©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 1 Chapter 8 Accounting for Inventory

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 2 Learning Objective 1 Describe goods available for sale and name its components.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 3 Tracking Inventory Costs The terms “merchandise inventory” and “inventory” are often used to describe the cost of the items as well as the items themselves.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 4 Tracking Inventory Costs

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 5 Learning Objective 2 Explain the relationship between ending inventory and cost of goods sold.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 6 Beginninginventory$200 Purchases$700 Relationships Among GAFS, EI, and COGS Endinginventory$150 Cost of goods sold$750 Goodsavailable for sale $900

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 7 Flow of Inventory Purchases + Beginning inventory Goods available = Units still on hand (Ending inventory) Units sold (Cost of goods sold)

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 8 Learning Objective 3 Differentiate between the physical flow of merchandise and the cost flow of merchandise.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones8 - 9 Physical Flow of Inventory (Reality) Computer Exchange, Inc., purchased a computer on January 17, 2003, for $800, and placed it in its warehouse. The company sold the computer to a customer on February 6, 2003, for $1,500.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Physical Flow of Inventory (Reality) Manufacturer Customer Sale 2/6/03 ComputerExchange’swarehouse Purchase 1/17/03

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Inventory Cost Flow (Measurement of Reality) January 31 Units Cost Beginning inventory, January 1 0$ 0 + Purchases = Goods available for sale – Cost of goods sold 0 0 = Ending inventory 1$800

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Computer Exchange’s Financial Statements Computer Exchange, Inc. Income Statement For the Month Ended January 31, 2003 Sales$ 0 Cost of goods sold 0 Gross margin$ 0 Operating expenses: Warehouse rent – 200 Net income (loss)$ – 200

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Computer Exchange’s Financial Statements Computer Exchange, Inc. Statement of Retained Earnings For the Month Ended January 31, 2003 Beginning retained earnings$ 0 Net income (loss) – 200 $ –200 Less dividends 0 Ending retained earnings$ –200

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Computer Exchange’s Financial Statements Assets: Cash$22,000 Merchandise inventory 800 Total assets$22,800 Liabilities and stockholders’ equity: Common stock 15,000 Additional paid-in capital 8,000 Retained earnings – 200 Total liabilities and stockholders’ equity$22,800 Computer Exchange, Inc. Balance Sheet Balance Sheet January 31, 2003

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Inventory Cost Flow (Measurement of Reality) February 28 Units Cost Beginning inventory, January 1 0$ 0 + Purchases = Goods available for sale – Cost of goods sold = Ending inventory 0$ 0

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Computer Exchange’s Financial Statements Computer Exchange, Inc. Income Statement For the Month Ended February 28, 2003 Sales$1,500 Cost of goods sold 800 Gross margin$ 700 Operating expenses: Warehouse rent – 200 Net income (loss)$ 500

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Computer Exchange’s Financial Statements Computer Exchange, Inc. Statement of Retained Earnings For the Month Ended February 28, 2003 Beginning retained earnings$ – 200 Net income (loss) 500 $ 300 Less dividends 0 Ending retained earnings$ 300

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Computer Exchange’s Financial Statements Assets: Cash$21,800 Accounts receivable 1,500 Merchandise inventory 0 Total assets$23,300 Liabilities and stockholders’ equity: Common stock 15,000 Additional paid-in capital 8,000 Retained earnings 300 Total liabilities and stockholders’ equity$23,300 Computer Exchange, Inc. Balance Sheet Balance Sheet February 28, 2003

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Physical Movement of Computer Manufacturer Purchase 1/17/03ComputerExchange’swarehouse Sale 2/6/03Customer Purchase 1/17/03ComputerExchange’s Balance sheet: $800 asset Sale 2/6/03ComputerExchange’s Income statement: $800 cost of goods old

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 4 Explain the differences between periodic and perpetual inventory systems.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Under a periodic system, companies do their inventory and cost of goods sold calculations at the end of the income statement period. Inventory Systems Under a perpetual system, companies update their inventory records continually to keep track of both the physical count of inventory units and the cost of those units.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Inventory Control Report: Perpetual System Date1/172/06ExplanationPurchaseSaleUnits1 Unit Cost $800 Total Cost $800 Purchases Date1/172/06ExplanationPurchaseSaleUnits1 Unit Cost $800 Total Cost $800 Cost of Goods Sold Date1/172/06ExplanationPurchaseSaleUnits10 Unit Cost $800 Total Cost $800$0 Inventory Balance

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones The Necessity of Physical Inventory Count Beginning inventory, 1/120$200 +Purchases =Goods available for sale –Cost of goods sold =Ending inventory15$150 Book Inventory Units Cost A physical count reveals that there are only 13 units in inventory.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones The Necessity of Physical Inventory Count Beginning inventory, 1/120$200 +Purchases =Goods available for sale –Cost of goods sold =Ending inventory13$130 Adjusted Record Units Cost

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 5 List three different inventory cost flow assumptions and contrast how they affect net income.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones SpecificIdentification Inventory Cost Flow Methods Average Cost First-in, First-out Last-in, First-out

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Specific Identification Date Date Selling Purchased Description Cost Sold Price Beginning inventory: 10/15/ Bentley$ 35,00003/05/03$45,000 12/20/ Mercedes 15,000 01/25/ Thunderbird 25,00003/09/03 38,000 02/10/ Model A Ford 24,00003/18/03 36,000 Purchases: 03/10/ Cadillac 20,000 03/25/ Corvette 31,000 Cost of goods available$150,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Specific Identification Cost of goods sold: Bentley$35,000 Thunderbird 25,000 Ford 24,000 Total$84,000 Ending inventory: Mercedes$15,000 Cadillac 20,000 Corvette 31,000 Total$66,000 Bentley$45,000 Thunderbird 38,000 Ford 36,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 6 Calculate cost of goods sold and the cost of ending inventory using FIFO, LIFO, and average cost inventory cost flow assumptions

