In this chapter we have described the basic characteristics of the most common inventory sys- tems. In practice, businesses often modify these systems to suit their particular needs. Some businesses also use different inventory systems for different purposes.
We described one modification in Chapter 6—a company that maintains little inventory may simply charge (debit) all purchases directly to the cost of goods sold. Another common modifica- tion is to maintain perpetual inventory records showing only the quantities of merchandise bought and sold, with no dollar amounts. Such systems require less record keeping than a full-blown perpetual system, and they still provide management with useful information about sales and inventories. To generate the dollar amounts needed in financial statements and tax returns, these companies might use the gross profit method, the retail method, or a periodic inventory system.
Businesses such as restaurants often update their inventory records by physically counting products on a daily or weekly basis. In effect, they use frequent periodic counts as the basis for maintaining a perpetual inventory system.
In summary, real-world inventory systems often differ from the illustrations in a textbook.
But the underlying principles remain the same.
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Financial Analysis and Decision Making
Inventory often is the largest of a company’s current assets.
But how liquid is this asset? How quickly will it be converted into cash? As a step toward answering these questions, short- term creditors often compute the inventory turnover.
Inventory Turnover
The inventory turnover is equal to the cost of goods sold divided by the average amount of inventory (beginning inventory plus ending inventory, divided by 2). This ratio indicates how many times in the course of a year the company is able to sell the amount of its average
inventory. The higher this rate, the more quickly the company sells its inventory.
To illustrate, a recent annual report of Target shows a cost of goods sold of $44,157 million and average inventory of $6,743 million. The inventory turnover rate for Target, therefore, is 6.55 ($44,157 million $6,743 million). We may compute the
number of days required for the company to sell its inventory by dividing 365 days by the turnover rate. Thus Target requires 56 days to turn over (sell) the amount of its average inventory.
The computation of Target’s inventory turnover and the aver- age number of days required to sell its inventory is summarized as follows:
*Average Inventory (Beginning Inventory Ending Inventory) 2
Inventory Turnover
Average Number of Days to Sell Inventory Days in the Year
_________________
Inventory Turnover _________ 365 days
6.55 times 56 days Cost of Goods Sold
_________________
Average Inventory* $44,157 million ______________
$6,743 million 6.55 times
Users of financial statements find the inventory turnover useful in evaluating the liquidity of the company’s inventory.
Managers and independent auditors may use this computa- tion to help identify inventory that is not selling well and that may have become obsolete. A declining turnover indi- cates that merchandise is not selling as quickly as in the past.
Comparing a company’s inventory turnover with that of com- petitors is particularly useful in evaluating how effective a company is at managing its inventory, often one of its largest assets.
Receivables Turnover
Most businesses sell merchandise on account. Therefore, the sale of inventory often does not provide an immediate source of cash. To determine how quickly inventory is converted into cash, the number of days required to sell the inventory must be combined with the number of days required to collect the accounts receivable.
The number of days required to collect accounts receiv- able depends on a company’s accounts receivable turnover.
This figure is computed by dividing net sales by the average accounts receivable. The number of days required to collect these receivables then is determined by dividing 365 days by the turnover rate. Data for the Target annual report indicate that the company needed approximately 5 days (on average) for receivables to convert to cash.
Length of the Operating Cycle The operating cycle of a merchandising company is the average time period between the purchase of merchandise and the conversion of this merchandise back into cash. In other words, the mer- chandise acquired as inventory gradually is converted into
L e a r n i n g O b j e c t i v e Compute the inventory turnover and explain its uses.
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359 accounts receivable by sale of the goods on account, and
these receivables are converted into cash through the process of collection.
The operating cycle of Target was approximately 105 days, computed by adding the average 100 days required to sell its
inventory and the 5 days required to collect cash from custom- ers. From the viewpoint of short-term creditors, the shorter the operating cycle, the higher the quality of the company’s liquid assets because they will be converted into cash more quickly.
Assume that you are employed by GE Capital as a credit analyst, and that Target is seek- ing to borrow money using its merchandise inventory as collateral. You have determined that the company’s inventory turnover is 3.46 times, and that the average time to sell its inventory is 100 days (see previous computations). Assume that Target’s inventory reported at cost is currently $3.2 billion, and that its gross profit as a percentage of sales is approximately 37 percent. Estimate the market value of the company’s inventory for use as collateral.
(See our comments on the Online Learning Center Web site.) Y O U R T U R N You as a Credit Analyst
Concluding Remarks
Throughout this chapter we have learned about different inventory valuation methods. Each method is based upon a particular assumption about cost flows and does not necessarily paral- lel the physical movement of merchandise. Moreover, the choice of valuation by management can have significant effects on a company’s income statement, balance sheet, and tax returns.
