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Transcript of 6-1 ©2006 Prentice Hall, Inc.. 6-2 ©2006 Prentice Hall, Inc. REPORTING AND ANALYZING INVENTORY ...
6-2©2006 Prentice Hall, Inc.
REPORTING ANDREPORTING ANDANALYZING INVENTORYANALYZING INVENTORY
Learning objectivesInventory cost flow assumptionsHow inventory cost flow assumpt
ions affect financial statementsLower-of-cost-or-market ruleFinancial statement analysisBusiness risk, control, and ethics
6-3©2006 Prentice Hall, Inc.
Learning ObjectivesLearning Objectives(1 of 2)(1 of 2)
Explain and apply the four cost flow assumptions for valuing inventory and cost of goods sold
Explain the effects of the inventory cost flow assumption on the financial statements
Explain the lower-of-cost-or-market rule for valuing inventory
6-4©2006 Prentice Hall, Inc.
Learning ObjectivesLearning Objectives(2 of 2)(2 of 2)
Evaluate a firm’s inventory management using the inventory turnover ratio.
Recognize special risks and controls associated with inventory.
6-5©2006 Prentice Hall, Inc.
Inventory Cost Flow Inventory Cost Flow Assumptions Assumptions (1 of 3)(1 of 3)
During March, Jeremy’s Friendly Market showed the following results:Beginning inventory of Big Q Beans was
400 cans at $0.75 per canPurchased 1,000 cans of Big Q Beans for
$0.79 per can. Later that month, they purchased 2,000 more cans of Big Q Beans for $0.84 per can
It sells 2,400 cans of beans during March
6-6©2006 Prentice Hall, Inc.
Inventory Cost Flow Inventory Cost Flow Assumptions Assumptions (2 of 3)(2 of 3)
What is the cost of the beans sold?What is the cost of the beans remaining
in merchandise inventory?Cost flow assumptions allocate goods
available for sale (GAS) to cost of goods sold and ending inventory (EI)BI + Purch = GASGAS – EI + GoGS (GAS = EI + GoGS)
6-7©2006 Prentice Hall, Inc.
Inventory Cost Flow Inventory Cost Flow Assumptions Assumptions (3 of 3)(3 of 3)
Alternate inventory cost flow assumptionsSpecific identificationWeighted averageFirst-in, first-out (FIFO)Last-in, last-out (LIFO)
6-8©2006 Prentice Hall, Inc.
Specific Identification
Specific identification does NOT make any cost-flow assumptionsThe accounting system tracks the
actual cost of each item in merchandise inventory and the actual cost of items sold
For what types of goods would a company use specific identification?
6-9©2006 Prentice Hall, Inc.
Weighted Average Cost(1 of 2)
Same cost is assigned to all GAS for each inventory item carried by the business.
For what types of goods would a company use weighted average?
Average cost per unit in GAS: Total cost of inventory item _
Total # of units of inventory item
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©2006 Prentice Hall, Inc.
Weighted Average Cost(2 of 2)
Cost of goods sold# of units sold x avg cost per unit
Ending inventory# of units in EI x avg cost per unit
Calculate for Big Q Beans:GAS, CoGS, and EI
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©2006 Prentice Hall, Inc.
FIFO
Assumes that FIRST items purchased are first items soldOldest costs are in CoGSMost recent costs are in EI
Calculate for Big Q Beans:GAS, CoGS, and EIAre your answers different than for
weighted average? Why or why not?
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©2006 Prentice Hall, Inc.
LIFO(1 of 3)
Assumes that LAST items purchased are first items soldMost recent costs are in CoGSOldest costs are in EI
Calculate for Big Q Beans:GAS, CoGS, and EIAre your answers different than for
FIFO? Why or why not?
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©2006 Prentice Hall, Inc.
LIFO(2 of 3)
Use of LIFO requires extra disclosures in financial statement footnotes
What effect would making an extra purchase of inventory at the end of the period have on CoGS under LIFO if:Inventory costs are rising? Falling?How would the extra purchase affect
CoGS under FIFO?
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©2006 Prentice Hall, Inc.
LIFO(3 of 3)
What would happen company using LIFO kept an inventory reserve (never sold all of its inventory)?
