Inventory Chapter 8 Why is accounting for inventory so important? A. It is one of the largest current assets for a merchandising company – affects the balance sheet B. Cost of goods sold is one of the largest expenses on the income statement – affects the income statement Proper valuation of inventory has a material impact on the financial reports 1 1

Describe inventory and discuss the related internal controls Objective 1 Describe inventory and discuss the related internal controls

Inventory Goods that a business owns and has available to sell to customers as part of normal operations Current asset – usually listed after accounts receivable

Internal Controls Separation of access to assets from access to record Secure inventory items Physical count at least once a year Maintain perpetual records of inventory transactions Document purchases and sales Goals are to keep inventory physically safe and organized. Also to ensure that the accounting records are accurate

Objective 2 Compute inventory costs using first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost methods and journalize inventory transactions

Inventory Costing Methods Specific Unit Cost FIFO LIFO Average Cost When cost of inventory per unit does not change, accounting for cost of inventory is easy. But what happens when costs do change….let’s say you have 5 units inventory on the shelf that cost $1 per unit, but when you buy 10 new units of inventory in January, they cost $2 per unit. When you later sell 6 units, which cost should be assigned to cost of goods sold? $1 or $2? All of these methods are acceptable according to GAAP.

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

FIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 40 $40

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

FIFO Perpetual Inventory Accounting Date Description Debit Credit Inventory. 270 Accounts Payable 270 July 5

FIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

First-In, First-Out (FIFO) Valued based on the earlier cost of purchases. Cost of Goods Sold Valued based on the most recent costs of purchases Ending Inventory

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

FIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $470 Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

FIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $470 15 1 $40 $40 3 $45 $135 3 $45 $135

FIFO Perpetual Inventory Accounting Date Description Debit Credit Accounts Receivable 320 Sales 320 Cost of Goods Sold 175 Inventory 175 July 15

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

FIFO Perpetual Inventory Accounting Date Description Debit Credit Inventory. 350 Accounts Payable 350 July 26

FIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 15 1 $40 $40 3 $45 $135 3 $45 $135 26 7 $50 $350 3 $45 $135 7 $50 $350

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

First-In, First-Out (FIFO) Valued based on the earlier cost of purchases. Cost of Goods Sold Valued based on the most recent costs of purchases Ending Inventory

FIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $470 15 1 $40 $40 3 $45 $135 3 $45 $135 26 7 $50 $350 3 $45 $135 7 $50 $350

FIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $470 15 1 $40 $40 3 $45 $135 3 $45 $135 26 7 $50 $350 3 $45 $135 7 $50 $350 31 3 $45 $135 5 $50 $250 2 $50 $100

FIFO Perpetual Inventory Accounting Date Description Debit Credit Accounts Receivable 640 Sales 640 Cost of Goods Sold 385 Inventory 385 July 31

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

FIFO Perpetual Inventory Accounting Date Description Debit Credit Inventory. 275 Accounts Payable 275 July 31

FIFO Perpetual Inventory Account Item DVD’s Purchases Cost Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $470 15 1 $40 $40 3 $45 $135 3 $45 $135 26 7 $50 $350 3 $45 $135 7 $50 $350 31 3 $45 $135 31 5 $50 $250 2 $50 $100 31 5 $55 $275 2 $50 $100 5 $55 $275

Inventory Shrinkage Loss of inventory Compare physical count with balance in books Sources Breakage Theft Obsolescence

Inventory Shrinkage Took a physical count of DVD’s and determined that two were damaged during shipment. Record the adjusting entry for inventory shrinkage.

FIFO Perpetual Inventory Account Item Suede Jacket Purchases Cost Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $470 15 1 $40 $40 3 $45 $135 3 $45 $135 26 7 $50 $350 3 $45 $135 7 $50 $350 31 3 $45 $135 31 5 $50 $250 2 $50 $100 31 5 $55 $275 2 $50 $100 5 $55 $275

First-In, First-Out (FIFO) Valued based on the earlier cost of purchases. Cost of Goods Sold and shrinkage Valued based on the most recent costs of purchases Ending Inventory

Inventory value of 5 units Remaining Inventory Shrinkage Inventory value of 5 units Remaining 5 at $55 = $275 ($375-$275 = $100)

FIFO Inventory Shrinkage Date Description Debit Credit Cost of Goods Sold 100 Inventory 100 July 31

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

LIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 40 $40

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

LIFO Perpetual Inventory Accounting Date Description Debit Credit Inventory 270 Accounts Payable 270 July 5

LIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Nov. 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

Last-In, First-Out (LIFO) Valued based on the most recent costs of purchases Cost of Goods Sold Valued based on the earlier costs of purchases Ending Inventory

LIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

Last-In, First-Out (LIFO) Valued based on the most recent costs of purchases Cost of Goods Sold Valued based on the earlier costs of purchases Ending Inventory

LIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

LIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 15 1 $40 $40 4 $45 $180 2 $45 $90

LIFO Perpetual Inventory Accounting Date Description Debit Credit Accounts Receivable 320 Sales 320 Cost of Goods Sold 180 Inventory 180 July 15

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

LIFO Perpetual Inventory Accounting Date Description Debit Credit Inventory. 350 Accounts Payable 350 July 26

LIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 15 1 $40 $40 4 $45 $180 2 $45 $90 26 7 $50 $350 1 $40 $50 2 $45 $90 7 $50 $350

