Inventory and Accounting for Merchandisers Module 6

SAP 2007 / SAP University Alliances Introductory Accounting Describe merchandising activities. Describe perpetual and periodic inventory systems.Analyze and record merchandise purchases transactions using a perpetual system.Analyze and record sales of merchandise transactions using a perpetual system.Examine adjusting entries for a merchandising company.Describe the two income statement types for a merchandising company.Prepare closing entries for a merchandising company.Identify the costs included in merchandise inventory.Compute cost of goods sold and merchandise inventory using specific identification, moving weighted average, FIFO, LIFO for a perpetual system.Analyze the effects of the costing methods on financial reporting.Compute the lower of cost or market value of inventory.Analyze the effects of inventory errors on current and future financial statements.Apply both the gross profit and retail inventory methods to estimate inventory.Compute cost of goods sold and merchandise inventory using specific identification, moving weighted average, FIFO, LIFO for a periodic system.Outline merchandise turnover and days sales in inventory ratios. Learning Objectives

SAP 2007 / SAP University Alliances Introductory Accounting Merchandising Activities Merchandiser: A company that earns net income by buying and selling merchandise. Examples: The Bay, Canadian Tire, The Gap Wholesaler: A company that buys products from manufacturers or other wholesalers and sells them to retailers or other wholesalers. Examples: Provigo, The Oshawa Group

SAP 2007 / SAP University Alliances Introductory Accounting Computing Net Income Net Sales Cost of Goods Sold Gross Profit Operating Expenses Net Income Operating Expenses Revenue MerchandiserService Company

SAP 2007 / SAP University Alliances Introductory Accounting Products a company owns for the purpose of selling to customers. It is: Often referred to as Merchandise Inventory. Classified as a current asset. Inventory

SAP 2007 / SAP University Alliances Introductory Accounting Cost of inventory includes: Costs incurred to purchase the goods. Shipping costs. Other costs required to make goods ready for sale. Inventory

SAP 2007 / SAP University Alliances Introductory Accounting Perpetual Provides a continuous record of: The amount of inventory on hand. Cost of goods sold to date. Periodic Requires a physical count of goods to determine: The amount of inventory on hand. Cost of goods sold. Inventory Systems

SAP 2007 / SAP University Alliances Introductory Accounting May. 1 Inventory 66,000 Accounts Payable 6,000 Purchased inventory on account May. 4 Accounts Payable 2,000 Inventory 2,000 Defective merchandise returned to supplier. Purchases Purchase Returns and Allowances Perpetual System-Example

SAP 2007 / SAP University Alliances Introductory Accounting Terms Time Due Discount Period = 10 days (Full amount minus 2% discount) due between May.1 and May.11 Credit Period = 30 days Full amount due anytime between Mayt.12 and May.31 Purchase or Sale A deduction from the invoice price granted to induce early payment of the amount due. Example – 2/10, n30 May.1 May.11May.31 Purchase/Sales Discounts

SAP 2007 / SAP University Alliances Introductory Accounting Purchase Discounts- Assume the purchase of inventory on May 1 was on the terms 2/10,n30. Case 1-Discount taken May.11 Accounts Payable 644,000 Inventory 80 Cash 3,920 2% x (6, ,000) = 80 Case 2-Discount not taken Oct.31 Accounts Payable 4,000 Cash 4,000 Perpetual System — Example

SAP 2007 / SAP University Alliances Introductory Accounting FOB Shipping Point (Buyer pays shipping charges) FOB Destination (Seller pays for shipping charges) Goods SellerBuyer Carrier Transportation Charges — Perpetual System

SAP 2007 / SAP University Alliances Introductory Accounting Transportation Charges May. 2 Inventory 100 Accounts Payable 100 Transportation charges on goods purchased FOB shipping point. Perpetual System — Example

