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

Inventory is recorded at the price paid for it. Inventory is recorded at the price paid for it. Agenda Inventory Cost

Inventory t Inventory is tangible property that is held for resale or will be used in producing goods or services. t Inventory is reported on the balance sheet as a current asset. t Types of inventory: Merchandise inventory Merchandise inventory Raw materials inventory These 3 will Raw materials inventory These 3 will Work in process inventory be studied Work in process inventory be studied Finished goods inventory in managerial accounting. Finished goods inventory in managerial accounting.

t The amount recorded for inventory should include: u Invoice price, transportation charges, inspection costs, and preparation costs. t Inventory may be tracked with either a periodic or a perpetual inventory system. Inventory Cost

Shipping Terms (Sales & Purchases) t F.O.B. shipping point or destination u tells who pays shipping t F.O.B shipping indicates that the title to the goods changes hands at shipping. t F.O.B. destination indicates that the title to the goods changes hands at destination.

t Whoever owns the goods while they are in-transit pays for the shipping. t Shipping costs to get the inventory IN are included as part of the cost of the inventory. t Shipping costs for a sale are part of operating expenses. Shipping Costs

t 2/10, n/30 (for example) u 2% discount if invoice paid in ten days u tells when and how much must be paid u high interest cost of not taking purchase discounts Terms of Sale and Purchases

Recording Inventory Purchases and Freight Costs t 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. t What is the total cost of the cameras? t (100 * $125) = $12,500 + $50 = $12,550 t Why is the cost of the freight added to the cost of the cameras?

Recording Inventory Purchases and Freight Costs t The total cost of the asset, inventory, will equal all costs incurred to bring the asset to its intended use. t 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 t How would the purchase of inventory be recorded under a perpetual inventory system? DateTransaction DebitCredit Mar 10 Inventory12,550 Accounts payable12,550

Recording Inventory Purchases and Freight Costs t How would the purchase of inventory be recorded under a periodic inventory system? DateTransaction DebitCredit Mar 10 Purchases12,500 Freight in50 Accounts payable12,550

Recording Inventory Purchases with a Purchase Discount t If Paul pays for the cameras within 10 days, then Paul will take a 3% discount on the purchase price of the cameras. u Freight is excluded in calculating the discount since Paul paid $50 to ship the inventory whether or not the discount is taken. t 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 t How would the payment for the inventory on March 20 be recorded under a perpetual inventory system? DateTransaction DebitCredit Mar 20 Accounts payable12,550 Inventory375 Cash 12,175

Recording Inventory Purchases with a Purchase Discount t How would the payment for the inventory on March 20, be recorded under a periodic inventory system? DateTransaction DebitCredit Mar 20 Accounts payable12,550 Purchase discounts375 Cash 12,175

Recording Inventory Purchases with a Purchase Discount t How would the payment be recorded under a perpetual inventory system on March 25? DateTransaction DebitCredit Mar 25 Accounts payable12,550 Cash 12,550

Recording Inventory Purchases with a Purchase Discount t How would the payment be recorded under a periodic inventory system on March 25? DateTransaction DebitCredit Mar 25 Accounts payable12,550 Cash 12,550

Recording Inventory Purchases with a Purchase Discount t Notice that if Paul does not take advantage of the discount offered by the vendor, then the cost of the inventory remains $12,550. t If Paul does take advantage of the discount, then the cost of the inventory is reduced to $12,175. u ($12,500 - $375) + $50 freight in

Recording Purchase Returns and Allowances t Assume on March 15, Paul returns $140 of defective inventory that had not been paid for yet. t How would the return be recorded under a perpetual inventory system? DateTransaction DebitCredit Mar 15 Accounts payable140 Inventory 140

Recording Purchase Returns and Allowances t Assume on March15, Paul returns $140 of defective inventory that had not been paid for yet. t How would the return be recorded under a periodic inventory system? DateTransaction DebitCredit Mar 15 Accounts payable140 Purchase returns & allowances 140

Beginning inventory Add: Purchases (net) Goods available for sale Deduct: Ending inventory Cost of goods sold Agenda Cost of Goods Sold

Recording Sales Under a Perpetual Inventory system: t Under a perpetual inventory system, the inventory account balance is updated anytime a sale occurs. t Recording the sale involves two steps: u Step 1: Record the sale u Step 2: Recognize Cost of goods sold and update the Inventory account.

