Download Chapter 6 - Sacramento State

Accounting Fundamentals
Dr. Yan Xiong
Department of Accountancy
CSU Sacramento
The lecture notes are primarily based on Reimers
(2003).
7/11/03
Chapter 6: Inventory and Liabilities
Agenda





Inventory Cost
Cost of Goods Sold
Inventory Cost Flow Methods
Inventory Management
Lower of Cost or Market
Agenda
Inventory Cost
Inventory is
recorded at the
price paid for it.
Inventory
 Inventory is tangible property that is held for resale
or will be used in producing goods or services.
 Inventory is reported on the balance sheet as a
current asset.
 Types of inventory:
 Merchandise inventory
 Raw materials inventory
These 3 will


Work in process inventory
Finished goods inventory
be studied
in managerial
accounting.
Inventory Cost


The amount recorded for inventory
should include:
Invoice price, transportation charges,
inspection costs, and preparation
costs.
Inventory may be tracked with either a
periodic or a perpetual inventory
system.
Shipping Terms
(Sales & Purchases)
 F.O.B. shipping point or destination
tells
who pays shipping
 F.O.B shipping indicates that the title to
the goods changes hands at shipping.
 F.O.B. destination indicates that the title
to the goods changes hands at
destination.
Shipping Costs
 Whoever owns the goods
while they are in-transit
pays for the shipping.
 Shipping costs to get the
inventory IN are included
as part of the cost of the
inventory.
 Shipping costs for a sale
are part of operating
expenses.
Terms of Sale and Purchases
 2/10, n/30 (for example)
2%
discount if invoice paid in ten
days
tells when and how much must be
paid
high interest cost of not taking
purchase discounts
Recording Inventory Purchases and
Freight Costs




On March 10, Paul’s Photo Center purchases
100 cameras that cost $125 each with credit
terms 3/10, n/30. The goods were shipped FOB
shipping point and the invoice included $50 in
freight charges.
What is the total cost of the cameras?
(100 * $125) = $12,500 + $50 = $12,550
Why is the cost of the freight added to the cost
of the cameras?
Recording Inventory Purchases
and Freight Costs


The total cost of the asset, inventory,
will equal all costs incurred to bring the
asset to its intended use.
Thus, the $12,550 is the purchase price
of the cameras plus the cost of the
shipping and handling.
Recording Inventory Purchases and
Freight Costs

How would the purchase of inventory be
recorded under a perpetual inventory
system?
Date
Transaction
Mar 10 Inventory
Accounts payable
Debit Credit
12,550
12,550
Recording Inventory Purchases and
Freight Costs

How would the purchase of inventory be
recorded under a periodic inventory
system?
Date
Transaction
Mar 10 Purchases
Freight in
Accounts payable
Debit Credit
12,500
50
12,550
Recording Inventory Purchases
with a Purchase Discount


If Paul pays for the cameras within 10 days,
then Paul will take a 3% discount on the
purchase price of the cameras.
Freight is excluded in calculating the
discount since Paul paid $50 to ship the
inventory whether or not the discount is
taken.
By paying the invoice within the discount
period, Paul is decreasing the cost of the
inventory by 3% or $375. ($12,500 * .03)
Recording Inventory Purchases with a
Purchase Discount

How would the payment for the inventory
on March 20 be recorded under a perpetual
inventory system?
Date
Transaction
Mar 20 Accounts payable
Inventory
Cash
Debit Credit
12,550
375
12,175
Recording Inventory Purchases with a
Purchase Discount

How would the payment for the inventory
on March 20, be recorded under a periodic
inventory system?
Date
Transaction
Mar 20 Accounts payable
Purchase discounts
Cash
Debit Credit
12,550
375
12,175
Recording Inventory Purchases with a
Purchase Discount

How would the payment be recorded under a
perpetual inventory system on March 25?
Date
Transaction
Mar 25 Accounts payable
Cash
Debit Credit
12,550
12,550
Recording Inventory Purchases with a
Purchase Discount

How would the payment be recorded under
a periodic inventory system on March 25?
Date
Transaction
Mar 25 Accounts payable
Cash
Debit Credit
12,550
12,550
Recording Inventory Purchases with
a Purchase Discount


Notice that if Paul does not take
advantage of the discount offered by the
vendor, then the cost of the inventory
remains $12,550.
If Paul does take advantage of the
discount, then the cost of the inventory is
reduced to $12,175.
($12,500 - $375) + $50 freight in
Recording Purchase Returns and
Allowances


Assume on March 15, Paul returns $140 of
defective inventory that had not been paid for yet.
How would the return be recorded under a
perpetual inventory system?
Date
Transaction
Mar 15 Accounts payable
Inventory
Debit Credit
140
140
Recording Purchase Returns and
Allowances


