Chapter 6 – Inventories (Comprehensive Bullet-Point Notes)

Learning Objective 1 – Classify & Determine Inventory

Classifying Inventory

• Merchandising company

  • Single classification: Inventory (goods held for resale)

• Manufacturing company

  • \text{Raw Materials} – inputs not yet placed into production

  • \text{Work in Process} – goods partially through production

  • \text{Finished Goods} – completed products ready for sale

• Regardless of type, all inventories are reported under Current Assets on the balance sheet.

Just-in-Time (JIT) Systems – Real-World Risk (Ford, Japanese Automakers)

• JIT minimizes inventory carrying costs but heightens dependence on an uninterrupted supply chain.

• Disruptions (earthquake, snowstorm) caused plant shutdowns; tens of thousands of cars were not produced.

• Mitigation strategies:

  • Geographically diversify suppliers & plants

  • Avoid single-supplier dependency

  • Formal weather / disaster contingency plans

Physical Inventory Counts

• Reasons

  • Perpetual system: verify records & identify losses (waste, theft)

  • Periodic system: compute ending inventory & \text{COGS} for the period

• Usually performed when operations are slow or closed and at period-end.

• Procedures: count, weigh, or measure every inventory item.

• Ethics example – salad-oil fraud: tanks filled mostly with water, tank numbers repainted to fool auditors.

Ethical Issues in Inventory Reporting

• Leslie Fay & Craig Electronics – overstated inventory to boost income and secure financing.

• Effect of overstatement:

  • \text{Inventory} ↑, \text{Retained Earnings} ↑ (Balance Sheet looks stronger)

  • \text{COGS} ↓, \text{Net Income} ↑ (Income Statement looks better)

Determining Ownership of Goods

• Goods in transit belong to the party holding legal title.

  • Title determined by shipping terms:

  • FOB Shipping Point – buyer owns once public carrier receives goods.

  • FOB Destination – seller owns until goods reach buyer.

• Consigned goods – held by agent for a fee; remain owner’s inventory (dealer does not record them).

Review Example – Hasbeen Company

1. Consigned goods 15{,}000 → deduct.

2. Purchases in transit (FOB Shipping Point) 10{,}000 → add.

3. Goods sold, FOB Shipping Point → already excluded (correct).
   Resulting inventory = 200{,}000 - 15{,}000 + 10{,}000 = 195{,}000.

Learning Objective 2 – Inventory Cost Flow Methods & Financial Effects

Cost Includes

• All expenditures to acquire goods and prepare them for sale (purchase price, freight-in, handling, etc.).

Specific Identification

• Each physical unit traced to its actual cost.

• Rare; susceptible to income manipulation (sell cheaper or more expensive units at will).

• Example (Crivitz TV): sold Feb 3 (700) & May 22 (800) units ⇒ \text{COGS}=1{,}500, ending inventory =750.

Cost Flow Assumptions (Periodic Illustration – Houston Electronics)

• FIFO – First-in, First-out

  • Earliest costs → \text{COGS}; recent costs remain in ending inventory.

  • Think “LISH” (Last-in Still Here).

• LIFO – Last-in, First-out

  • Latest costs → \text{COGS}; earliest costs remain.

  • Think “FISH” (First-in Still Here).

  • Often differs from physical flow (exception: piles of coal, hay, sand).

• Average-Cost (Weighted-Average)

  • \text{Weighted-Average Cost per Unit} = \frac{\text{Cost of Goods Available}}{\text{Units Available}}

  • Apply rate to units in ending inventory & \text{COGS}.

Shumway Ag Implements – DO IT 2 (Periodic)

• Cost of goods available =36{,}000; ending units =3{,}000.

  • FIFO \text{COGS}=24{,}000

  • LIFO \text{COGS}=27{,}000

  • Average Cost 3.60 per unit → \text{COGS}=25{,}200

Method Usage (U.S.)

• Many firms: FIFO (Reebok, Wendy’s), LIFO (Campbell Soup, Walgreens), Avg-Cost (Starbucks, Motorola).

• Stanley Black & Decker: LIFO domestically, FIFO abroad.

Financial Statement Effects – Inflationary Environment

• Income Statement

  • FIFO: lowest \text{COGS} → highest \text{Gross Profit} & \text{Net Income}.

  • LIFO: highest \text{COGS} → lowest profits; minimizes taxes.

• Balance Sheet

  • FIFO ending inventory ~ current replacement cost.

  • LIFO ending inventory may be understated.

• Tax Effects

  • LIFO conformity rule: must use LIFO for financial reporting if used for taxation.

Conceptual Debate – ExxonMobil “Is LIFO Fair?”

• Support: matches current costs with current revenues, hedges inflation.

• Criticism: understates income & taxes, hampers comparability with IFRS firms (which cannot use LIFO).

Learning Objective 3 – Effects of Inventory Errors

Common Causes

• Miscounts, costing mistakes, incorrect legal title recognition for goods in transit.

Two-Period Impact on Income Statement

• \text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}

• If ending inventory is overstated:

  • Year 1: \text{COGS} understated → \text{Net Income} overstated.

  • Year 2: beginning inventory overstated → reverse effect (net income understated).

  • Over the two-year span total income is correct (errors offset).

Balance Sheet Effects (Year of Error)

• Overstated ending inventory → Assets ↑, Stockholders’ Equity ↑ (via retained earnings). Liabilities unaffected.

• Understated ending inventory → Assets ↓, Equity ↓.

Review Q&A

• Understating ending inventory overstates \text{COGS} (answer b). Assets, net income, equity are understated.

DO IT 3 – Visual Company

• 2021 ending inventory overstated 22{,}000:

  • 2021: Inventory ↑ 22,000, \text{COGS} ↓ 22,000, Equity ↑ 22,000.