Recording Sales Under a Perpetual Inventory system: t Assume on April 2, Paul’s Photo Center sells 20 cameras for $250 each on account. t How would the sale be recorded? DateTransaction DebitCredit Apr 2 Accounts receivable5,000 Sales 5,000 Cost of goods sold2,500 Inventory2,500

Recording Sales Under a Periodic Inventory system: t Under a periodic inventory system, the Inventory account is not updated until the end of the accounting period. t How would the sale be recorded? DateTransaction DebitCredit Apr 2 Accounts receivable5,000 Sales 5,000

Agenda t Inventory Cost Flow Methods

Alternative Inventory Cost Flow Methods FIFO LIFO WeightedAverage SpecificIdentification

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??

t Cost of goods sold is calculated as the number of units sold during the period multiplied by their unit costs. t Cost of goods sold is a major expense item for most nonservice businesses. t The measurement of cost of goods sold is an excellent example of the application of the matching principle. Costs of Goods Sold

t The cost of the oldest inventory items are charged to cost of goods sold when goods are sold. t The cost of the newest inventory items remain in ending inventory. t The actual physical flow of inventory items may differ from the FIFO cost flow assumptions. First-In, First-Out

t The cost of the newest inventory items are charged to cost of goods sold when goods are sold. t The cost of the oldest inventory items remain in ending inventory. t The actual physical flow of inventory items may differ from the LIFO cost flow assumptions. Last-In, First-Out

Weighted-Average t Take the average cost of all goods available for sale to value both CGS and Ending Inventory. t BE SURE IT’S WEIGHTED!

Specific Identification t Specific cost of each inventory item is known. t Used with small volume, high dollar inventory.

Example DateEventUnitsPriceTotal 3/1Beg. Inv. 10$ 6$ 60 3/10Purchase /15Purchase /27Sale

Cost of Goods Sold: FromUnitsPriceCost 3/1 10$ 6$ 60 3/1 10$ 6$ 60 3/ / Totals 18$116 t Ending Inventory: FromUnitsPriceCost 3/10 4$ 7$ 28 3/ Totals 15$116 FIFO

t Cost of Goods Sold: FromUnitsPriceCost 3/15 11$ 8$ 88 3/15 11$ 8$ 88 3/ / Totals 18$137 t Ending Inventory: FromUnitsPriceCost 3/10 5$ 7$ 35 3/ Totals 15$ 95 LIFO

Average cost per unit: Cost of GAFS$ 232 Cost of GAFS$ 232 # of units GAFS 33 Cost of Goods Sold: 18 $7.03 = $127 (rounded) Ending Inventory: 15 $7.03 = $105 (rounded) = $7.03 Weighted Average

RevenuesExpenses Net Income Sales Cost of Goods Sold Gross margin Operating Expenses Income before taxes Income Taxes Net income Multistep Income Statement Income Statements Singlestep Income Statement

Income Statements FIFOLIFOWt. Avg. FIFOLIFOWt. Avg.SalesCGSGM Oper. exp. Pretax inc. Taxes (40%) Net Income [Given operating expenses of $50 and a 40% tax rate]

FIFOLIFOWt. Avg. Sales$270$270$ 270 CGS GM Oper. exp Pretax inc Taxes (40%) Net Income$ 62$ 50$ 56 Income Statements [Given operating expenses of $50 and a 40% tax rate]

Comparison of Methods t Each of the four methods is acceptable, and an argument can be made for using each. t 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... 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...

