Classifying Inventory

How a company classifies its inventory depends on whether the firm is a merchandiser or a manufacturer. In a merchandising company, such as those described in Chapter 5, inventory consists of many different items. For example, in a grocery store, canned goods, dairy products, meats, and produce are just a few of the inventory items on hand. These items have two common characteristics: (1) they are owned by the company, and (2) they are in a form ready for sale to customers in the ordinary course of business. Thus, merchandisers need only one inventory classification, merchandise inventory, to describe the many different items that make up the total inventory.

In a manufacturing company, some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories: finished goods, work in process, and raw materials. Finished goods inventory is manufactured items that are completed and ready for sale. Work in process is that portion of manufactured inventory that has been placed into the production process but is not yet complete. Raw materials are the basic goods that will be used in production but have not yet been placed into production.

• HELPFUL HINT Regardless of the classification, companies report all inventories under Current Assets on the statement of financial position.

For example, Komatsu (JPN) classifies earthmoving tractors completed and ready for sale as finished goods. It classifies the tractors on the assembly line in various stages of production as work in process. The steel, glass, tires, and other components that are on hand waiting to be used in the production of tractors are identified as raw materials. Illustration 6-1 shows an excerpt from Note 5 of Komatsu’s annual report.

By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management’s production plans. For example, low levels of raw materials and high levels of finished goods suggest that management believes it has enough inventory on hand and production will be slowing down—perhaps in anticipation of a recession. Conversely, high levels of raw materials and low levels of finished goods probably signal that management is planning to step up production.

Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, companies manufacture or purchase goods only when needed for use. Dell (USA) is famous for having developed a system for making computers in response to individual customer requests. Even though it makes each computer to meet each customer’s particular specifications, Dell is able to assemble the computer and put it on a truck in less than 48 hours. The success of the JIT system depends on reliable suppliers. By integrating its information systems with those of its suppliers, Dell reduced its inventories to nearly zero. This is a huge advantage in an industry where products become obsolete nearly overnight.

The accounting concepts discussed in this chapter apply to the inventory classifications of both merchandising and manufacturing companies. Our focus here is on merchandise inventory.

Determining Inventory Quantities

No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory for two reasons:

1. To check the accuracy of their perpetual inventory records.
2. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.

Companies using a periodic inventory system take a physical inventory for two different purposes: to determine the inventory on hand at the statement of financial position date, and to determine the cost of goods sold for the period.

Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.

TAKING A PHYSICAL INVENTORY

Companies take a physical inventory at the end of the accounting period. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. In many companies, taking an inventory is a formidable task. Retailers such as PPR (FRA), Esprit Holdings (HKG), or Kingfisher (GBR) have thousands of different inventory items. An inventory count is generally more accurate when goods are not being sold or received during the counting. Consequently, companies often “take inventory” when the business is closed or when business is slow. Many retailers close early on a chosen day in January—after the holiday sales and returns, when inventories are at their lowest level—to count inventory. For example, Wal-Mart Stores, Inc. (USA) has a year-end of January 31.

DETERMINING OWNERSHIP OF GOODS

One challenge in computing inventory quantities is determining what inventory a company owns. To determine ownership of goods, two questions must be answered: Do all of the goods included in the count belong to the company? Does the company own any goods that were not included in the count?

GOODS IN TRANSIT A complication in determining ownership is goods in transit (on board a truck, train, ship, or plane) at the end of the period. The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. To arrive at an accurate count, the company must determine ownership of these goods.

Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale, as shown in Illustration 6-2 and described below.

1. When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
2. When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.

If goods in transit at the statement date are ignored, inventory quantities may be seriously miscounted. Assume, for example, that Hargrove Company has 20,000 units of inventory on hand on December 31. It also has the following goods in transit:

1. Sales of 1,500 units shipped December 31 FOB destination.
2. Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.

Hargrove has legal title to both the 1,500 units sold and the 2,500 units purchased. If the company ignores the units in transit, it would understate inventory quantities by 4,000 units $\left(\mathrm{1,500}+\mathrm{2,500}\right)$.

As we will see later in the chapter, inaccurate inventory counts affect not only the inventory amount shown on the statement of financial position but also the cost of goods sold calculation on the income statement.

CONSIGNED GOODS In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods.

For example, you might have a used car that you would like to sell. If you take the item to a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is sold. Under this agreement, the dealer would not take ownership of the car, which would still belong to you. Therefore, if an inventory count were taken, the car would not be included in the dealer’s inventory.

Many car, boat, and antique dealers sell goods on consignment to keep their inventory costs down and to avoid the risk of purchasing an item that they will not be able to sell. Today, even some manufacturers are making consignment agreements with their suppliers in order to keep their inventory levels low.

Inventory Costing

Learning Objective 2

Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. For example, freight costs incurred to acquire inventory are added to the cost of inventory, but the cost of shipping goods to a customer are a selling expense.

After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold. This process can be complicated if a company has purchased inventory items at different times and at different prices.

For example, assume that Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of £700, £750, and £800. During the year, Crivitz sold two sets at £1,200 each. These facts are summarized in Illustration 6-3.

Cost of goods sold will differ depending on which two TVs the company sold. For example, it might be $\mathrm{\pounds }\mathrm{1,450}\left(\mathrm{\pounds }700+\mathrm{\pounds }750\right)$, or $\mathrm{\pounds }\mathrm{1,500}\left(\mathrm{\pounds }700+\mathrm{\pounds }800\right)$, or $\mathrm{\pounds }\mathrm{1,550}\left(\mathrm{\pounds }750+\mathrm{\pounds }800\right)$. In this section, we discuss alternative costing methods available to Crivitz.

