Chapter 5 Powerpoint

Chapter 5: Inventories and Cost of Sales

Learning Objectives

• Conceptual Objectives

  • Identify items and costs of merchandise inventory.

• Analytical Objectives

  • Analyze effects of inventory methods for both financial and tax reporting.

  • Analyze effects of inventory errors on financial statements.

  • Assess inventory management using inventory turnover and days’ sales in inventory.

• Procedural Objectives

  • Compute inventory using various methods in a perpetual system:

    • Specific identification

    • FIFO (First-In, First-Out)

    • LIFO (Last-In, First-Out)

    • Weighted average

  • Compute the lower of cost or market amount of inventory.

  • Apply retail inventory and gross profit methods to estimate inventory.

Determining Inventory Items

• Merchandise inventory includes all goods owned and held for sale, regardless of location during inventory counting.

• Items requiring special attention include:

  • Goods in Transit

    • FOB Shipping Point: Included in buyer's inventory when shipped.

    • FOB Destination: Included in buyer's inventory after arrival at the destination.

  • Goods on Consignment

    • Consignor: Owner of goods.

    • Consignee: Sells goods for the owner; goods are included in the consignor's inventory.

  • Goods Damaged or Obsolete

    • Not included in inventory if unsellable.

    • Included in inventory at net realizable value if sellable.

Determining Inventory Costs

• Inventory costs include expenditures to bring an item to a salable condition and location.

• Inventory Cost Formula: Invoice cost - discounts + other costs (shipping, storage, insurance, import duties).

Physical Inventory Count

• Companies take a physical count at least once a year.

• Good internal controls for inventory count:

  1. Prenumbered inventory tickets.

  2. Counters have no inventory responsibility.

  3. Counters verify existence, amount, and condition of inventory.

  4. Second count taken by a different counter.

  5. Manager confirms each item is counted only once.

Inventory Costing Methods

• Four methods to assign costs to inventory and cost of goods sold:

  1. Specific identification

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

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

  4. Weighted Average

Effects of Inventory Methods on Financial Statements

• Different costing methods yield different amounts:

  • FIFO: Smooth out price changes; lower cost of goods sold (CGS) impacts profit positively during inflation.

  • LIFO: Can inflate CGS, reducing tax liability in times of rising prices.

  • Weighted Average: Balances costs over the period.

Tax Effects of Costing Methods

• The LIFO conformity rule requires consistent use of LIFO for both tax and financial reporting.

Lower of Cost or Market

• Inventory reported at market value when less than cost:

  • Applied individually, by category, or to total inventory.

  • Defined as current replacement cost.

Effects of Inventory Errors

• Inventory errors impact both income statement and balance sheet:

  • Affects CGS and net income.

  • Errors in the current period can reverse in future periods, distorting financial statements.

Assessing Inventory Management

• Inventory Turnover:

  • Formula: Cost of Goods Sold / Average Inventory

  • Indicates how often inventory is sold and replaced over a specific period.

• Days’ Sales in Inventory:

  • Formula: Ending Inventory / Cost of Goods Sold × 365

  • Reveals how many days inventory is held before sale.

Appendix: Periodic and Estimation Methods

• Periodic Inventory System: Specific identification, FIFO, LIFO, weighted average can all be applied.

• Inventory Estimation Methods: Used when physical counts are impractical (e.g., fire or flood).

  • Retail and Gross Profit methods for estimation.

Conclusion

• Understanding inventories and their costing methods is crucial for accurate financial reporting and effective inventory management.