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Inventories: Measurement. 8. Those assets that a company:. Inventory. 1. Intends to sell in the normal course of business. 2. Has in production (work in process) for future sale. 3. Uses currently in the production of goods to be sold (raw materials). Merchandise Inventory.

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inventory
Those assets that a company:Inventory

1. Intends to sell in the normal

course of business.

2. Has in production (work in process) for future sale.

3. Uses currently in the production

of goods to be sold (raw materials).

types of inventories

Merchandise Inventory

Manufacturing Inventory

Goods acquired for resale

  • Raw Materials
  • Work-in-Process
  • Finished Goods
Types of Inventories

Types of Inventory

inventory cost flows
Inventory Cost Flows

RawMaterials

FinishedGoods

Work inProcess

$XX (7)

$XX (4)

$XX

(1) $XX

$XX

$XX (8)

DirectLabor

Cost of GoodSold

$XX (5)

(2) $XX

ManufacturingOverhead

$XX

$XX (6)

(3) $XX

  • Raw materials purchased
  • Direct labor incurred
  • Manufacturing overhead incurred
  • Raw materials used
  • Direct labor applied
  • Manufacturing overhead applied
  • Work in process transferred to finished goods
  • Finished goods sold
learning objective
Learning Objective

Explain the difference between a

perpetual inventory system and aperiodic inventory system.

LO1

inventory methods

Perpetual Inventory System

Periodic Inventory System

The inventory account is continuously updated as purchases and sales are made.

The inventory account is adjusted at the end of a reporting cycle.

Inventory Methods

Two accounting systems are used to record transactions involving inventory:

perpetual inventory system

GENERAL JOURNAL

Date

Description

Debit

Credit

2006

600,000

Inventory

Accounts Payable

600,000

Perpetual Inventory System

Matrix, Inc. purchases on account $600,000 of merchandise for resale to customers.

Returnsof inventory are credited to the inventory account.

Discountson inventory purchases can be recorded using the gross or net method.

perpetual inventory system1

GENERAL JOURNAL

Date

Description

Debit

Credit

2006

Accounts Receivable

820,000

820,000

Sales

Cost of Goods Sold

540,000

540,000

Inventory

Perpetual Inventory System

Matrix, Inc. sold, on account, inventory with a

retail price of $820,000 and a cost basisof $540,000, to a customer.

periodic inventory system

GENERAL JOURNAL

Date

Description

Debit

Credit

2006

600,000

Purchases

Accounts Payable

600,000

Periodic Inventory System

Matrix, Inc. purchases on account $600,000 of merchandise for resale to customers.

Returnsof inventory are credited to the Purchase Returns and Allowances account.

Discountson inventory purchases can be recorded using the gross or net method.

periodic inventory system1

GENERAL JOURNAL

Date

Description

Debit

Credit

2006

Accounts Receivable

820,000

820,000

Sales

Periodic Inventory System

Matrix, Inc. sold on account, inventory with a

retail price of $820,000 and a cost basisof $540,000, to a customer.

No entry is made to record Cost of Good Sold. Assuming BeginningInventory of $120,000. A physical count of Ending Inventory showsa balance of $180,000. Let’s calculate Cost of Goods Sold atthe end of the accounting period.

learning objective1
Learning Objective

Explain which physical quantities of goods should be included in inventory.

LO2

what is included in inventory
General Rule

All goods owned by the company on the inventory date, regardless of their location.

What is Included in Inventory?

Goods in Transit

Goods on Consignment

Depends on FOB shipping terms.

learning objective2
Learning Objective

Determine the expenditures that shouldbe included in the cost of inventory.

LO3

expenditures included in inventory

Invoice Price

Purchase Returns

+

Freight-in on Purchases

Purchase Discounts

Expenditures Included in Inventory
purchase discounts
Purchase Discounts

Discount terms are 2/10, n/30.

$14,000x 0.02$ 280

Partial payment not made within the discount period

net method using perpetual and periodic
Net Method Using Perpetual and Periodic

Matrix, Inc. purchased on account $6,000 of merchandise for resale to customers. The merchandise was purchased subject to a cash discount of 2/10, n/30. The company incurred $160 in freight-in on the merchandise. Upon inspection, the company found that $200 of merchandise was damaged and the seller agreed to accept the merchandise return and credit the account of the company. The inventory was sold for $8,300 on account. Let’s look at the journal entries under both the perpetual and periodic accounting system assuming Matrix uses the net method to record merchandise purchases.

learning objective3
Learning Objective

Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost of goods sold.

LO4

inventory cost flow methods
Specific cost identification

Average cost

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Inventory Cost Flow Methods
specific cost identification
Items are added to inventory at cost when they are purchased.

COGS for each sale is based on the specific cost of the item sold.

Specific Cost Identification
  • The specific cost of each inventory item must be known.
  • By selecting specific items from inventory at the time of sale, income can be manipulated.
weighted average periodic system
Weighted-Average Periodic System

The following schedule shows the frame inventory for Yore Frame, Inc. for September.

