POA_Ch08.ppt

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Inventories8

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Managing Inventories

OBJECTIVE 1: Explain the management

decisions related to inventory accounting,

evaluation o inventory level, and the eects

o inventory misstatements on incomemeasurement!

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Key Ratios

Inventory turnover

Days inventory on hand

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Figure 1: Management Choices in

Accounting for Inventories

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Figure 2: Inventory Turnover for Selected

Industries

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Figure : !ays" Inventory on #and for

Selected Industries

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Merchandise inventory is a current asset.

The matching principle is applied to inventory

valuation.The higher the ending inventory, the lower the

cost of goods sold and the higher the gross

profit and net income.

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Merchandise inventory is a current asset.

(cont.

Management chooses an inventory system(periodic or perpetual, an inventory costing

system (specific identification, average cost,

!I!", or #I!", and a method of valuing

inventory at mar$et.

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In managing inventory levels, it is important to

ta$e into consideration %oth the costs of

handling, storing, and financing inventories and

the cost of lost sales.

Inventory turnover (cost of goods sold divided %y

average inventory is the num%er of times, on

average, inventory is sold during the period.

Days inventory on hand (&' divided %y inventory

turnover is the num%er of days it ta$es to sell

inventory.

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In managing inventory levels, it is

important to ta$e into consideration %oth

the costs of handling, storing, and financinginventories and the cost of lost sales. (cont.

Inventory levels are minimi)ed %y using

supply*chain management in a +ust*in*time

operating environment.

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eginning and ending inventory are an integral

part of the calculation of cost of goods sold

and, therefore, income %efore income ta-es.

hen ending inventory is under* or overstated,

income %efore income ta-es will %e under* or

overstated, respectively.

hen %eginning inventory is under* or overstated,income %efore income ta-es will %e over* or

understated, respectively.

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eginning and ending inventory are an

integral part of the calculation of cost of

goods sold and, therefore, income %eforeincome ta-es. (cont.

Inventory errors are counter%alancing %ecause

their effects are reversed within two accounting

periods.

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13/522011 Cengage Learning All Rights Reserved. May not be scanned, copied or dplicate, or posted to a pblicly accessible !ebsite, in !hole or in part.

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Inventory Cost and $aluation

OBJECTIVE ": #eine inventory cost,

contrast goods lo$ and cost lo$, and

explain the lo$er%o%cost%or%mar&et '(C)*

rule!

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Figure %: Merchandise in Transit

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Inventory cost includes purchase price less

discounts/ freight*in and insurance in

transit/ and ta-es and tariffs.

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0oods flows and cost flows

0oods flow is the actual physical flow of

goods into and out of the company.

1ost flow is an assumption made a%out costs

for accounting purposes.

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0oods flows and cost flows (cont.

Merchandise inventory also includes the

following costs2

Incoming goods shipped !" shipping point

"utgoing goods shipped !" destination

0oods consigned to another company

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0oods flows and cost flows (cont.

Merchandise inventory would not include the

following costs2

Incoming goods shipped !" destination

"utgoing goods shipped !" shipping point

0oods held on consignment from another company

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Inventory should %e valued at the lower of

cost or mar$et.

!irst, cost is determined %y historical, ororiginal, cost.

Mar$et is defined as replacement cost.

1ost is compared with mar$et.

3se of #1M can %e an indicator that a

company is in trou%le.

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21/522011 Cengage Learning All Rights Reserved. May not be scanned, copied or dplicate, or posted to a pblicly accessible !ebsite, in !hole or in part.

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Inventory Cost &nder the 'eriodic

Inventory System

OBJECTIVE +: Calculate inventory cost

under the periodic inventory system using

various costing methods!

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Figure (: The Im)act of Costing Methods on the

Income Statement and *alance Sheet &nder the

'eriodic Inventory System

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Inventory System

3nder the specific identification method,

ending inventory can %e identified as

having come from specific purchases.The specific identification method is usedprimarily for high*priced items such as

automo%iles, furniture, and e-pensive +ewelry.

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Inventory System

3nder the average*cost method, an average

cost per unit is calculated on goods

availa%le for sale to determine ending

inventory and cost of goods sold.

4n advantage of the average*cost method is that

cost increases and decreases are leveled out.

4 disadvantage of the average*cost method isthat the most current costs are not used in

income determination.

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Inventory System

3nder !I!", the first goods purchased are

assumed to %e the first sold.

In a period of rising prices, !I!" will producethe highest net income of the four methods.

!I!" is critici)ed for magnifying the effects of

the %usiness cycle on income.

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Inventory System

3nder #I!", the goods purchased most

recently are assumed to %e the first sold.

#I!" matches current costs with current revenues,

and the effects of the %usiness cycle are smoothed

out.

