6-1 ©2006 Prentice Hall, Inc.. 6-2 ©2006 Prentice Hall, Inc. REPORTING AND ANALYZING INVENTORY Learning objectives Learning objectives Inventory cost

6-1©2006 Prentice Hall, Inc.


REPORTING ANDREPORTING ANDANALYZING INVENTORYANALYZING INVENTORY

Learning objectivesInventory cost flow assumptionsHow inventory cost flow assumpt

ions affect financial statementsLower-of-cost-or-market ruleFinancial statement analysisBusiness risk, control, and ethics


Learning ObjectivesLearning Objectives(1 of 2)(1 of 2)

Explain and apply the four cost flow assumptions for valuing inventory and cost of goods sold

Explain the effects of the inventory cost flow assumption on the financial statements

Explain the lower-of-cost-or-market rule for valuing inventory


Learning ObjectivesLearning Objectives(2 of 2)(2 of 2)

Evaluate a firm’s inventory management using the inventory turnover ratio.

Recognize special risks and controls associated with inventory.


Inventory Cost Flow Inventory Cost Flow Assumptions Assumptions (1 of 3)(1 of 3)

During March, Jeremy’s Friendly Market showed the following results:Beginning inventory of Big Q Beans was

400 cans at $0.75 per canPurchased 1,000 cans of Big Q Beans for

$0.79 per can. Later that month, they purchased 2,000 more cans of Big Q Beans for $0.84 per can

It sells 2,400 cans of beans during March



What is the cost of the beans sold?What is the cost of the beans remaining

in merchandise inventory?Cost flow assumptions allocate goods

available for sale (GAS) to cost of goods sold and ending inventory (EI)BI + Purch = GASGAS – EI + GoGS (GAS = EI + GoGS)



Alternate inventory cost flow assumptionsSpecific identificationWeighted averageFirst-in, first-out (FIFO)Last-in, last-out (LIFO)


Specific Identification

Specific identification does NOT make any cost-flow assumptionsThe accounting system tracks the

actual cost of each item in merchandise inventory and the actual cost of items sold

For what types of goods would a company use specific identification?


Weighted Average Cost(1 of 2)

Same cost is assigned to all GAS for each inventory item carried by the business.

For what types of goods would a company use weighted average?

Average cost per unit in GAS: Total cost of inventory item _

Total # of units of inventory item

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©2006 Prentice Hall, Inc.

Weighted Average Cost(2 of 2)

Cost of goods sold# of units sold x avg cost per unit

Ending inventory# of units in EI x avg cost per unit

Calculate for Big Q Beans:GAS, CoGS, and EI

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FIFO

Assumes that FIRST items purchased are first items soldOldest costs are in CoGSMost recent costs are in EI

Calculate for Big Q Beans:GAS, CoGS, and EIAre your answers different than for

weighted average? Why or why not?

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LIFO(1 of 3)

Assumes that LAST items purchased are first items soldMost recent costs are in CoGSOldest costs are in EI

Calculate for Big Q Beans:GAS, CoGS, and EIAre your answers different than for

FIFO? Why or why not?

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LIFO(2 of 3)

Use of LIFO requires extra disclosures in financial statement footnotes

What effect would making an extra purchase of inventory at the end of the period have on CoGS under LIFO if:Inventory costs are rising? Falling?How would the extra purchase affect

CoGS under FIFO?

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LIFO(3 of 3)

What would happen company using LIFO kept an inventory reserve (never sold all of its inventory)?

If a company sells all of its inventory each period (no BI), would CoGS change under the different methods? Why or why not?

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Effect of Cost Flow Effect of Cost Flow Assumptions on Financial Assumptions on Financial

StatementsStatements (1 of 3) (1 of 3)

FIFO LIFO Wt. Avg.Sales $ 3,000 $ 3,000 $ 3,000Cost of G. S. 1,930 1,996 1,955Gross Margin 1,070 1,004 1,045Oper. exp. 250 250 250Pretax Inc. 820 754 795Taxes (30%) 246 226 239Net Income $574 $528 $556Assumes sales price $1.25/can & op exp $250

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FIFO LIFO Wt. Avg.Inflows:

Sales collected $ 3,000 $ 3,000 $ 3,000Outflows:

Purch paid for 2,470 2,470 2,470Op. exp. paid 250 250 250Taxes paid 246 226 239

Net cash flow $ 34 $ 54$ 41Assumes sales price $1.25/can & op exp $250

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Effect of reported inventory and CoGS under different cost flow assumptions

Income tax effects under LIFO and FIFO

Choosing an inventory cost flow method

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Effect of Cost Flow Assumptions

on CoGS and EI

Which method produces the highest net income in times of rising inventory costs? Falling inventory costs?

Which method produces the highest ending inventory under rising inventory costs? Falling inventory costs?

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Income Tax Effects Under LIFO and FIFO

In times of rising inventory costs, which inventory method produces the highest income tax expense?Does this affect which method

produces the highest net income?How does this affect cash flow?

How do your answers change if inventory costs are falling

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Choosing an Inventory Cost Flow Method (1 of 2)

Factors that may affect choice of inventory cost flow assumptionCompatibility with similar companiesMaximize tax savings and cash flowsMaximize net income

If LIFO is used for tax purposes, it must also be used for financial statement purposes

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Choosing an Inventory Cost Flow Method (2 of 2)

How does choice of cost flow method affect the following ratios in times of rising inventory costs? Falling costs?Current ratioQuick ratioGross profit ratioProfit margin ratioInventory turnover ratio

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Lower-of-cost-or-market Lower-of-cost-or-market RuleRule

Which reporting constraint (see ch 2) requires inventory to be stated at lower of cost or market value? Replacement cost is used to estimate market value

If market value is lower than costReduce the inventory accountReduce net income

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Financial Statement Financial Statement AnalysisAnalysis

(1 of 2)(1 of 2)

Inventory turnoverMeasures how quickly a firm is selling

its inventory Cost of goods sold

Average inventoryAverage inventory = (BI + EI) / 2

Average days in inventory365 (days in year) / Inventory turnover

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Financial Statement Financial Statement AnalysisAnalysis

(2 of 2)(2 of 2)

In general, do companies want higher or lower inventory turnover?Compared to what?

What happens if inventory turnover is too high? Too low?

Which industry would have higher inventory turnover, a jeweler or grocer?Who would have a higher profit margin?

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Business Risk, Control, Business Risk, Control, and Ethicsand Ethics

(1 of 2)(1 of 2)

What is inventory padding?How else can a company

artificially inflate its assets?Safeguarding assets

Physical controlsIncludes ensuring that products

don’t spoil

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Business Risk, Control, Business Risk, Control, and Ethicsand Ethics

(2 of 2)(2 of 2)

RFID tagsHow to they help control costs?What inventory method do they

enable businesses to use that they could not use previously?

Controlling inventory levels and monitoring product developments to prevent inventory obsolescence

Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’s

Kenneth W. Monfort College of [email protected] 6-

27©2006 Prentice Hall, Inc.

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6-1 ©2006 Prentice Hall, Inc.. 6-2 ©2006 Prentice Hall, Inc. REPORTING AND ANALYZING INVENTORY Learning objectives Learning objectives Inventory cost