Chapter 6

Define accounting principles related to inventory

ConsistencyDisclosure MaterialityConservatism Copyright (c) 2009 Prentice Hall. All rights reserved.3

 Consistency ◦ Businesses should use the same accounting methods from period to period  Disclosure ◦ Companies should report enough information for outsiders to make decisions about the company  Materiality ◦ Companies must follow accounting rules for significant items  Significant – cause a user to change decision  Conservatism ◦ Exercise caution in financial reporting Copyright (c) 2009 Prentice Hall. All rights reserved.4

 A. Conservatism  B. Cost  C. Consistency  D. Matching Copyright (c) 2009 Prentice Hall. All rights reserved.5

 A. Conservatism  B. Cost  C. Consistency  D. Matching Copyright (c) 2009 Prentice Hall. All rights reserved.6

Define inventory costing methods

Specific-unit cost First-in, First-out Last-in, First-out Average- cost Copyright (c) 2009 Prentice Hall. All rights reserved.8

 Each inventory item is identified by its specific cost  Used by business that sell unique, easily identified items ◦ Examples: Cars, fine jewelry, real estate Copyright (c) 2009 Prentice Hall. All rights reserved.9

10 Assumes oldest items are sold first Oldest Costs Cost of Goods Sold Therefore, newest items are on hand Recent Costs Ending Inventory

Copyright (c) 2009 Prentice Hall. All rights reserved.11 Recent Costs Cost of Goods Sold Oldest Costs Ending Inventory Assumes newest items are sold first Therefore, oldest items are on hand

Copyright (c) 2009 Prentice Hall. All rights reserved.12 The average cost of each unit in inventory is assigned to cost of goods sold Average Cost Cost of Inventory on Hand Number of Units on Hand ÷=

Copyright (c) 2009 Prentice Hall. All rights reserved.13

Copyright (c) 2009 Prentice Hall. All rights reserved.14

Account for perpetual inventory by the three most common costing methods

Copyright (c) 2009 Prentice Hall. All rights reserved.16 $10 Beginning Inventory Purchase 5 shirts $12

Copyright (c) 2009 Prentice Hall. All rights reserved.17 $10 Beginning Inventory Purchase 5 shirts Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of goods sold? First-In, First-Out $12

Copyright (c) 2009 Prentice Hall. All rights reserved.18 $10 Beginning Inventory Purchase 5 shirts Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of goods sold? First-In, First-Out $12

Copyright (c) 2009 Prentice Hall. All rights reserved.19 Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of goods sold? First-In, First-Out Cost of good sold = $42Inventory = $48 $10 $12

Copyright (c) 2009 Prentice Hall. All rights reserved.20 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Accounts receivable ($20 x 4)80 Sales revenue80 To record sales on account Cost of goods sold42 Inventory42 To record cost of sales

Sales$80 Cost of goods sold 42 Gross profit$38 Copyright (c) 2009 Prentice Hall. All rights reserved.21

Copyright (c) 2009 Prentice Hall. All rights reserved.22 $10 Beginning Inventory Purchase 5 shirts Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of goods sold? Last-In, First-Out Cost of good sold = $48Inventory = $42 $12

Copyright (c) 2009 Prentice Hall. All rights reserved.23 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Accounts receivable ($20 x 4)80 Sales revenue80 To record sales on account Cost of goods sold48 Inventory48 To record cost of sales

Sales$80 Cost of goods sold 48 Gross profit$32 Copyright (c) 2009 Prentice Hall. All rights reserved.24

Copyright (c) 2009 Prentice Hall. All rights reserved.25 $10 Beginning Inventory $12 Purchase 5 shirts Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of goods sold? Compute the Average Cost UnitsCost Beginning inventory3$30 Purchases560 Total8$90 Average = $90/8 = $11.25 Cost of good sold = $11.25 x 4 = $45Inventory = $11.25 x 4 = $45 $12

Copyright (c) 2009 Prentice Hall. All rights reserved.26 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Accounts receivable ($20 x 4)80 Sales revenue80 To record sales on account Cost of goods sold45 Inventory45 To record cost of sales

Sales$80 Cost of goods sold 45 Gross profit$35 Copyright (c) 2009 Prentice Hall. All rights reserved.27

Compare the effects of the three most common costing methods

Copyright (c) 2009 Prentice Hall. All rights reserved.29

FIFOLIFOAverage Sales$80 Cost of goods sold$42$48$45 Gross profit$38$32$35 30 Highest gross profit; highest net income Lowest gross profit; lowest net income If inventory prices are increasing Copyright (c) 2009 Prentice Hall. All rights reserved.

31 High income attracts investors “Middle ground” Lower income = Less taxes Last-In, First-Out First-In, First-Out Average Cost

Copyright (c) 2009 Prentice Hall. All rights reserved.32

Copyright (c) 2009 Prentice Hall. All rights reserved.33

Apply the lower-of-cost-or market rule to inventory

 Example of Accounting Conservatism  Inventory is reported at lower of: ◦ Historical cost or ◦ Market value (current replacement cost)  If market is lower than cost, write down inventory value: Copyright (c) 2009 Prentice Hall. All rights reserved.35

Copyright (c) 2009 Prentice Hall. All rights reserved.36 $25,000 #1 #2 $105,000 - $25,000

Copyright (c) 2009 Prentice Hall. All rights reserved.37 #3 $405,000 + $25,000 #4 Conservatism

 A. CONSERVATISM  B. CONSISTENCY  C. DISCLOSURE  D. MATERIALITY  E. COST Copyright (c) 2009 Prentice Hall. All rights reserved.38

 A. CONSERVATISM  B. CONSISTENCY  C. DISCLOSURE  D. MATERIALITY  E. COST Copyright (c) 2009 Prentice Hall. All rights reserved.39

Measure the effects of inventory errors

Ending inventory overstated Cost of goods sold understated Gross profit and net income overstated Next period beginning inventory overstated Copyright (c) 2009 Prentice Hall. All rights reserved.41

If Ending Inventory Overstated SALES SALES COGS6072 COGS5577 G.PROFIT4048 G.PROFIT4543 OP. EXP.2526 OP. EXP.2526 NET INCOME152237NET INCOME BEG.INVENT5070 if BEG.INVENT5075 PURCHASES80 +PURCHASES80 END.INVNET7078 -END.INVNET7578 COGS6072 COGS5577

Ending inventory understated Cost of goods sold overstated Gross profit and net income understated Next period beginning inventory understated Copyright (c) 2009 Prentice Hall. All rights reserved.43

Estimate ending inventory by the gross profit method

 Method to estimate ending inventory using the gross profit percent Copyright (c) 2009 Prentice Hall. All rights reserved.45 Beginning inventory$15,000 Net purchases 70,000 Cost of goods available 85,000 Estimated cost of goods sold: Sales revenue$100,000 Less: Estimated gross profit of 35% (35,000) Estimated cost of goods sold(65,000) Estimated cost of ending inventory$20,000

Copyright (c) 2009 Prentice Hall. All rights reserved.46 Beginning inventory$47,000 Net purchases 30,300 Cost of goods available 77,300 Estimated cost of goods sold: Sales revenue$63,000 Less: Estimated gross profit of 35% (22,050) Estimated cost of goods sold(40,950) Estimated cost of ending inventory$36,350