The physical inventory count at September 30 shows 600frames in ending inventory.

Use theperiodicweighted-average method to determine:

(1) Ending inventory cost.

(2) Cost of goods sold.

weighted average periodic system2

Ending Inventory

(600 units)

Beginning Inventory (800 units)

Purchases (1,150 units)

Available

for Sale

(1,950 units)

Goods Sold

(1,350)

Weighted-Average Periodic System

Now, we have to assign costs to ending inventory and cost of goods sold.

$47,650 ÷ 1,950 = $24.4359 weighted-average per unit cost

moving average perpetual system
Moving-Average Perpetual System

The following schedule shows the Frame inventory for Yore Frame, Inc. for September.

The physical inventory count at September 30 shows 600frames in ending inventory.

Use theperpetualweighted-average method to determine:

(1) Ending inventory cost.

(2) Cost of goods sold.

moving average perpetual system3
Moving-Average Perpetual System

$11,600.00 ÷ (800-600+300) = $23.200

moving average perpetual system4
Moving-Average Perpetual System

$27,490.00 ÷ (800-600+300-300+250+200+400) = $26.181

first in first out
The cost of the oldest inventory items are charged to COGS when goods are sold.

The cost of the newest inventory items remain in ending inventory.

First-In, First-Out

The FIFO method assumes that items are sold in the chronological order of their acquisition.

first in first out1
First-In, First-Out

Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory . . .

. . . COGS and Ending Inventory Cost are the same under both approaches.

fifo periodic system
FIFO - Periodic System

The following schedule shows the frame inventory for Yore Frame, Inc. for September.

The physical inventory count at September 30 shows 600frames in ending inventory.

Use theperiodicFIFO method to determine:

(1) Ending inventory cost.

(2) Cost of goods sold.

fifo periodic system1
FIFO - Periodic System

These are the 600 most recently acquired units.

fifo periodic system3
FIFO - Periodic System

These are the first 1,350 units acquired.

fifo perpetual system
FIFO - Perpetual System

The following schedule shows the frame inventory for Yore Frame, Inc. for September.

The physical inventory count at September 30 shows 600frames in ending inventory.

Use theperpetualFIFO method to determine:

(1) Ending inventory cost.

(2) Cost of goods sold.

fifo perpetual system2
FIFO - Perpetual System

200

The ending inventory on 9/1 consists of:

200 units from beginning inventory @ $22.00

fifo perpetual system3
FIFO - Perpetual System

200

The ending inventory on 9/3 consists of:

200 units from beginning inventory @ $22.00

300 units from the 9/3 purchase @ $24.00

fifo perpetual system4
FIFO - Perpetual System

200

The ending inventory on 9/10 consists of:

200 units from the 9/3 purchase @ $24.00

fifo perpetual system5
FIFO - Perpetual System

200

The ending inventory on 9/15 consists of:

200 units from the 9/3 purchase @ $24.00

250 units from the 9/15 purchase @ $25.00

fifo perpetual system6
FIFO - Perpetual System

200

The ending inventory on 9/21 consists of:

200 units from the 9/3 purchase @ $24.00

250 units from the 9/15 purchase @ $25.00

200 units from the 9/21 purchase @ $27.00

fifo perpetual system7
FIFO - Perpetual System

200

The ending inventory on 9/29 consists of:

200 units from the 9/3 purchase @ $24.00

250 units from the 9/15 purchase @ $25.00

200 units from the 9/21 purchase @ $27.00

400 units from the 9/29 purchase @ $28.00

fifo perpetual system8
FIFO - Perpetual System

The ending inventory on 9/30 consists of:

200 units from the 9/21 purchase @ $27.00

400 units from the 9/29 purchase @ $28.00.

fifo perpetual system9
FIFO - Perpetual System

Note that this is the same COGS computed using the Periodic approach.

last in first out
Last-In, First-Out

Any questions before we run into LIFO?

last in first out1
The cost of the newest inventory items are charged to COGS when goods are sold.

The cost of the oldest inventory items remain in inventory.

Last-In, First-Out

The LIFO method assumes that the newest items are sold first, leaving the older units in inventory.

last in first out2
Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches. Last-In, First-Out
lifo periodic system
LIFO - Periodic System

The following schedule shows the frame inventory for Yore Frame, Inc. for September.

The physical inventory count at September 30 shows 600frames in ending inventory.

Use theperiodicLIFO method to determine:

(1) Ending inventory cost.

(2) Cost of goods sold.

lifo periodic system1
LIFO - Periodic System

These are the 600 oldest units in inventory.

lifo periodic system3

200

LIFO - Periodic System

These are the most recently acquired 1,350 units.

600 x $22.00

lifo periodic system4

200

LIFO - Periodic System

200 x $22.00

$4,400 + $30,050

lifo perpetual system
LIFO - Perpetual System

The following schedule shows the frame inventory for Yore Frame, Inc. for September.

The physical inventory count at September 30 shows 600frames in ending inventory.

Use theperpetualLIFO method to determine:

(1) Ending inventory cost.

(2) Cost of goods sold.

lifo perpetual system2
LIFO - Perpetual System

200

In LIFO, we assume that we sell the newest units in inventory first.

In this case, the 600 “newest” units come from beginning inventory, leaving 200 units in the beginning inventory layer.

lifo perpetual system3
LIFO - Perpetual System

200

The ending inventory on 9/3 consists of:

200 units from beginning inventory @ $22.00

300 units from the 9/3 purchase @ $24.00

lifo perpetual system4
LIFO - Perpetual System

200

For the 9/10 sale, we must identify the 300 newest units. They all come from the September 3 purchase.

Note that all of the 9/3 units have been “sold” and only 200 of the beginning inventory units remain.

lifo perpetual system5
LIFO - Perpetual System

200

The ending inventory on 9/15 consists of:

200 units from beginning inventory @ $22.00

250 units from the 9/15 purchase @ $25.00

lifo perpetual system6
LIFO - Perpetual System

200

The ending inventory on 9/21 consists of:

200 units from beginning inventory @ $22.00

250 units from the 9/15 purchase @ $25.00

200 units from the 9/21 purchase @ $27.00

lifo perpetual system7
LIFO - Perpetual System

200

The ending inventory on 9/29 consists of:

200 units from beginning inventory @ $22.00

250 units from the 9/15 purchase @ $25.00

200 units from the 9/21 purchase @ $27.00

400 units from the 9/29 purchase @ $28.00.

lifo perpetual system8
LIFO - Perpetual System

200

150

For the 9/30 sale, we must identify the 450 newest units. 400 of them come from the 9/29 purchase. The other 50 come from the 9/21 purchase.

lifo perpetual system9
LIFO - Perpetual System

200

150

The ending inventory on 9/30 consists of:

200 units from beginning inventory @ $22.00

250 units from the 9/15 purchase @ $25.00

150 units from the 9/21 purchase @ $27.00.

when prices are rising
LIFO

Matches high (newer) costs with current (higher) sales.

Inventory is valued based on low (older) cost basis.

Results in lower taxable income.

Is not officially endorsed by the IASC.

FIFO

Matches low (older) costs with current (higher) sales.

Inventory is valued at approximate replacement cost.

Results in higher taxable income.

When Prices Are Rising . . .
comparison of cost flow methods1
Comparison of Cost Flow Methods

Inventory Method Used by Major Companies

2003

1973

learning objective4
Learning Objective

Discuss the factors affecting a company’s choice of inventory method.

LO5

decision makers perspective

How closely do reported

costs reflect actual

flow of inventory?

How well are costs

matched against

related revenues?

Decision Makers’ Perspective

What factors motivate companies to

select one inventory method over another?

How accurate is the timing of reported income

and income taxes?

learning objective5
Learning Objective

Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income.

LO6

lifo liquidation
LIFO Liquidation

When prices rise . . .

  • LIFO inventory costs on the balance
  • sheet are “out of date” because they reflect
  • old purchase transactions.

If inventory declines, these “out of date” costs may be charged to current earnings.

This LIFO

liquidation results in “paper profits.”

lifo reserves
LIFO Reserves

Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost.

The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this:

learning objective6
Learning Objective

Calculate the key ratios used by analysts to monitor a company’s investment in inventories.

LO7

gross profit ratio

Gross profitratio

Gross profit

Net sales

=

Gross Profit Ratio

This measure indicates how much

of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

inventory turnover ratio
This ratio measures how many times a company’s inventory has been sold and replaced during the year.Inventory Turnover Ratio

Inventory

turnover ratio

Cost of goods sold

Average inventory

=

If a company’s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong sorts of inventory.

earnings quality
Earnings Quality

Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.

learning objective7
Learning Objective

Determine ending inventory using thedollar-value LIFO inventory method.

LO8

lifo inventory pools
LIFO Inventory Pools

Inventory Poolsconsist of inventory units grouped according to similarities.

Using Inventory Pools with LIFO simplifies record keeping.

For example, all similar units purchased at the same time can be “pooled” and assigned an average unit cost.

dollar value lifo dvl
Dollar-Value LIFO (DVL)

DVL inventory pools are viewed as layers of value, rather than layers of similar units.

DVL simplifies LIFO record-keeping.

At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory.

Example

The replacement inventory differs from the old inventory on hand. We just create a new layer.

DVL minimizes the probability of layer liquidation.

dollar value lifo dvl1
Dollar-Value LIFO (DVL)

We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase in inventory.

1a. Compute a Cost Index for the year.

dollar value lifo dvl2
Dollar-Value LIFO (DVL)

1b. Deflate the ending inventory value using the cost index.

1c. Compare ending inventory (at base year cost) to beginning inventory.

dollar value lifo dvl3
Dollar-Value LIFO (DVL)

Next, identify the layers in ending inventory and the years they were created.

Convert each layer’s base year cost to layer year cost by multiplying times the cost index.

Sum all the layers to arrive at Ending Inventory at DVL cost.

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