... the consistency principle requires that companies use the same accounting methods period after period so the financial statements of succeeding periods will be comparable. Consistency Principle

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 books LIFO for taxes

Example: Periodic vs. Perpetual t BI15 $20 each t 1/5/95 purchased20 $21 each t 3/6/95 sold10 units t 5/16/95 purchased30 $22 each t 7/5/95 sold20 units t 9/3/95 purchased 10 $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 t $20 = $300 t $21 = $420 t $22 = $660 t $23 = $230 $1610 $1610 FOR SALE

FIFO--Perpetual u Sale on 3/6 of 10 units comes from $20 each u Sale on 7/5 of 20 units comes from BI (5 $20) and from 1/5 purchase (15 $21) u Total CGS = $200 + $100 + $315 = $615 u Ending Inv. = 1/5/95 $21 = 105 $22 = 660 $995 $22 = 660 $995 $23 = 230 $23 = 230

FIFO--Periodic Total sales of 30 units Total sales of 30 units u Start with the oldest for CGS: 15 units from BI = $ units from BI = $ units from 1/5/95 purchase =$ units from 1/5/95 purchase =$315 Total CGS = $615 u Ending Inv. = 1/5/95 $21 = 105 $22 = 660 $995 $22 = 660 $995 $23 = 230 $23 = 230

LIFO--Perpetual u Sale on 3/6 of 10 units comes from 1/5 purchase (the most recent one at the time of the sale): $210 u Sale on 7/5 of 20 units comes from 5/16 purchase: $440 u Total CGS = $210 + $440 = $650 u Ending Inv. = $20 = $300 $21 = 210 $21 = 210 $22 = 220 $960 $22 = 220 $960 $23 = 230 $23 = 230

LIFO--Periodic Total sales of 30 units Total sales of 30 units u Start with the latest purchases for CGS: 10 units from 9/3/95 purchase =$ units from 9/3/95 purchase =$ units from 5/16/95 purchase =$440 Total CGS = $670 u Ending Inv. $20 =$300 1/5/95 $21 =$420 1/5/95 $21 =$420 5/16/95 $22 =$220 5/16/95 $22 =$220$940

Agenda t Inventory Management

The accounting system plays three roles in inventory management: t Provides accurate information for financial statements and tax reports. t Provides up-to-date information on inventory quantities and cost. t Provides information necessary to protect inventory from theft and misuse. Accounting and Inventory Management

t Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover This ratio is often used to measure the liquidity (nearness to cash) of the inventory. Financial Statement Analysis

Agenda t Lower of Cost or Market

t Ending inventory is reported at the lower of cost or market (LCM). t Market refers to the replacement cost of the merchandise. t This practice is in keeping with the generally accepted accounting principle of conservatism. Lower of Cost or Market

t Misstatements in inventory may cause errors in the following areas: u Income Statement v Cost of Goods Sold, Gross Profit, Net Income u Balance Sheet v Inventory, Payables, Retained Earnings t Because the ending inventory of one period becomes the beginning inventory of the next period, ending inventory errors affect two accounting periods. Errors in Measuring Ending Inventory

Inventory Errors u Beginning inventory 2002: no effect u Purchases in 2002: no effect u Goods available for sale in 2002: no effect u Cost of Goods Sold in 2002: understated u Gross margin in 2002: overstated u Net income in 2002: overstated The ending inventory for CBCR Co. was overstated by $2000 for the year What effect did the error have on

t Beginning inventory 2003: overstated t Purchases for 2003: no effect t Goods available for sale in 2003: overstated overstated t Cost of Goods Sold for 2003: overstated t Gross margin for 2003: understated t Net income for 2003: understated The Next Year

t Gross margin %: u gross margin as a percent of sales u Net sales - CGS (=gross margin) Net sales Net sales Ratios: Gross Margin Percentage

t Return on sales = Net income Net sales Net sales Revenues - expenses Net sales Ratios: Return on Sales

Net Income Assets Return on Assets = Ratios: Return on Assets