2. 6 - 2
DETERMINING INVENTORY ITEMS
Merchandise inventory includes all goods that aMerchandise inventory includes all goods that a
company owns and holds for sale, regardless of wherecompany owns and holds for sale, regardless of where
the goods are located when inventory is counted.the goods are located when inventory is counted.
Items requiring special attention include:Items requiring special attention include:Items requiring special attention include:Items requiring special attention include:
Goods in
Transit
Goods
Damaged or
ObsoleteGoods on
Consignment
C1
3. 6 - 3
FOB Destination Point
Public
Carrier
Seller Buyer
GOODS IN TRANSIT
Public
Carrier
Seller Buyer
FOB Shipping Point
Ownership passes
to the buyer here.
C1
4. 6 - 4
GOODS ON CONSIGNMENT
Merchandise is included in the inventory of the
consignor, the owner of the inventory.
Consignor
Consignee
Thanks for selling my
inventory in your
store.
C1
5. 6 - 5
GOODS DAMAGED OR OBSOLETE
Damaged or obsolete goods are not counted in
inventory if they cannot be sold.
Cost should be reduced to net realizable
value if they can be sold.
C1
6. 6 - 6
DETERMINING INVENTORY COSTS
Invoice
Cost
Invoice
Cost
Include all expenditures necessary to bring an item toInclude all expenditures necessary to bring an item to
a salable condition and location.a salable condition and location.
Minus
Discounts
and
Allowances
Minus
Discounts
and
Allowances
Plus Import
Duties
Plus Import
Duties Plus
Freight
Plus
Freight
Plus
Storage
Plus
Storage
Plus
Insurance
Plus
Insurance
C2
7. 6 - 7
Most companies take a
physical count of
inventory at least once
each year.
INTERNAL CONTROLS AND TAKING A
PHYSICAL COUNT
When the physical count
does not match the
Merchandise Inventory
account, an adjustment
must be made.
Good internal controls over count include:
1.Pre-numbered inventory tickets.
2.Counters have no inventory responsibility.
3.Counts confirm existence, amount, and
quality of inventory item.
4.Second count is taken.
5.Manager confirms all items counted.
Good internal controls over count include:
1.Pre-numbered inventory tickets.
2.Counters have no inventory responsibility.
3.Counts confirm existence, amount, and
quality of inventory item.
4.Second count is taken.
5.Manager confirms all items counted.
C2
8. 6 - 8
INVENTORY COST FLOW
ASSUMPTIONS
First-In, First-OutFirst-In, First-Out
(FIFO)(FIFO)
Assumes costs flow in the orderAssumes costs flow in the order
incurred.incurred.
Last-In, First-OutLast-In, First-Out
(LIFO)(LIFO)
Assumes costs flow in theAssumes costs flow in the
reverse order incurred.reverse order incurred.
WeightedWeighted
AverageAverage
Assumes costs flow at anAssumes costs flow at an
average of the costs available.average of the costs available.
P1
9. 6 - 9
FIRST-IN, FIRST-OUT (FIFO)
Cost of
Goods Sold
Cost of
Goods Sold
Ending
Inventory
Ending
Inventory
Oldest
Costs
Oldest
Costs
Recent
Costs
Recent
Costs
P1
10. 6 - 10
LAST-IN, FIRST-OUT (LIFO)
Cost of
Goods Sold
Cost of
Goods Sold
Recent
Costs
Recent
Costs
Oldest
Costs
Oldest
Costs
P1
11. 6 - 11
WEIGHTED AVERAGE
When a unit is sold, the average
cost of each unit in inventory is
assigned to cost of goods sold.
Cost of Goods
Available for
Sale
Units on hand
on the date of
sale
÷
P1
12. 6 - 12
FINANCIAL STATEMENT EFFECTS
OF COSTING METHODS
Because prices change, inventory methods nearly always
assign different cost amounts.
A1
13. 6 - 13
FINANCIAL STATEMENT EFFECTS
OF COSTING METHODS
Advantages of MethodsAdvantages of MethodsAdvantages of MethodsAdvantages of Methods
Smoothes out
price changes.
Smoothes out
price changes.
Better matches
current costs in cost
of goods sold with
revenues.
Better matches
current costs in cost
of goods sold with
revenues.
Ending inventory
approximates
current
replacement cost.
Ending inventory
approximates
current
replacement cost.
First-In,
First-Out
First-In,
First-Out
Weighted
Average
Weighted
Average
Last-In,
First-Out
Last-In,
First-Out
A1
14. 6 - 14
TAX EFFECTS OF COSTING
METHODS
The Internal Revenue Service (IRS) identifies severalThe Internal Revenue Service (IRS) identifies several
acceptable inventory costing methods for reportingacceptable inventory costing methods for reporting
taxable income.taxable income.
If LIFO is used for taxIf LIFO is used for tax
purposes, the IRS requirespurposes, the IRS requires
it be used in financialit be used in financial
statements.statements.
If LIFO is used for taxIf LIFO is used for tax
purposes, the IRS requirespurposes, the IRS requires
it be used in financialit be used in financial
statements.statements.