Disadvantages of #I!" include reporting the

lowest net income of the four methods in

inflationary times, often an unrealistic inventory

valuation, and lac$ of acceptance in most other

countries.

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2011 Cengage Learning All Rights Reserved. May not be scanned, copied or dplicate, or posted to a pblicly accessible !ebsite, in !hole or in part.

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Im)act of Inventory !ecisions

OBJECTIVE : Explain the eects o

inventory costing methods on income

determination and income taxes!

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Ta+le 1: ,ffects of Inventory Costing

Methods on -ross Margin

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Figure .: Inventory Costing Methods &sed

+y .// 0arge Com)anies

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During periods of rising prices, !I!"

provides a higher gross margin than #I!".

The average*cost method produces grossmargin that is %etween those of !I!" and

#I!". 5o generali)ation can %e made a%out

the specific identification method.

During periods of falling prices, #I!"

produces a higher gross margin than !I!".

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6ffects on the financial statements

In general, #I!" %est follows the matching rule.

In general, !I!" provides a more up*to*dateending inventory figure for %alance sheet

purposes.

The inventory method chosen must %e applied

consistently. hen #I!" is used for ta-purposes, it must also %e used for financial

reporting.

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4 #I!" li7uidation occurs when the 7uantityof ending inventory is less than the 7uantityof %eginning inventory. This generally

produces higher income %efore ta-es.hen ending inventory is understated, income

%efore income ta-es for the period will %eunderstated.

hen ending inventory is overstated, income%efore income ta-es for the period will %eoverstated.

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4 #I!" li7uidation occurs when the 7uantityof ending inventory is less than the 7uantityof %eginning inventory. This generally

produces higher income %efore ta-es. (cont.hen %eginning inventory is understated,

income %efore income ta-es for the period will%e overstated.

hen %eginning inventory is overstated, income%efore income ta-es for the period will %eunderstated.

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4 companys choice of inventory method

will affect not only its profita%ility, %ut also

its li7uidity and cash flows.

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Inventory Cost &nder the 'er)etual

Inventory System

-.//(E)E0T( OBJECTIVE 2: Calculate

inventory cost under the perpetual inventory

system using various costing methods!

Fi Th I t f C ti M th d th

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Figure : The Im)act of Costing Methods on the

Income Statement and *alance Sheet &nder the

'er)etual Inventory System

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Inventory System

The specific identification method is

applied the same way in the perpetual

system as in the periodic system and

produces the same results.

3sing the average*cost method in a

perpetual system, a moving average is

computed after each purchase.

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Inventory System

3sing !I!" and #I!" in a perpetual

system, list each inventory layer separately.

!I!" will yield the same ending inventoryfigure under the perpetual system as under

the periodic system.

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Inventory System

#I!" will usually produce different figures

for ending inventory and cost of goods sold

in a perpetual system than in a periodic

system.

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$aluing Inventory +y ,stimation

-.//(E)E0T( OBJECTIVE 3: .se the

retail method and gross proit method to

estimate the cost o ending inventory!

T +l 2 R t il M th d f I t

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Ta+le 2: Retail Method of Inventory

,stimation

T +l - ' fit M th d f I t

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Ta+le : -ross 'rofit Method of Inventory

,stimation

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The retail method can %e used when the

relationship %etween cost and selling price is

relatively constant. 4pplying this method is

complicated %y retail prices that change duringthe year, different mar$ups that e-ist on different

types of merchandise, and sales volumes of

different types of merchandise that vary.

ith the retail method, records must %e $ept at cost

and at retail.

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The retail method can %e used when the

relationship %etween cost and selling price

is relatively constant. 4pplying this method

is complicated %y retail prices that change

during the year, different mar$ups that e-ist

on different types of merchandise, and sales

volumes of different types of merchandisethat vary. (cont.

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4pplying the retail method involves four steps.

1ompute goods availa%le for sale at cost and at

retail.

1ompute a cost*to*retail ratio. 8u%tract sales from goods availa%le for sale at retail

to o%tain ending inventory at retail.

Multiply ending inventory at retail %y the cost*to*

retail ratio to determine ending inventory at cost.

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The gross profit method can %e used when

the gross profit ratio remains relatively

constant.

The gross profit method is used in place of the

retail method when records of retail prices of

%eginning inventory and purchases are not

$ept.The gross profit method is generally used when

inventory is destroyed or stolen.

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The gross profit method can %e used when thegross profit ratio remains relatively constant.4pplying the gross profit method involves three

steps. 1ompute goods availa%le for sale (at cost %y addingpurchases to %eginning inventory.

1ompute estimated cost of goods sold %y deductingthe estimated gross margin from sales.

8u%tract estimated cost of goods sold from cost ofgoods availa%le for sale to o%tain estimated endinginventory.

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POA_Ch08.ppt

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