Chaptger 9: Inventories Learning objectives

1. Chaptger 9: InventoriesLearning objectives • The relationship between inventory valuation and cost of goods sold. • The two methods used to allocate the total inventory cost between the COGS and the ending inventories—perpetual and periodic. • What kinds of costs are included in inventory. • What absorption costing is and how it complicates financial analysis. • The difference between inventory cost flow assumptions—weighted average, FIFO and LIFO. 9-1

2. Learning objectives concluded • How LIFO reserve disclosures can be used to estimate inventory holding gains and to transform LIFO firms to a FIFO basis. • How LIFO affects firms’ income taxes. • How to eliminate realized holding gains from FIFO income. • Economic incentives guiding the choice of inventory methods. 9-2

3. Learning objectives concluded • How to apply the lower of cost or market method. • The key differences between GAAP and IFRS requirements for inventory accounting. 9-3

4. Main Types of Businesses • Service Companies: • Travel agency, Entertainment, Internet, etc. • Merchandising Companies: • Wholesalers and retailer: to buy and sell ready-to-sell merchandise. • Manufacturing Companies • Acquire and process raw materials into finished goods.

5. Main Types of Businesses • For both merchandising and manufacturing companies, inventories are important assets. • Therefore, inventory accounting is crucial to financial reporting.

6. Inventory types Manufacturer: Wholesaler or retailer: Manufacturer Supplier Firm Includes other manufacturing costs ( Direct labor costs, direct materials, manufacturing overhead, etc.) Firm Raw materials Merchandise inventory Work-in-process Finished goods Customer Customer Gross Profit: Sales – Cost of Goods Sold

7. Overview of accounting issues Old unit New unit Issue: What kind of costs are included in inventory? Issue: How is the cost of goods available for sale split between the balance sheet and the income statement? 9-7

8. Overview of accounting issues:Summary • Three methods for allocating the cost of goods available for sale: • GAAP does not require the cost flow assumption to correspond to the actual physical flow of inventory. • If the cost of inventory never changes, all three cost flow assumptions would yield the same financial statement result. • No matter what assumption is used, the total dollar amount assigned to the balance sheet and the income statement is the same ($640 in this example). Weighted average FIFO LIFO 9-8

9. Uses the average cost of the two units. FIFO produces a smaller expense First-in, first-out (FIFO) approach: Oldest unit cost flows to income. LIFO produces a larger expense Last-in, last-out (LIFO) approach: Newest unit cost flows to income. Overview of accounting issues:Allocating the cost of goods available for sale Weighted average approach: Uses the average cost of the two units. 9-9

10. Overview of accounting issues: • How to allocate total inventory between the COGS and the ending inventory? • What items should be included in ending inventory? • What costs should be included in inventory purchases (and eventually in ending inventory)? • What different cost flow assumptions can be used in determine the COGS under each inventory method (i.e., perpetual vs. periodic)? 9-10

11. Learning Objective: How to allocate total inventory between the COGS and the ending inventory?

12. Perpetual inventory system • This approach keeps a running (or “perpetual”) record of the amount of inventory on hand. • The inventory T-account under a perpetual inventory system looks like this: Entries are made as units are purchased Entries are made as units are sold

13. Determining inventory quantities:Periodic inventory system • This approach does NOT keep a running (or “perpetual”) record of the amount of inventory on hand. Entries are made as units are purchased • Ending inventory and cost of goods sold must be determined by physically counting the goods on hand at the end of the period.

14. Determining inventory quantities:Journal entries illustrated Beginning Inv.(1,400) + Purchases (9,100) – Ending Inv. (3,500)=COGS (7,000)

15. Less recordkeeping means lower cost to maintain. Less management control over inventory. COGS is a “plug” figure and there is no way to determine the extent of inventory losses (“shrinkage”). Typically used when inventory volumes are high and per-unit costs are low. More complicated and usually more expensive. Does NOT eliminate the need to take a physical inventory. Better management control over inventories including “stock outs”. Typically used for low volume, high unit cost items or when continuous monitoring of inventory levels is essential. Periodic and perpetual compared Periodic inventory Perpetual inventory

16. Learning Objective: What items should be included in ending inventory? .

17. Items included in inventory • In day-to-day operations, most firms record inventory when they physically receive it. • When it comes to preparing financial statements, the firm must determine whether all inventory items are legally owned. • Goods in transit may be “owned” by the buyer or the seller. • The party that has legal title during transit will record the items as inventory. • Consignment goods should not be counted as inventory for the consignee. 9-17

18. General Rule All goods legally owned by the company on the inventory date, regardless of their location. What is Included in Ending Inventory? Goods in Transit Goods on Consignment Depends on FOB shipping terms.