In the following chapter, we will see that a similar situation exists with respect to alterna- tive methods used to account for plant and equipment.
Concluding Remarks
Th h t thi h t h l d b t diff t i t l ti th d E h
Ethics, Fraud & Corporate Governance
As discussed previously in this chapter, the valuation of inventory and the cost of goods sold is of critical importance to managers and to users of the company’s financial statements.
The two primary issues with regard to inventory valuation are existence and valuation.
In a well-known case of inventory fraud, the Securities and Exchange Commission (SEC) brought an enforcement action against an officer of MiniScribe Corporation related to his involvement in overstating inventory reported in the company’s balance sheet. The overstatement of inventory resulted in an understatement of cost of goods sold and an overstatement of profits reported in the company’s income statement (MiniScribe’s net income was actually inflated by $22 million, or 244 percent).
Prior to being acquired by Maxtor Corporation, Mini- Scribe manufactured computer disk drives and its stock was
quoted on NASDAQ. The company had discovered a material shortfall in its inventory balance. Reporting this shortfall would have increased the cost of goods sold and reduced the company’s net income significantly. So MiniScribe concealed the shortfall from its independent auditors by taking a number of actions to inappropriately overstate its actual inventory balance. First, it recorded a fictitious transfer of nonexistent inventory from its headquarters to an overseas subsidiary. Second, it repackaged scrap items and obsolete inventory as if they were “good” inventory items. Third, it packed bricks into computer disk drive boxes and shipped them to its distributors (these shipments were still counted as inventory by MiniScribe until the distributors sold the boxes).
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END-OF-CHAPTER REVIEW
In a perpetual inventory system, determine the cost of goods sold using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. Discuss the advantages and shortcomings of each method. By the specific identification method, the actual costs of the specific units sold are transferred from inventory to the cost of goods sold.
(Debit Cost of Goods Sold: credit Inventory.) This method achieves the proper matching of sales revenue and cost of goods sold when the individual units in the inventory are unique.
However, the method becomes cumbersome and may produce misleading results if the inventory consists of homogeneous items.
The remaining three methods are flow assumptions, which should be applied only to an inventory of homogeneous items.
By the average-cost method, the average cost of all units in the inventory is computed and used in recording the cost of goods sold. This is the only method in which all units are assigned the same (average) per-unit cost.
FIFO (first-in, first-out) is the assumption that the first units purchased are the first units sold. Thus, inventory is assumed to consist of the most recently purchased units. FIFO assigns cur- rent costs to inventory but older (and often lower) costs to the cost of goods sold.
LIFO (last-in, first-out) is the assumption that the most recently acquired goods are sold first. This method matches sales revenue with relatively current costs. In a period of infla- tion, LIFO usually results in lower reported profits and lower income taxes than the other methods. However, the oldest purchase costs are assigned to inventory, which may result in inventory becoming grossly understated in terms of current replacement costs.
Explain the need for taking a physical inventory. In a perpetual inventory system, a physical inventory is taken to adjust the inventory records for shrinkage losses. In a periodic inventory system, the physical inventory is the basis for determining the cost of the ending inventory and for computing the cost of goods sold.
Record shrinkage losses and other year-end adjustments to inventory. Shrinkage losses are recorded by removing from the Inventory account the cost of the missing or damaged units. The offsetting debit may be to Cost of Goods Sold, if the shrinkage is normal in amount, or to a special loss account. If inventory is found to be obsolete and unlikely to be sold, it is written down to zero (or its scrap value, if any). If inventory is valued at the lower-of-cost-or- market, it is written down to its current replacement cost, if at year-end this amount is substantially below the cost shown in the inventory records.
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S U M M A R Y O F L E A R N I N G O B J E C T I V E S
In a periodic inventory system, determine the ending inventory and the cost of goods sold using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. The cost of goods sold is determined by combining the beginning inventory with the purchases during the period and subtracting the cost of the ending inventory. Thus, the cost assigned to ending inventory also determines the cost of goods sold.
By the specific identification method, the ending inventory is determined by the specific costs associated with the units on hand. By the average-cost method, the ending inventory is deter- mined by multiplying the number of units on hand by the aver- age cost of the units available for sale during the year. By FIFO, the units in inventory are priced using the unit costs from the most recent cost layers. By the LIFO method, inventory is priced using the unit costs in the oldest cost layers.
Explain the effects on the income statement of errors in inventory valuation. In the current year, an error in the costs assigned to ending inventory will cause an opposite error in the cost of goods sold and, therefore, a repetition of the original error in the amount of gross profit. For example, understating ending inventory results in an overstatement of the cost of goods sold and an understatement of gross profit.