Specific Identification

If Crivitz can positively identify which particular units it sold and which are still in ending inventory, it can use the specific identification method of inventory costing. For example, if Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $\mathrm{\pounds }\mathrm{1,500}\left(\mathrm{\pounds }700+\mathrm{\pounds }800\right)$, and its ending inventory is £750 (see Illustration 6-4). Using this method, companies can accurately determine ending inventory and cost of goods sold.

Specific identification requires that companies keep records of the original cost of each individual inventory item. Historically, specific identification was possible only when a company sold a limited variety of high-unit-cost items that could be identified clearly from the time of purchase through the time of sale. Examples of such products are cars, pianos, or expensive antiques.

Today, bar coding, electronic product codes, and radio frequency identification make it theoretically possible to do specific identification with nearly any type of product. The reality is, however, that this practice is still relatively rare. Instead, rather than keep track of the cost of each particular item sold, most companies make assumptions, called cost flow assumptions, about which units were sold.

Cost Flow Assumptions

Because specific identification is often impractical, other cost flow methods are permitted. These differ from specific identification in that they assume flows of costs that may be unrelated to the physical flow of goods. There are two assumed cost flow methods:

1. First-in, first-out (FIFO)
2. Average-cost

There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost flow method.

To demonstrate the two cost flow methods, we will use a periodic inventory system. We assume a periodic system for two main reasons. First, many small companies use periodic rather than perpetual systems. Second, very few companies use perpetual FIFO or average-cost to cost their inventory and related cost of goods sold. Instead, companies that use perpetual systems often use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they recalculate cost of goods sold using periodic FIFO or average-cost and adjust cost of goods sold to this recalculated number.¹

To illustrate the two inventory cost flow methods, we will use the data for Lin Electronics’ Astro condensers, shown in Illustration 6-5.

The cost of goods sold formula in a periodic system is:

Lin Electronics had a total of 100 units available to sell during the period (beginning inventory plus purchases). The total cost of these 100 units is HK$12,000, referred to as cost of goods available for sale. A physical inventory taken at December 31 determined that there were 45 units in ending inventory. Therefore, Lin sold 55 units (100 − 45) during the period. To determine the cost of the 55 units that were sold (the cost of goods sold), we assign a cost to the ending inventory and subtract that value from the cost of goods available for sale. The value assigned to the ending inventory will depend on which cost flow method we use. No matter which cost flow assumption we use, though, the sum of cost of goods sold plus the cost of the ending inventory must equal the cost of goods available for sale—in this case, HK$12,000.

FIRST-IN, FIRST-OUT (FIFO)

The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. FIFO often parallels the actual physical flow of merchandise. That is, it generally is good business practice to sell the oldest units first. Under the FIFO method, therefore, the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold. (This does not necessarily mean that the oldest units are sold first, but that the costs of the oldest units are recognized first. In a bin of picture hangers at the hardware store, for example, no one really knows, nor would it matter, which hangers are sold first.) Illustration 6-6 shows the allocation of the cost of goods available for sale at Lin Electronics under FIFO.

• HELPFUL HINT Note the sequencing of the allocation:

1. compute ending inventory, and
2. determine cost of goods sold.

• HELPFUL HINT Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here.

Under FIFO, since it is assumed that the first goods purchased were the first goods sold, ending inventory is based on the prices of the most recent units purchased. That is, under FIFO, companies obtain 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. In this example, Lin Electronics prices the 45 units of ending inventory using the most recent prices. The last purchase was 40 units at HK$130 on November 27. The remaining 5 units are priced using the unit cost of the second most recent purchase, HK$120, on August 24. Next, Lin Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale.

Illustration 6-7 demonstrates that companies also can calculate cost of goods sold by pricing the 55 units sold using the prices of the first 55 units acquired. Note that of the 30 units purchased on August 24, only 25 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 5 of these units were assumed unsold and thus included in ending inventory.

AVERAGE-COST

The average-cost method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. The average-cost method assumes that goods are similar in nature. Illustration 6-8 presents the formula and a sample computation of the weighted-average unit cost.

The company then applies the weighted-average unit cost to the units on hand to determine the cost of the ending inventory. Illustration 6-9 shows the allocation of the cost of goods available for sale at Lin Electronics using average-cost.

We can verify the cost of goods sold under this method by multiplying the units sold times the weighted-average unit cost $(55\times \mathrm{HK\$}120=\mathrm{HK\$}\mathrm{6,600})$. Note that this method does not use the average of the unit costs. That average is $\text{HK}\mathrm{\$}115\left(\text{HK}\mathrm{\$}100+\text{HK}\mathrm{\$}110+\text{HK}\mathrm{\$}120+\text{HK}\mathrm{\$}130=\text{HK}\mathrm{\$}460;\text{HK}\mathrm{\$}460÷4\right)$. The average-cost method instead uses the average weighted by the quantities purchased at each unit cost.²

Financial Statement and Tax Effects of Cost Flow Methods

Learning Objective 3

Explain the financial effects of the inventory cost flow assumptions.

Either of the two cost flow assumptions is acceptable for use. For example, adidas (DEU) and Lenovo (CHN) use the average-cost method, whereas Syngenta Group (CHE) and Nokia (FIN) use FIFO. A recent survey of IFRS companies indicated that approximately 60% of these companies use the average-cost method, with 40% using FIFO. In fact, approximately 23% use both average-cost and FIFO for different parts of their inventory.

The reasons companies adopt different inventory cost flow methods are varied, but they usually involve one of three factors: (1) income statement effects, (2) statement of financial position effects, or (3) tax effects.

INCOME STATEMENT EFFECTS

To understand why companies choose either FIFO or average-cost, let’s examine the effects of these two cost flow assumptions on the financial statements of Lin Electronics. The condensed income statements in Illustration 6-10 (page 288) assume that Lin sold its 55 units for HK$11,500, had operating expenses of HK$2,000, and is subject to an income tax rate of 30%.

