Chapter 6: Inventories

Prepared by Coby HarmonUniversity of California, Santa BarbaraWestmont College

Chapter Outline

Learning Objectives

• LO 1: Discuss how to classify and determine inventory.

• LO 2: Apply inventory cost flow methods and discuss their financial effects.

• LO 3: Indicate the effects of inventory errors on the financial statements.

• LO 4: Explain the statement presentation and analysis of inventory.

Classifying and Determining Inventory

LO 1Classification

• Merchandising Company: Only one classification for inventory, typically encompassing the products for resale.

• Manufacturing Company: Three classifications:

  • Raw Materials: Basic inputs that can be used to produce products.

  • Work in Process: Items that are in the production process but not yet completed.

  • Finished Goods: Completed products ready for sale.

Physical Inventory Reasons

• Perpetual System:

  • Maintains ongoing records of inventory transactions, allowing real-time tracking of inventory levels and costs.

  • Commonly used in large retail operations where inventory counts are essential for accurate reporting.

  • Helps in checking the accuracy of inventory records and determining inventory loss due to waste, theft, etc.

• Periodic System:

  • Conducts inventory counts at specific intervals to determine the inventory on hand and the cost of goods sold for the period.

  • Allows for simplified record-keeping but may result in less accurate tracking of inventory changes.

Determining Inventory Quantities

Taking a Physical Inventory:

• Involves counting, weighing, or measuring inventory.

• Common during business closures or slow periods, typically at the end of the accounting period to ensure accurate financial reporting.

Determining Ownership of Goods:

• Goods in Transit:

  • Purchased goods that have not yet been received, or sold goods that have not yet been delivered.

  • Included in the inventory of the company that has legal title, which is determined by shipping terms:

    • FOB Destination: Ownership remains with the seller until delivery to the buyer's location.

    • FOB Shipping Point: Ownership transfers to the buyer once the goods are accepted by the carrier.

• Consigned Goods:

  • Goods held for sale by one party for another without taking ownership.

  • Examples include auto or boat dealerships selling vehicles on consignment, where the dealer does not own the inventory but sells it for the owner.

Accounting for Inventory at Cost

LO 2

• Cost Flow Assumptions:

  • Inventory is accounted for at cost, which includes all expenditures necessary to acquire goods and prepare them for sale.

  • Costing methods include:

    • Specific Identification: Exact costing of individual items, allowing for precise tracking of inventory costs. This method is less common due to its complexity.

    • FIFO (First-In, First-Out): Assumes that the oldest goods purchased are the first to be sold. This method reflects current costs better in ending inventory, especially during inflationary periods.

    • LIFO (Last-In, First-Out): Assumes that the latest goods purchased are the first to be sold. It may provide tax advantages during rising prices but does not always align with actual physical movement unless applied to bulk items.

    • Average-Cost Method: Allocates costs based on the weighted average cost of all units available for sale during the period.

Example: Crivitz TV Company purchases equipment made on various dates at different costs, showcasing the impact of cost flow assumptions in financial reporting.

Inventory Errors

LO 3

• Effects of Inventory Errors:

  • The basic equation for calculating cost of goods sold is:

    • Beginning Inventory + Cost of Goods Purchased - Ending Inventory = Cost of Goods Sold

  • Inventory errors can affect both the income statement and the balance sheet. Understating/overstating beginning or ending inventory can understate or overstate net income and total assets, respectively.

  • Errors have opposite effects in subsequent periods; consistent errors can lead to accurate net income over two periods but can misrepresent individual period results.

  • Balance Sheet Effects:

    • Using the accounting equation (Assets = Liabilities + Equity), errors in inventory impact recorded assets, liabilities, and stockholders' equity.

Statement Presentation and Analysis

LO 4

• Presentation:

  • Inventory is classified as a current asset on the balance sheet. On the income statement, cost of goods sold is subtracted from sales revenue.

  • Companies must disclose major inventory classifications, accounting basis, and methods used for costing.

• Lower-of-Cost-or-Net Realizable Value:

  • If the value of inventory drops below its recorded cost, companies need to adjust the asset's value down to its net realizable value.

  • Companies must ensure effective write-downs to achieve realizable values, enhancing transparency and accuracy in financial reports.

• Inventory Management Analysis:

  • High inventory levels can lead to increased carrying costs, which decrease profitability.

  • Conversely, low inventory levels can result in stockouts, leading to potential loss of sales and customer trust.

• Inventory Turnover and Days in Inventory:

  • Inventory Turnover = Cost of Goods Sold / Average Inventory. A high turnover rate indicates efficient inventory management.

  • Days in Inventory = Days in Year (365) / Inventory Turnover, conveying how long inventory is held before being sold.

IFRS Comparison

Similarities with GAAP:

• Both accounting frameworks typically treat inventory at historical cost, with similar approaches for accounting ownership and related costs.

Key Differences:

• IFRS adheres to more principles-based guidelines, while GAAP provides more detailed rules.

• A significant difference exists concerning LIFO, which is prohibited under IFRS but permitted under GAAP.

Future Outlook

• There are ongoing convergence issues relating to the LIFO method due to its favorable tax implications and superior matching of costs to revenues.