The error has exactly the opposite effect on the cost of goods sold and the gross profit of the following year, because the error is now in the cost assigned to beginning inventory.
Estimate the cost of goods sold and ending inventory by the gross profit method and by the retail method. Both the gross profit and retail methods use a cost ratio to estimate the cost of goods sold and ending inventory. The cost of goods sold is estimated by multiplying net sales by this cost ratio; ending inventory then is estimated by subtracting this cost of goods sold from the cost of goods available for sale.
In the gross profit method, the cost ratio is 100 percent minus the company’s historical gross profit rate. In the retail method, the cost ratio is the percentage of cost to the retail prices of mer- chandise available for sale.
Compute the inventory turnover and explain its uses. The inventory turnover rate is equal to the cost of goods sold divided by the average inventory. Users of financial statements find the inventory turnover rate useful in evaluating the liquidity of the company’s inventory. In addition, managers and independent auditors use this computation to help identify inventory that is not selling well and that may have become obsolete.
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Demonstration Problem 361
Key Terms Introduced or Emphasized in Chapter 8
average-cost method (p. 342) A method of valuing all units in inventory at the same average per-unit cost, which is recom- puted after every purchase.
consistency (in inventory valuation) (p. 347) An accounting principle that calls for the use of the same method of inventory pric- ing from year to year, with full disclosure of the effects of any change in method. Intended to make financial statements comparable.
cost flow assumption (p. 342) Assumption as to the sequence in which units are removed from inventory for the purpose of sale. Is not required to parallel the physical movement of mer- chandise if the units are homogeneous.
cost layer (p. 341) Units of merchandise acquired at the same unit cost. An inventory comprised of several cost layers is charac- teristic of all inventory valuation methods except average cost.
cost ratio (p. 356) The cost of merchandise expressed as a per- centage of its retail selling price. Used in inventory estimating techniques, such as the gross profit method and the retail method.
first-in, first-out (FIFO) method (p. 343) A method of com- puting the cost of inventory and the cost of goods sold based on the assumption that the first merchandise acquired is the first merchandise sold and that the ending inventory consists of the most recently acquired goods.
F.O.B. destination (p. 351) A term meaning the seller bears the cost of shipping goods to the buyer’s location. Title to the goods remains with the seller while the goods are in transit.
F.O.B. shipping point (p. 351) The buyer of goods bears the cost of transportation from the seller’s location to the buyer’s location. Title to the goods passes at the point of shipment, and the goods are the property of the buyer while in transit.
gross profit method (p. 356) A method of estimating the cost of the ending inventory based on the assumption that the rate of gross profit remains approximately the same from year to year.
Used for interim valuations and for estimating losses.
inventory turnover (p. 358) The cost of goods sold divided by the average amount of inventory. Indicates how many times the average inventory is sold during the course of the year.
just-in-time (JIT) inventory system (p. 347) A technique designed to minimize a company’s investment in inventory. In a manufacturing company, this means receiving purchases of raw materials just in time for use in the manufacturing process and completing the manufacture of finished goods just in time to fill sales orders. Just-in-time also may be described as the philoso- phy of constantly striving to become more efficient by purchas- ing and storing less inventory.
last-in, first-out (LIFO) method (p. 344) A method of com- puting the cost of goods sold by use of the prices paid for the most recently acquired units. Ending inventory is valued on the basis of prices paid for the units first acquired.
lower-of-cost-or-market (LCM) rule (p. 350) A method of inventory pricing in which goods are valued at original cost or replacement cost (market), whichever is lower.
moving average method (p. 342) A method of valuing all units of inventory at the same average per-unit cost, recalculat- ing this cost after each purchase. This method is used in a per- petual inventory system.
physical inventory (p. 349) A systematic count of all goods on hand, followed by the application of unit prices to the quanti- ties counted and development of a dollar valuation of the ending inventory.
retail method (p. 357) A method of estimating the cost of goods sold and ending inventory. Similar to the gross profit method, except that the cost ratio is based on current cost- to-retail price relationships rather than on those of the prior year.
shrinkage losses (p. 349) Losses of inventory resulting from theft, spoilage, or breakage.
specific identification (p. 342) Recording as the cost of goods sold the actual costs of the specific units sold. Necessary if each unit in inventory is unique, but not if the inventory consists of homogeneous products.
write-down (of an asset) (p. 350) A reduction in the carry- ing amount of an asset because it has become obsolete or its usefulness has otherwise been impaired. Involves a credit to the appropriate asset account, with an offsetting debit to a loss account.
Demonstration Problem
The Audiophile sells high-performance stereo equipment. Massachusetts Acoustic recently intro- duced the Carnegie-440, a state-of-the-art speaker system. During the current year, The Audiophile purchased nine of these speaker systems at the following dates and acquisition costs: