BSAD 221 Introductory Financial Accounting Donna Gunn, CA

Royal LePage Real Estate Merchandising Company Income Statements Service revenue $ XXX Expenses Operating and administrative expense X Depreciation expense X Income tax expense X Net income $ X Service Company Royal LePage Real Estate Income Statement Year Ended December 31, 2012 Revenue $ 703.2 Cost of goods sold 419.8 Gross profit 283.4 Operating expenses: Operating and administrative expense X Depreciation expense X Income tax expense $ X Net income $ 56.9 Merchandising Company Leon’s Furniture Ltd. Income Statement Year Ended December 31, 2012 Note that on the service company’s income statement there is no COGS. COGS is something that only applies to companies who sell products and thus deal with inventory.

Royal Lepage Real Estate Merchandising Company Balance Sheets Current assets: Cash $ X Short-term investments X Accounts receivable, net X Prepaid expenses X Service Company Royal Lepage Real Estate Balance Sheet December 31, 2012 Current assets: Cash $ X Short-term investments X Accounts receivable, net X Inventory 84 Prepaid expenses X Merchandising Company Leon’s Furniture Ltd. Balance Sheet December 31, 2012

Accounting for Inventory Cost of inventory on hand = Inventory (Asset on balance sheet) Balance Sheet Inventory = Number of units on hand × unit cost

Accounting for Inventory Cost of Inventory that’s been sold = Cost of Goods Sold (Expense on income statement) Income Statement Cost of goods sold = Number of units sold × unit cost

Costs Included in Inventory Purchases The cost principle requires that inventory be recorded at the price paid or the consideration given. Include all costs incurred to bring the asset to useable or saleable condition. Invoice Price Freight Your inventory is the complete cost of that item to you. If you have to pay for delivery – that’s a cost of the inventory and you add it in. Anything that is required to make the inventory useable or saleable. Inspection Costs Preparation Costs

Flow of Inventory Costs Merchandise Purchases Cost of Goods Sold Merchandise Inventory Merchandiser Raw Materials Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Manufacturer Direct Labor Factory Overhead There are really two types of companies that deal with inventory. Merchandisers – just buy it and sell it – E.g. wal-mart, future shop etc. Manufacturers – make something and then sell it

Comparing Merchandising and Manufacturing Activities Merchandisers . . . Buy finished goods. Sell finished goods. Manufacturers . . . Buy raw materials. Produce and sell finished goods. This is an example of the difference. The company that produces the bacon wrapped scallop is a manufacturer. They buy raw materials (scallops, bacon, etc.) and make a finished product. Superstore is a merchandiser. They buy the finished product from the manufacturer and resell it to their customer. For the manufacturer the bacon and scallops they buy that are untouched are raw materials. As soon as they start working on them to turn them into a finished product they become work in progress. Once all the work is done and they are ready to sell to superstore it is a finished good.

Nature of Cost of Goods Sold Beginning Inventory Purchases for the Period Goods available for Sale Ending Inventory (Balance Sheet) Cost of Goods Sold (Income Statement) Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of goods sold

Perpetual and Periodic Inventory Systems Provides up-to-date inventory records. Perpetual System Provides up-to-date cost of sales records. Perpetual systems are fantastic but they are more work for companies that don’t have sophisticated accounting systems. A lot of organizations (most) rely on a perpetual system. Companies who use perpetual tend to fall into two groups – large companies with sophisticated systems, or companies who inventories are high value/high risk and they need to constantly keep track of them. E.g. I had a client who was a pharmacy – they didn’t track everything perpetually but all narcotics were on a perpetual system – they needed to keep stronger controls over them. In a periodic inventory system, ending inventory and cost of goods sold are determined at the end of the accounting period based on a physical count.

Recording Transactions in the Perpetual System Dr. Cash or Accounts Receivable Cr. Sales Revenue To record sales revenue Dr. Cost of Goods Sold Cr. Inventory To record COGS

Recording Transactions in the Perpetual System Purchase price of the inventory $570,000 + Freight-in 4,000 – Purchase discounts – 14,000 = Net purchases of inventory $560,000

Recording Transactions Inventory 560,000 Accounts Payable 560,000 Purchased inventory on account Beg. 100,000 560,000 Inventory Accounts Payable 560,000

Recording Transactions and the T-Accounts Sale on account $900,000 (cost $540,000): Accounts Receivable 900,000 Sales Revenue 900,000 Cost of Goods Sold 540,000 Inventory 540,000

Recording Transactions Cost of Goods Sold 540,000 Inventory 540,000 Inventory Cost of Goods Sold 540,000 Beg. 100,000 560,000 120,000 540,000

Reporting in the Financial Statements Income Statement (partial) Sales revenue $900,000 Cost of goods sold 540,000 Gross margin $360,000 Ending Balance Sheet (partial) Current assets: Cash $ XXX Short-term investments XXX Accounts receivable, net XXX Inventory 120,000

Inventory Costing Methods FIFO Weighted Average Specific Identification There are 3 primary ways to track inventory costing. 24 24 24 24

Specific Identification When units are sold, the specific cost of the unit sold is added to cost of goods sold. Specific identification means you actually know how much each unit of inventory cost and you track the cost to that individual item. It’s the way most people likely think inventory is cost. In reality this is a lot of work and for a company like Wal-mart for example, this would be impossible. When it is used in real life is for high value items that the cost is really individual too and can vary significantly. E.g. a house.

