Chapter 6 - Reporting and Analyzing Inventory Study Guide

Classification and Ownership of Inventory

• Reporting inventory at the end of an accounting period requires two key steps:

  • Classification of inventory based on the degree of completeness.

  • Determination of inventory amounts through physical counts and ownership rules.

• Inventory Classification by Business Type:

  • Manufacturing Companies: Maintain three main classifications of inventory: raw materials, work in process, and finished goods. Raw materials inventory consists of goods on hand that have been purchased for use in manufacturing but have not yet been placed into production.

  • Merchandising Companies: Use a periodic inventory system or perpetual inventory system to determine goods on hand at period-end.

• Determining Inventory Ownership:

  • Physical possession does not always equal legal ownership. Goods in transit and consigned goods require careful evaluation to establish legal title.

• Goods in Transit:

  • Goods in transit refer to merchandise shipped by a seller that has not yet reached the buyer.

  • Free On Board (FOB) Shipping Point:

  • Ownership transfers from the seller to the buyer as soon as the public carrier accepts the goods from the seller (when loaded on the truck).

  • The buyer is responsible for freight costs.

  • Goods in transit must be included in the buyer's inventory balance.

• Free On Board (FOB) Destination:

  • Ownership remains with the seller until the goods reach the buyer's destination and delivery is complete.

  • The seller is responsible for freight costs.

  • Goods in transit remain in the seller's inventory balance until final delivery.

• Consigned Goods:

  • Under a consignment arrangement, goods are held for sale by a holder (consignee) who attempts to sell the goods for a fee on behalf of the actual owner (consignor).

  • The holder of the goods does not own the goods.

  • Consigned goods are excluded from the holder's inventory count because legal ownership has not passed.

• Worked Example: Hasbeen Company Ownership Adjustments (Do It! 1)

  • Initial physical inventory count: $\$200,000$.

  • Item 1: Included goods held on consignment for Falls Co. costing $\$15,000$.

  • Adjustment: Deduct $\$15,000$ (Hasbeen does not own consigned goods).

  • Item 2: Excluded purchased goods in transit costing $\$10,000$ shipped FOB shipping point.

  • Adjustment: Add $\$10,000$ (ownership passed to Hasbeen upon carrier acceptance).

  • Item 3: Excluded inventory sold with a cost of $\$12,000$ currently in transit shipped FOB shipping point.

  • Adjustment: No effect (ownership passed to the buyer when shipped).

  • Adjusted Final Inventory Calculation:     $\text{Adjusted Inventory} = \$200,000 - \$15,000 + \$10,000 = \$195,000$

Inventory Costing Methods and Cost Flow Assumptions

• Inventory costing methods establish how purchase costs are allocated between Cost of Goods Sold (income statement) and Ending Inventory (balance sheet).

• There is no accounting requirement that the selected cost flow assumption must match the physical movement of goods.

• Specific Identification Method:

  • Applied when a company can positively identify which specific units of inventory were sold and which remain on hand.

  • Tracks the actual physical flow of individual items.

  • Used primarily for high-unit-cost, distinguishable merchandise (e.g., automobiles, custom jewelry, high-end electronics).

• Worked Example: Crivitz TV Specific Identification

  • Crivitz TV purchases three identical 50-inch TVs on different dates:

    • February 3: 1 TV purchased at $\$700$

    • March 5: 1 TV purchased at $\$750$

    • May 22: 1 TV purchased at $\$800$

  • Crivitz TV sells two TVs (purchased February 3 and May 22) for $\$1,200$ each.

  • Cost of Goods Sold Calculation:       $\text{Cost of Goods Sold} = \$700 + \$800 = \$1,500$

  • Ending Inventory Valuation:       $\text{Ending Inventory} = \$750$

  • Cost Flow Assumptions:

• When items are interchangeable and purchased at varying costs, companies utilize cost flow assumptions.

• First-In, First-Out (FIFO):

  • Assumes that the earliest goods purchased are the first to be sold.

  • Cost of Goods Sold consists of the unit costs of the earliest purchases.

  • Cost of Ending Inventory consists of the unit costs of the most recent purchases (calculated by working backward from recent purchases).

  • Sometimes summarized as LISH (Last-In, Still Here).

• Last-In, First-Out (LIFO):

  • Assumes that the latest goods purchased are the first to be sold.

