1 Chapter 7: Merchandise Inventory Merchandise Inventory What is inventory?  Items held for resale to customers Who has inventory?  Wholesaler or Retailer Merchandise Inventory  Manufacturer - Raw Materials Work in Process Finished Goods Merchandise Inventory Acquisition of inventory: What costs to capitalize? Recording inventory activity: Which method? Selling inventory: Which cost flow assumption? Ending inventory: Lower-of-cost-or market valuation Acquiring Inventory  What items or units to include? – General rule: complete and unrestricted ownership Acquiring inventory - contd  Which costs are included in inventory? – General rule: all costs associated with purchase or manufacture, including shipping to facility – Freight-in (transportation-in) adds to the cost of inventory – Purchase returns reduce the cost of purchases (contra) for returned inventory – Purchase allowances reduce the cost of purchases (contra) for reduced prices due to damage or errors – Purchase discounts from early cash payments (contra) reduce the cost of purchases Perpetual Method Figure 7.3: Perpetual System December 10 Purchase of 100 units @ $20: Inventory 2,000 Accts Pay 2,000 December 20 Sale of 50 units @ $30: Cash 1,500 Sales 1,500 COGS 1,000 Inventory 1,000 December 30 AJE to recognize loss of units @$20 each (170 on hand, books show 175) Loss 100 Inventory 100 Class Exercise E7-6 Sales Cost of Goods Sold (COGS): BI Purchases GAS Less: EI COGS Gross Profit 2008 $1,262 $268 857 $1,125 239 2007 $1,277 $287 887 $1,174 268 886 $376 906 $371 10 E7-6 b Error in Ending Inventory in 2008: = The 2007 error in the Ending Inventory changes the Beginning Inventory in 2008 and the Goods Available for sale to $318 + $857 = $1,175 To calculate the Cost of Goods Sold the Ending Inventory for 2008 is deducted from the revised Goods Available for Sale: $1,175 – ($239 - $50) = $986 The gross profit would then be $1,262 - $986 = $276 14 E7-6 c 2008 Original CGS $886 Corrected CGS $986 2007 $906 $856 15 Cost Flow Assumptions Given: BI + P (net) = EI + COGS  How to assign costs of inflows [BI + P(net)] to EI and COGS? Methods:  Specific identification  Average for both COGS and EI  FIFO - (first-in, first-out) for COGS  – and LISH (last-in, still here) for EI  LIFO - (last-in, first-out) for COGS – and FISH (first-in, still here) for EI 16 International Perspective – Cost Flow Assumptions     Under IFRS the LIFO method is prohibited This poses an important potential impediment to the adoption of IFRS in the US Most LIFO users in the US have chosen LIFO because it results in an income tax savings DuPont, for example, has saved over $150 million in income taxes because it uses LIFO A shift to IFRS could impose a huge and immediate tax burden on LIFO users in the US 17 Cost Flows 18 Cost Flows - Average 19 Cost Flows - FIFO 20 Cost Flows - LIFO 21 Cost Flows – Effects on Financial Statements 22 Cost Flows – Effects on Federal Income Taxes 23 Choosing an Inventory Cost Flow Assumption: Trade-Offs Income and Asset Measurement  Economic Consequences  – Income Taxes and Liquidity – Bookkeeping Costs – LIFO Liquidation and Inventory Purchasing Practices – Debt and Compensation Practices – The Capital Market 24 Ending Inventory: Applying the Lower-of-Cost-orMarket Rule  Applying the lower-of-cost-or-market rule to ending inventory is accomplished by comparing the cost allocated to ending inventory with the market value of the inventory If the market value exceeds the cost, no adjustment is made and the inventory remains at cost If the market value is less than the cost, the inventories are written down to market value with an adjusting journal entry 25 The Lower-of-Cost-or-Market Rule and Hidden Reserves   Based on conservatism, ending inventory is valued at cost or market value, whichever is lower Problem: can create hidden reserves – Recognizes price decreases immediately – Defers price increase recognition until sold  US GAAP and IFRS use different market values when applying the lower-of-cost-ormarket rule Under US GAAP the market value is usually the replacement cost Under IFRS it is normally the realizable value 26 International Perspective: Japanese Business and Inventory Accounting   Just-in-time (JIT) inventory systems, which reduce the costs of carrying large amounts of inventory without jeopardizing customer service, have long been a characteristic of this Japanese system and have given the Japanese a definite advantage when competing against U.S industry Japan has adopted international reporting standards (IFRS), which does not allow the use of LIFO 27 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein 28 [...]