  • 2022: Beginning inventory ↑ 22,000, so \text{COGS} ↑ 22,000, Equity ↓ 22,000. Inventory correct by year-end.

Learning Objective 4 – Statement Presentation & Analysis

Presentation Requirements

• Balance Sheet: Inventory listed under Current Assets.

• Income Statement: \text{COGS} deducted from net sales.

• Disclosures:

  • Major inventory classifications

  • Cost basis used (cost or LCNRV)

  • Costing method (FIFO, LIFO, average-cost)

Lower-of-Cost-or-Net Realizable Value (LCNRV)

• If \text{NRV} < \text{Cost}, write down to \text{NRV}.

• Conservatism principle; loss recognized in current period.

• Example (Ken Tuckie TV): compare cost vs NRV for each product line; record lower value per item or in total (company policy).

Inventory Management Trade-off

• High levels → carrying costs (financing, storage, insurance, obsolescence).

• Low levels → risk of stock-outs & lost sales.

Key Ratios

• \text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}

• \text{Days in Inventory} = \frac{365}{\text{Inventory Turnover}}

• Walmart example: \text{COGS}=360,984\text{ million}, average inventory =(45,141+44,469)/2=44,805\text{ million} ⇒

  • \text{Turnover} = \frac{360,984}{44,805} ≈ 8.1 times

  • \text{Days} ≈ 45.1 days

DO IT 4 – Tracy Company (LCNRV)

• Gas 79,000, Wood 250,000, Pellet 101,000 → total 430,000 (lower value per line item).

Sony Case – Days in Inventory

• Prior reduction to 38 days freed cash & reduced obsolescence risk.

• Later build-up to 59 days raised concerns over discounting losses; low inventory risks stock-outs.

Learning Objective 5 – Perpetual System Applications (Appendix 6A)

FIFO (Perpetual)

• Same cost flow assumption, but \text{COGS} & inventory updated with each sale.

LIFO (Perpetual)

• Different results than periodic LIFO because layers liquidated continuously.

• Example data (Illustration 6A.3) shows running inventory balances & \text{COGS}.

Moving-Average (Perpetual)

• Recompute \text{Average Cost per Unit} after every purchase:

  • \text{New Avg Cost} = \frac{\text{Cost in Inventory} + \text{Cost of New Purchase}}{\text{Units in Inventory} + \text{Units Purchased}}

  • Apply to subsequent sales.

Learning Objective 6 – Inventory Estimation Methods (Appendix 6B)

Gross Profit Method

• Requires: Net Sales, Cost of Goods Available, expected Gross Profit Rate.

• Steps:

  1. \text{Estimated Gross Profit} = \text{Net Sales} \times \text{GP Rate}

  2. \text{Estimated COGS} = \text{Net Sales} - \text{Estimated GP}

  3. \text{Estimated Ending Inventory} = \text{Cost of Goods Available} - \text{Estimated COGS}

• Example (Kishwaukee):

  • \text{Net Sales}=200{,}000, \text{Beginning Inv}=40{,}000, Purchases 120{,}000 ⇒ Available 160{,}000

  • \text{GP Rate}=30\% → \text{GP}=60{,}000

  • \text{COGS}=140{,}000

  • \text{Ending Inventory}=160{,}000-140{,}000=20{,}000

Retail Inventory Method

• Maintains cost-to-retail percentage.

• \text{Ending Inventory at Cost} = \text{Ending Inventory at Retail} \times \text{Cost-to-Retail \%}

• Advantage: no physical count needed for interim reports.

• Limitation: Averaging approach; incorrect if ending mix differs greatly from historical mix.

Learning Objective 7 – GAAP vs IFRS

Similarities

• Inventories recorded at historical cost; subsequently reported at LCNRV.

• Ownership rules for goods in transit, consignment, etc. essentially the same.

Differences

• IFRS principles-based; GAAP offers more detailed guidance.

• LIFO:

  • Permitted under GAAP (if also used for taxes – conformity rule).

  • Prohibited under IFRS; only FIFO, average-cost, and specific identification allowed.

• Comparability issues arise when U.S. firms use LIFO and foreign competitors do not.

IFRS Self-Test Questions

• Goods held on consignment from another company are excluded from inventory (answer a).

• Inventory costing method prohibited under IFRS: LIFO.

Ethics & Fraud Highlights

• Anatomy of a Fraud – Dally Industries

  • CEO altered inventory tags (units & unit costs) to inflate inventory, reduce \text{COGS}, and boost income.

  • Missing control: independent internal verification (surprise counts, vendor price checks).

  • Fraud amount: 245,000.

• Core lesson: segregation of duties, periodic spot checks, and robust audit trails are critical.

Key Formulas & Mnemonics

• \text{COGS} = \text{Beg. Inv} + \text{Purchases} - \text{End Inv}

• \text{Weighted-Avg Cost} = \frac{\text{Cost of Goods Available}}{\text{Units Available}}

• \text{Inventory Turnover} = \frac{\text{COGS}}{\text{Average Inventory}}

• \text{Days in Inventory} = \frac{365}{\text{Inventory Turnover}}

• FIFO mnemonic: LISH (Last-in Still Here)

• LIFO mnemonic: FISH (First-in Still Here)

Practical Implications & Takeaways

• Choice of cost flow assumption affects profitability, taxes, cash flows, and comparability.

• Accurate inventory reporting is vital; misstatements ripple through both balance sheet & income statement.

• Inventory management must balance liquidity, customer satisfaction, and obsolescence risk.

• Globalization requires awareness of IFRS differences, especially the prohibition of LIFO.