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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