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.

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.

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. On the other hand, 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 just in time 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 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 6-1 and described below.

Illustration 6-1 Terms of sale

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 (1,500 + 2,500).

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

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 6-2.

Illustration 6-2 Data for inventory costing example

Cost of goods sold will differ depending on which two TVs the company sold. For example, it might be £1,450 (£700 + £750), or £1,500 (£700 + £800), or £1,550 (£750 + £800). 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 £1,500 (£700 + £800), and its ending inventory is £750 (see Illustration 6-3). Using this method, companies can accurately determine ending inventory and cost of goods sold.

Illustration 6-3 Specific identification method

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. Unfortunately, for most companies, the specific identification method is still not practical. 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 6-4.

Illustration 6-4 Data for Lin Electronics

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 6-5 shows the allocation of the cost of goods available for sale at Lin Electronics under FIFO.

Illustration 6-5 Allocation of costs—FIFO method

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 6-6 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.

Illustration 6-6 Proof of cost of goods sold

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 6-7 presents the formula and a sample computation of the weighted-average unit cost.

Illustration 6-7 Formula for 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 6-8 shows the allocation of the cost of goods available for sale at Lin Electronics using average-cost.

Illustration 6-8 Allocation of costs—average-cost method

We can verify the cost of goods sold under this method by multiplying the units sold times the weighted-average unit cost (55 × HK$120 = HK$6,600). Note that this method does not use the average of the unit costs. That average is HK$115 (HK$100 + HK$110 + HK$120 + HK$130 = HK$460; HK$460 ÷ 4). 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

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 6-9 (page 274) 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.

Illustration 6-9 Comparative effects of cost flow methods

In periods of changing prices, the cost flow assumption can have a significant impact on income and on evaluations based on income. In most instances, prices are rising (inflation). 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. 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). 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 concept of consistency, 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

The value of inventory for companies selling high-technology or fashion goods can drop very quickly due to changes in technology or fashion. 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 6-10. Note that the amounts shown in the final column are the lower-of-cost-or-net realizable value amounts for each item.

Illustration 6-10 Computation of lower-of-cost-or-net realizable value

Inventory Errors

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

Under a periodic inventory system, both the beginning and ending inventories appear in the income statement. 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 entering incorrect data in the formula in Illustration 6-11 and then substituting the correct data.

Illustration 6-11 Formula for cost of goods sold

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 6-12 shows the effects of inventory errors on the current year's income statement.

Illustration 6-12 Effects of inventory errors on 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 6-13 shows this effect. As you study the illustration, you will see that the reverse effect comes from the fact that understating ending inventory in 2013 results in understating beginning inventory in 2014 and overstating net income in 2014.

Over the two years, though, total net income is correct because the errors offset each other. Notice that total income using incorrect data is €35,000 (€22,000 + €13,000), which is the same as the total income of €35,000 (€25,000 + €10,000) 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.

Illustration 6-13 Effects of inventory errors on two years' income statements

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: Assets = Liabilities + Equity. Errors in the ending inventory have the effects shown in Illustration 6-14.

Illustration 6-14 Effects of ending inventory errors on the statement of financial position

The effect of an error in ending inventory on the subsequent period was shown in Illustration 6-13. 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 2014 will also be correct.

Statement Presentation and Analysis

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$2,997 million under current assets. The accompanying notes to the financial statements, as shown in Illustration 6-15, disclosed the following information.

Illustration 6-15 Inventory disclosures by Esprit Holdings

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

Analysis

The amount of inventory carried by a company has significant economic consequences. And inventory management is a double-edged sword that requires constant attention. On the one hand, management wants to have a great variety and quantity on hand so that customers have a wide selection and items are always in stock. But, such a policy may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). On the other hand, low inventory levels lead to stock-outs and lost sales. Common ratios used to manage and evaluate inventory levels are inventory turnover and a related measure, days in inventory.

Inventory turnover measures the number of times on average the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. The inventory turnover is computed by dividing cost of goods sold by the average inventory during the period. Unless seasonal factors are significant, average inventory can be computed from the beginning and ending inventory balances. For example, Esprit Holdings (HKG) reported in a recent annual report a beginning inventory of HK$3,170 million, an ending inventory of HK$2,997 million, and cost of goods sold for the year ended of HK$16,523 million. The inventory turnover formula and computation for Esprit Holdings are shown below.

Illustration 6-16 Inventory turnover formula and computation for Esprit Holdings

A variant of the inventory turnover ratio is days in inventory. This measures the average number of days inventory is held. It is calculated as 365 divided by the inventory turnover ratio. For example, Esprit Holdings' inventory turnover of 5.4 times divided into 365 is approximately 68 days. This is the approximate time that it takes a company to sell the inventory once it arrives at the store.