  • Cost of Goods Sold consists of the unit costs of the most recent purchases.

  • Cost of Ending Inventory consists of the unit costs of the earliest purchases (calculated by working forward from beginning inventory).

  • Sometimes summarized as FISH (First-In, Still Here).

• Average-Cost Method:

  • Used when inventory items are similar in nature.

  • Allocates the cost of goods available for sale based on a weighted-average unit cost.

  • Formula:       $\text{Weighted-Average Unit Cost} = \frac{\text{Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}}$

  • The weighted-average unit cost is applied to units sold (for COGS) and units on hand (for Ending Inventory).

  • Comprehensive Comparative Example (July 5 & 15 Transactions):

• Base Data:

  • Beginning Inventory: $2\text{ units} \times \$40 = \$80$

  • July 5 Purchase: $6\text{ units} \times \$45 = \$270$

  • Total Available for Sale: $8\text{ units}$, total cost = $\$350$

  • July 15 Sale: $4\text{ units}$ sold (leaving $4\text{ units}$ in ending inventory)

• FIFO Breakdown:     \text{Cost of Goods Sold} = (2 \times \40) + (2 \times \$45) = \$80 + \$90 = \$170$     $\text{Ending Inventory} = 4 \times \$45 = \$180$

• LIFO Breakdown:     $\text{Cost of Goods Sold} = 4 \times \$45 = \$180$     \text{Ending Inventory} = (2 \times \40) + (2 \times \$45) = \$80 + \$90 = \$170$

• Average-Cost Breakdown:     \text{Weighted-Average Unit Cost} = \frac{\350}{8\text{ units}} = \$43.75$     $\text{Cost of Goods Sold} = 4 \times \$43.75 = \$175$     $\text{Ending Inventory} = 4 \times \$43.75 = \$175$

  • Worked Example: Shumway Ag Implement Cost Flow Methods

• Base Data:

  • Beginning Inventory: $4,000\text{ units}$ at $\$3$

  • Purchases: $6,000\text{ units}$ at $\$4$

  • Sales: $7,000\text{ units}$ at $\$12$

  • Total Available Units: $4,000 + 6,000 = 10,000\text{ units}$

  • Total Cost of Goods Available for Sale: (4,000 \times \3) + (6,000 \times \$4) = \$12,000 + \$24,000 = \$36,000$

  • Ending Inventory Units: $10,000 - 7,000 = 3,000\text{ units}$

• FIFO Solution:     \text{COGS} = (4,000 \times \3) + (3,000 \times \$4) = \$12,000 + \$12,000 = \$24,000$

• LIFO Solution:     \text{COGS} = (6,000 \times \4) + (1,000 \times \$3) = \$24,000 + \$3,000 = \$27,000$

• Average-Cost Solution:     \text{Weighted-Average Unit Cost} = \frac{\36,000}{10,000\text{ units}} = \$3.60\text{ per unit}$     $\text{Ending Inventory} = 3,000 \times \$3.60 = \$10,800$     $\text{COGS} = \$36,000 - \$10,800 = \$25,200$

Financial Statement Impact of Inventory Costing Methods

• Income Statement Effects (In Inflationary Environments with Rising Prices):

  • Houston Electronics Case Study:

  • Assumed Tax Rate: $20\%$ for corporate income tax.

  • Sales Revenue: $\$18,500$ across all methods.

  • Beginning Inventory: $\$1,000$

  • Purchases: $\$11,000$

  • Cost of Goods Available for Sale: $\$12,000$

  • Operating Expenses: $\$9,000$

• Comparative Statement Values:

  • FIFO:

    • Ending Inventory: $\$5,800$

    • Cost of Goods Sold: $\$6,200$

    • Gross Profit: $\$12,300$

    • Income before Income Taxes: $\$3,300$

    • Income Tax Expense ($20\%$): $\$660$

    • Net Income: $\$2,640$

  • LIFO:

    • Ending Inventory: $\$5,000$

    • Cost of Goods Sold: $\$7,000$

    • Gross Profit: $\$11,500$

    • Income before Income Taxes: $\$2,500$

    • Income Tax Expense ($20\%$): $\$500$

    • Net Income: $\$2,000$

  • Average-Cost:

    • Ending Inventory: $\$5,400$

    • Cost of Goods Sold: $\$6,600$

    • Gross Profit: $\$11,900$

    • Income before Income Taxes: $\$2,900$

    • Income Tax Expense ($20\%$): $\$580$

    • Net Income: $\$2,320$

  • Key Trade-offs Between FIFO and LIFO During Rising Prices:

• FIFO Advantages/Effects:

  • Produces higher net income ($\$2,640$ vs $\$2,000$ for LIFO).

  • Results in higher executive/management bonuses if bonuses depend on net income metrics.

  • Viewed more favorably by external users and shareholders due to higher reported earnings.

• LIFO Advantages/Effects:

  • Provides a more realistic net income figure by matching current higher costs against current revenues.

  • Produces lower income tax expense ($\$500$ vs $\$660$ for FIFO), resulting in superior tax savings and cash savings.

  • Balance Sheet Effects:

• FIFO: During periods of inflation, costs allocated to ending inventory approximate current replacement cost.

• LIFO: During periods of inflation, costs allocated to ending inventory may be significantly understated relative to current market value.

  • The Consistency Principle:

• Requires that a company use its selected cost flow method consistently from one accounting period to the next.

• Enhances financial statement comparability across successive time periods.

• Does not preclude a company from changing its inventory costing method, provided the change is justified and its financial effects are fully disclosed in financial statement notes.

Consistency Principle and Valuation Techniques

• Lower-of-Cost-or-Net Realizable Value (LCNRV):

  • When the value of inventory drops below its original cost, companies must write down inventory to its net realizable value.

  • Net Realizable Value (NRV): Defined as the net amount that a company expects to receive from the sale of inventory (estimated selling price less estimated completion and disposal costs).

  • Grounded in the fundamental accounting concept of conservatism.

• Worked Example: Ken Tuckie Electronics LCNRV Application

  • Flat-screen TVs: $100\text{ units}$, Cost = $\$600$, NRV = $\$550$

  • Applied LCNRV: $100 \times \$550 = \$55,000$

  • Wireless speakers: $500\text{ units}$, Cost = $\$90$, NRV = $\$104$

  • Applied LCNRV: $500 \times \$90 = \$45,000$

  • Bluetooth headphones: $850\text{ units}$, Cost = $\$50$, NRV = $\$48$

  • Applied LCNRV: $850 \times \$48 = \$40,800$

  • Smart watch accessories: $900\text{ units}$, Cost = $\$4$, NRV = $\$8$

  • Applied LCNRV: $900 \times \$4 = \$3,600$

  • Total Inventory Valuation under LCNRV:     $\text{Total Valuation} = \$55,000 + \$45,000 + \$40,800 + \$3,600 = \$144,400$

• Worked Example: Tracy Company Heating Stoves LCNRV (Do It! 3a)

  • Gas Stoves: Cost = $\$84,000$, NRV = $\$79,000$

  • Lower value: $\$79,000$

  • Wood Stoves: Cost = $\$250,000$, NRV = $\$280,000$

  • Lower value: $\$250,000$

  • Pellet Stoves: Cost = $\$112,000$, NRV = $\$101,000$

  • Lower value: $\$101,000$

  • Total Inventory Value under LCNRV:     $\text{Total Valuation} = \$79,000 + \$250,000 + \$101,000 = \$430,000$

Inventory Financial Ratios and Analytics

• Key financial ratios measure inventory management efficiency and liquidity.

• Inventory Turnover Ratio:

  • Measures the number of times, on average, inventory is sold during the accounting period.

  • Indicates inventory liquidity.

  $\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

  $\text{Average Inventory} = \frac{\text{Beginning Inventory} + \text{Ending Inventory}}{2}$

• Days in Inventory:

  • Measures the average number of days inventory is held before being sold.

  $\text{Days in Inventory} = \frac{365}{\text{Inventory Turnover}}$

• Real-World Analysis: Walmart, Inc. vs. Target Benchmark

  • Walmart Financial Data ($in millions$):

  • Cost of Goods Sold: $\$394,605$

  • Beginning Inventory: $\$44,269$

  • Ending Inventory: $\$44,435$

  • Walmart Ratio Calculations:     $\text{Average Inventory} = \frac{\$44,269 + \$44,435}{2} = \$44,352$     $\text{Inventory Turnover} = \frac{\$394,605}{\$44,352} = 8.9\text{ times}$     $\text{Days in Inventory} = \frac{365}{8.9} = 41.0\text{ days}$

  • Target Comparative Ratios:

  • Inventory Turnover: $5.9\text{ times}$

  • Days in Inventory: $61.9\text{ days}$

• Worked Example: Westmoreland Company JIT Transition (Do It! 3b)

  • Early in 2025, Westmoreland Company switched to a Just-In-Time (JIT) inventory system.