SAP 2007 / SAP University Alliances Introductory Accounting Sales of Merchandise May.15 Accounts Receivable 4,000 Sales 4,000 Sale of merchandise, terms 1/10, n30 Cost of goods sold 3,000 Inventory 3,000 To record cost of merchandise sold Perpetual System — Example

SAP 2007 / SAP University Alliances Introductory Accounting Sales Returns and Allowances Msy.17 Sales Returns & Allowance 400 Accounts Receivable 400 Defective merchandise returned Inventory 300 Cost of Goods Sold 300 To record return of inventory Perpetual System — Example

SAP 2007 / SAP University Alliances Introductory Accounting Sales Discounts Case 1- Discount taken Perpetual System — Example May.25 Cash 3,564 Sales Discounts 36 Accounts Receivable 3,600 1% X (4, ) = 36 Case 2- Discount not taken May.25 Cash 3,600 Accounts Receivable 3,600 (4, )

SAP 2007 / SAP University Alliances Introductory Accounting Adjustments — Perpetual Inventory Perpetual inventory systems keep a running total of inventory levels by recording sales and purchase transactions. Periodic adjustments must be made to account for shrinkage (loss due to theft or deterioration of inventory).

SAP 2007 / SAP University Alliances Introductory Accounting Inventory per accounting records: $187,000 Inventory per physical count: $184,200 Difference (shrinkage) $2,800 Adjustment required: Perpetual System — Example May.31 Cost of Goods Sold 2,800 Inventory 2,800 To record inventory shrinkage revealed by physical count.

SAP 2007 / SAP University Alliances Introductory Accounting Income Statement Formats Income statements may be formatted in a variety of ways. Typical formats are: Classified, Multiple-Step Multiple-Step Single-Step

SAP 2007 / SAP University Alliances Introductory Accounting Classified Multi-step Format

SAP 2007 / SAP University Alliances Introductory Accounting Multi-step Format

SAP 2007 / SAP University Alliances Introductory Accounting Single- step Format

SAP 2007 / SAP University Alliances Introductory Accounting Closing Entries — Perpetual System The closing process is similar for merchandising and service companies. Merchandising companies have additional temporary accounts that must be closed. These include: Sales Sales Returns & Allowances Sales Discounts Cost of Goods Sold

SAP 2007 / SAP University Alliances Introductory Accounting Periodic and Perpetual Inventory Systems Compared Periodic systems Inventory is updated at the end of the period based on a physical count. Perpetual systems Inventory is updated after each sale or purchase.

Example Purchases5,000Inventory5,000 Accounts Payable5,000 Accounts Payable5,000 Purchase of Merchandise Return of Merchandise Accounts Payable1,000Accounts Payable1,000 Purchase Returns1,000 Inventory1,000 Periodic SystemPerpetual System SAP 2007 / SAP University Alliances Introductory Accounting

Example Accounts Payable4,000Accounts Payable4,000 Purchase Discounts 80 Inventory 80 Cash3,920 Cash3,920 Purchase Discount Taken (2/10, n30) Transportation Charges Transportation-in 100Inventory100 Accounts Payable 100 Accounts Payable 100 Periodic SystemPerpetual System SAP 2007 / SAP University Alliances Introductory Accounting

Example Accounts Receivable4,000Accounts Receivable4,000 Sales 4,000 Sales4,000 Cost of Goods Sold3,000 Inventory3,000 Sale of merchandise Periodic SystemPerpetual System SAP 2007 / SAP University Alliances Introductory Accounting

Example Sales Returns400Sales Returns400 Accounts Receivable400 Accounts Receivable400 Inventory300 Cost of Goods Sold300 Sales Return Periodic SystemPerpetual System SAP 2007 / SAP University Alliances Introductory Accounting

Accounting for inventory requires several decisions which include: Items to include in cost.Inventory System. Perpetual or Periodic Costing Method. FIFO, LIFO, Weighted Average, Specific ID Use of estimates. Gross profit method, Retail inventory method Assigning Costs to Inventory SAP 2007 / SAP University Alliances Introductory Accounting