... 26 International Perspective: Japanese Business and Inventory Accounting   Just -in- time (JIT) inventory systems, which reduce the costs of carrying large amounts of inventory without jeopardizing customer service, have long been a characteristic of this Japanese system and have given the Japanese a definite advantage when competing against U.S industry Japan has adopted international reporting standards... Flows – Effects on Financial Statements 22 Cost Flows – Effects on Federal Income Taxes 23 Choosing an Inventory Cost Flow Assumption: Trade-Offs Income and Asset Measurement  Economic Consequences  – Income Taxes and Liquidity – Bookkeeping Costs – LIFO Liquidation and Inventory Purchasing Practices – Debt and Compensation Practices – The Capital Market 24 Ending Inventory: Applying the Lower-of-Cost-orMarket... Error in Ending Inventory in 2008: = The 2 007 error in the Ending Inventory changes the Beginning Inventory in 2008 and the Goods Available for sale to $318 + $857 = $1,175 To calculate the Cost of Goods Sold the Ending Inventory for 2008 is deducted from the revised Goods Available for Sale: $1,175 – ($239 - $50) = $986 The gross profit would then be $1,262 - $986 = $276 14 E7-6 c 2008 Original CGS... counting errors caused the ending inventory (EI) in 2 007 to be understated by $50 and the ending inventory in 2008 to be overstated by $50 Compute the impact of these errors on cost of goods sold for the year ended December 31, 2 007 and on the inventory balance as of December 31, 2 007 a 11 E7-6 b Compute the impact of these errors on cost of goods sold for the year ended December 31, 2008 and on the inventory... Lower-of-Cost-orMarket Rule  Applying the lower-of-cost-or-market rule to ending inventory is accomplished by comparing the cost allocated to ending inventory with the market value of the inventory If the market value exceeds the cost, no adjustment is made and the inventory remains at cost If the market value is less than the cost, the inventories are written down to market value with an adjusting journal entry 25... inventory balance as of December 31, 2008 c What is the impact of these errors on cost of goods sold over the two-year period ended December 31, 2008? 12 E7-6 a Error in Ending Inventory in 2 007: The $50 understated error in the Ending inventory means that the Ending Inventory should have been $268 + $50 = $318 This would change the Cost of goods sold to $1,174 - $318 = $856 which would then increase the... IFRS the LIFO method is prohibited This poses an important potential impediment to the adoption of IFRS in the US Most LIFO users in the US have chosen LIFO because it results in an income tax savings DuPont, for example, has saved over $150 million in income taxes because it uses LIFO A shift to IFRS could impose a huge and immediate tax burden on LIFO users in the US 17 Cost Flows 18 Cost Flows - Average... Corrected CGS $986 2 007 $906 $856 15 3 Cost Flow Assumptions Given: BI + P (net) = EI + COGS  How to assign costs of inflows [BI + P(net)] to EI and COGS? Methods:  Specific identification  Average for both COGS and EI  FIFO - (first -in, first-out) for COGS  – and LISH (last -in, still here) for EI  LIFO - (last -in, first-out) for COGS – and FISH (first -in, still here) for EI 16 International Perspective... adjusting journal entry 25 The Lower-of-Cost-or-Market Rule and Hidden Reserves   Based on conservatism, ending inventory is valued at cost or market value, whichever is lower Problem: can create hidden reserves – Recognizes price decreases immediately – Defers price increase recognition until sold  US GAAP and IFRS use different market values when applying the lower-of-cost-ormarket rule Under US GAAP the... & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not