Merchandise Inventory Chapter 6 Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

Accounting principles and controls related to merchandise inventory

Consistency Principle Businesses should use the same accounting methods and procedures from period to period. Consistency helps users of financial statement information to compare financial statements from one period to the next. A change in the accounting methods, must be reported to the investors and creditors in the Notes to the Financial Statements. There are several principles upon which the foundations of accrual accounting are built. The first of these is Consistency. The basic principle states that, even though companies have choices with respect to the accounting principles they choose to apply, once chosen, they should use the same principles from one period to the next, unless there is a compelling business reason to change. And if they change the accounting principles they apply, they should communicate the change to their stakeholders.

Disclosure Principle A company should report enough information to allow users to make knowledgeable decisions about the company. Information should be relevant and have faithful representation. The Disclosure Principle states that a company should disclose sufficient information to their stockholders and creditors to allow them to make informed decisions about resource allocation. Source: Green Mountain Coffee Roasters, Inc., 2011 Financial Statements, Note 1.

Materiality Concept Many large companies report their financial numbers in millions. Cash on the balance sheet of $7,500 might be $7,500,000,000 because the last six zeroes have been left off. Anything below $1,000,000 is considered to be immaterial. A company must follow strictly proper accounting only for significant items. Information is significant when it would cause someone to change a decision. The Materiality Concept states that companies need not report every cent. In essence, the Concept recognizes that the size of the dollar amounts of transactions is most relevant when compared to the overall size of the company. For example, a $1,000,000 transaction is very relevant to a $10,000,000 company. However, to a $1 billion company, a $1,000,000 transaction is probably not large enough to, of itself, impact the decision of an stockholder or creditor.

Conservatism A company should report the least favorable figures in the financial statements when two or more possible options are presented. Goal: Never overstate assets or net income. Anticipate no gains Provide for probable losses Conservatively report assets and liabilities When in doubt record an expense instead of an asset Choose options that undervalue the business Conservatism is a principle that states that when a company has a choice between different accounting treatments, the company should choose the accounting treatment that is least likely to overstate assets or net income.

Recording Merchandise Inventory At the end of the period, count the units in ending inventory and assign dollars to the account. At the end of the period, determine the units sold during the period and assign dollars to Cost of Goods Sold. At the end of each fiscal period, there are two accounts that reflect information about inventory—Merchandise Inventory and Cost of Goods Sold. The number of units in Merchandise Inventory at the end of the period can be determined by physically counting the amount of inventory owned by the company at the end of the period. The number of units sold during the period will be determined and then multiplied by the per-unit-cost of the inventory.

Inventory Costing Methods There are four basic GAAP-acceptable approaches to assigning cost to inventory Specific Identification First-in, first-out (FIFO) Last-in, last-out (LIFO) Weighted-Average 4 Basically, there are for approaches that are acceptable to GAAP for computing the amount of dollars to assign to ending inventory and to cost of goods sold. Those methods are Specific Identification, First-In First-Out (FIFO), Last-In last-Out (LIFO), and Weighted Average.

Perpetual Specific Identification Used when the specific cost for each unit of inventory can be tracked. As each unit is sold, its specific cost is transferred from inventory to Cost of Goods Sold. Used for inventories that include: Automobiles Unique Artwork Jewels Real Estate Specific Identification is dependent on being able to identify the specific cost associated with each individual item in inventory. This is most efficient when each item in inventory is unique with a unique identifier. Examples include automobiles that have a unique vehicle identification number (VIN), one-of-a-kind pieces of artwork, real estate, and expensive diamonds that have an ID number engraved on the bezel of the stone.