There are typical levels of inventory in every industry. Companies that are able to keep their inventory at lower levels and higher turnovers and still satisfy customer needs are the most successful.

SUMMARY OF LEARNING OBJECTIVES

1 Describe the steps in determining inventory quantities. The steps are (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.

2 Explain the accounting for inventories and apply the inventory cost flow methods. The primary basis of accounting for inventories is cost. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory costing methods are specific identification and two assumed cost flow methods—FIFO and average-cost.

3 Explain the financial effects of the inventory cost flow assumptions. Companies may allocate the cost of goods available for sale to cost of goods sold and ending inventory by specific identification or by a method based on an assumed cost flow. When prices are rising, the first-in, first-out (FIFO) method results in lower cost of goods sold and higher net income than average-cost. The reverse is true when prices are falling. In the statement of financial position, FIFO results in an ending inventory that is closer to current value; inventory under average-cost is further from current value. Average-cost results in lower income taxes.

4 Explain the lower-of-cost-or-net realizable value basis of accounting for inventories. Companies use the lower-of-cost-or-net realizable value (LCNRV) basis when the net realizable value is less than cost. Under LCNRV, companies recognize the loss in the period in which the price decline occurs.

5 Indicate the effects of inventory errors on the financial statements. In the income statement of the current year: (a) An error in beginning inventory will have a reverse effect on net income. (b) An error in ending inventory will have a similar effect on net income. In the following period, its effect on net income for that period is reversed, and total net income for the two years will be correct.

In the statement of financial position: Ending inventory errors will have the same effect on total assets and total equity and no effect on liabilities.

6 Compute and interpret the inventory turnover ratio. The inventory turnover ratio is cost of goods sold divided by average inventory. To convert it to average days in inventory, divide 365 days by the inventory turnover ratio.

GLOSSARY

Average-cost method Inventory costing method that uses the weighted-average unit cost to allocate to ending inventory and cost of goods sold the cost of goods available for sale. (p. 272).

Consigned goods Goods held for sale by one party although ownership of the goods is retained by another party. (p. 267).

Consistency concept Dictates that a company use the same accounting principles and methods from year to year. (p. 274).

Days in inventory Measure of the average number of days inventory is held; calculated as 365 divided by inventory turnover ratio. (p. 279).

Finished goods inventory Manufactured items that are completed and ready for sale. (p. 264).

First-in, first-out (FIFO) method Inventory costing method that assumes that the costs of the earliest goods purchased are the first to be recognized as cost of goods sold. (p. 270).

FOB (free on board) destination Freight terms indicating that ownership of the goods remains with the seller until the goods reach the buyer. (p. 266).

FOB (free on board) shipping point Freight terms indicating that ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. (p. 266).

Inventory turnover A ratio that measures the number of times on average the inventory sold during the period; computed by dividing cost of goods sold by the average inventory during the period. (p. 279).

Just-in-time (JIT) inventory method Inventory system in which companies manufacture or purchase goods just in time for use. (p. 264).

Lower-of-cost-or-net realizable value (LCNRV) basis A basis whereby inventory is stated at the lower of either its cost or its net realizable value. (p. 275).

Net realizable value Net amount that a company expects to realize (receive) from the sale of inventory. Specifically, it is estimated selling price in the normal course of business, less estimated costs to complete and sell. (p. 275).

Prudence Concept that dictates that when in doubt, choose the method that will be least likely to overstate assets and net income. (p. 275).

Raw materials Basic goods that will be used in production but have not yet been placed into production. (p. 264).

Specific identification method An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory. (p. 269).

Weighted-average unit cost Average cost that is weighted by the number of units purchased at each unit cost. (p. 272).

Work in process That portion of manufactured inventory that has been placed into the production process but is not yet complete. (p. 264).

APPENDIX 6A INVENTORY COST FLOW METHODS IN PERPETUAL INVENTORY SYSTEMS

What inventory cost flow methods do companies employ if they use a perpetual inventory system? Simple—they can use one of the inventory cost flow methods described in the chapter. To illustrate the application of the two assumed cost flow methods (FIFO and average-cost), we will use the data shown in Illustration 6A-1 and in this chapter for Lin Electronics' Astro condenser.

Illustration 6A-1 Inventoriable units and costs

First-In, First-Out (FIFO)

Under FIFO, the company charges to cost of goods sold the cost of the earliest goods on hand prior to each sale. Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and August 24. Illustration 6A-2 shows the inventory under a FIFO method perpetual system.

Illustration 6A-2 Perpetual system—FIFO

The ending inventory in this situation is HK$5,800, and the cost of goods sold is HK$6,200 [(10 @ HK$100) + (20 @ HK$110) + (25 @ HK$120)].

