Reporting and Analyzing Inventory
Chapter 6: Reporting and Analyzing Inventory
Chapter Outline
Learning Objectives
LO 1: Discuss how to classify and determine inventory.
LO 2: Apply inventory cost flow methods and discuss their financial effects.
LO 3: Explain the statement presentation and analysis of inventory.
Learning Objective 1: Discuss How to Classify and Determine Inventory
Reporting Inventory
Reporting requires two key steps at the end of the accounting period:
Classification of inventory based on the degree of completeness.
Determination of inventory amounts.
Classifying Inventory
Merchandising Company:
Merchandise Inventory.
Regardless of classification, companies report all inventories as Current Assets on the balance sheet.
Manufacturing Company:
Must classify inventory into various categories such as raw materials, work in progress, and finished goods.
Determining Inventory Quantities
Physical Count is performed through:
Perpetual System:
A physical count checks the accuracy of inventory records.
Determines inventory lost due to factors such as waste, theft (shoplifting or employee theft).
Periodic System:
A physical count determines the inventory on hand at the balance sheet date.
It also helps ascertain the cost of goods sold for the period.
Taking a Physical Inventory
Involves counting, weighing, or measuring each type of inventory on hand.
Usually performed when the business is not operational, particularly at the end of the accounting period.
Ownership of Goods in Transit
Goods in transit are included as part of inventory if legal title is owned.
Legal title determined by the terms of sale.
Includes:
Purchased goods not yet received (FOB shipping).
Sold goods not yet delivered to the customer (FOB destination).
Inventory Ownership Terms
FOB Shipping Point:
Ownership passes to the buyer when the public carrier accepts the goods from the seller.
Buyer incurs freight costs (Freight in).
FOB Destination:
Ownership remains with the seller until goods reach the buyer.
Seller incurs freight costs (Freight out).
Effects of Ignoring Goods in Transit
Ignoring goods in transit can significantly miscount inventory.
Example:
Hargrove Company has 20,000 units of inventory on hand on December 31.
Goods in transit include:
Sales of 1,500 units shipped December 31 FOB destination.
Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.
Total units understated = 1,500 + 2,500 = 4,000 units.
Learning Objective 2: Apply Inventory Cost Flow Methods and Discuss Their Financial Effects
Financial Effects of Inventory
Inventory is accounted for at cost.
Unit costs applied to quantities determine:
Cost of inventory on the balance sheet.
Cost of goods sold on the income statement.
Inventory Methods
Specific Identification:
Used when a company can identify specific inventory items sold.
Tracks the actual flow of inventory.
Costs of specific items assigned to units sold and those in ending inventory.
Cost Flow Assumptions:
First-In First-Out (FIFO)
Last-In First-Out (LIFO)
Average-Cost
Specific Identification Explained
Example:
Crivitz TV purchases three identical 50-inch TVs on different dates at varying costs.
Sold TVs purchased on February 3 and May 22 at $1,200 each.
Purchases include:
February 3: 1 TV at $700
March 5: 1 TV at $750
May 22: 1 TV at $800
Cost of Goods Sold = $700 + $800 = $1,500.
Ending Inventory = Cost of remaining TV = $750.
Cost Flow Assumptions Detailed
First-In First-Out (FIFO):
Assumes earliest goods purchased are the first sold.
Cost of goods sold recognized from earliest purchases.
Cost of ending inventory calculated from the most recent purchases working backward.
Last-In First-Out (LIFO):
Assumes latest goods purchased are the first sold.
Cost of goods sold recognized from latest purchases.
Cost of ending inventory calculated from the earliest goods available for sale working forward.
Average-Cost:
Used by companies selling similar items.
Allocates cost based on weighted-average unit cost incurred.
Weighted-average unit cost is the total cost of goods available for sale divided by total units available for sale.
Cost of Goods Sold Calculation
Under periodic inventory:
At the period's end, inventory counted.
Cost of Goods Sold determined using periodic measurement:
ext{Cost of Goods Sold} = ext{Beginning Inventory} + ext{Cost of Goods Purchased} - ext{Ending Inventory}
Financial Statement and Tax Effects of Cost Flow Methods
Reasons for differing inventory cost flow method choices:
Income statement effects.
Balance sheet effects.
Tax effects.
Income Statement Effects Example: Houston Electronics
Summary of income statements (FIFO, LIFO, Average-Cost):
Sales Revenue: $18,500 (identical for all methods)
Beginning Inventory: 1,000
Purchases: 11,000
Cost of Goods Available for Sale: 12,000
Ending Inventory: Estimated values (FIFO: 5,800, LIFO: 5,000, Average-Cost: 5,400)
Cost of Goods Sold: Estimated values (FIFO: 6,200, LIFO: 7,000, Average-Cost: 6,600)
Gross Profit: Estimated values (FIFO: 12,300, LIFO: 11,500, Average-Cost: 11,900)
Net Income after Tax: Estimated (FIFO: 2,640, LIFO: 2,000, Average-Cost: 2,320)
Impacts on Cost Flow Assumptions When Prices Change
Net income is impacted by the choice of FIFO and LIFO in rising and falling cost environments.
Choosing FIFO or LIFO with Rising Prices
FIFO:
Results in higher net income.
May lead to higher bonuses if based on net income.
Viewed favorably by external parties.
LIFO:
Provides a more realistic representation of net income.
Matches more recent costs against current revenues.
Results in lower income taxes.
Balance Sheet Effects
FIFO:
In inflationary periods, costs allocated to ending inventory approximate current costs.
LIFO:
In inflationary periods, costs allocated to ending inventory may be significantly understated.
Tax Effects
Companies utilizing LIFO can achieve lower income taxes during rising cost phases due to lower reported net incomes.
Tax savings allow for more cash availability for business operations.
Income Tax Effects when Prices are Rising
Reiterates the income statements with Houston Electronics for FIFO, LIFO, and Average-Cost reflecting how each affects net income and tax expenses.
Knowledge Check
Identify that FIFO often parallels actual physical flow of merchandise.
Determine how inventory management decisions affect taxes under inflation conditions, showing the LIFO method results in the lowest tax liabilities.
Learning Objective 3: Explain the Statement Presentation and Analysis of Inventory
Inventory Presentation on Financial Statements
Inventory recorded as current assets immediately below receivables on the balance sheet.
Disclosures include:
Basis of accounting (cost or lower-of-cost-or-net realizable value).
Cost method (FIFO, LIFO, or average cost).
Lower-of-Cost-or-Net Realizable Value (LCNRV) Explained
Companies must write down inventory to its net realizable value if it falls below cost.
Net Realizable Value (NRV):
The net expected realizable amount from inventory sales.
This standard follows conservative accounting principles.
Application of Lower-of-Cost-or-Net Realizable Value
Applied post-cost flow method evaluation using specific identification, FIFO or average cost.
Companies using LIFO must deploy a lower-of-cost-or-market (LCM) method instead of LCNRV.
Accounting for Inventory under LCNRV Example
Assume the following inventory items with costs and market values:
Flat-screen TVs: 100 units, cost $600, NRV $550.
Wireless speakers: 100 units, cost $90, NRV $104.
Bluetooth headphones: 850 units, cost $50, NRV $48.
Smartwatch accessories: 900 units, cost $4, NRV $8.
Total value: $144,400.
Inventory Turnover Definition
Measures how many times inventory is sold over a period, indicating liquidity and average holding duration before sale.
Example: Walmart, Inc. Inventory Turnover Data
Ending inventory: $44,269 million
Beginning inventory: $44,435 million
Cost of goods sold: $394,605 million