Perpetual Inventory Record Specific Identification Assume that we have a hypothetical company that begins the period on August 1 with 2 units in inventory that cost $350 each. On August 5, they acquire an additional 4 units of inventory at $360 per unit. On August 15, 4 units are sold. Assume that the units are individually identifiable and that we know that 1 of the 4 units sold cost us $350, and the other three units sold each cost $360 per unit. On August 26, an additional 12 units are acquired at a cost of $380 per unit. On August 31, 10 units are sold. We are able to identify that 1 of those units is the remaining $350 unit, and that the rest each cost us $380 per unit. In effect, each time there is a sale, we remove from inventory only the cost that is “specifically” identified with the specific units that are sold.

Account for merchandise inventory costs under a periodic inventory system (Appendix 6A)

Periodic Inventory Accounting Inventory is not tracked in the accounting system continuously. Beginning inventory balance is carried until the end of the period. Purchases are accumulated during the period. Ending inventory balance replaces the beginning inventory balance. An alternative to accounting for inventory using a perpetual approach is to account for the inventory using a periodic approach. Under the periodic approach, the tedious task of recording each sale as it impacts Cost of Goods Sold and the inventory account is eliminated. Essentially, we will start the month with a balance in beginning inventory. As we acquire additional inventory, we record that inventory in a Purchases account. When we sell inventory, we do not record an adjustment to the inventory or Cost of Goods Sold account. Rather, we only record the sale and its impact on Cash or Accounts Receivable. At the end of the month we use the traditional inventory model to “back into” the Cost of Goods Sold number.

Inventory Costing Methods Three approaches to assigning cost to inventory in a periodic system. First-in, first-out (FIFO) Last-in, last-out (LIFO) Weighted-Average 3 The Periodic approach can be applied to all three basic approaches—FIFO, LIFO, and Weighted Average.

Using the information below, let’s see how we would apply a periodic system to determine Cost of Goods Sold. We will start with the information in the accounting records regarding the flow of inventory during the period. We can see from the inventory record that we started the month with 2 units in inventory. We purchased more inventory on August 5 (4 units) and on August 26 (12 units), for a total of 16 units purchased during the month. Combined with the beginning inventory of 2 units, there are 18 units available for sale during the month. We sold inventory on August 15 (4 units) and on August 31 (10 units), for a total of 14 units sold during the month. Once we know this information, we can compute ending inventory using one of our three methods. 18 units available for sale during August

Periodic Inventory—FIFO Ending Inventory will be costed out using the NEWEST items in inventory. Cost of Goods Sold will include the OLDEST costs. In FIFO, we assume that the oldest units in inventory will be sold first, so we take those out of inventory before taking any other units out of inventory. We assume that the ending inventory is comprised of the newest units in inventory. In our example, the beginning inventory of 2 units @ $350 ($700) plus the net purchases for the period ($6,000) will give use $6,700 of inventory available for sale during the month. We know that we have 4 units left in ending inventory, and those units will represent the 4 most recently purchased units. The 4 most recently purchased units were purchased at a cost of $380 per unit, giving us an ending inventory of $1,520 (4 x $380). The Cost of Goods Sold is determined by subtracting the ending inventory ($1,520) from the Cost of Goods Available for Sale ($6,700) to arrive at COGS for the period of $5,180.

Using the information below, let’s see how we would apply a periodic system to determine Cost of Goods Sold. We will start with the information in the accounting records regarding the flow of inventory during the period. We can see from the inventory record that we started the month with 2 units in inventory. We purchased more inventory on August 5 (4 units) and on August 26 (12 units), for a total of 16 units purchased during the month. Combined with the beginning inventory of 2 units, there are 18 units available for sale during the month. We sold inventory on August 15 (4 units) and on August 31 (10 units), for a total of 14 units sold during the month. Once we know this information, we can compute ending inventory using one of our three methods.