First-In, First-Out Method Cost of Goods Sold Oldest Costs Ending Inventory First in first out assumes that what you bought first you sold first. If you are a grocery store and you have 100 cans of soup on a shelf you are going to assume that the one you bought first is sold first, so that is the cost of good sold you will use. In reality the shopper could have picked up any can – not necessarily the oldest, but an assumption is required. Recent Costs

Weighted-Average Cost Method When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Weighted-average cost (WAC) per unit: Cost of goods available for sale Number of units available for sale Ending Inventory = Ending Units x WAC per Unit Cost of Good Sold = Units Sold x WAC per Unit

Illustration of Costing Leon’s began the period with 10 lamps costing $10 each; During the period, Leon’s bought 50 more lamps sold 40 lamps, and ended the period with 20 lamps. Beginning bal. (10 units @ $10) $100 Purchases: No. 1 (25 units @ $14) $350 No. 2 (25 units @ $18) 450 Ending bal. (20 units @ $?) Inventory Cost of goods sold: (40 units @ $?) ?

Illustration of Costing The big accounting questions are: What is the cost of goods sold for the income statement? What is the cost of the ending inventory for the balance sheet?

Illustration of Costing Total Dollar Amount of Goods Available for Sale Inventory Costing Method Ending Inventory Cost of Goods Sold

Weighted-Average $900 total cost ÷ 60 units = $15/unit Cost of goods sold = 40 × $15 = $600 Ending inventory = 20 × $15 = $300

Assume inventory on hand are from most recent purchase at $18 per unit First-In, First-Out Beginning (10 units @ $10) $100 Purchase No. 1 (25 units @ $14) 350 Purchase No. 2 (25 units @ $18) 450 40 units sold and 20 still on hand Ending inventory cost = 20 units × $18 per unit = $360 Assume inventory on hand are from most recent purchase at $18 per unit

First-In, First-Out Cost of Goods Sold Beginning (10 units @ $10) $100 Purchase No. 1 (25 units @ $14) 350 Purchase No. 2 (25 units @ $18) 450 40 units sold and 20 still on hand Cost of Goods Sold = 10 units x $10 +25 units x $14 + 5 units x $8 = $540 Assume inventory sold was the inventory purchased first

First-In, First-Out 10 Units @ $10 Cost of Goods Sold $100 350 90 $540

Changing Costs When inventory costs are increasing: Weighted Average cost of goods sold is highest because it is based on the average of the costs for the period, so includes the new higher costs. FIFO cost of goods sold is lowest because it is based on the oldest costs and ignores the most recent costs.

Financial Statement Effects of Costing Methods Advantages of Methods First-In, First-Out Weighted Average Ending inventory approximates current replacement cost. Smoothes out price changes.

Accounting Standards and Inventories Comparability (including consistency) Disclosure

Accounting Principles and Inventory Comparability states that businesses should use the same accounting methods and procedures from period to period. Disclosure Principle holds that a company’s financial statements should report enough information for outsiders to make informed decisions about the company.

Lower of Cost or Net Realizable Value Ending inventory is reported at the lower of cost or net realizable value (LCNRV). Net Realizable Value = The expected sales price less selling costs 74 74 74 74

Estimating Inventory The gross margin method of estimating ending inventory is based on the COGS model. Beginning inventory + Purchases = Goods available for sale – Ending inventory = Cost of goods sold

Estimating Inventory Rearranging ending inventory and cost of goods sold makes the model useful for estimating ending inventory. Beginning inventory + Purchases = Goods available for sale – Cost of goods sold = Ending inventory

Estimating Inventory Beginning inventory $18,000 Purchases 72,000 Cost of goods available for sale 90,000 Cost of goods sold: Net sales revenue $100,000 Less estimated gross margin of 40.3% – 40,300 Estimated cost of goods sold 59,700 Estimated cost of ending inventory $30,300 6 -

Effects of Inventory Errors An error in the ending inventory creates errors for cost of goods sold and gross margin. The current year’s ending inventory is next year’s beginning inventory.

Effects of Inventory Errors Period 1 Ending Inventory Overstated by $5,000 Period 1 Beginning Inventory Overstated by $5,000 Period 1 Correct Sales revenue Cost of goods sold: Beg. inventory Purchases Cost of goods available for sale Ending inventory Cost of goods sold Gross margin $100,000 $10,000 50,000 $60,000 (15,000) 45,000 $ 55,000 $100,000 $15,000 50,000 $65,000 (10,000) 55,000 45,000 $100,000 $10,000 50,000 $60,000 (10,000) $ 50,000

Ethical Considerations Managers of companies whose profits do not meet shareholder expectations are sometimes tempted to “cook the books” to increase reported income. What are some possibilities? 1. Overstating ending inventory 2. Creating fictitious sales revenue