U 7 Flash

CHAPTER 7

Reporting and Analyzing Inventory and Receivables

Learning Objectives

1. Discuss how to classify and determine inventory.

1. Apply inventory cost flow methods and discuss their financial effects.

1. Explain how companies recognize and value receivables.

4. Explain the statement presentation and analysis of inventory. 

Chapter Outline

Learning Objective 1 – Discuss How to Classify and Determine Inventory 

• Classifying and Determining Inventory—two important steps in the reporting of inventory at the end of the accounting period are the classification of inventory based on its degree of completeness and the determination of inventory amounts.

• Classifying Inventory—depends on whether the firm is a merchandiser of a manufacturer.

• In a merchandising company, inventory consists of many different items.

• These items have two common characteristics: (1) they are owned by the company and (2) they are in a form ready for sale to customers in the ordinary course of business. 

• Only one inventory classification, merchandise inventory, is needed to describe the many different items that make up the total inventory.

• In a manufacturing company, inventory is usually classified into three categories: 

• Raw materials inventory—the basic goods that will be used in production but have not yet been placed into production. 

• Work in process—portion of manufactured inventory that has been placed into the production process but is not yet complete. 

• Finished goods inventory—manufactured items that are completed and ready for sale. 

• Determining Inventory Quantities—no matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period.

• If using a perpetual system, companies take a physical inventory at year-end for two purposes: (1) to check the accuracy of their perpetual inventory records and (2) to determine the amount of inventory lost due to shrinkage: wasted raw materials, shoplifting, or employee theft.

• Companies using a period inventory system must take a physical inventory for two different purposes: (1) to determine the inventory on hand at the balance sheet date, and (2) to determine the cost of goods sold for the period.

• Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.

• Taking a Physical Inventory—taken at the end of the accounting period.

• Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand.

• Determining Ownership of Goods—two questions must be answered:

1. Do all of the goods included in the count belong to the company?

2. Does the company own any goods that were not included in the count?

• To arrive at an accurate count, ownership of goods in transit (on board a truck, train, ship, or plane) must be determined. 

• Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale.

• When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

• When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.

• In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods.

Learning Objective 2 - Apply Inventory Cost Flow Methods and Discuss Their Financial Effects

• Inventory Costing—after a company has determined the quantity of units of inventory, it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold. There are different inventory costing methods available:

• Specific identification method requires that companies keep records of the original cost of each individual inventory item.

• A major disadvantage of this method is that management may be able to manipulate net income. For example, it can boost net income by selling units purchased at a low cost, or reduce net income by selling units purchased at a high cost.

• Cost Flow Assumptions—because specific identification is often impractical, other cost flow methods are permitted. These differ from specific identification method in that they assume flows of costs that may be unrelated to the actual physical flow of goods. There are three assumed cost flow methods:

• First-in, first out (FIFO)

• Last-in, first out (LIFO)

• Average-cost

• There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost flow method to be used for accounting purposes.

• The cost of goods sold formula in a periodic system is as follows:

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

• The value assigned to the ending inventory depends on which cost flow method we use.

• No matter which cost flow assumption we use, though, the sum of cost of goods sold plus the cost of the ending inventory must equal the cost of goods available for sale.

• The First-in, First-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. FIFO often parallels the actual physical flow of merchandise.

• The costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold.

• Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.

• Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here.

• The Last-in, First-out (LIFO) method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. 

• The costs of the latest goods purchased are the first to be recognized in determining cost of goods sold. 

• Companies determine the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed.

• Under a periodic inventory system, which we are using here, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.

• Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—first in still here.

• The Average-cost method assumes that goods are similar in nature. 

• It allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred.

• The weighted-average unit cost is the average cost computed by dividing the cost of goods available for sale by the total units available for sale.

• Company then applies the weighted-average unit cost to the units on hand to determine the cost of the ending inventory.

• Financial Statement and Tax Effects of Cost Flow Methods—each of the three assumed cost flow methods is acceptable under GAAP.

• The reasons companies adopt different inventory cost flow methods are varied, but they usually involve one of the following three factors:

• Income statement effects.

• Balance sheet effects.

• Tax effects.

1. Income Statement Effects—in period of inflation: FIFO produces a higher net income and LIFO produces a lower net income. In prices are falling, the results from the use of FIFO and LIFO are reversed. Regardless of whether prices are rising and falling, average-cost produces net income between FIFO and LIFO. 

• To management, higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. 

• Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO.

• The use of FIFO creates “paper or phantom profits” – that is, earnings that do not really exist.

• Balance Sheet Effects—in a period of inflation, the costs allocated to ending inventory, using FIFO, will approximate the inventory’s current costs. Conversely, a major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost.

• Tax Effects—a tax rule, often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes they must also use it for financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.

Learning Objective 3 – Explain how Companies Recognize and Value Receivables

• Types of Receivables—the term receivables refers to amounts due from individuals and companies. Receivables are claims that are expected to be collected in cash. Receivables represent one of a company’s most liquid assets. Receivables are frequently classified as:

• Accounts receivable:

• Are amounts customers owe on account.

• Result from the sale of goods and services.

• Are expected to be collected within 30 to 60 days.

• Are usually the most significant type of claim held by a company.

• Notes receivable:

• Are written promise (as evidenced by a formal instrument) for amounts to be received.

