LECTURE OUTLINE
A.Classifying and Determining Inventory.
1.Inventory of a merchandising company has two common characteristics:
a.It is owned by the company.
b.It is in a form ready for sale to customers in the ordinary course of business.
2.In a manufacturing company, some inventory may not yet be ready for sale.As a result, manufacturers usually classify inventory into three categories:
a.Finished goods; manufactured items that are completed and ready for sale.
b.Work in process; the portion of manufactured inventory that has been placed into the production process but is not yet complete.
c.Raw materials; the basic goods that will be used in production but have not yet been placed into production.
ACCOUNTING ACROSS THE ORGANIZATION
JIT can save a company a lot of money, but it isn’t without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese automakers experienced such a disruption when an earthquake damaged a company that supplies 50% of the automaker’s piston rings.
What steps might companies take to avoid such a serious disruption in the future?
Answer:The manufacturer of the piston rings should spread its manufacturing facilities across a few locations that are far enough apart that they would not all be at risk at once. In addition, the automakers might consider becoming less dependent on a single supplier as well as having weather contingency plans.
B.Determining Inventory Quantities.
1.Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.
a.Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand.
b.Determining ownership of goods.
(1)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:
(a)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.
(b)When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.
(2)Consigned goods are goods held by one party although ownership of the goods is retained by another party. If an inventory count is taken, the goods would not be included in the holding party’s inventory because they do not own these goods.
2.Taking a physical inventory involves counting, weighing, or measuring each kind of inventory on hand. Internal control procedures should be followed in order to minimize errors.
C.Inventory Costing.
1.Inventory is accounted for at cost.
2.Cost includes all expenditures necessary to acquire goods and place them in condition ready for sale.
3.Cost of goods available for sale includes:
a.The cost of beginning inventory.
b.The cost of goods purchased.
4.Cost of goods available for sale is allocated to either ending inventory or to cost of goods sold.
D.Specific Identification.
1.Specific identification requires that companies keep records of the original cost of each individual inventory item.
2.Bar coding, electronic product codes, and radio frequency identification make it theoretically possible to do specific identification with nearly any type of product.
3.This method, however, may enable management to manipulate net income.
E.Cost Flow Assumptions—FIFO, LIFO, and Average-Cost.
1.The FIFO (first-in, first-out) method assumes that the earliest goods purchased are the first to be recognized in determining cost of goods sold.
a.FIFO often parallels the actual physical flow of merchandise because it generally is good business practice to sell the oldest units first.
b.Under FIFO, companies obtain 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.
2.The LIFO (last-in, first-out) method assumes that the latest goods purchased are the first to be recognized in determining cost of goods sold.
a.LIFO seldom coincides with the actual physical flow of inventory. All goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.
b.Under LIFO, companies obtain 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.
3.The average-cost method assumes that the goods are similar in nature.
a.Under this method, the cost of goods available for sale is allocated on the basis of the weighted-average unit cost.
b.The weighted-average unit cost is computed by dividing cost of goods available for sale by total units available for sale.
c.The company then applies the weighted-average unit cost to the units on hand to determine the cost of ending inventory.
F.Financial Statement and Tax Effects of Cost Flow Methods.
1.Income statement effects.
a.Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes.
b.In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues.
c.Some argue that the use of LIFO in a period of inflation enables the company to avoid reporting paper (or phantom) profit as economic gain.
2.Balance sheet effects.
a.A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost.
b.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.
3.Tax effects. LIFO results in lower income taxes, because of lower net
H.Inventory Errors.
1.The effects of inventory errors on net income of the current year are:
a.An error in beginning inventory will have a reverse effect on net
income (overstatement of inventory results in understatement of net income).
b.An error in ending inventory will have a similar effect on net income (overstatement of inventory results in overstatement of net income).
c.If ending inventory errors are not corrected in the following period, their effect on net income for that period is reversed, and total net income for the two years will be correct.
2.Errors in ending inventory have no effect on liabilities and have the sameeffect on total assets and total owners’ equity (overstatement of inventory results in overstatement of total assets and owners’ equity).
I.Statement Presentation and Analysis.
1.Inventory is classified as a current asset immediately below receivables in the balance sheet. Cost of goods sold is subtracted from sales revenue in a multiple-step income statement.
2.There should be disclosure in the notes to the financial statements of:
a.the major inventory classifications.
b.the basis of accounting (cost, or lower of cost or market).
c.the costing method (FIFO, LIFO, or average cost).
3.The value of inventory for companies in certain industries can drop very quickly due to changes in technology or fashions. This situation requires a departure from the cost basis of accounting. This is done by valuing the inventory at the lower-of-cost-or-market (LCM) in the period in which the price decline occurs.
4.Companies apply LCM to the items in inventory after they have used one of cost flow methods to determine cost. Under LCM, companies recognize the loss in the period in which the price decline occurs.
a.LCM is an example of the accounting convention of conservatism, which means that the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income.
b.Under the LCM basis, market is defined as current replacement cost, not selling price. Current replacement cost is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities.
5.Companies apply LCM to the items in inventory after they have used one of the cost flow methods to determine cost.
6.Inventory turnover measures the number of times on average the inventory is sold during the period.
7.A variant of the inventory turnover is to compute the number of days inventory is held. It is computed by dividing 365 days by the inventory turnover.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1.When prices are rising, FIFO results in a higher ending inventory than LIFO.
TrueFalse
2.We can use the LIFO inventory method only if we know that the newest units are always sold first.
TrueFalse
3.Goods in transit would be included in the ending inventory of the buyer and the seller.
TrueFalse
4.Under the LCM basis, market is defined as current replacement cost, not selling price.
TrueFalse
5.When beginning inventory is understated, net income will be understated.
TrueFalse
6.Cost of goods purchased less the ending inventory equals cost of goods sold.
TrueFalse
7.The LIFO method assumes that the earliest goods purchased are the first to be sold.
TrueFalse
8.Inventory turnover is computed by dividing the cost of goods sold by the ending inventory.
TrueFalse
*9.The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales.
TrueFalse
*10.The retail inventory method and the gross profit method are both methods of inventory estimation.
TrueFalse
Multiple Choice
1.The cost flow method that results in the lowest income taxes when prices are rising is
a.average cost.
b.FIFO.
c.LIFO.
d.specific identification.
2.The data below are for Parrett Enterprises:
Beginning inventory150 units at $2.00
Purchase—August375 units at $1.50
Purchase—October150 units at $3.00
A periodic inventory system is used; ending inventory is 330 units. What is the ending inventory under FIFO?
a.$570
b.$743
c.$593
d.$720
3.Double-counting an inventory item at year end will result in
a.understated tax liability.
b.overstated cost of goods sold.
c.overstated net income.
d.understated beginning inventory for the next period.
*4.A retail company has goods available for sale of $300,000 at retail and $210,000 at cost, and ending inventory of $80,000 at retail. What is the estimated cost of goods sold?
a.$220,000
b.$154,000
c.$210,000
d.$56,000
*5.Which method might be used to estimate inventory costs when physical inventories are not taken?
a.First-in, first-out
b.Last-in, first-out
c.Average cost method
d.Gross profit method
ANSWERS TO QUIZ
True/False
1. True 6.False
2. False 7.False
3. False 8.False
4. True *9.True
5. False *10.True
Multiple Choice
1. c.
2. d.
3. c.
*4. b.
*5. d.
Copyright © 2015 John Wiley & Sons, Inc.Weygandt, Financial and Managerial 2e, Instructor’s Manual
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