Note the cost of goods available for sale (HK$12,000) is the same under both FIFO and average-cost. However, the ending inventories and the costs of goods sold are different. This difference is due to the unit costs that the company allocated to cost of goods sold and to ending inventory. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes. For Lin, a HK$400 difference exists between cost of goods sold using FIFO versus average-cost.

In periods of changing prices, the cost flow assumption can have a significant impact on income and on evaluations based on income, such as the following.

1. In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues.
2. In a period of rising prices (as is the case in the Lin example), FIFO reports a higher net income (HK$2,310) than average-cost (HK$2,030).
3. If prices are falling, the results from the use of FIFO and average-cost are reversed. FIFO will report the lower net income and average-cost the higher.

To management, higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO because it results in higher net income.

STATEMENT OF FINANCIAL POSITION EFFECTS

A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost. For example, for Lin Electronics, 40 of the 45 units in the ending inventory are costed under FIFO at the higher November 27 unit cost of HK$130.

Conversely, a shortcoming of the average-cost method is that in a period of inflation, the costs allocated to ending inventory may be understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior accounting periods.

TAX EFFECTS

We have seen that both inventory on the statement of financial position and net income on the income statement are higher when companies use FIFO in a period of inflation. Yet, some companies use average-cost. Why? The reason is that average-cost results in lower income taxes (because of lower net income) during times of rising prices. For example, at Lin Electronics, income taxes are HK$870 under average-cost, compared to HK$990 under FIFO. The tax savings of HK$120 makes more cash available for use in the business.

Using Inventory Cost Flow Methods Consistently

Whatever cost flow method a company chooses, it should use that method consistently from one accounting period to another. This approach is often referred to as the consistency concept, which means that a company uses the same accounting principles and methods from year to year. Consistent application enhances the comparability of financial statements over successive time periods. In contrast, using the FIFO method one year and the average-cost method the next year would make it difficult to compare the net incomes of the two years.

Although consistent application is preferred, it does not mean that a company may never change its inventory costing method. When a company adopts a different method, it should disclose in the financial statements the change and its effects on net income.

Lower-of-Cost-or-Net Realizable Value

Learning Objective 4

Explain the lower-of-cost-or-net realizable value basis of accounting for inventories.

The value of inventory for companies selling high-technology or fashion goods can drop very quickly due to continual changes in technology or styles. These circumstances sometimes call for inventory valuation methods other than those presented so far. For example, assume that purchasing managers at Mulroy Company decided to make a large purchase of palladium, a precious metal used in vehicle emission devices. They made this purchase because they feared a future shortage. The shortage did not materialize, and by the end of the year the price of palladium had plummeted. Mulroy’s inventory was then worth $1 billion less than its original cost. Do you think Mulroy’s inventory should have been stated at cost, in accordance with the historical cost principle, or at its net realizable value?

As you probably reasoned, this situation requires a departure from the cost basis of accounting. When the value of inventory is lower than its cost, companies must “write down” the inventory to its net realizable value. This is done by valuing the inventory at the lower-of-cost-or-net realizable value (LCNRV) in the period in which the price decline occurs. LCNRV is an example of the accounting concept of prudence, which means that the best choice among accounting alternatives is the method that is least likely to overstate assets and net income.

Under the LCNRV basis, net realizable value refers to the net amount that a company expects to realize (receive) from the sale of inventory. Specifically, net realizable value is the estimated selling price in the normal course of business, less estimated costs to complete and sell.

Companies apply LCNRV to the items in inventory after they have used one of the inventory costing methods (specific identification, FIFO, or average-cost) to determine cost. To illustrate the application of LCNRV, assume that Gāo TV has the following lines of merchandise with costs and net realizable values as indicated. LCNRV produces the results shown in Illustration 6-11. Note that the amounts shown in the final column are the lower-of-cost-or-net realizable value amounts for each item.

Inventory Errors

Learning Objective 5

Indicate the effects of inventory errors on the financial statements.

Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by failure to count or price the inventory correctly. In other cases, errors occur because companies do not properly recognize the transfer of legal title to goods that are in transit. When errors occur, they affect both the income statement and the statement of financial position.

Income Statement Effects

The ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold and net income in two periods.

The effects on cost of goods sold can be computed by first entering incorrect data in the formula in Illustration 6-12 and then substituting the correct data.

If the error understates beginning inventory, cost of goods sold will be understated. If the error understates ending inventory, cost of goods sold will be overstated. Illustration 6-13 shows the effects of inventory errors on the current year’s income statement.

So far, the effects of inventory errors are fairly straightforward. Now, though, comes the (at first) surprising part: An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period. Illustration 6-14 shows this effect. As you study the illustration, you will see that the reverse effect comes from the fact that understating ending inventory in 2016 results in understating beginning inventory in 2017 and overstating net income in 2017.

Over the two years, though, total net income is correct because the errors offset each other. Notice that total income using incorrect data is $\mathrm{€}\mathrm{35,000}\left(\mathrm{€}\mathrm{22,000}+\mathrm{€}\mathrm{13,000}\right)$, which is the same as the total income of $\mathrm{€}\mathrm{35,000}\left(\mathrm{€}\mathrm{25,000}+\mathrm{€}\mathrm{10,000}\right)$ using correct data. Also note in this example that an error in the beginning inventory does not result in a corresponding error in the ending inventory for that period. The correctness of the ending inventory depends entirely on the accuracy of taking and costing the inventory at the statement of financial position date under the periodic inventory system.