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

Last-In, First-Out (LIFO) Valued based on the most recent costs of purchases Cost of Goods Sold Valued based on the earlier costs of purchases Ending Inventory

LIFO Perpetual Inventory Account Item DVD’s Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 15 1 $40 $40 4 $45 $180 2 $45 $90 26 7 $50 $350 1 $40 $50 2 $45 $90 7 $50 $350

LIFO Perpetual Inventory Account Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 15 1 $40 $40 4 $45 $180 2 $45 $90 26 7 $50 $350 1 $40 $50 2 $45 $90 7 $50 $350 31 7 $50 $350 1 $40 $40 1 $45 $45 1 $45 $45

LIFO Perpetual Inventory Accounting Date Description Debit Credit Accounts Receivable 640 Sales 640 Cost of Goods Sold 395 Inventory 395 July 31

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Smart Touch Learning Units Cost Price July 1 Inventory 1 $40 5 Purchase 6 $45 15 Sale 4 $80 26 Purchase 7 $50 31 Sale 8 $80 31 Purchase 5 $55 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

LIFO Perpetual Inventory Accounting Date Description Debit Credit Inventory. 275 Accounts Payable 275 July 31

LIFO Perpetual Inventory Account Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 15 1 $40 $40 4 $45 $180 2 $45 $90 26 7 $50 $350 1 $40 $50 2 $45 $90 7 $50 $350 31 7 $50 $350 1 $40 $40 1 $45 $45 1 $45 $45 31 5 $55 $275 1 $40 $40 1 $45 $45 5 $55 $275

Inventory Shrinkage Loss of inventory Compare physical count with balance in books Sources Breakage Theft Obsolescence

Inventory Shrinkage Took a physical count of DVD’s and determined that two were damaged during shipment. Record the adjusting entry for inventory shrinkage.

LIFO Perpetual Inventory Account Purchases Cost of Goods Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost July 1 1 $40 $40 5 6 $45 $270 1 $40 $40 6 $45 $270 15 1 $40 $40 4 $45 $180 2 $45 $90 26 7 $50 $350 1 $40 $50 2 $45 $90 7 $50 $350 31 7 $50 $350 1 $40 $40 1 $45 $45 1 $45 $45 31 5 $55 $275 1 $40 $40 1 $45 $45 5 $55 $275

Last-In, First-Out (LIFO) Valued based on the most recent costs of purchases Cost of Goods Sold and shrinkage Valued based on the earlier costs of purchases Ending Inventory

Inventory value of 5 units Remaining Inventory Shrinkage Inventory value of 5 units Remaining 1 at $40 = $40 1 at $45 = $45 3 at $55= $165 $250 ($360-$250 = $110)

LIFO Inventory Shrinkage Date Description Debit Credit Cost of Goods Sold 110 Inventory 110 July 31

Objective 3 Compare the effects of the different costing methods on the financial statements

Comparison FIFO LIFO Sales $960 COGS Gross Profit $660 $300 $685 $275 During rising costs, FIFO will have a larger gross profit and net income that LIFO. Average will be in the middle. Discuss how the opposite is true when price decrease.

Comparison FIFO LIFO Inventory $275 $250 During rising costs, FIFO will have a larger gross profit and net income that LIFO. Average will be in the middle. Discuss how the opposite is true when price decrease.

Advantage of Each Method Weighted Average First-In, First-Out Last-In, First-Out Smoothes out price changes Matches actual flow of goods. Inventory valued closest to replacement value During inflation minimizes net income and income taxes. Better matching of current costs in cost of goods sold with revenues “If you were responsible for deciding which method your company should use, what method would you select, why? “ Talk about which costing method might be most appropriate for various types of inventory.

Use of Inventory Methods in Practice

Apply the lower-of-cost-or-market (LCM) rule to value inventory Objective 4 Apply the lower-of-cost-or-market (LCM) rule to value inventory

Conservatism Principle Exercise caution in reporting items in the financial statements Report realistic figures Talk about recognizing losses when indicated and gains when realized – goal is not to overstate net income Another goal is to not overstate assets or understate liabilities.

Lower-of-Cost-or-Market Inventory is reported at whichever is lower – historical cost or market value (current replacement cost) If market is lower than cost – write inventory down Debit Cost of Goods Sold Credit Inventory

Lower-of-Cost-or-Market Must disclose method of valuation in financial statements As parenthetical in statements or In notes to financial statements

Objective 5 Report inventory on the balance sheet and measure the effect of inventory errors

Materiality Concept A company must perform strictly proper accounting only for significant items An item is material if its presentation in the financial statements would cause a reader to change a decision. If an item is considered immaterial, GAAP does not have to be strictly applied

Full Disclosure Principle Report enough information for outsiders to make wise decisions about the company Must disclose the method used to value inventory

Consistency in Reporting A company should use the same accounting methods from period to period so that financial statements are comparable across periods

Effects of Inventory Errors Ending inventory becomes next year’s beginning inventory Results in misstatement of income statement over two years Misstatement of balance sheet in first year and then error counterbalances itself Even with the best internal controls over inventory, errors can be made. Mistakes can be made when taking a physical count of inventory.

Effects of Inventory Errors If ending inventory is overstated, so is net income and gross profit. Cost of Goods sold is understated. If ending inventory is understated, so is net income and gross profit. Cost of Goods sold is overstated. In year two, the effects of year one are reversed. Hint: Remember, the two I’s are affected the same way I – Inventory I – Income

End of Chapter 6