CHAPTER 6

INVENTORIES

I. Importance of Accounting for Inventories

II. Terminology

A. Inventory – Goods businesses intend to sell to their customers or raw materials or on-process items that will be converted into salable goods.

B. Inventory cost flow

C. Inventory equation = Beginning inventory + Purchases – Ending Inventory =

COGS

D. Physical inventory

III. Record Systems - Objective of inventory management is to maintain an adequate supply of goods while minimizing investment in inventory and other carrying costs.

A. Periodic vs perpetual - Difference is the frequency with which physical flows are assigned a value.

Perpetual system – COGS kept on a day-to-day basis rather than being determined periodically. Inventory account debited as purchases are made.

Periodic – No COGS recorded until the end of the period. Purchases account.

Inventory account remains unchanged during the period.

B. COGS and inventory allocations – Allocate costs between COGS and Ending Inventory.

JIT inventory systems.

C. Effect on net income of errors

D. Income tax effect

IV. Inventory valuation

A. Items to be included in inventory

1. Goods in transit - When does title pass?

FOB shipping point

FOB destination

More than just an accounting question.

Generally, Freight In is considered part of Purchases

Generally, Freight Out is considered a selling expense.

2. Consigned goods

3. Special sale agreements - buyback agreements, high rates of return, installment sales

B. Costs to be included in inventory

1. Product vs period costs = Product costs are those costs that are directly connected with bringing goods to buyer’s place of business and converting to saleable condition.

Note: Selling costs are not part of inventory

2. Variable costing vs absorption costing

Under variable costint only costs that vary directly with production are charged to products. Under absorption costing, which is GAAP, all manufacturing costs are included in the cost of inventory (including factory utilities, depreciation of factory, taxes on factory property, etc.)

3. Purchase discounts

Gross method - Assumer ABC Company purchases merchandise for $100, terms 2/10,n/30.

C. Choice of a Cost Flow Assumption

This problem arises when numerous purchases have been made at different prices and it is necessary to identify which goods remain on hand and which have been sold. Purpose is to allocate COG available between COGS and ending inventory.

ARB 43 - Major objective should be to choose the one which, under the circumstance, most clearly reflects periodic income

FASB - Choose method that is most helpful to users for purpose of predicting future cash flows

Not a physical flow.

1. Illustration

2. Effect on Net income

3. Advantages and disadvantages of each method - Assuming rising prices

  1. LIFO –

Advantages: better matching of current costs against current revenues, tax benefits, improved cash flow, future earnings hedge

Disadvantages: EPS effect, inventory understated, complex and costly, involuntary liquidations,

Note : most companies do not use LIFO for internal purposes.

  1. FIFO –

Advantages: inventory account more closely approximates current costs, EPS effect, contractual arrangements where current ratio must be maintained, compensation plans

Disadvantages: Higher tax bill, does not match current costs with current revenues.

VI Analyzing Inventory

A. Inventory Turnover Ratio = COGS/Average Inventory

B. Gross Profit Margin =