Statement of Financial Position Effects

Companies can determine the effect of ending inventory errors on the statement of financial position by using the basic accounting equation: $\text{Assets}=\text{Liabilities}+\text{Equity}$. Errors in the ending inventory have the effects shown in Illustration 6-15.

The effect of an error in ending inventory on the subsequent period was shown in Illustration 6-14. Recall that if the error is not corrected, the combined total net income for the two periods would be correct. Thus, total equity reported on the statement of financial position at the end of 2017 will also be correct.

Statement Presentation and Analysis

Learning Objective 6

Discuss the presentation and analysis of inventory.

Presentation

As indicated in Chapter 5, inventory is classified in the statement of financial position as a current asset. In an income statement, cost of goods sold is subtracted from sales. There also should be disclosure of (1) the major inventory classifications, (2) the basis of accounting (cost, or lower-of-cost-or-net realizable value), and (3) the cost method (specific identification, FIFO, or average-cost).

Esprit Holdings (HKG), for example, in a recent statement of financial position reported inventories of HK$3,254 million under current assets. The accompanying notes to the financial statements, as shown in Illustration 6-16, disclosed the following information.

As indicated in this note, Esprit Holdings values its inventories at the lower-of-cost-or-net realizable value using average-cost.

1. “The key to successful business operations is effective inventory management.” Do you agree? Explain.

2. An item must possess two characteristics to be classified as inventory by a merchandiser. What are these two characteristics?

3. Your friend Art Mega has been hired to help take the physical inventory in Jaegar Hardware Store. Explain to Art Mega what this job will entail.

4. 1. Girard Company ships merchandise to Liu Company on December 30. The merchandise reaches the buyer on January 6. Indicate the terms of sale that will result in the goods being included in (1) Girard’s December 31 inventory, and (2) Liu’s December 31 inventory.

   2. Under what circumstances should Girard Company include consigned goods in its inventory?

5. Topp Hat Shop received a shipment of hats for which it paid the wholesaler £2,970. The price of the hats was £3,000, but Topp was given a £30 cash discount and required to pay freight charges of £80. In addition, Topp paid £130 to cover the travel expenses of an employee who negotiated the purchase of the hats. What amount will Topp record for inventory? Why?

6. Explain the difference between the terms FOB shipping point and FOB destination.

7. Min-jun believes that the allocation of inventoriable costs should be based on the actual physical flow of the goods. Explain to Min-jun why this may be both impractical and inappropriate.

8. What is a major advantage and a major disadvantage of the specific identification method of inventory costing?

9. “The selection of an inventory cost flow method is a decision made by accountants.” Do you agree? Explain. Once a method has been selected, what accounting requirement applies?

10. Which assumed inventory cost flow method:

    1. usually parallels the actual physical flow of merchandise?

    2. assumes that goods available for sale during an accounting period are identical?

    3. assumes that the first units purchased are the first to be sold?

11. Beatriz Diaz is studying for the next accounting mid-term examination. What should Beatriz know about (a) departing from the cost basis of accounting for inventories and (b) the meaning of “net realizable value” in the lower-of-cost-or-net realizable value method?

12. Beethovan Music Center has 5 televisions on hand at the statement of financial position date. Each cost €100. The net realizable value is €90 per unit. Under the lower-of-cost-or-net realizable value basis of accounting for inventories, what value should be reported for the televisions on the statement of financial position? Why?

13. Maggie Stores has 20 toasters on hand at the statement of financial position date. Each cost £28. The net realizable value is £30 per unit. Under the lower-of-cost-or-net realizable value basis of accounting for inventories, what value should Maggie report for the toasters on the statement of financial position? Why?

14. Bakkar Company discovers in 2017 that its ending inventory at December 31, 2016, was €7,600 understated. What effect will this error have on (a) 2016 net income, (b) 2017 net income, and (c) the combined net income for the 2 years?

15. Xu Company’s statement of financial position shows Inventory HK$1,628,000. What additional disclosures should be made?

16. Under what circumstances might inventory turnover be too high? That is, what possible negative consequences might occur?

17.  

    How does the average-cost method of inventory costing differ between a perpetual inventory system and a periodic inventory system?

18.  

    When is it necessary to estimate inventories?

19.  

    Both the gross profit method and the retail inventory method are based on averages. For each method, indicate the average used, how it is determined, and how it is applied.

20.  

    Szabo Company has net sales of €400,000 and cost of goods available for sale of €300,000. If the gross profit rate is 40%, what is the estimated cost of the ending inventory? Show computations.

21.  

    Park Shoe Shop, Ltd. had goods available for sale in 2017 with a retail price of £120,000. The cost of these goods was £84,000. If sales during the period were £90,000, what is the estimated cost of ending inventory using the retail inventory method?

22.  

    In a period of rising prices, the inventory reported in Kanth Company’s statement of financial position is close to the current cost of the inventory. Phelan Company’s inventory is considerably below its current cost. Identify the inventory cost flow method being used by each company. Which company has probably been reporting the higher gross profit?

23.  

    “When perpetual inventory records are kept, the results under the FIFO and LIFO methods are the same as they would be in a periodic inventory system.” Do you agree? Explain.

24.  

    Why might the use of the LIFO method for costing inventories result in lower income taxes?

BRIEF EXERCISES

Identify items to be included in taking a physical inventory.

(LO 1)

BE6-1 Lazio Company, SpA identifies the following items for possible inclusion in the taking of a physical inventory. Indicate whether each item should be included or excluded from the inventory taking.

1. Goods shipped on consignment by Lazio to another company.
2. Goods in transit from a supplier shipped FOB destination.
3. Goods sold but being held for customer pickup.
4. Goods held on consignment from another company.

Determine ending inventory amount.

