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Inventories

Inventories. chapter8. Different kind of inventories. Merchandising Manufacturing Raw materials Work in process Finished goods. Income determination. Proper vs. the most realistic inventory value Two different objectives Sometimes incompatible

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Inventories

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  1. Inventories chapter8

  2. Different kind of inventories • Merchandising • Manufacturing • Raw materials • Work in process • Finished goods

  3. Income determination • Proper vs. the most realistic inventory value • Two different objectives • Sometimes incompatible • But proper income determination takes precedence

  4. Relationships through form Net sales Less cost of goods sold Equal to Gross margin Less other expenses Equal to Net income or Net loss

  5. Importance of the value assigned to ending inventory • It affects cost of goods sold • And thus affects net income or net loss • Just over state ending inventory • Will understate cost of goods sold • Will overstate gross margin • Will overstate net income

  6. Choices • With regard to inventory systems and methods • Two inventory processing systems • 4 inventory costing methods • Two inventory valuation methods • 2 times 2 time 4 equals to ??

  7. Contextual conditions • Federal income tax • Performance evaluation • Lower income so that company can pay less tax • Higher income so that management can get better bonus

  8. Level of inventory • Inventory turn over rate • Equals to costs of good sold divided by average inventory where average inventory can be one half of (beginning inventory + ending inventory) • See formula on page 376

  9. Two flows • Goods flow – the actual movement of goods in the operation • Cost flow – the association of costs with their assumed flow in the operation of a company

  10. Inventory costing methods • Specific identification • Average-cost • First-in, First out • Last in, First out

  11. Example (p.379)

  12. Costing methods under the Periodic inventory system • Specific identification • 50 from June 1 • 100 from June 13 • 70 from June 25 • How much is cost of goods sold • How much is ending inventory

  13. Average-cost method • Cost of goods available for sale divided by units available for sale = average unit cost • Sales * average unit cost = cost of goods sold • Ending inventory units * average unit cost = ending inventory cost

  14. First-In, First-Out • That is, 50 units from Jun 1, 50 units from Jun 6, 150 units from Jun 13, 30 units from Jun 20 • Or one can calculate ending inventory cost first – 150 units from Jun 25 and 70 units from Jun 20

  15. Last-in, First-out • That is, 150 unit from June 25, 100 units from Jun 20, and 30 units from June 13 • Or calculate ending inventory cost first and then use cost of goods available for sales to minus ending inventory cost

  16. Comparison of inventory cost methods • Specific identification will be the same under period or perpetual because it uses actual cost

  17. Comparison of methods • In a period of rising prices, LIFO has the highest cost of goods sold • Average cost will be in between LIFO and FIFO • In a period of declining prices, the reverse would occur.

  18. Effect on financial statements • Use form to reason the impact • Higher cost of goods sold means lower gross margin which also means lower net income.

  19. Rule of consistency • A company can choose any inventory cost method • But once a method is chosen, the change of it will be subject to approval by IRS for tax purpose • The nature and effect of the change must be shown on the company’s financial statement

  20. LIFO liquidation • Sales have reduced inventories below the levels established in prior year when LIFO is used in a rising price period • Effects: will have higher income before tax

  21. Effects of misstatements in inventory measurement • List the forms first and then put in numbers one can see the effects easily (will demonstrate this with spreadsheet in class) • When cost of goods sold understated, gross margin will be overstated, and so will be income; one can see the reverse effects too.

  22. Effects of misstatement • Since this year’s ending inventory is the coming year’s beginning inventory, we can see the impact on the coming year. • If cost of goods sold (year 0) is under stated, I.e., ending inventory (year 1) will be overstated, and thus beginning inventory (year 2) will be overstated, and thus COGS will be overstated, …

  23. Lower of Cost or Market • An example of the application of the convention of conservatism

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