A1
15. 6 - 15
LOWER OF COST OR MARKET
Inventory must be reported at market valueInventory must be reported at market value
whenwhen marketmarket isis lowerlower than cost.than cost.
Can be applied three ways:
(1) separately to each
individual item.
(2) to major categories of
assets.
(3) to the whole inventory.
Can be applied three ways:
(1) separately to each
individual item.
(2) to major categories of
assets.
(3) to the whole inventory.
P2
16. 6 - 16
FINANCIAL STATEMENT EFFECTS OF
INVENTORY ERRORS
Income Statement EffectsIncome Statement Effects
A2
Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. We must pay special attention to include inventory that we own but that is in transit or on consignment. We should also consider the condition of inventory that is damaged or obsolete when determining a cost for the inventory.
Transportation costs are sometimes included in the cost of Merchandise Inventory. The FOB terms designate when title passes and who pays the transportation costs. FOB stands for “Free On Board.” So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means the buyer will pay all transportation costs. In this case, the transportation costs will be added to the merchandise inventory account. On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means the seller will pay the transportation costs.
Goods on consignment are goods that we own, but that are on display for sale at another place of business. Even though these goods are not in our physical possession, we still have ownership of them and should include them in our inventory count.
Damaged and obsolete goods are not counted in inventory if they cannot be sold. If these goods can be sold at a reduced price, they are included in inventory at a conservative estimate of their net realizable value. Net realizable value is sales price minus the cost of making the sale.
The cost of inventory includes any cost that is necessary and reasonable to get the inventory to your place of business and to get it in a salable condition. We already know that the invoice price and transportation costs are included in the total cost of inventory. Other costs to include are insurance, storage and import duties. Any purchase discounts or allowances received reduce the cost of the inventory purchased.
Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in our inventory records. In reality, this is not the case. The physical count may not match our records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps us get our records up to date to reflect what we actually have on hand. A company has adequate internal controls over the inventory count if, (1) it uses pre-numbered inventory tags, (2) inventory counters have no responsibility for inventory, (3) the count confirms the existence, amount, and quality of inventory items counted, (4) a second count of the inventory is made, and (5) a count supervisor confirms that all items in inventory have been counted.
We must make assumptions about the inventory cost flow. First-in, first-out assumes costs flow in the order incurred. Last-in, first-out assumes costs flow in the reverse order incurred. Weighted average assumes costs flow at an average of the costs available.
The first-in, first-out method is abbreviated as FIFO, and pronounced as Fifo. When using FIFO, we assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory.
The last-in, first-out method is abbreviated as LIFO, and pronounced as Lifo. When using LIFO, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory.
When using weighted average, we assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand.
This slide presents a comparison of the impact on the income statement of using the different inventory costing methods. Everything is the same in each example, except the amount of Cost of Goods Sold, and its flow through effects on Income Before Taxes, Income Tax Expense, and Net Income. Specific identification provides the most accurate cost of goods sold amount. But, this method is very costly to use. In periods of rising prices, of the other three methods, FIFO will provide the lowest Cost of Goods Sold amount. This is because it uses the older costs which tend to be lower to arrive at this amount. LIFO will provide the highest Cost of Goods Sold amount. This is because it uses the most recent costs which tend to be higher to arrive at this amount. Weighted average will provide a Cost of Goods Sold amount that falls between FIFO and LIFO. As you can see, the impact on net income is that FIFO results in the highest net income, LIFO results in the lowest net income, and weighted average results in net income that falls in the middle of these two.
An advantage of weighted average is that it smoothes out peaks and valleys in price changes that may occur during the period. FIFO does a great job of valuing Ending Inventory at an approximate replacement cost. This is because FIFO uses the most recent costs to value Ending Inventory. LIFO does a great job of matching current costs in Cost of Goods Sold with current revenues. This is because LIFO uses the most recent costs to determine Cost of Goods Sold.
Using LIFO for tax reporting purposes makes sense because it provides the lowest net income figure, and, therefore, the lowest tax expense of the three methods. However, the Internal Revenue Service requires that if a company uses LIFO for tax reporting purposes, it must also use LIFO for financial reporting.
When we report inventory on the balance sheet, we report it at the lower of cost or market value. Cost is determined using one of the methods we just discussed: Specific identification, FIFO, LIFO or weighted average. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market value follows the conservatism principle by not overstating the value of assets. We can apply the lower of cost or market concept on an individual item basis, for similar categories of inventory, or for the inventory as a whole.
Take a few minutes and review this chart. It shows the impact of inventory errors on the income statement. For example, if Ending Inventory is understated, that will result in an overstatement of Cost of Goods Sold which will result in an understatement of Net Income.
Take a few minutes and review this chart. It shows the impact of inventory errors on the balance sheet. As we just noted on the previous slide, if Ending Inventory is understated, Cost of Goods Sold will be overstated, which will result in an understatement of net income. An understatement of net income will result in an understatement of equity. Also, if Ending Inventory is understated, then assets on the balance sheet will be understated.