(LO 1)

BE6-2 Stallman Company took a physical inventory on December 31 and determined that goods costing €200,000 were on hand. Not included in the physical count were €25,000 of goods purchased from Pelzer Corporation, FOB shipping point, and €22,000 of goods sold to Alvarez Company for €30,000, FOB destination. Both the Pelzer purchase and the Alvarez sale were in transit at year-end. What amount should Stallman report as its December 31 inventory?

Compute ending inventory using FIFO and average-cost.

(LO 2)

BE6-3 In its first month of operations, Tatung Company made three purchases of merchandise in the following sequence: (1) 300 units at NT$180, (2) 400 units at NT$210, and (3) 200 units at NT$240. Assuming there are 420 units on hand, compute the cost of the ending inventory under the (a) FIFO method and (b) average-cost method. Tatung uses a periodic inventory system. (Round average unit cost to two decimal places.)

Explain the financial statement effect of inventory cost flow assumptions.

(LO 3)

BE6-4 The management of Muni Corp. is considering the effects of inventory-costing methods on its financial statements and its income tax expense. Assuming that the price the company pays for inventory is increasing, which method will:

1. Provide the higher net income?
2. Provide the higher ending inventory?
3. Result in the lower income tax expense?
4. Result in the more stable earnings over a number of years?

Determine the LCNRV valuation using inventory categories.

(LO 4)

BE6-5 Blackburn Appliance Center accumulates the following cost and net realizable value data at December 31.

Compute the lower-of-cost-or-net realizable value valuation for the company’s total inventory.

Determine correct income statement amounts.

(LO 5)

BE6-6 Zammit Company reports net income of €90,000 in 2017. However, ending inventory was understated €5,000. What is the correct net income for 2017? What effect, if any, will this error have on total assets as reported in the statement of financial position at December 31, 2017?

Compute inventory turnover and days in inventory.

(LO 6)

BE6-7 At December 31, 2017, the following information was available for Tai Lin Company: ending inventory HK$400,000, beginning inventory HK$580,000, cost of goods sold HK$2,842,000, and sales revenue HK$3,800,000. Calculate inventory turnover and days in inventory for Tai Lin Company, Ltd.

Apply cost flow methods to perpetual inventory records.

(LO 7)

*BE6-8 Abbott’s Department Store, Ltd. uses a perpetual inventory system. Data for product E2-D2 include the following purchases.

On June 1, Abbott’s sold 30 units, and on August 27, 35 more units. Prepare the perpetual inventory schedule for the above transactions using (a) FIFO and (b) moving-average cost.

Apply the gross profit method.

(LO 8)

*BE6-9 At May 31, Chang Company has net sales of ¥330,000 and cost of goods available for sale of ¥230,000. Compute the estimated cost of the ending inventory, assuming the gross profit rate is 45%.

Apply the retail inventory method.

(LO 8)

*BE6-10 On June 30, Lyon Fabrics, SA has the following data pertaining to the retail inventory method: goods available for sale: at cost €35,000 and at retail €50,000, net sales €42,000, and ending inventory at retail €8,000. Compute the estimated cost of the ending inventory using the retail inventory method.

Compute the ending inventory using LIFO (periodic).

(LO 9)

*BE6-11 Data for Tatung Company are presented in BE6-3. Compute the cost of the ending inventory under the LIFO method, assuming there are 420 units on hand.

EXERCISES

Determine the correct inventory amount.

(LO 1)

E6-1 Premier Bank and Trust is considering giving Alou Company a loan. Before doing so, management decides that further discussions with Alou’s accountant may be desirable. One area of particular concern is the inventory account, which has a year-end balance of £297,000. Discussions with the accountant reveal the following.

1. Alou sold goods costing £38,000 to Comerico Company, FOB shipping point, on December 28. The goods are not expected to arrive at Comerico until January 12. The goods were not included in the physical inventory because they were not in the warehouse.
2. The physical count of the inventory did not include goods costing £91,000 that were shipped to Alou FOB destination on December 27 and were still in transit at year-end.
3. Alou received goods costing £25,000 on January 2. The goods were shipped FOB shipping point on December 26 by Grant Co. The goods were not included in the physical count.
4. Alou sold goods costing £35,000 to Emerick Co., FOB destination, on December 30. The goods were received at Emerick on January 8. They were not included in Alou’s physical inventory.
5. Alou received goods costing £44,000 on January 2 that were shipped FOB shipping point on December 29. The shipment was a rush order that was supposed to arrive December 31. This purchase was included in the ending inventory of £297,000.

Instructions

Determine the correct inventory amount on December 31.

Determine the correct inventory amount.

(LO 1)

E6-2 Kale Wilson, an auditor with Sneed Chartered Accountants, is performing a review of Platinum Company’s inventory account. Platinum did not have a good year, and top management is under pressure to boost reported income. According to its records, the inventory balance at year-end was £740,000. However, the following information was not considered when determining that amount.

1. Included in the company’s count were goods with a cost of £250,000 that the company is holding on consignment. The goods belong to Superior, Ltd.
2. The physical count did not include goods purchased by Platinum with a cost of £40,000 that were shipped FOB destination on December 28 and did not arrive at Platinum’s warehouse until January 3.
3. Included in the inventory account was £17,000 of office supplies that were stored in the warehouse and were to be used by the company’s supervisors and managers during the coming year.
4. The company received an order on December 29 that was boxed and sitting on the loading dock awaiting pick-up on December 31. The shipper picked up the goods on January 1 and delivered them on January 6. The shipping terms were FOB shipping point. The goods had a selling price of £49,000 and a cost of £33,000. The goods were not included in the count because they were sitting on the dock.
5. Included in the count was £48,000 of goods that were parts for a machine that the company no longer made. Given the high-tech nature of Platinum’s products, it was unlikely that these obsolete parts had any other use. However, management would prefer to keep them on the books at cost, “since that is what we paid for them, after all.”