Compare Illustrations 6-5 (page 271) and 6A-2. You can see that the results under FIFO in a perpetual system are the same as in a periodic system. In both cases, the ending inventory is HK$5,800 and cost of goods sold is HK$6,200. Regardless of the system, the first costs in are the costs assigned to cost of goods sold.

Average-Cost

The average-cost method in a perpetual inventory system is called the moving-average method. Under this method, the company computes a new average after each purchase by dividing the cost of goods available for sale by the units on hand. It then applies the average cost to (1) the units sold to determine the cost of goods sold, and (2) the remaining units on hand to determine the ending inventory amount. Illustration 6A-3 shows the application of the moving-average cost method by Lin Electronics.

Illustration 6A-3 Perpetual system—average-cost method

As indicated, Lin Electronics computes a new average each time it makes a purchase. On April 15, after it buys 20 units for HK$2,200, a total of 30 units costing HK$3,200 (HK$1,000 + HK$2,200) are on hand. The average unit cost is HK$106.667 (HK$3,200 ÷ 30). On August 24, after Lin Electronics buys 30 units for HK$3,600, a total of 60 units costing HK$6,800 (HK$1,000 + HK$2,200 + HK$3,600) are on hand, at an average cost per unit of HK$113.333 (HK$6,800 ÷ 60). Lin Electronics uses this unit cost of HK$113.333 in costing sales until it makes another purchase, when the company computes a new unit cost. Accordingly, the unit cost of the 55 units sold (on September 10) is HK$113.333, and the total cost of goods sold is HK$6,233. On November 27, following the purchase of 40 units for HK$5,200, there are 45 units on hand costing HK$5,767 (HK$567 + HK$5,200) with a new average cost of HK$128.156 (HK$5,767 ÷ 45).

Compare this moving-average cost under the perpetual inventory system to Illustration 6-8 (on page 272) showing the average-cost method under a periodic inventory system. Unlike FIFO, which results in the same cost for ending inventory under the perpetual and periodic systems, the moving-average method produces different costs.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 6A

7 Apply the inventory cost flow methods to perpetual inventory records. Under FIFO and a perpetual inventory system, companies charge to cost of goods sold the cost of the earliest goods on hand prior to each sale. Under the moving-average (average-cost) method and a perpetual system, companies compute a new average cost after each purchase.

APPENDIX 6B ESTIMATING INVENTORIES

In the chapter, we assumed that a company would be able to physically count its inventory. What if it cannot? What if the inventory were destroyed by fire or flood, for example? In that case, the company would use an estimate.

Two circumstances explain why companies sometimes estimate inventories. First, a casualty such as fire, flood, or earthquake may make it impossible to take a physical inventory. Second, managers may want monthly or quarterly financial statements, but a physical inventory is taken only annually. The need for estimating inventories occurs primarily with a periodic inventory system because of the absence of perpetual inventory records.

There are two widely used methods of estimating inventories: (1) the gross profit method, and (2) the retail inventory method.

Gross Profit Method

The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales. This method is relatively simple but effective. Accountants, auditors, and managers frequently use the gross profit method to test the reasonableness of the ending inventory amount. It will detect large errors.

To use this method, a company needs to know its net sales, cost of goods available for sale, and gross profit rate. The company then can estimate its gross profit for the period. Illustration 6B-1 shows the formulas for using the gross profit method.

Illustration 6B-1 Gross profit method formulas

To illustrate, assume that Kishwaukee Company wishes to prepare an income statement for the month of January. Its records show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. In the preceding year, the company realized a 30% gross profit rate. It expects to earn the same rate this year. Given these facts and assumptions, Kishwaukee can compute the estimated cost of the ending inventory at January 31 under the gross profit method as follows.

Illustration 6B-2 Example of gross profit method

The gross profit method is based on the assumption that the gross profit rate will remain constant. But, it may not remain constant due to a change in merchandising policies or in market conditions. In such cases, the company should adjust the rate to reflect current operating conditions. In some cases, companies can obtain a more accurate estimate by applying this method on a department or product-line basis.

Note that companies should not use the gross profit method to prepare financial statements at the end of the year. These statements should be based on a physical inventory count.

Retail Inventory Method

A retail store, such as President Chain Store (TWN), Marks and Spencer plc (GBR), or Wal-Mart (USA), has thousands of different types of merchandise at low unit costs. In such cases, it is difficult and time-consuming to apply unit costs to inventory quantities. An alternative is to use the retail inventory method to estimate the cost of inventory. Most retail companies can establish a relationship between cost and sales price. The company then applies the cost-to-retail percentage to the ending inventory at retail prices to determine inventory at cost.

Under the retail inventory method, a company's records must show both the cost and retail value of the goods available for sale. Illustration 6B-3 presents the formulas for using the retail inventory method.