• Normally requires the collection of interest and extends for time periods of 60-90 days or longer.

• Notes and accounts receivable that result from sales transactions are often called trade receivables.

• Other receivables:

• Include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable.

• They are generally classified and reported as separate items in the balance sheet.

• Recognizing Accounts Receivable

• A service organization records a receivable when it performs a service on account.

• A merchandiser records accounts receivable at the point of sale of merchandise on account. When a merchandiser sells goods, it increases Accounts Receivable and increases Sales Revenue.

• A receivable may be reduced by sales discounts and/or sales returns.

♦  Valuing accounts receivable—determining the amount of accounts receivable to report is sometimes difficult because some receivables will become uncollectible. This creates bad debt expense—a normal and necessary risk of doing business on a credit basis. Two methods are used in accounting for uncollectible accounts:

1. The direct write-off method. 

2. The allowance method.

• Direct Write-Off Method for Uncollectible Accounts—when a company determines receivables from a particular company to be uncollectible, it charges the loss to Bad Debt Expense.

• Bad debts expense will only show actual losses from uncollectibles. 

• The company reports accounts receivable at its gross amount without any adjustment for estimated losses for bad debts.

• Companies often record bad debt expense in a period after the period in which they recorded revenue.

• No attempt is made to align bad debts expense to sales revenue in the income statement. Nor does the company try to show accounts receivable in the balance sheet at the amount actually expected to be received.

• Unless a company expects bad debt losses to be insignificant, the direct write-off method is not acceptable for financial reporting purposes.

• Allowance Method for Uncollectible Accounts—involves estimating uncollectible accounts at the end of each period. This provides a closer relationship of expenses with revenues on the income statement. It ensures that receivables are stated at their cash (net) realizable value on the balance sheet.

• Cash (net) realizable value is the net amount a company expects to receive in cash from receivables; it excludes amounts that the company estimates it will not collect.

• Estimated uncollectible receivables reduce the amount of receivables reported on the balance sheet through use of the allowance method.

• Companies must use the allowance method for financial reporting purposes when bad debts are material in amount. It has three essential features:

1. Companies estimated uncollectible accounts receivable and match them against revenues in the same accounting period in which the revenues are recorded.

2. Companies record estimated uncollectibles as an increase to Bad Debt Expense and an increase to Allowance for Doubtful Accounts (a contra asset account) through an adjustment at the end of each period.

3. Companies record actual uncollectibles by decreasing Allowance for Doubtful Accounts and Accounts Receivable at the time the specific account is written off as uncollectible.

• Recording Estimated Uncollectibles

• Allowance for Doubtful Accounts shows the estimated amount of claims on customers that companies expect will become uncollectible in the future.

• Companies use a contra account instead of a direct reduction to Accounts Receivable because they do not know which customers will not pay.

• The balance in the allowance account will absorb the specific write-offs when they occur.

• Recording the Write-Off of An Uncollectible Account

• To prevent premature or unauthorized write-offs, authorized management personnel should formally approve each write-off.

• To maintain segregation of duties, the employee authorized to write off accounts should not have daily responsibilities related to cash or receivables.

• Under the allowance method, a company records every bad debt write-off to the allowance account and not to Bad Debt Expense.

• Cash realizable value in the balance sheet remains the same before and after the write-off.

• Estimating the Allowance—in “real life,” companies must estimate the amount of expected uncollectible accounts if they use the allowance method, generally using one of the following two methods:

• The percentage-of-receivables basis, where management establishes a percentage relationship between the amount of receivables and expected losses from uncollectible accounts.

• Aging the accounts receivable, which is a schedule that classifies customer balances by the length of time they have been unpaid. An aging schedule helps users determine if the amount of past due accounts is increasing and which accounts require management’s attention.

• Data Analytics and Receivables Management—opportunities abound to improve receivables management through data analytics. Software packages promise increases in working capital, improved revenues, and enhanced customer relations. Visualization software, which presents data in sophisticated graph format, enables managers to more quickly identify issues and obtain a deeper understanding of the factors that influence successful receivables management. 

Learning Objective 4 – Explain the Statement Presentation and Analysis of Inventory

• Inventory is a current asset in the balance sheet, and cost of goods sold is subtracted from net sales in the income statement. There is disclosure of inventory classifications, basis of accounting, and cost method.

• Analysis of Inventory—for companies that sell goods, managing inventory levels can be one of the most critical tasks. Having too much inventory on hand costs the company money in storage costs, interest cost, and costs associated with the obsolescence of technical goods or shifts in fashion.

• Inventory management benefits greatly from data analytics. Many companies collect massive amounts of data about every inventory item and every customer. They analyze customer habits, buying patterns and sales trends. Using sophisticated models that incorporate economic variables, weather patterns, and many other factors, companies strive to optimize inventory levels to maximize sales while minimizing inventory holding costs.

• Inventory Turnover is calculated as cost of goods sold divided by average inventory. It indicates the liquidity inventory by measuring the number of times the average inventory “turns over” (is sold) during the year.

• Inventory turnover can be divided into 365 days to compute days in inventory, which indicates the average number of days inventory is held

• High inventory turnover (low days in inventory) indicates the company has minimal funds tied up in inventory. 

• Management should closely monitor the inventory turnover ratio to achieve the best balance between too much and too little inventory.

• Just-in-Time (JIT) Inventory—companies manufacture or purchase goods only when needed.