Instructions

Prepare a schedule to determine the correct inventory amount. Provide explanations for each item above, saying why you did or did not make an adjustment for each item.

Calculate cost of goods sold using specific identification and FIFO.

(LO 2, 3)

E6-3 On December 1, Discount Electronics Ltd. has three DVD players left in stock. All are identical, all are priced to sell at NT$4,500. One of the three DVD players left in stock, with serial #1012, was purchased on June 1 at a cost of NT$3,000. Another, with serial #1045, was purchased on November 1 for NT$2,760. The last player, serial #1056, was purchased on November 30 for NT$2,520.

Instructions

1. Calculate the cost of goods sold using the FIFO periodic inventory method assuming that two of the three players were sold by the end of December, Discount Electronics’ year-end.
2. If Discount Electronics used the specific identification method instead of the FIFO method, how might it alter its earnings by “selectively choosing” which particular players to sell to the two customers? What would Discount’s cost of goods sold be if the company wished to minimize earnings? Maximize earnings?
3. Which of the two inventory methods do you recommend that Discount use? Explain why.

Compute inventory and cost of goods sold using FIFO and average-cost.

(LO 2)

E6-4 Zhu Boards sells a snowboard, Xpert, that is popular with snowboard enthusiasts. Information relating to Zhu’s purchases of Xpert snowboards during September is shown on the next page. During the same month, 121 Xpert snowboards were sold. Zhu’s uses a periodic inventory system.

Instructions

1. Compute the ending inventory at September 30 and cost of goods sold using the FIFO and average-cost methods. Prove the amount allocated to cost of goods sold under each method.
2. For both FIFO and average-cost, calculate the sum of ending inventory and cost of goods sold. What do you notice about the answers you found for each method?

Compute inventory and cost of goods sold using FIFO and average-cost.

(LO 2)

E6-5 Zambian Co. uses a periodic inventory system. Its records show the following for the month of May, in which 68 units were sold.

Instructions

Compute the ending inventory at May 31 and cost of goods sold using the FIFO and average-cost methods. Prove the amount allocated to cost of goods sold under each method.

Compute inventory and cost of goods sold using FIFO and average-cost.

(LO 2, 3)

E6-6 Howsham Company, Ltd. reports the following for the month of June.

Instructions

1. Compute the cost of the ending inventory and the cost of goods sold under (1) FIFO and (2) average-cost.
2. Which costing method gives the higher ending inventory? Why?
3. Which method results in the higher cost of goods sold? Why?

Compute inventory under FIFO and average-cost.

(LO 2, 3)

E6-7 Thaam Company Ltd. had 100 units in beginning inventory at a total cost of NT$300,000. The company purchased 200 units at a total cost of NT$680,000. At the end of the year, Thaam had 75 units in ending inventory.

Instructions

1. Compute the cost of the ending inventory and the cost of goods sold under (1) FIFO and (2) average-cost.
2. Which cost flow method would result in the higher net income?
3. Which cost flow method would result in inventories approximating current cost in the statement of financial position?
4. Which cost flow method would result in Thaam paying fewer taxes in the first year?

Determine ending inventory under LCNRV.

(LO 4)

E6-8 Kinshasa Camera Shop uses the lower-of-cost-or-net realizable value basis for its inventory. The following data are available at December 31.

Item	Units	Unit Cost	Net Realizable Value
Cameras:
Minolta	8	170,000	156,000
Canon	6	150,000	152,000
Light meters:
Vivitar	12	125,000	115,000
Kodak	14	115,000	135,000

Instructions

Determine the amount of the ending inventory by applying the lower-of-cost-or-net realizable value basis.

Compute lower-of-cost-or-net realizable value.

(LO 4)

E6-9 Banovic Company OAO applied FIFO to its inventory and got the following results for its ending inventory.

The net realizable value per unit at year-end was tennis shoes €70, running shoes €71, and basketball shoes €74.

Instructions

Determine the amount of ending inventory at lower-of-cost-or-net realizable value.

Determine effects of inventory errors.

(LO 5)

E6-10 Bamburgh Hardware reported cost of goods sold as follows.

Bamburgh made two errors: (1) 2016 ending inventory was overstated €2,000, and (2) 2017 ending inventory was understated €6,000.

Instructions

Compute the correct cost of goods sold for each year.

Prepare correct income statements.

(LO 5)

E6-11 Wu Watch Company, Ltd. reported the following income statement data for a 2-year period.

Wu uses a periodic inventory system. The inventories at January 1, 2016, and December 31, 2017, are correct. However, the ending inventory at December 31, 2016, was understated HK$60,000.

Instructions

1. Prepare correct income statement data for the 2 years.
2. What is the cumulative effect of the inventory error on total gross profit for the 2 years?
3. Explain in a letter to the president of Wu Watch Company, Ltd. what has happened, i.e., the nature of the error and its effect on the financial statements.

Compute inventory turnover, days in inventory, and gross profit rate.

(LO 6)

E6-12 This information is available for Sepia Photo Ltd. for 2015, 2016, and 2017.

Instructions

Calculate inventory turnover, days in inventory, and gross profit rate (from Chapter 5) for Sepia Photo for 2015, 2016, and 2017. Comment on any trends.

Compute inventory turnover and days in inventory.

(LO 6)

E6-13 The cost of goods sold computations for Gouda Company NV and Edam Company NV are shown below.

Instructions

1. Compute inventory turnover and days in inventory for each company.
2. Which company moves its inventory more quickly?

Apply cost flow methods to perpetual records.

