Chapter 6 Notes

Horngren's Accounting: The Financial Chapters - Merchandise Inventory

6.1: Identify accounting principles and controls related to merchandise inventory
6.2: Account for merchandise inventory costs under a perpetual inventory system
6.3: Compare the effects on the financial statements when using different inventory costing methods
6.4: Apply the lower-of-cost-or-market rule to merchandise inventory
6.5: Measure the effects of merchandise inventory errors on the financial statements
6.6: Use inventory turnover and days’ sales in inventory to evaluate business performance

Purpose: Accounting principles assist in classifying and reporting inventory on financial statements.
Key Principles:
- Consistency:
- Definition: A business should consistently apply the same accounting methods over periods to aid comparison for investors and creditors.
- Implication: Any changes in accounting methods must be disclosed in financial statement notes.
- Disclosure:
- Definition: Financial statements should contain sufficient information for external decision-making.
- Implication: Information must be relevant and faithfully represented.
- Materiality:
- Definition: Emphasizes proper accounting for significant items that may influence decisions.
- Example: $10,000 is material for a small business with $100,000 in sales but not for a large company with $1 billion in sales.
- Conservatism:
- Definition: Businesses should report the least favorable figures when multiple options exist.
- Practices:
  - Anticipate no gains, but account for probable losses.
  - Record assets at the lowest reasonable value and liabilities at the highest.
  - Err on the side of expensing instead of capitalizing assets.

Importance: Effective inventory controls are vital for authorizing and accounting for purchases and sales.
Key Controls:
- Authorization for inventory purchases.
- Tracking/documenting inventory receipts.
- Proper recording of damaged inventory.
- Annual physical inventory counts.
- Recording and removing sold inventory.

Procedure:
1. At period end, count ending inventory and assign value.
2. Determine units sold during the period and calculate Costs of Goods Sold (COGS).
Cost Assignment: Different inventory groups may require varied cost assignments.
Inventory Costing Methods Allowed by GAAP:
- Specific Identification Method:
- Links specific costs to individual units.
- Common in high-value inventories (e.g. automobiles, jewels).
- First-In, First-Out (FIFO) Method:
- Oldest purchases sold first.
- Ending inventory reflects current replacement costs.
- Last-In, First-Out (LIFO) Method:
- Newest costs are assigned first as COGS.
- Ending inventory retains oldest costs.
- Weighted-Average Method:
- Computes a new weighted average after each purchase.
- COGS and ending inventory based on this average.

Use Case: Specific items (such as cars or real estate) with identifiable costs.

Assumption: First items purchased are the first sold.
Impact: Shows higher ending inventory values during price increases due to more recently lower costs.

Assumption: Last items purchased are sold first.
Impact: Shows lower tax liability during inflation as COGS are based on higher recent costs.

Definition: Average cost provides a consistent pricing across inventory.
Formula: Weight average cost per unit = Total cost of goods available for sale / Total units available for sale.

**Income Statement: **
- COGS is higher under LIFO compared to FIFO when costs rise, impacting net income negatively.
- FIFO generally results in higher gross profits due to lower COGS.
Balance Sheet:
- FIFO results in higher reported inventory values, while LIFO shows lower due to older cost valuations.

Income Statement Example: Comparison of different costing methods:
- Specific Identification: COGS of $5,200, Gross Profit of $1,800.
- FIFO: COGS of $5,180, Gross Profit of $1,820.
- LIFO: COGS of $5,240, Gross Profit of $1,760.
- Weighted Average: COGS of $5,193, Gross Profit of $1,807.
Balance Sheet Example: Comparison of inventory values and repercussions:
- Ending Merchandise Inventory under respective methods:
- Specific Identification: $1,500
- FIFO: $1,520
- LIFO: $1,460
- Weighted Average: $1,507

Definition: Inventory must be reported at the lower of its cost or market (current replacement) value.
Journal Entry Example: Adjusting carrying amount when market value drops:
- If purchased inventory cost is $3,000 but can be replaced for $2,200:
- Debit: Cost of Goods Sold $800
- Credit: Merchandise Inventory $800
- Statement of Accounting Policy: Merchandise inventories valued at LCM method, cost determined using FIFO method.

Errors in inventory lead to cascading effects on:
- Cost of Goods Sold
- Gross Profit
- Net Income

Overstating ending inventory results in gross profit and net income inflation; conversely, understating it affects profits negatively.
Exhibit: Details calculation impacts of inventory errors over periods and reflects on overall profits moving forward.
Key Insight: Errors correct themselves after two accounting periods as opposite impacts balance each other out.

Definition: Measures the speed at which inventory is sold and replaced in a period.
**Enterprise Evaluation: **
- High rates signify efficient sales processes.
- Low rates indicate potential slow-moving inventory issues.

Definition: Average duration of inventory holding before it is sold.
Importance: Especially critical for perishable goods as it directly affects business cash flows.

Inventory Turnover: 8.70 times/year calculated based on
- Cost of Goods Sold: $37,075 million
- Beginning Inventory: $4,172 million
- Ending Inventory: $4,347 million
Days’ Sales in Inventory: 42 days calculated using co=ts and inventory values.