determine ownership of these goods

determine ownership of these goods

But industry analysts, as well as the com-

pany’s managers, thought otherwise. In order to

maintain Caterpillar’s position as the industry

leader, management began another major overhaul

of inventory production and inventory management

processes. The goal: to cut the number of repairs in

half, increase productivity by 20%, and increase

inventory turnover by 40%. In short, Caterpillar’s

ability to manage its inventory has been a key rea-

son for its past success, and inventory management

will very likely play a huge part in its ability to suc-

ceed in the future.



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Helpful Hint Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

Reporting and Analyzing Inventory

In the previous chapter, we discussed the accounting for merchandise inventory using a perpetual inventory sys- tem. In this chapter, we explain the methods used to calculate the cost of inventory on hand at the balance sheet date and the cost of goods sold. We conclude by illustrating methods for analyzing inventory.

The content and organization of this chapter are as follows.

Classifying Inventory How a company classifies its inventory depends on whether the firm is a mer- chandiser or a manufacturer. In a merchandising company, such as those de- scribed 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 character- istics: (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: fin- ished 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 begun 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, Caterpillar classifies earth-moving 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 trac- tors are identified as raw materials.

The accounting concepts discussed in this chapter apply to the inventory classifications of both merchandising and manufacturing companies. Our focus throughout most of this chapter is on merchandise inventory.

By observing the levels and changes in the levels of these three inven- tory 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 reces- sion. On the other hand, high levels of raw materials and low levels of finished goods probably indicate that management is planning to step up production.

preview of chapter 6

• Merchandising • Manufacturing • Just-in-time

Classifying Inventory

• Taking a physical inventory • Determining ownership of


Determining Inventory Quantities

• Specific identification • Cost flow assumptions • Financial statement and tax

effects • Consistent use • Lower-of-cost-or-market

Inventory Costing

• Inventory turnover ratio • LIFO reserve

Analysis of Inventory


c06ReportingandAnalyzingInventory.qxd 8/14/10 2:24 PM Page 282

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 is famous for having developed a system for making computers in response to individual customer requests. Even though it makes computers to meet a customer’s particular spec- ifications, Dell is able to assemble the computer and put it on a truck in less than 48 hours. The success of a JIT system depends on reliable suppliers. By in- tegrating its information systems with those of its suppliers, Dell reduced its in- ventories to nearly zero. This is a huge advantage in an industry where products become obsolete nearly overnight.

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 purposes: The first purpose is to check the accuracy of their perpetual inventory records. The second is to determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.

Companies using a periodic inventory system must take a physical inventory for two different purposes: to determine the inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period.

Determining inventory quantities involves two steps: (1) taking a physical in- ventory of goods on hand and (2) determining the ownership of goods.


Companies take the physical inventory at the end of the accounting period. Tak- ing a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. In many companies, taking an inventory is a formi- dable task. Retailers such as Target, True Value Hardware, or Home Depot have thousands of different inventory items. An inventory count is generally more ac- curate when a limited number of goods are 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 low- est level—to count inventory. Recall from Chapter 5 that Wal-Mart had a year- end of January 31.

Determining Inventory Quantities 283

A Big Hiccup

JIT can save a company a lot of money, but it isn’t without risk. An unex- pected disruption in the supply chain can cost a company a lot of money. Japanese au- tomakers experienced just such a disruption when a 6.8-magnitude earthquake caused major damage to the company that produces 50% of their piston rings. The rings them- selves cost only $1.50, but without them you cannot make a car. No other supplier could quickly begin producing sufficient quantities of the rings to match the desired specifi- cations. As a result, the automakers were forced to shut down production for a few days—a loss of tens of thousands of cars.

Source: Amy Chozick, “A Key Strategy of Japan’s Car Makers Backfires,” Wall Street Journal (July 20, 2007).

Accounting Across the Organization

?What steps might the companies take to avoid such a serious disruption in the future?(See page 330.)

1 Describe the steps in determining inventory quantities.

Ethics Note In a famous fraud, a salad oil company filled its storage tanks mostly with water. The oil rose to the top, so auditors thought the tanks were full of oil. The company also said it had more tanks than it really did: it repainted numbers on the tanks to confuse auditors.

study objective

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284 chapter 6 Reporting and Analyzing Inventory


One challenge in determining inventory quantities is making sure a company owns the inventory. 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.

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