Spiceland_FA_6e_Chap06_PPT-1

Chapter Overview: Inventory and Cost of Goods Sold

• Focuses on how inventory is handled and reported in financial accounting, particularly for companies involved in manufacturing and merchandising.

Understanding Inventory

Definition of Inventory

• Inventory consists of items a company plans to sell in the ordinary course of business.

• Includes items not yet finished (raw materials, work in process).

• Typically classified as a current asset on the balance sheet.

Types of Companies

• Manufacturing Companies:

  • Manage raw materials, work in process, and finished goods.

• Merchandising Companies:

  • Handle finished goods for resale.

Inventory Reporting Examples

• Intel (Manufacturing):

  • Raw materials: $840 million

  • Work in process: $6,225 million

  • Finished goods: $1,679 million

• Best Buy (Merchandising):

  • Merchandise inventories: $5,174 million

Key Point on Revenue Recognition

• Service companies recognize revenue upon providing services.

• Merchandising and manufacturing companies recognize revenue upon the sale of inventory.

Types and Methods of Inventory Costing

Inventory Cost Methods

1. Specific Identification

   • Tracks and matches each specific item sold with its cost.

     • Car company - each car has specific serial number that’s easy to track

   • Most practical for unique, high-value items.

2. First-In, First-Out (FIFO)

   • Assumes that the oldest inventory is sold first.

   • Results in lower cost of goods sold during inflationary periods.

   • Grocery stores use this to ensure perishable goods are sold before they expire

3. Last-In, First-Out (LIFO)

   • Assumes the latest inventory is sold first.

   • Typically results in higher cost of goods sold in rising price environments.

4. Weighted-Average Cost

   • Calculates and applies an average cost to inventory sold and remaining inventory.

Common Mistakes in Costing

• Students may forget to count beginning inventory in FIFO calculations.

• Companies can report inventory costs using assumed amounts (LIFO or FIFO). This can affect financial statements in periods of rising costs.

Financial Reporting of Inventory

Multi-Step Income Statement Structure

• Gross Profit:

  • Calculated as Net Revenues - Cost of Goods Sold.

• Operating Income:

  • Gross Profit - Operating Expenses.

• Net Income:

  • Total Revenues - Total Expenses.

Reporting Requirements

• Companies must disclose their inventory accounting methods in financial statements.

• Difference between reported and actual inventory methods must be noted (LIFO reserve).

Financial Statement Effects of Errors

Inventory Errors Impact:

• Overstated Ending Inventory:

  • Results in understating cost of goods sold and overstating net income.

• Understated Ending Inventory:

  • Leads to overstated cost of goods sold and net depreciation of income.

Analysis of Inventory Management

Inventory Turnover Ratio

• Measures how often a company’s inventory is sold and replaced over a period:

  • Formula: Cost of Goods Sold / Average Inventory

  • Indicates efficiency in inventory management.

Gross Profit Ratio

• Indicates profitability concerning inventory management:

  • Formula: Gross Profit / Net Sales

Comparison of Best Buy and Tiffany’s

• Although Tiffany has a lower inventory turnover, it compensates with a higher gross profit margin.

Conclusion

• Different inventory methods (FIFO, LIFO, Weighted Average) affect both financial reporting and tax obligations differently.

• It's important for companies to choose inventory accounting methods prudently based on their sales strategies and financial goals.

• Net realizable value: if technology becomes obsolete (blackberries), value inventory at its present value.