Periodic Inventory—LIFO Ending Inventory will be costed out using the OLDEST items in inventory. Cost of Goods Sold will include the NEWEST costs. In LIFO, we assume that the newest units in inventory will be sold first, so we take those out of inventory before taking any other units out of inventory. We assume that the ending inventory is comprised of the oldest units in inventory. In our example, the beginning inventory of 2 units @ $350 ($700) plus the net purchases for the period ($6,000) will give use $6,700 of inventory available for sale during the month. We know that we have 4 units left in ending inventory, and those units will represent the 4 oldest units. The 4 oldest units will be comprised of the 2 units from beginning inventory (2 x $350 = $700) plus 2 of the units from the August 5 purchase (2 x $360 = $720), giving us an ending inventory of $1,420 ($700 + $720 = $1,420). The Cost of Goods Sold is determined by subtracting the ending inventory ($1,420) from the Cost of Goods Available for Sale ($6,700) to arrive at COGS for the period of $5,280.

Periodic Inventory—Weighted Average Average cost $6,700 ÷18 = $372.22 Ending Inventory is costed using the AVERAGE cost of inventory. Cost of Goods Sold will also be costed using AVERAGE cost of inventory. In Weighted Average, the order of the sale is irrelevant. All inventory will be removed from inventory using the average cost of the inventory for the period. The first step is to determine the weighted average cost per unit of inventory. The weighted average cost per unit is determined by the following formula: Cost of Goods Available for Sale during the period divided by the number of units available for sale during the period: $6,700 ÷ 18 units = $372.22 per unit To estimate the cost of ending inventory, we multiply the weighted average cost per unit times the number of units in ending inventory: $372.22 x 4 = $1,489 The Cost of Goods Sold is determined by subtracting the ending inventory ($1,489) from the Cost of Goods Available for Sale ($6,700) to arrive at COGS for the period of $5,211.

5,280 5,211 $ 1,420 $ 1,489

The relationship that we observed with our inventory example will be true any time that costs are constantly increasing. When prices are constantly decreasing, the relationship will be just the opposite.

Lower-of-Cost-or-Market The LCM rule requires that inventory should be reported in the financial statements at the lower of the inventory’s original cost or its market value. Big Inc. is holding inventory that cost $2 million. However, due to technological developments, the market value of that inventory is only $1.2 million. The inventory should be written down to $1.2 million. Even after we have used one of the inventory methods to determine the cost of the ending inventory and Cost of Goods Sold, there is a limiting rule in accounting called the “Lower of Cost or Market Rule,” or LCM Rule. Under the LCM rule, the final carrying amount of the inventory on the books will be the lower of the cost (as determined using one of our inventory methods) or the market value of the inventory. In some cases, inventory will decrease permanently in value while it is being held by the company. For example, a new product may be introduced by a competitor that makes all existing inventories obsolete. In such cases, the market value of the inventory on hand may actually be lower than its original cost. In those cases, we will adjust inventory to the lower amount. In this example, the inventory has a cost of $2 million. However, the market value of that inventory is only $1.2 million. There is a need to write down the inventory to $1.2 million, because the LCM Rule tells us that inventory must be carried at the LOWER of cost or market.

Adjusting Inventory for Lower-of-Cost-or-Market Smart Touch Learning paid $3,000 for its TAB0503 inventory. By December 31, it can be replaced for only $2,200. Let’s assume that Smart Touch Learning paid $3,000 for some inventory. By December 31, that inventory is only worth $2,200. We will adjust the $3,000 debit balance in inventory by crediting if for $800, bringing the balance to $2,200. The debit for the adjustment will be to Cost of Goods Sold.

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Effect of Inventory Errors An error in inventory can lead to errors in other accounts. Because the ending inventory number is used in other computations, when ending inventory is incorrect, other numbers will also be incorrect. Smart Touch Learning reported $5,000 more ending inventory than it actually had. How does this error impact other numbers? It is crucial that the ending inventory amount on the balance sheet is correct. If it is incorrect, it will have a domino effect on several other numbers, making them incorrect also. Let’s assume that Smart Touch Learning reported ending inventory at an amount $5,000 higher than it should.

Effect of Inventory Errors The ending inventory is overstated by $5,000, violating our Conservatism Principle. However, when ending inventory is overstated, that means that the Cost of Goods Sold will be understated, leading to both Gross Profit and Net Income being overstated.