Assume on March15, Paul returns $140 of defective
inventory that had not been paid for yet.
How would the return be recorded under a periodic
inventory system?
Date
Transaction
Debit Credit
Mar 15 Accounts payable
140
Purchase returns & allowances
140
Agenda
Cost of Goods Sold
Beginning inventory
Add: Purchases (net)
Goods available for sale
Deduct: Ending inventory
Cost of goods sold
Recording Sales Under a Perpetual
Inventory system:


Under a perpetual inventory system, the
inventory account balance is updated
anytime a sale occurs.
Recording the sale involves two steps:
Step 1: Record the sale
Step 2: Recognize Cost of goods sold
and update the Inventory account.
Recording Sales Under a Perpetual
Inventory system:


Assume on April 2, Paul’s Photo Center sells
20 cameras for $250 each on account.
How would the sale be recorded?
Date
Transaction
Apr 2 Accounts receivable
Sales
Cost of goods sold
Inventory
Debit Credit
5,000
5,000
2,500
2,500
Recording Sales Under a Periodic
Inventory system:


Under a periodic inventory system, the
Inventory account is not updated until the
end of the accounting period.
How would the sale be recorded?
Date
Transaction
Apr 2 Accounts receivable
Sales
Debit Credit
5,000
5,000
Agenda

Inventory Cost Flow Methods
Alternative Inventory Cost Flow Methods
FIFO
Weighted
Average
LIFO
Inventory Cost Flow Methods
These four inventory costing methods are
used to assign the total dollar amount of
goods available for sale between ending
inventory and cost of goods sold.
Ending
inventory
or CGS??
Costs of Goods Sold
 Cost of goods sold is calculated as the
number of units sold during the period
multiplied by their unit costs.
 Cost of goods sold is a major expense item
for most nonservice businesses.
 The measurement of cost of goods sold is an
excellent example of the application of the
matching principle.
First-In, First-Out



The cost of the oldest inventory items are
charged to cost of goods sold when goods
are sold.
The cost of the newest inventory items
remain in ending inventory.
The actual physical flow of inventory items
may differ from the FIFO cost flow
assumptions.
Last-In, First-Out



The cost of the newest inventory items are
charged to cost of goods sold when goods
are sold.
The cost of the oldest inventory items remain
in ending inventory.
The actual physical flow of inventory items
may differ from the LIFO cost flow
assumptions.
Weighted-Average


Take the average cost of all goods
available for sale to value both CGS and
Ending Inventory.
BE SURE IT’S WEIGHTED!
Specific Identification


Specific cost of each inventory
item is known.
Used with small volume, high
dollar inventory.
Example
Date
3/1
3/10
3/15
3/27
Event
Beg. Inv.
Purchase
Purchase
Sale
Units
10
12
11
18
Price
$ 6
7
8
15
Total
$ 60
84
88
270
FIFO
Cost of Goods Sold:
From
Units
3/1
10
3/10
8
Totals
18

Price
$ 6
7
Cost
$ 60
56
$116
Price
$ 7
8
Cost
$ 28
88
$116
Ending Inventory:
From
3/10
3/15
Totals
Units
4
11
15
LIFO
Cost of Goods Sold:
From
Units
3/15
11
3/10
7
Totals
18
 Ending Inventory:
From
Units
3/10
5
3/1
10
Totals
15

Price
$ 8
7
Cost
$ 88
49
$137
Price
$ 7
6
Cost
$ 35
60
$ 95
Weighted Average
Average cost per unit:
Cost of GAFS
# of units GAFS
$ 232
33
= $7.03
Cost of Goods Sold:
18 units @ $7.03 = $127 (rounded)
Ending Inventory:
15 units @ $7.03 = $105 (rounded)
Income Statements
Singlestep Income Statement
Revenues
Expenses
Net Income
Multistep Income Statement
Sales
Cost of Goods Sold
Gross margin
Operating Expenses
Income before taxes
Income Taxes
Net income
Income Statements
[Given operating expenses of $50 and a 40% tax rate]
FIFO
Sales
CGS
GM
Oper. exp.
Pretax inc.
Taxes (40%)
Net Income
LIFO
Wt. Avg.
Income Statements
[Given operating expenses of $50 and a 40% tax rate]
Sales
CGS
GM
Oper. exp.
Pretax inc.
Taxes (40%)
Net Income
FIFO
LIFO
Wt. Avg.
$270
116
154
50
104
42
$ 62
$270
137
133
50
83
33
$ 50
$ 270
127
143
50
93
37
$ 56
Comparison of Methods