If a company sells all of its inventory each period (no BI), would CoGS change under the different methods? Why or why not?
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©2006 Prentice Hall, Inc.
Effect of Cost Flow Effect of Cost Flow Assumptions on Financial Assumptions on Financial
StatementsStatements (1 of 3) (1 of 3)
FIFO LIFO Wt. Avg.Sales $ 3,000 $ 3,000 $ 3,000Cost of G. S. 1,930 1,996 1,955Gross Margin 1,070 1,004 1,045Oper. exp. 250 250 250Pretax Inc. 820 754 795Taxes (30%) 246 226 239Net Income $574 $528 $556Assumes sales price $1.25/can & op exp $250
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©2006 Prentice Hall, Inc.
Effect of Cost Flow Effect of Cost Flow Assumptions on Financial Assumptions on Financial
StatementsStatements (2 of 3) (2 of 3)
FIFO LIFO Wt. Avg.Inflows:
Sales collected $ 3,000 $ 3,000 $ 3,000Outflows:
Purch paid for 2,470 2,470 2,470Op. exp. paid 250 250 250Taxes paid 246 226 239
Net cash flow $ 34 $ 54$ 41Assumes sales price $1.25/can & op exp $250
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©2006 Prentice Hall, Inc.
Effect of Cost Flow Effect of Cost Flow Assumptions on Financial Assumptions on Financial
StatementsStatements (3 of 3) (3 of 3)
Effect of reported inventory and CoGS under different cost flow assumptions
Income tax effects under LIFO and FIFO
Choosing an inventory cost flow method
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Effect of Cost Flow Assumptions
on CoGS and EI
Which method produces the highest net income in times of rising inventory costs? Falling inventory costs?
Which method produces the highest ending inventory under rising inventory costs? Falling inventory costs?
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Income Tax Effects Under LIFO and FIFO
In times of rising inventory costs, which inventory method produces the highest income tax expense?Does this affect which method
produces the highest net income?How does this affect cash flow?
How do your answers change if inventory costs are falling
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©2006 Prentice Hall, Inc.
Choosing an Inventory Cost Flow Method (1 of 2)
Factors that may affect choice of inventory cost flow assumptionCompatibility with similar companiesMaximize tax savings and cash flowsMaximize net income
If LIFO is used for tax purposes, it must also be used for financial statement purposes
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Choosing an Inventory Cost Flow Method (2 of 2)
How does choice of cost flow method affect the following ratios in times of rising inventory costs? Falling costs?Current ratioQuick ratioGross profit ratioProfit margin ratioInventory turnover ratio
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Lower-of-cost-or-market Lower-of-cost-or-market RuleRule
Which reporting constraint (see ch 2) requires inventory to be stated at lower of cost or market value? Replacement cost is used to estimate market value
If market value is lower than costReduce the inventory accountReduce net income
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Financial Statement Financial Statement AnalysisAnalysis
(1 of 2)(1 of 2)
Inventory turnoverMeasures how quickly a firm is selling
its inventory Cost of goods sold
Average inventoryAverage inventory = (BI + EI) / 2
Average days in inventory365 (days in year) / Inventory turnover
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Financial Statement Financial Statement AnalysisAnalysis
(2 of 2)(2 of 2)
In general, do companies want higher or lower inventory turnover?Compared to what?
What happens if inventory turnover is too high? Too low?
Which industry would have higher inventory turnover, a jeweler or grocer?Who would have a higher profit margin?
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Business Risk, Control, Business Risk, Control, and Ethicsand Ethics
(1 of 2)(1 of 2)
What is inventory padding?How else can a company
artificially inflate its assets?Safeguarding assets
Physical controlsIncludes ensuring that products
don’t spoil
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©2006 Prentice Hall, Inc.
Business Risk, Control, Business Risk, Control, and Ethicsand Ethics
(2 of 2)(2 of 2)
RFID tagsHow to they help control costs?What inventory method do they
enable businesses to use that they could not use previously?
Controlling inventory levels and monitoring product developments to prevent inventory obsolescence
Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’s
Kenneth W. Monfort College of [email protected] 6-
27©2006 Prentice Hall, Inc.