(LO 7)

*E6-14 Roselle Appliance SA uses a perpetual inventory system. For its flat-screen television sets, the January 1 inventory was 3 sets at €600 each. On January 10, Roselle purchased 6 units at €648 each. The company sold 2 units on January 8 and 4 units on January 15.

Instructions

Compute the ending inventory under (1) FIFO and (2) moving-average cost. (Round the unit cost to the nearest cent.)

Calculate inventory and cost of goods sold using two cost flow methods in a perpetual inventory system.

(LO 7)

*E6-15 Howsham Company, Ltd. reports the following for the month of June.

Instructions

1. Calculate the cost of the ending inventory and the cost of goods sold for (1) FIFO and (2) moving-average cost, using a perpetual inventory system. Assume a sale of 400 units occurred on June 15 for a selling price of £8 and a sale of 440 units on June 27 for £9.
2. How do the results differ from E6-6?
3. Why is the average unit cost not $\mathrm{\pounds }6\left[\left(\mathrm{\pounds }5+\mathrm{\pounds }6+\mathrm{\pounds }7\right)÷3=\mathrm{\pounds }6\right]$?

Apply cost flow methods to perpetual records.

(LO 7)

*E6-16 Information about Zhu Boards is presented in E6-4. Additional data regarding Zhu’s sales of Xpert snowboards are provided below. Assume that Zhu uses a perpetual inventory system.

Instructions

1. Compute ending inventory at September 30 using FIFO and moving-average cost.
2. Compare ending inventory using a perpetual inventory system to ending inventory using a periodic inventory system (from E6-4).
3. Which inventory cost flow method (FIFO, moving-average cost) gives the same ending inventory value under both periodic and perpetual? Which method gives different ending inventory values?

Use the gross profit method to estimate inventory.

(LO 8)

*E6-17 Punjab Company, Ltd. reported the following information for November and December 2017.

Punjab’s ending inventory at December 31 was destroyed in a fire.

Instructions

1. Compute the gross profit rate for November.
2. Using the gross profit rate for November, determine the estimated cost of inventory lost in the fire.

Determine merchandise lost using the gross profit method of estimating inventory.

(LO 8)

*E6-18 The inventory of Ipswich Company Ltd. was destroyed by fire on March 1. From an examination of the accounting records, the following data for the first 2 months of the year are obtained: Sales Revenue £51,000, Sales Returns and Allowances £1,000, Purchases £31,200, Freight-In £1,200, and Purchase Returns and Allowances £1,800.

Instructions

Determine the merchandise lost by fire, assuming:

1. A beginning inventory of £20,000 and a gross profit rate of 40% on net sales.
2. A beginning inventory of £30,000 and a gross profit rate of 32% on net sales.

Determine ending inventory at cost using retail method.

(LO 8)

*E6-19 Zapatos, SLU uses the retail inventory method for its two departments, Women’s Shoes and Men’s Shoes. The following information for each department is obtained.

Instructions

Compute the estimated cost of the ending inventory for each department under the retail inventory method.

Apply the LIFO cost method (periodic).

(LO 9)

*E6-20 Using the data in E6-6, compute the cost of the ending inventory and the cost of goods sold using LIFO periodic.

Apply the LIFO cost method (periodic).

(LO 9)

*E6-21 (a) Using the data in E6-7, compute the cost of the ending inventory and cost of goods sold using LIFO periodic. In addition, answer instructions (b), (c), and (d) from E6-7 as it relates to the three cost flow methods.

PROBLEMS: SET A

COMPREHENSIVE PROBLEM

CP6 On December 1, 2017, Cambridge Company, Ltd. had the account balances shown below.

The following transactions occurred during December.

Adjustment data:

1. Accrued salaries payable £400.
2. Depreciation £200 per month.

Instructions

1. Journalize the December transactions and adjusting entries, assuming Cambridge uses the perpetual inventory method.
2. Enter the December 1 balances in the ledger T-accounts and post the December transactions. In addition to the accounts mentioned above, use the following additional accounts: Cost of Goods Sold, Depreciation Expense, Salaries and Wages Expense, Salaries and Wages Payable, Sales Revenue, and Sales Returns and Allowances.
3. Prepare an adjusted trial balance as of December 31, 2017.
4. Prepare an income statement for December 2017 and a classified statement of financial position at December 31, 2017.
5. Compute ending inventory and cost of goods sold under FIFO, assuming Cambridge Company uses the periodic inventory system.
6. Compute ending inventory and cost of goods sold under average-cost, assuming Cambridge Company uses the periodic inventory system.

MATCHA CREATIONS

BROADENING YOUR PERSPECTIVE

Financial Reporting and Analysis

Financial Reporting Problem: TSMC, Ltd. (TWN)

BYP6-1 The notes that accompany a company’s financial statements provide informative details that would clutter the amounts and descriptions presented in the statements. Refer to the financial statements of TSMC in Appendix A and the 2013 annual report’s Notes to the Consolidated Financial Statements, available in the Investors section of the company’s website, www.tsmc.com.

Instructions

Answer the following questions. Complete the requirements in millions of new Taiwan dollars, as shown in TSMC’s annual report.

1. What did TSMC report for the amount of inventories in its consolidated statement of financial position at December 31, 2013? At December 31, 2012?
2. Compute the new Taiwan dollar amount of change and the percentage change in inventories between 2012 and 2013. Compute inventory as a percentage of current assets at December 31, 2013.
3. How does TSMC value its inventories? Which inventory cost flow method does TSMC use? (See Notes to the Consolidated Financial Statements.)
4. What is the cost of sales (cost of goods sold) reported by TSMC for 2013 and 2012? Compute the percentage of cost of sales to net sales in 2013.