Illustration 6B-3 Retail inventory method formulas

We can demonstrate the logic of the retail method by using unit-cost data. Assume that Ortiz Inc. has marked 10 units purchased at $7 to sell for $10 per unit. Thus, the cost-to-retail ratio is 70% ($70 ÷ $100). If four units remain unsold, their retail value is $40 (4 × $10), and their cost is $28 ($40 × 70%). This amount agrees with the total cost of goods on hand on a per unit basis (4 × $7).

Illustration 6B-4 shows application of the retail method for Valley West Co. Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time.

Illustration 6B-4 Application of retail inventory method

The retail inventory method also facilitates taking a physical inventory at the end of the year. Valley West can value the goods on hand at the prices marked on the merchandise and then apply the cost-to-retail ratio to the goods on hand at retail to determine the ending inventory at cost.

The major disadvantage of the retail method is that it is an averaging technique. Thus, it may produce an incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale. Assume, for example, that the cost-to-retail ratio of 75% for Valley West consists of equal proportions of inventory items that have cost-to-retail ratios of 70%, 75%, and 80%. If the ending inventory contains only items with a 70% ratio, an incorrect inventory cost will result. Companies can minimize this problem by applying the retail method on a department or product-line basis.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 6B

8 Describe the two methods of estimating inventories. The two methods of estimating inventories are the gross profit method and the retail inventory method. Under the gross profit method, companies apply a gross profit rate to net sales to determine estimated cost of goods sold. They then subtract estimated cost of goods sold from cost of goods available for sale to determine the estimated cost of the ending inventory.

Under the retail inventory method, companies compute a cost-to-retail ratio by dividing the cost of goods available for sale by the retail value of the goods available for sale. They then apply this ratio to the ending inventory at retail to determine the estimated cost of the ending inventory.

GLOSSARY FOR APPENDIX 6B

Gross profit method A method for estimating the cost of the ending inventory by applying a gross profit rate to net sales and subtracting estimated cost of goods sold from cost of goods available for sale. (p. 285).

Retail inventory method A method for estimating the cost of the ending inventory by applying a cost-to-retail ratio to the ending inventory at retail. (p. 286).

APPENDIX 6C LIFO INVENTORY METHOD

As indicated in the chapter, under IFRS, LIFO is not permitted for financial reporting purposes. In prohibiting LIFO, the IASB noted that use of LIFO results in inventories being recognized in the statement of financial position at amounts that bear little relationship to recent cost levels of inventories. Nonetheless, LIFO is used for financial reporting in the United States, and it is permitted for tax purposes in some countries. Its use can result in significant tax savings in a period of rising prices.

The last-in, first-out (LIFO) method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. (Exceptions include goods stored in piles, such as coal or hay, where goods are removed from the top of the pile as they are sold.) Under the LIFO method, the costs of the latest goods purchased are the first to be recognized in determining cost of goods sold. Illustration 6C-1 shows the allocation of the cost of goods available for sale at Lin Electronics under LIFO. The number of units sold during November are 55 and therefore ending inventory is comprised of 45 units.

Illustration 6C-1 Allocation of costs—LIFO method

Under LIFO, since it is assumed that the first goods sold were those that were most recently purchased, ending inventory is based on the prices of the oldest units purchased. That is, under LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed. In this example, Lin Electronics prices the 45 units of ending inventory using the earliest prices. The first purchase was 10 units at HK$100 in the January 1 beginning inventory. Then, 20 units were purchased at HK$110. The remaining 15 units needed are priced at HK$120 per unit (August 24 purchase). 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 6C-2 demonstrates that companies also can calculate cost of goods sold by pricing the 55 units sold using the prices of the last 55 units acquired. Note that of the 30 units purchased on August 24, only 15 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 15 of these units were assumed unsold and thus included in ending inventory.

Illustration 6C-2 Proof of cost of goods sold

Under a periodic inventory system, which we are using here, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.

A major disadvantage of the LIFO method is that in a period of rising prices, the costs allocated to ending inventory may be significantly understated in the statement of financial position. For example, Caterpillar (USA) has used LIFO for over 50 years. Its statement of financial position shows ending inventory of $8,781 million. But, the inventory's actual current cost if FIFO had been used is $11,964 million.

One reason why U.S. companies use LIFO relates to tax benefits. In a period of rising prices, companies using LIFO report lower income taxes (because of lower taxable income) and therefore higher cash flow.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 6C

9 Apply the LIFO inventory costing method. The LIFO (last-in, first-out) method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of goods. This method matches costs of the most recently purchased items with revenues in the period. In periods of rising prices, use of the LIFO method results in lower income taxes and higher cash flow.

GLOSSARY FOR APPENDIX 6C

LIFO (last-in, first-out) method Inventory costing method that assumes that the latest goods purchased are the first to be sold. (p. 288).