Each of the four methods is acceptable,
and an argument can be made for using
each.
The choice of an inventory method will
depend on management’s incentives,
the tax laws, and the reporting
company’s particular economic
circumstances.
Consistency Principle
Because the choice of an
inventory method can
significantly affect the
financial statements, a
company might be inclined
to select a new method
each year that would result
in the most favorable
financial statements.
However . . .
Consistency Principle
. . . the consistency principle requires
that companies use the same
accounting methods period after
period so the financial statements of
succeeding periods will be
comparable.
Alternative Inventory Costing
Methods in Practice
The LIFO conformity rule states that
if LIFO is used for taxes, then LIFO
must also be used for financial
reporting.
LIFO for
taxes
LIFO for
books
Example: Periodic vs. Perpetual






BI
1/5/95 purchased
3/6/95 sold
5/16/95 purchased
7/5/95 sold
9/3/95 purchased
15 units @ $20 each
20 units @ $21 each
10 units
30 units @ $22 each
20 units
10 units @ $23 each
Calculate Ending Inventory and Cost of Goods
Sold under
1-FIFO perpetual
2-FIFO periodic
3-LIFO perpetual
4-LIFO periodic
Goods Available for Sale




15 @ $20 = $300
20 @ $21 = $420
30 @ $22 = $660
10 @ $23 = $230
$1610
FOR SALE
FIFO--Perpetual
Sale on 3/6 of 10 units comes from BI @ $20 each
 Sale on 7/5 of 20 units comes from BI (5 units @ $20) and
from 1/5 purchase (15 units @ $21)
 Total CGS = $200 + $100 + $315 = $615
 Ending Inv. = 1/5/95
5 @ $21 = 105
5/16/95 30 @ $22 = 660
$995
9/3/95
10 @ $23 = 230

FIFO--Periodic
Total sales of 30 units
 Start with the oldest for CGS:
15 units from BI
=
15 units from 1/5/95 purchase =
Total CGS
=

Ending Inv. = 1/5/95
5/16/95
9/3/95
5 @ $21 = 105
30 @ $22 = 660
10 @ $23 = 230
$300
$315
$615
$995
LIFO--Perpetual
 Sale
on 3/6 of 10 units comes from 1/5 purchase
(the most recent one at the time of the sale): $210
 Sale on 7/5 of 20 units comes from 5/16 purchase:
$440
 Total CGS = $210 + $440 = $650
 Ending Inv. = BI
15 @ $20 = $300
1/5/95 10 @ $21 = 210
5/16/95 10 @ $22 = 220
$960
9/3/95 10 @ $23 = 230
LIFO--Periodic
Total sales of 30 units
 Start with the latest purchases for CGS:
10 units from 9/3/95 purchase =
20 units from 5/16/95 purchase =
Total CGS
=

Ending Inv. =
BI
1/5/95
5/16/95
15 @ $20 =
20 @ $21 =
10 @ $22 =
$230
$440
$670
$300
$420
$220
$940
Agenda

Inventory Management
Accounting and Inventory
Management
The accounting system plays three roles in
inventory management:
 Provides accurate information for financial
statements and tax reports.
 Provides up-to-date information on inventory
quantities and cost.
 Provides information necessary to protect
inventory from theft and misuse.
Financial Statement Analysis

Inventory Turnover
Inventory
=
Turnover
Cost of Goods Sold
Average Inventory
This ratio is often used to
measure the liquidity (nearness
to cash) of the inventory.
Agenda

Lower of Cost or Market
Lower of Cost or Market



Ending inventory is reported at the
lower of cost or market (LCM).
Market refers to the replacement cost
of the merchandise.
This practice is in keeping with the
generally accepted accounting
principle of conservatism.
Errors in Measuring Ending Inventory


Misstatements in inventory may cause errors in the
following areas:
 Income Statement
Cost of Goods Sold, Gross Profit, Net Income
 Balance Sheet
Inventory, Payables, Retained Earnings
Because the ending inventory of one period
becomes the beginning inventory of the next period,
ending inventory errors affect two accounting
periods.
Inventory Errors
The ending inventory for CBCR Co. was overstated
by $2000 for the year 2002. What effect did the
error have on
 Beginning inventory 2002:
no effect
 Purchases in 2002:
no effect
 Goods available for sale in 2002:
no effect
 Cost of Goods Sold in 2002:
understated
 Gross margin in 2002:
overstated
 Net income in 2002:
overstated
The Next Year






Beginning inventory 2003:
overstated
Purchases for 2003:
no effect
Goods available for sale in 2003:
overstated
Cost of Goods Sold for 2003:
overstated
Gross margin for 2003:
understated
Net income for 2003:
understated
Ratios: Gross Margin Percentage
 Gross margin %:
gross
sales
Net
margin as a percent of
sales - CGS (=gross margin)
Net sales
Ratios: Return on Sales
 Return on sales =
Net income
Net sales
Revenues - expenses
Net sales
Ratios: Return on Assets
Return on Assets
=
Net Income
Assets