Chapter 10 Lecture and Notes

Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions

Accounting for inventory is a critical function of management. Inventory accounting is significantly complicated by the fact that it is an ongoing process of constant change, in part because

1. Most companies offer a large variety of products for sale
2. Product purchases occur at irregular times
3. Products are acquired for differing prices
4. Inventory acquisitions are based on sales projections, which are always uncertain and often sporadic

Inventory affects the balance sheet and the income statement:

Four Methods of Tracking Inventory Costs

• Specific identification: tracks the actual cost of the specific item being sold
• Generally used only on expensive items that are highly customized, such as cars or unique gems.
• First-in, first-out (FIFO): records costs relating to a sale as if the earliest purchased item would be sold first. However, the physical flow of the units sold under both the periodic and perpetual methods would be the same.
• Last-in, first-out (LIFO): records costs relating to a sale as if the latest purchased item would be sold first
• Weighted average: requires a calculation of the average cost of all units of each particular inventory item and records inventory costs based on that average

Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method

Cost Flow Assumptions: First-in, First-out (FIFO)

• Costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold.
• Often parallels actual physical flow of merchandise.
• Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.

Cost Flow Assumptions: Last-in, First-out (LIFO)

• Costs of the latest goods purchased are the first to be recognized in determining cost of goods sold.
  
• Seldom coincides with actual physical flow of merchandise.
• Exceptions include goods stored in piles, such as coal or hay.

Cost Flow Assumptions: Average-cost

• Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred.
• Applies weighted-average unit cost to the units on hand to determine cost of the ending inventory.

Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method

Gross Margin Comparison: Different Methods Under Perpetual Tracking

Under either scenario in the above comparison, the same inventory items were sold, but the result on the financial statement varies due to the cost flow method chosen by the company. In this example, it may not seem like a big difference, but inventory is a major component of any retailer. To think about the difference the inventory cost method can have, add six zeroes to each of these numbers, and it is easier to see the effect of the different methods.

Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet

Errors in the valuation of ending merchandise inventory affect both the balance sheet and the income statement.

• When cost of goods sold is overstated, inventory and net income are understated.
• When cost of goods sold is understated, inventory and net income are overstated.
• An error in ending inventory carries into the next period because ending inventory of one period becomes the beginning inventory of the next period.
• Over a two-year period, misstatements of ending inventory will balance themselves out.
  • An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.
  • Over the two years, the total net income is correct because the errors offset each other.
  • Ending inventory depends entirely on the accuracy of taking and costing the inventory.

• However, financial statements are prepared for one period, so all this means is that two years of cost of goods sold are misstated (the first year is overstated/understated, and the second year is understated/overstated.)

Effect of inventory errors on the balance sheet is determined by using the basic accounting equation: Assets = Liabilities + Stockholders’ Equity. 

Errors in the ending inventory have the following effects.

Statement Presentation and Analysis

Presentation of Inventory on Financial Statements

Balance Sheet - Inventory classified as current asset.  

Income Statement - Cost of goods sold is subtracted from sales.

There also should be disclosure of the

1. major inventory classifications,
2. basis of accounting (cost or LCNRV), and
3. costing method (F I F O, L I F O, or average-cost).

Examine the Efficiency of Inventory Management Using Financial Ratios

Inventory ratio analysis relates to how well the inventory is being managed.

Inventory management is a double-edged sword

1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage).
2. Low Inventory Levels – may lead to stock-outs and lost sales.

Two ratios can be used to assess how efficiently management is handling inventory.

• Inventory turnover ratio: measures the number of times an average quantity of inventory was bought and sold during the period
  • Cost of Goods Sold ÷ Average Inventory
• Number of days’ sales in inventory ratio: measures how many days it takes to complete the cycle between buying and selling inventory
  • Average Inventory ÷ Average Daily Cost of Goods Sold

• Merchandise inventory is maintained using either the periodic or the perpetual updating system. Periodic updating is performed at the end of the period only, whereas perpetual updating is an ongoing activity that maintains inventory records that are approximately equal to the actual inventory on hand at any time.
• There are four basic inventory cost flow allocation methods, which are alternative ways to estimate the cost of the units that are sold and the value of the ending inventory. The costing methods are not indicative of the flow of the goods, which often moves in a different order than the flow of the costs.
• Companies using the periodic and perpetual method for inventory updating choose between the basic four cost flow assumption methods, which are first-in, first-out (FIFO); last-in, first-out (LIFO); specific identification (SI); and weighted average (AVG).
• Utilizing different cost allocation options results in marked differences in reported cost of goods sold, net income, and inventory balances.
• Most modern inventory systems utilize the perpetual inventory system, due to the benefits it offers for efficiency, ease of operation, availability of real-time updating, and accuracy.
• The value for cost of the goods available for sale is dependent on accurate beginning and ending inventory numbers. Because of the interrelationship between inventory values and cost of goods sold, when the inventory values are incorrect, the associated income statement and balance sheet accounts are also incorrect.
• Inventory errors at the beginning of a reporting period affect only the income statement. Inventory errors at the end of a reporting period affect both the income statement and the balance sheet.
• Inventory ratio analysis tools help management to identify inefficient management practices and pinpoint troublesome scenarios within their inventory operations processes.
• The inventory turnover ratio measures how fast the inventory sells, which can be useful for inter-period comparison as well as comparisons with competitor firms.
• The number of days’ sales in inventory ratio indicates how long it takes for inventory to be sold, on average, which can help the firm identify instances of too much or too little inventory, indicating such cases as product obsolescence or excess stocking, or the reverse scenario: insufficient inventory, which could result in customer dissatisfaction and lost sales.