Effect of Inventory Errors A common fraud is for a company to intentionally overstate ending inventory, because it leads to higher Net Income. Sometimes ending inventory is understated. Suppose that Smart Touch Learning understated inventory by $1,200. How does this error impact other numbers? Next, let’s assume that Smart Touch Learning reported ending inventory at an amount $1,200 lower than it should.

Effect of Inventory Errors When the ending inventory is understated by $1,200, Cost of Goods Sold will be overstated, leading to both Gross Profit and Net Income being understated.

Inventory Errors: Multiple Periods Recall that one period’s ending inventory becomes the next period’s beginning inventory. As a result, an error in ending inventory carries over into the next period. Period 1’s ending inventory is overstated by $5,000; Period 1’s ending inventory should be $10,000. The error carries over to Period 2. Period 3 is correct. In fact, both Period 1 and Period 2 should look like Period 3. Ending inventory is subtracted to compute cost of goods sold in one period. The same amount is added as beginning inventory in the next period. Therefore, an inventory error cancels out after two periods. The overstatement of cost of goods sold in Period 2 counterbalances the understatement for Period 1. So, total gross profit for the two periods combined is correct.

Use inventory turnover and days’ sales in inventory to evaluate business performance(liquidity)

Inventory Turnover Measures how rapidly inventory is sold. Inventory turnover should be evaluated against industry averages. A high turnover rate indicates ease of selling. A low turnover rate indicates difficulty of selling. There are a few ratios that relate to inventory and are helpful in assessing the company’s overall financial health. The first of those ratios is Inventory Turnover. This is a measure of how frequently a company has to replace its inventory. Knowing this frequency will help to establish how much inventory to purchase and how often to place orders.

Example Average Inventory = $467,363

Days’ Sales in Inventory Measures average number of days inventory is held by the company. Different types of inventory will move faster. For inventory with an expiration date, this measure is very important. The Days’ in Sales Inventory is a measure of how old inventory is. We compute it by dividing the number of days in a fiscal year by the Inventory Turnover Ratio. This ratio will tell us the age of the inventory, which is of particular use when we handle inventory with an expiration date.

Example

Inventory Estimation methods Gross profit method and the retail method (Appendix 6B)

Gross Profit Method If the ending inventory cannot be counted, it can be estimated. Cost of Goods Sold can be estimated using Sales Revenue and the Gross Profit percent. Not acceptable for Financial reporting Used for interim reporting or casualty loss estimates Sometimes, we are unable to determine how many units we have in ending inventory. When that happens, it is also difficult to determine Cost of Goods Sold. There are two methods we can use to “estimate” ending inventory by estimating Cost of Goods Sold. Both methods will rely on our understanding of the relationship between Sales, Cost of Goods Sold, and Gross Profit.

Gross Profit Method Suppose Smart Touch Learning’s ending inventory was destroyed. Assume: Beginning Inventory was $14,000. Purchases for the period were $66,000. Sales for the period were $100,000 and the gross profit percent = 40%. The Gross Profit Method will first estimate Cost of Goods sold and then use the estimated Cost of Goods Sold to compute Ending Inventory.

Gross Profit Method To estimate Cost of Goods Sold, subtract the normal gross profit from sales. $100,000 – $40,000 = $60,000 This will allow you to estimate Ending Inventory. Our earlier information told us that Cost of Goods Available for Sale was $80,000 ($14,000 + $66,000). By subtracting our estimate of Cost of Goods Sold of $60,000, we can estimate that ending inventory should be $20,000.

Retail Method If the ending inventory cannot be counted, it can be estimated. Ending Inventory is estimated using the ratio of Goods Available for Sale at Cost to Goods Available for Sale at Retail. Acceptable for financial reporting purposes Under the Retail Method, we are going to estimate the value of the ending inventory at retail and then reduce it back to a cost estimate using the Cost to Retail Ratio. Kohl's Footnote