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 1 Chapter 7: Merchandise Inventory  2 Merchandise Inventory What is inventory?  Items held for resale to customers Who has inventory?  Wholesaler or Retailer o Merchandise Inventory  Manufacturer o Raw Materials o Work in Process o Finished Goods  3 The Relative Size of Inventories Figure 7-1 Inventory as a percentage of total assets and current assets  4 Four Important Inventory Issues 1. Acquiring inventory: What costs to capitalize? 2. Recording inventory activity: Which method? 3. Selling inventory: Which cost flow assumption? 4. Ending inventory: Lower-of-cost-or market valuation.  5 Figure 7-2 Accounting for Inventory: Four Important Issues  6 Acquiring Inventory What items or units to include? General rule: complete and unrestricted ownership. Ownership is usually possession; however, there are exceptions Consignment consignee takes physical possession but does not take ownership Goods in transit  FOB Shipping Point – seller is responsible for (owns) goods only until they are loaded on the common carrier  FOB Destination – seller is responsible for goods until they arrive at the destination (buyer).  7 Acquired Inventory: Which costs to attach? Which costs are included in inventory? General rule: all costs associated with manufacture, acquisition, storage or preparation of inventory including shipping to facility. Freight-in (transportation-in) adds to the cost of inventory. Purchase returns reduce the cost of purchases (contra) for returned inventory. Purchase allowances reduce the cost of purchases (contra) for reduced prices due to damage or errors. Purchase discounts from early cash payments (contra) reduce the cost of purchases.  8 Carrying Value: Perpetual Method Maintaining a continuous record Figure 7.3: Perpetual Inventory  9 Exercise E7-6 Sales Cost of Goods Sold (COGS): BI Purchases GAS Less: EI COGS Gross Profit 2012 $1,443 $220 983 $1,203 244 2011 $1,369 $194 915 $1,109 220 959 $484 889 $480  10 E7-6 Assume that counting errors caused the ending inventory (EI) in 2011 to be understated by $50 and the ending inventory in 2012 to be overstated by $50. a. Compute the impact of these errors on cost of goods sold for the year ended December 31, 2011 and on the inventory balance as of December 31, 2011.  11 E7-6 a. Error in Ending Inventory in 2011: The $50 understated error in the Ending inventory means that the Ending Inventory should have been $220 + $50 = $270. This would change the Cost of goods sold to $1,109 - $270 = $839 which would then increase the Gross profit to $530 ($1,369 - $839).  12 E7-6 b. Compute the impact of these errors on cost of goods sold for the year ended December 31, 2012 and on the inventory balance as of December 31, 2012. c. What is the impact of these errors on cost of goods sold over the two-year period ended December 31, 2012?  13 E7-6 b. Error in Ending Inventory in 2012: = The 2011 error in the Ending Inventory changes the Beginning Inventory in 2012 and the Goods Available for sale to $270 + $983 = $1,253. To calculate the Cost of Goods Sold the Ending Inventory for 2012 is deducted from the revised Goods Available for Sale: $1,253 – ($244 - $50) = $1,059. The gross profit would then be $1,443 $1,059 = $384.  14 E7-6 c. 2011 Original COGS Corrected COGS 2012 $889 $839 $959 $1,059  15 Cost Flow Assumptions Given: BI + P (net) = EI + COGS Management must decide how to assign costs of inflows [BI + P(net)] to EI and COGS? Methods: Specific identification Average for both COGS and EI FIFO - (first-in, first-out) for COGS and LISH (last-in, still here) for EI LIFO - (last-in, first-out) for COGS and FISH (first-in, still here) for EI  16 Cost Flows Figure 7.7 Inventory flow assumption: Average, FIFO, and LIFO  17 Cost Flows - Average  18 Cost Flows - FIFO  19 st Flows - LIFO  20 Effects on Financials/Taxes In an inflationary period (rising prices) which most periods are: FIFO has the highest inventory balance, lowest COGS, and highest income LIFO has the lowest inventory balance, highest COGS, and lowest income This means that LIFO pays the least taxes  21 Cost Flows – Effects on Financial Statements Figure 7-8 Financial statement effects  22 Cost Flows – Effects on Federal Income Taxes Figure 7-9 Income tax effects  23 Choosing an Inventory Cost Flow Assumption: Trade-Offs Income and Asset Measurement Economic Consequences Income Taxes and Liquidity Bookkeeping Costs LIFO Liquidation and Inventory Purchasing Practices Debt and Compensation Practices The Capital Market  24 Ending Inventory: Applying the Lowerof-Cost-or-Market Rule Applying the lower-of-cost-or-market rule to ending inventory is accomplished by comparing the cost allocated to ending inventory with the market value of the inventory. If the market value exceeds the cost, no adjustment is made and the inventory remains at cost. If the market value is less than the cost, the inventories are written down to market value with an adjusting journal entry.  25 The Lower-of-Cost-or-Market Rule and Hidden Reserves Based on conservatism, ending inventory is valued at cost or market value, whichever is lower.  Problem: can create hidden reserves  Recognizes price decreases immediately  Defers price increase recognition until sold US GAAP and IFRS use different market values when applying the lower-of-cost-ormarket rule. Under US GAAP the market value is usually the replacement cost. Under IFRS it is normally the realizable value.  26 International Perspective – Cost Flow Assumptions Under IFRS the LIFO method is prohibited. This poses an important potential impediment to the adoption of IFRS in the US. Most LIFO users in the US have chosen LIFO because it results in an income tax savings. DuPont, for example, has saved over $150 million in income taxes because it uses LIFO. A shift to IFRS could impose a huge and immediate tax burden on LIFO users in the US.  27 International Perspective: Japanese Business and Inventory Accounting Just-in-time (JIT) inventory systems, which reduce the costs of carrying large amounts of inventory without jeopardizing customer service, have long been a characteristic of this Japanese system and have given the Japanese a definite advantage when competing against U.S. industry. Japan has adopted international reporting standards (IFRS), which does not allow the use of LIFO.  28 Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.  29