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Cost Flow Assumptions Example March 1Beginning inventory1$ 800$ 800 March 3Purchase2$1,000 2,000 March 17Purchase1$1,200 1,200 March 22Sale1 March 26Purchase1$1,300 1,300 March 29Purchase1$1,400 1,400 March 30Sale1 Total goods available for sale$6,700 Unit Total Quantity Cost Cost

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Cost of Goods Sold and Ending Inventory Cost Under FIFO March 3Purchase 1 $1,000 = $1,000 March 17Purchase 1 $1,200 = $1,200 March 26Purchase 1 $1,300 = $1,300 March 29Purchase 1 $1,400 = $1,400 Ending inventory 4 units $4,900 Cost of goods sold = $6,700 – $4,900 = $1,800

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Cost of Goods Sold and Ending Inventory Cost Under LIFO March 1Beginning inventory 1 $ 800 =$ 800 March 3Purchase 2 $1,000 =$2,000 March 26Purchase 1 $1,300 =$1,300 Ending inventory 4 units$4,100 Cost of goods sold = $6,700 – $4,100 = $2,600

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Average Cost Method: March 22 Sale Unit cost = $4,000 ÷ 4 = $1,000 Cost of goods available for sale $4,000 –Endinginventory$3,000 (3 × $1,000) = Cost of goods sold $1,000 (1 × $1,000)

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Average Cost Method: March 30 Sale Unit cost = $5,700 ÷ 5 = $1,140 Cost of goods available for sale $5,700 –Endinginventory$4,560 (4 × $1,140) = Cost of goods sold $1,140 (1 × $1,140) Total cost of goods sold = $2,140

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Effects of Inventory Cost Assumptions Goods available for sale$6,700$6,700$6,700 Income statement: Cost of goods sold$1,800$2,600$2,140 Net income$1,000$ 200$ 660 Balance sheet: Ending inventory$4,900$4,100$4,560 Retained earnings$1,300$ 500$ 960 Average FIFO LIFO Cost Beginning retained earnings was $300.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Effects of FIFO FIFO matches the oldest product cost with current sales revenue. When inventory prices are changing, it is probable that sales revenue will be matched with costs that are older than the current replacement costs.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Effects of LIFO Palmer purchased 1,000 aloe vera plants at the beginning of 1983 for $1.00 each. The company has kept a minimum of 1,000 plants in inventory through the years. At the end of 2003, the company has 1,000 plants in inventory. Assume that the cost of nursery plants has increased 3% per year.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Effects of LIFO What is the inventory’s replacement cost? $1,000 ×1.86 = $1,860 How does Palmer value the inventory on hand? $1,000 × 1.00 = $1,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Use of Inventory Costing Methods

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 7 Calculate and interpret the inventory turnover ratio.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Using Financial Information Palmer Nursery, Inc. Income Statement For the Year Ended December 31, 2003 Sales$1,850,000 Cost of goods sold 1,125,000 Gross margin$ 725,000 Operating expenses 577,000 Net income (loss)$ 148,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Using Financial Information Assets: Cash$175,000$116,000 Merchandise inventory (using LIFO) 100, ,000 Other assets 415, ,000 Total assets$690,000$537,000 Liabilities and stockholders’ equity: Accounts payable$ 75,000$ 70,000 Common stock 25,000 25,000 Additional paid-in capital 10,000 10,000 Retained earnings 580, ,000 Total stockholders’ equity 615, ,000 Total liabilities and stockholders’ equity$690,000$537,000 Palmer Nursery, Inc. Balance Sheets December 31, 2003, and 2002

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Using Financial Information The inventory turnover ratio expresses the theoretical number of times the complete inventory was sold during the year. Cost of goods sold ÷ Average inventory 2003: $1,125,000 ÷ ($191,860 + $186,000) = $1,1251,000 ÷ $188,930 = 5.95 times FIFO inventory was $191,860 at the end of 2002 and $186,000 at the end of 2003.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Using Financial Information 2003: 365 ÷ 5.95 = days Average inventory holding period in days = 365 ÷ Inventory turnover ratio

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 8 Describe the impact of payment terms and freight terms.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Terms 2/10, N30 1/10, EOM, net 60 days EOM FOB shipping point FOB destination

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 9 Prepare journal entries associated with the purchase and sale of merchandise inventory.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Journal Entries On March 3, 2003, Montoya purchased two generators on account for $2,000, 2/10, net 30, FOB destination, freight collect March 3 Merchandise Inventory2,000 Accounts Payable2,000 On March 4, Montoya paid UPS $ March 4 Merchandise Inventory 125 Cash 125

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Journal Entries Assume that on March 12, 2003, Montoya paid for the generator it purchased on March March 12 Accounts Payable2,000 Cash1,960 Merchandise Inventory (or Purchase Discount) 40 On March 17, Montoya sold a generator carried in inventory at $800 for $1,500 with terms of 2/10, net 30.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Journal Entries 2003 March 17 Accounts Receivable1,500 Sales1,500 Cost of Goods Sold 800 Merchandise Inventory 800 On March 26, the buyers paid Montoya March 26 Cash1,470 Sales Discounts 30 Accounts Receivable1,500

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones End of Chapter 8