FOCUS ON BUSINESS PRACTICE
FOCUS ON BUSINESS PRACTICE
What Do You Do to Cure a Bottleneck Headache?
A single seat belt can have as many as 50 parts, and getting through the Internet rather than through faxes and phone the parts from suppliers was once a big problem for Autoliv, calls. This system allowed suppliers to monitor the inventory Inc. , a Swedish maker of auto safety devices. Autoliv’s plant at Autoliv and thus to anticipate problems. It also provided in Indianapolis was encountering constant bottlenecks in information on quantity and time of recent shipments, as dealing with 125 different suppliers. To keep the produc- well as continuously updated forecasts of parts that would tion lines going required high-priced, rush shipments on a
be needed in the next 12 weeks. With supply-chain man- daily basis. To solve the problem, the company began using agement, Autoliv reduced inventory by 75 percent and rush supply-chain management, keeping in touch with suppliers freight costs by 95 percent. 4
sold depends on the portion of cost of goods available for sale assigned to ending inventory. These relationships lead to the following conclusions:
씰 The higher the value of ending inventory, the lower the cost of goods sold
and the higher the gross margin. 씰 Conversely, the lower the value of ending inventory, the higher the cost of
goods sold and the lower the gross margin. Because the amount of gross margin has a direct effect on net income, the value
assigned to ending inventory also affects net income. In effect, the value of end- ing inventory determines what portion of the cost of goods available for sale is assigned to cost of goods sold and what portion is assigned to the balance sheet as inventory to be carried over into the next accounting period.
The basic issue in separating goods available for sale into two components—goods sold and goods not sold—is to assign a value to the goods not sold, the ending inven- tory. The portion of the cost of goods available for sale not assigned to the ending inventory is used to determine the cost of goods sold. Because the figures for ending inventory and cost of goods sold are related, a misstatement in the inventory figure at the end of an accounting period will cause an equal misstatement in gross margin and income before income taxes in the income statement. The amount of assets and stockholders’ equity on the balance sheet will be misstated by the same amount.
Inventory is particularly susceptible to fraudulent financial reporting. For example, it is easy to overstate or understate inventory by including end-of-the- year purchase and sales transactions in the wrong fiscal year or by simply misstat- ing inventory. A misstatement can occur because of mistakes in the accounting process. It can also occur because of deliberate manipulation of operating results motivated by a desire to enhance the market’s perception of the company, obtain bank financing, or achieve compensation incentives.
In one spectacular case of fraudulent financial reporting, Rite Aid Corporation , the large drugstore chain, falsified income by manipulating its computerized inven- tory system to cover losses it had sustained from shoplifting, employee theft, and spoilage. In another case, bookkeepers at RentWay, Inc. , a company that rents fur-
Managing Inventories
Example 1, ending inventory is correctly stated; in Example 2, it is overstated by $3,000; and in Example 3, it is understated by $3,000.
Example 1. Ending Inventory Correctly Stated at $5,000
Cost of Goods Sold for the Year
Income Statement for the Year
Beginning inventory
Net sales
Net cost of purchases
Cost of goods sold
Cost of goods
available for sale
Gross margin
Ending inventory
5,000 Operating expenses 16,000 Income before income
Cost of goods sold
Example 2. Ending Inventory Overstated by $3,000
Cost of Goods Sold for the Year
Income Statement for the Year
Beginning inventory
Net sales
Net cost of purchases
Cost of goods sold 27,000
Cost of goods
available for sale
Gross margin
Ending inventory
8,000 Operating expenses 16,000 Income before income
Cost of goods sold
Example 3. Ending Inventory Understated by $3,000
Cost of Goods Sold for the Year
Income Statement for the Year
Beginning inventory
Net sales
Net cost of purchases
Cost of goods sold 33,000
Cost of goods
available for sale
Gross margin
Ending inventory
2,000 Operating expenses 16,000 Income before income
$ 1,000 In all three examples, the cost of goods available for sale was $35,000. The
Cost of goods sold
taxes
difference in income before income taxes resulted from how this $35,000 was divided between ending inventory and cost of goods sold.
Because the ending inventory in one period becomes the beginning inven-
Study Note
tory in the following period, a misstatement in inventory valuation affects not
A misstatement of inventory only the current period but the following period as well. Over two periods, the has the opposite effect in two
errors in income before income taxes will offset, or counterbalance, each other. successive accounting periods.
For instance, in Example 2, the overstatement of ending inventory will cause a $3,000 overstatement of beginning inventory in the following year, which will result in a $3,000 understatement of income. Because the total income before
CHAPTER 6 Inventories The effects of inventory misstatements on income before income taxes are as
Ending inventory overstated
Beginning inventory overstated
Cost of goods sold understated
Cost of goods sold overstated
Income before income taxes
Income before income taxes
overstated
understated
Ending inventory understated
Beginning inventory understated
Cost of goods sold overstated
Cost of goods sold understated
Income before income taxes
Income before income taxes
understated
overstated