19. Goods in transit • The party with the legal title during transit will record the items as inventory. • FOB Shipping Point: the title transfers to the buyer at the shipping point (i.e., the seller’s facility). Thus, the buyer has the title during the transit. • FOB Destination: the title transfers to the buyer at the destination (i.e., buyer’s facility. Thus, the seller has the title during the transit.

20. In Class Exercise : Houston Corporation had the following inventory transactions in transit on 12/31/08. Indicate whether the inventory would be included in Houston’s ending inventory on 12/31/2010. 1. Purchased inventory “FOB Shipping Point”; shipped on 12/31/10. 2. Sold inventory “FOB Shipping Point”; shipped on 12/31/10. 3. Purchased inventory “FOB Destination”; shipped on 12/31/10. 4. Sold inventory “FOB Destination”; shipped on 12/31/10.

21. Learning Objective: What costs should be included in inventory purchases?

22. Costs included in inventory • All costs necessary to obtain the inventory and to make it saleable should be accounted for. • These costs include: • Purchase cost or production costs • Sales taxes and transportation costs (if paid by the buyer). • In-transit insurance costs (if paid by the buyer). • Storage costs.

23. Costs included in inventory • In theory, costs such as the costs of the purchasing department and other general and administrative costs associated with the acquisition and distribution of inventory should also be included in the inventory costs(referred to as the “indirect” costs”). • However, most firms exclude these items.

24. Costs included in inventory : • Non-manufacturing firms consider the following items in the cost of inventories: • Purchase costs ( invoice price) • + Freight-in (transportation-in) • - Purchase returns • - Purchase allowances (reduce the purchase price due to damages on goods). • - Purchase discounts (from early cash payments for the purchase) .

25. Costs included in inventory: Manufacturing firms • The inventory costs (i.e., product costs)of a manufacturer include: • Raw Material (variable) • Direct Labor (variable) • Overhead items: • Variableoverhead: indirect labor, indirect material, electricity used for production, etc. • Fixed overhead: depreciation expense of machine, property taxes of factories, rent expense for the factories, etc.

26. Costs included in inventory: Manufacturing firms (contd.) • The inventory costs are treated as assets (in work-in-process account for any raw material, labor and overhead in production process and in finished goods account when the production process is complete) until finished goods are sold. • When finished goods are sold, the carrying value of these finished goods is charged to cost of goods sold.

27. Costs included in inventory:Manufacturing industry ( FYI ) Two views on treatment of manufacturing overhead costs: Absorption and variable costing

28. Manufacturing Overhead:Variablecosting versus Absorption costing • Fixed overhead: • Manufacturing rentals and depreciation • Property taxes Fixed production costs Variable production costs Variable production costs • Raw materials • Direct labor • Variable overhead, like electricity Variable costs will change in proportion to the level of production. Variable costing of inventory (not allowed by GAAP) Absorption costing of inventory (required by GAAP) The rationale for absorption costing is that both variable and fixed production costs are assets since both are needed to produce a saleable product. Costs are considered to be Includable in inventory if they provide future benefits to the firm.

29. Manufacturing Overhead: Summary This approach is not allowed by GAAP. These are never included in inventory.

30. Costs included in inventory:How absorption costing can distort profitability • As we shall see, the GAAP gross margin increases from $110,000 in 2011 to $130,000 in 2012 even though variable production costs and selling price are constant, and sales revenue has fallen. 9-30

31. Costs included in inventory:Absorption costing distortion 9-31

32. Costs included in inventory:Variable costing illustration Under variable costing the gross margin falls 9-32

33. Absorption Costing and Earnings Management (source: RCJM Textbook) • A research study found that firms in danger of producing zero earnings resort to overproducing inventory to reduce sort of goods sold and thereby boost profits. • The evidence suggests that absorption costing provides opportunities for firms to manipulate earnings.

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

35. Cost flow assumptions:The concepts • In a few industries, it is possible to identify which particular units have been sold. Examples include jewelry stores and automobile dealerships. These firms use specific identification inventory costing. • For most firms, however, a cost flow assumption is required.

36. Uses the average cost of the two units. FIFO produces a smaller expense First-in, first-out (FIFO) Oldest unit cost flows to income. Oldest unit cost flows to income. LIFO produces a larger expense Last-in, first-out (LIFO) Newest unit cost flows to income. Cost Flow Assumptions:Allocating the cost of goods available for sale Assumption: the cost of inventory is rising Older inventory purchase: Unit price:$300 Most recent inventory purchase: Unit price ;$340 Weighted average

37. Cost Flow Assumptions: Summary • GAAP does not require the cost flow assumption to correspond to the actual physical flow of inventory. • If the cost of inventory never changes, all three cost flow assumptions would yield the same financial statement result. • No matter what assumption is used, the total amount assigned to the balance sheet and the income statement is the same (i.e., the amount of goods available for sale).

38. Cost flow assumptions:What assumptions do firms use?(Accounting Trends and Techniques)

39. Specific cost identification Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) Inventory Cost Flow Methods

40. 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 • Companies which can identify specific units sold can adopt the specific • identification method to allocate costs of goods sold and cost of ending • Inventory. Examples include jewelry stores and automobile dealerships. • The specific cost of each inventory item must be known. • By selecting specific items from inventory at the time of sale, income may be manipulated.

41. Weighted Average Cost Method

42. Weighted Average Method – Periodic system Begin Inventory 20 @ $ 9.00 $180 Purchase 1/10 40 @ 10.00 400 Purchase 1/22 30 @ 11.00 330 Sales 1/13 : 55 Units Ending Inventory on 1/31:20 + 40 + 30 - 55=35 units • Average unit cost: $ of Goods available cost( 180+400+330 ) = $10.11per unit Units of Goods available ( 20+40+30 ) • Ending Inventories: 35 units x $10.11 = $354 • Cost of Goods Sold: $180+ (400+330)– 354 = $556

43. Weighted Average Method – Perpetual system Begin Inventory 20 @ $ 9.00 $180 Purchase 1/10 40 @ 10.00 400 Purchase 1/22 30 @ 11.00 330 Sales 1/13 : 55 Units Ending Inventory on 1/31:20 + 40+ 30 – 55 = 35 units • Calculate weighted average unit cost on 1/10: Goods available cost ( 180+400 ) = $580 = $9.67 per unit Goods available units ( 20+40 )60 • Cost of Goods sold on 1/13: 55 units x $9.67 per unit = $ 531.85 • Calculate weighted average unit cost on1/22: Goods available cost ( 5*9.67+30*11) = $378 = $10.81 Goods available units ( 20+40-55+30 )35 • Cost of ending inventory on 1/31: 35 units x $10.81 per unit = $378.35

44. First-In, First-Out • The FIFO method assumes that items are sold in the chronological order of their acquisition. • 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. • The COGS and ending inventory cost are the same under periodic and perpetual approaches regardless their differences in the timing of adjustments to inventory.

45. First-in, First-out (FIFO) Newest units assumed still on hand Oldest units assumed sold

46. The computations are: First-in, First-out (FIFO) illustrated

47. Practice Problem: FIFO - Periodic system Beginning Inventory 20 @ $ 9.00 $180 Purchase 1/10 40 @ 10.00 $400 Purchase 1/22 30 @ 11.00 $330 Sales on 1/13: 55 Units Ending Inventory: 20+40+30-55 = 35 units • FIFO of cost of ending units (bottom up) : 35 units 30 @ $11 = $330 5 @ $10 = $ 50 Total = $380 • FIFO for COGS (top down) 55 units 20 @ $ 9 = $180 35 @ $10 = $350 Total = $530 Alternatively (recommended), COGS = beg. Inv. + net pur. – end. Inv. = $180 + (400+330) – 380 = $530.

48. Practice Problem: FIFO -Perpetual system Beginning Inventory 20 @ $ 9.00 $180 Purchase 1/10 40 @ 10.00 $400 Purchase 1/22 30 @ 11.00 $330 Sales on 1/13: 55 Units Ending Inventory: 20 + 40+ 30 - 55 = 35 units • FIFO COGS for 1/13 Sale FIFO Inventory on 1/13 55 units 20 @ $ 9 = $180 5 @ $10 = $50 35 @ $10 = $350 Total = $530 • Inventory on 1/22 (same as inventory on 1/31 due to no other transactions after 1/22 in January) 35 units 5 @ $10 = $ 50 30 @ $11 = $330 Total = $380

49. Last-In, First-Out • The LIFO method assumes that the newest items are sold first, leaving the older units in inventory. • 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. • Unlike FIFO, using the LIFO method may result in COGS and ending inventory Cost that differ under the periodic and perpetual approaches.

50. Last-in, First-out (LIFO) Newest units assumed sold Oldest units assumed still on hand