inventory cost methods to perpetual inventory records for accurate tracking.

• Appendix 6B: Methods for estimating end-of-period inventory, important for interim financial reporting.

14. Comparison of GAAP and IFRS

• Similarities: Both frameworks follow historical cost accounting and the principle of lower-of-cost-or-net realizable value for inventory post-acquisition.

• Differences:

  • GAAP allows the use of LIFO for inventory accounting, which is not permitted under IFRS.

  • Solutions in IFRS must conform to its principles-based criteria, allowing for more flexibility in interpretation than GAAP's rules-based approach.