  • Financial Data:

  • 2024: Sales Revenue = $\$2,000,000$; Cost of Goods Sold = $\$1,000,000$; Beginning Inventory = $\$290,000$; Ending Inventory = $\$210,000$

  • 2025: Sales Revenue = $\$1,800,000$; Cost of Goods Sold = $\$910,000$; Beginning Inventory = $\$210,000$; Ending Inventory = $\$50,000$

  • 2024 Ratio Calculations:     $\text{Average Inventory}_{2024} = \frac{\$290,000 + \$210,000}{2} = \$250,000$     $\text{Inventory Turnover}_{2024} = \frac{\$1,000,000}{\$250,000} = 4\text{ times}$     $\text{Days in Inventory}_{2024} = \frac{365}{4} = 91.3\text{ days}$

  • 2025 Ratio Calculations:     $\text{Average Inventory}_{2025} = \frac{\$210,000 + \$50,000}{2} = \$130,000$     $\text{Inventory Turnover}_{2025} = \frac{\$910,000}{\$130,000} = 7\text{ times}$     $\text{Days in Inventory}_{2025} = \frac{365}{7} = 52.1\text{ days}$

Causes and Financial Impact of Inventory Errors

• Common causes of inventory errors include:

  • Failure to count or price physical inventory correctly.

  • Failure to properly recognize the transfer of legal title for goods in transit.

• Fundamental Cost of Goods Sold Formula:   $\text{Beginning Inventory} + \text{Cost of Goods Purchased} - \text{Ending Inventory} = \text{Cost of Goods Sold}$

• Income Statement Effects:

  • An error in beginning or ending inventory affects Cost of Goods Sold and Net Income as follows:

  • Beginning Inventory Understated: Cost of Goods Sold is Understated; Net Income is Overstated.

  • Beginning Inventory Overstated: Cost of Goods Sold is Overstated; Net Income is Understated.

  • Ending Inventory Understated: Cost of Goods Sold is Overstated; Net Income is Understated.

  • Ending Inventory Overstated: Cost of Goods Sold is Understated; Net Income is Overstated.

• Multi-Year Counterbalancing Effect:

  • An error in ending inventory for the current accounting period has a reverse effect on net income in the subsequent accounting period because current ending inventory becomes next period's beginning inventory.

  • Over a two-year period, total combined net income is correct because the errors offset each other completely.

• Balance Sheet Effects:

  • Determined by evaluating the basic accounting equation: $\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}$

  • Ending Inventory Overstated: Assets are Overstated; Liabilities have No Effect; Stockholders' Equity is Overstated.

  • Ending Inventory Understated: Assets are Understated; Liabilities have No Effect; Stockholders' Equity is Understated.

Comprehensive Self-Assessment and Concept Review

• Question 1: Which type of company maintains a raw materials inventory balance?

  • Answer: Manufacturing companies.

• Question 2: What inventory system is used by a company that must conduct a physical count to determine goods on hand at period-end?

  • Answer: Periodic inventory system.

• Question 3: When should goods in transit be included in the buyer's inventory balance?

  • Answer: When the public carrier accepts the goods from the seller under FOB shipping point terms.

• Question 4: Which cost flow method most closely parallels the actual physical flow of merchandise?

  • Answer: FIFO method (or Specific Identification).

• Question 5: In a period of rising prices (inflation), which cost flow method yields the lowest income tax expense?

  • Answer: LIFO method.

• Question 6: Under rising prices, which cost flow method produces:

  1. Assumption that latest costs are allocated first to COGS? -> LIFO

  2. Lowest inventory balance on the balance sheet? -> LIFO

  3. Highest income tax expense? -> FIFO

  4. Highest net income on the income statement? -> FIFO

• Question 7: What is the financial statement impact of understating ending inventory?

  • Answer: Cost of goods sold is overstated; net income, assets, and stockholders' equity are understated.