Apply the cost principle to identify the amounts that should be included in inventory and the matching principle to determine cost of goods sold for typical retailers, wholesalers, and manufacturers.
Inventory should include all items owned that are held for resale. Costs flow into inventory when goods are purchased or manufactured. They flow out (as an expense) when they are sold or disposed of. In conformity with the matching principle, the total cost of the goods sold during the period must be matched with the sales revenue earned during the period.
Report inventory and cost of goods sold using the four inventory costing methods.
The chapter discussed four different inventory costing methods used to allocate costs between the units remaining in inventory and the units sold, and their applications in different economic circum- stances. The methods discussed were FIFO, LIFO, weighted average cost, and specific identification. Each of the inventory costing methods conforms with GAAP. Public companies using LIFO must provide note disclosures that allow conversion of inventory and cost of goods sold to FIFO amounts. Remember that the cost flow assumption need not match the physical flow of inventory.
Decide when the use of different inventory costing methods is beneficial to a company.
The selection of an inventory costing method is important because it will affect reported income, income tax expense (and hence cash flow), and the inventory valuation reported on the balance sheet. In a period of rising prices, FIFO normally results in a higher income and higher taxes than LIFO; in a period of falling prices, the opposite occurs. The choice of methods is normally made to minimize taxes.
Report inventory at the lower of cost or market (LCM).
Ending inventory should be measured based on the lower of actual cost or replacement cost (LCM basis). This practice can have a major effect on the statements of companies facing declining costs. Damaged, obsolete, and out-of-season inventory should also be written down to their current estimated net realizable value if below cost. The LCM adjustment increases cost of goods sold, decreases income, and decreases reported inventory in the year of the write-down.
Evaluate inventory management using the inventory turnover ratio and the effects of inventory on cash flows.
The inventory turnover ratio measures the efficiency of inventory management. It reflects how many times average inventory was produced and sold during the period. Analysts and creditors watch this ratio because a sudden decline may mean that a company is facing an unexpected drop in demand for its products or is becoming sloppy in its production management. When a net decrease in inventory for the period occurs, sales are more than purchases; thus, the decrease must be added in computing cash flows from operations. When a net increase in inventory for the period occurs, sales are less than purchases; thus, the increase must be subtracted in computing cash flows from operations.
Compare companies using different inventory costing methods.
These comparisons can be made by converting the LIFO company's statements to FIFO. Public companies using LIFO must disclose the differences between LIFO and FIFO values for beginning and ending inventory. These amounts are often called the LIFO reserve. The beginning LIFO reserve minus the ending LIFO reserve equals the difference in cost of goods sold under FIFO. Pretax income is affected by the same amount in the opposite direction. This amount times the tax rate is the tax effect.
Understand methods for controlling and keeping track of inventory and analyze the effects of inventory errors on financial statements.
Various control procedures can limit inventory theft or mismanagement. A company can keep track of the ending inventory and cost of goods sold for the period using (1) the perpetual inventory system, which is based on the maintenance of detailed and continuous inventory records, and (2) the periodic inventory system, which is based on a physical count of ending inventory and use of the inventory equation to determine cost of goods sold. An error in the measurement of ending inventory affects cost of goods sold on the current period's income statement and ending inventory on the balance sheet. Because this year's ending inventory becomes next year's beginning inventory, it also affects cost of goods sold in the following period, by the same amount, but in the opposite direction. These relationships can be seen through the cost of goods sold equation (BI + P - EI = CGS). In this and previous chapters, we discussed the current assets of a business. These assets are critical to operations, but many of them do not directly produce value. In Chapter 8, we will discuss the noncurrent assets property, plant, and equipment; natural resources; and intangibles that are the elements of productive capacity. Many of the noncurrent assets produce value, such as a factory that manufactures cars. These assets present some interesting accounting problems because they benefit a number of accounting periods.