Comparative Analysis Problem: Nestlé SA (CHE) vs. Petra Foods Ltd. (SGP)

BYP6-2 Nestlé’s financial statements are presented in Appendix B. Financial statements of Petra Foods are presented in Appendix C.

Instructions

1. Based on the information contained in these financial statements, compute the following ratios for each company for the most recent year shown.
   1. Inventory turnover. (Round to one decimal.)
   2. Days in inventory. (Round to nearest day.)
2. What conclusions concerning the management of the inventory can you draw from these data?

Real-World Focus

BYP6-3 A company’s annual report usually will identify the inventory method used. Knowing that, you can analyze the effects of the inventory method on the income statement and statement of financial position.

Address: www.cisco.com, or go to www.wiley.com/college/weygandt

Instructions

Answer the following questions based on the current year’s annual report on Cisco’s (USA) website.

1. At Cisco’s fiscal year-end, what was the inventory on the balance sheet (statement of financial position)?
2. How has this changed from the previous fiscal year-end?
3. How much of the inventory was finished goods?
4. What inventory method does Cisco use?

Critical Thinking

Decision-Making Across the Organization

BYP6-4 On April 10, 2017, fire damaged the office and warehouse of Ehlert Company, Ltd. Most of the accounting records were destroyed, but the following account balances were determined as of March 31, 2017: Inventory (January 1, 2017), £80,000; Sales Revenue (January 1–March 31, 2017), £180,000; Purchases (January 1–March 31, 2017), £94,000.

The company’s fiscal year ends on December 31. It uses a periodic inventory system.

From an analysis of the April bank statement, you discover cancelled checks of £4,200 for cash purchases during the period April 1–10. Deposits during the same period totaled £20,500. Of that amount, 60% were collections on accounts receivable, and the balance was cash sales.

Correspondence with the company’s principal suppliers revealed £12,400 of purchases on account from April 1 to April 10. Of that amount, £1,900 was for merchandise in transit on April 10 that was shipped FOB destination.

Correspondence with the company’s principal customers produced acknowledgments of credit sales totaling £37,000 from April 1 to April 10. It was estimated that £5,600 of credit sales will never be acknowledged or recovered from customers.

Ehlert Company reached an agreement with the insurance company that its fire-loss claim should be based on the average of the gross profit rates for the preceding 2 years. The financial statements for 2015 and 2016 showed the following data.

Inventory with a cost of £17,000 was salvaged from the fire.

Instructions

With the class divided into groups, answer the following.

1.  Determine the balances in (1) Sales Revenue and (2) Purchases at April 10.
2.    Determine the average gross profit rate for the years 2015 and 2016. (Hint: Find the gross profit rate for each year and divide the sum by 2.)
3.    Determine the inventory loss as a result of the fire, using the gross profit method.

Communication Activity

BYP6-5 You are the controller of Classic Toys Ltd. Kathy McDonnell, the president, recently mentioned to you that she found an error in the 2016 financial statements, which she believes has corrected itself. She determined, in discussions with the Purchasing Department, that 2016 ending inventory was overstated by €1 million. Kathy says that the 2017 ending inventory is correct. Thus, she assumes that 2017 income is correct. Kathy says to you, “What happened has happened—there’s no point in worrying about it anymore.”

Instructions

You conclude that Kathy is incorrect. Write a brief, tactful memo to Kathy, clarifying the situation.

Answers to Insight and Accounting Across the Organization Questions

p. 279 A Big Hiccup Q: What steps might the companies take to avoid such a serious disruption in the future? A: The manufacturer of the piston rings should spread its manufacturing facilities across a few locations that are far enough apart that they would not all be at risk at once. In addition, the automakers might consider becoming less dependent on a single supplier.

p. 280 Falsifying Inventory to Boost Income Q: What effect does an overstatement of inventory have on a company’s financial statements? A: The statement of financial position looks stronger because inventory and retained earnings are overstated. The income statement looks better because cost of goods sold is understated and income is overstated.

p. 289 Is LIFO Fair? Q: What are the arguments for and against the use of LIFO? A: Proponents of LIFO argue that it is conceptually superior because it matches the most recent cost with the most recent selling price. Critics contend that it artificially understates the company’s net income and consequently reduces tax payments. Also, because mostly only U.S. companies are allowed to use LIFO, its use reduces the ability of investors to compare U.S. companies with non-U.S. companies.

p. 293 Improving Inventory Control with RFID Q: Why is inventory control important to managers at retailers, such as those at Carrefour (FRA) and Metro (DEU)? A: In the very competitive environment of retailing, where Carrefour and Metro are major players, small differences in price matter to the customer. These companies sell a high volume of inventory at a low gross profit rate. When operating in a high-volume, low-margin environment, small cost savings can mean the difference between being profitable or going out of business.

Key Points

• The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.
• IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.

Similarities

• The definitions for inventory are essentially similar under GAAP and IFRS. Both define inventory as assets held-for-sale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).
• Who owns the goods—goods in transit or consigned goods—as well as the costs to include in inventory, are accounted for the same under GAAP and IFRS.

Differences

• Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used.
• A major difference between GAAP and IFRS relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS.
• When testing to see if the value of inventory has fallen below its cost, IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs to complete and sell. In other words, net realizable value is the best estimate of the net amounts that inventories are expected to realize. GAAP, on the other hand, defines market as essentially replacement cost. The GAAP method of inventory valuation is often referred to as the lower-of-cost-or-market (LCM).
• Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement.
• An example of the use of lower-of-cost-or-market under GAAP follows.
• IFRS generally requires pre-harvest inventories of agricultural products (e.g., growing crops and farm animals) to be reported at fair value less cost of disposal. GAAP generally requires these items to be recorded at cost.