Inventory includes all goods owned by a company and held for sale. Items requiring special attention: Goods in transit Goods on consignment Obsolete or damaged goods Items in Merchandise Inventory SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting All expenditures necessary to bring an item to a saleable condition and location. This includes: Invoice price less discounts Import duties Transportation-in Storage Insurance Costs of Merchandise Inventory

SAP 2007 / SAP University Alliances Introductory Accounting Management must decide on method of determining unit cost. This will affect both the income statement and the balance sheet. Methods: Specific Identification FIFO LIFO Average Cost Assigning Costs to Inventory

Merchandise Available for Sale Net Cost of Purchases Cost of Goods Sold Beginning Inventory Ending Inventory Balance Sheet Income Statement Merchandising Cost Flows SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting This method is used when items: Are unique. Can be directly identified with a specific purchase and its invoice. Specific Identification Examples: Automobiles, custom furniture, art.

SAP 2007 / SAP University Alliances Introductory Accounting Specific Identification — Example The opening inventory consists of 10 $91/unit.

SAP 2007 / SAP University Alliances Introductory Accounting Specific Identification — Example This results in two layers of inventory. Additional units are $106/unit.

SAP 2007 / SAP University Alliances Introductory Accounting Specific Identification — Example On August 14, 20 units are sold. Eight of these units came from the opening inventory and the remaining 12 units came from the August 3 purchase.

SAP 2007 / SAP University Alliances Introductory Accounting Specific Identification — Example This leaves 2 units remaining from the original inventory and 3 units remaining from the August 3 purchase.

SAP 2007 / SAP University Alliances Introductory Accounting First-In, First-Out (FIFO) Based on the assumption that the items are sold in the order acquired. When a sale occurs: The earliest units purchased are charged to Cost of Goods Sold. The cost of the most recent purchases remain in inventory.

SAP 2007 / SAP University Alliances Introductory Accounting FIFO — Example The opening inventory consists of 10 $91/unit.

SAP 2007 / SAP University Alliances Introductory Accounting FIFO — Example Additional units re $106/unit. This results in two layers of inventory. Additional units are $106/unit.

SAP 2007 / SAP University Alliances Introductory Accounting FIFO — Example Under FIFO, units are assumed to be sold in the order acquired. Therefore, of the 20 units sold on August 14, the first 10 units come from beginning inventory. Therefore, those 10 units are removed from the inventory record based on the cost of those units of $91.

SAP 2007 / SAP University Alliances Introductory Accounting FIFO — Example The remaining 10 units sold on August 14 th come from the next purchase, made on August 3 rd. Therefore, these units are removed from the inventory record based on their cost of $106.

SAP 2007 / SAP University Alliances Introductory Accounting FIFO — Example The ending inventory consists of the 5 remaining units from the August 3 purchase.

SAP 2007 / SAP University Alliances Introductory Accounting Last-In, First-Out (LIFO) Based on the assumption that the most recently purchased items are sold first. When a sale occurs: The latest units purchased are charged to Cost of Goods Sold. The cost of the earliest purchases remain in inventory.

SAP 2007 / SAP University Alliances Introductory Accounting LIFO — Example The opening inventory consists of 10 $91/unit.

SAP 2007 / SAP University Alliances Introductory Accounting LIFO — Example Additional units are $106/unit. This results in two layers of inventory.

SAP 2007 / SAP University Alliances Introductory Accounting LIFO — Example Of the 20 units sold, these units are assumed to be sold first.

SAP 2007 / SAP University Alliances Introductory Accounting LIFO — Example Once the latest units purchased are sold, units are sold from the previous purchase.

SAP 2007 / SAP University Alliances Introductory Accounting LIFO — Example This leaves 5 units remaining from the first purchase.

SAP 2007 / SAP University Alliances Introductory Accounting Under this method, the cost of all units are averaged together. Cost of goods available for sale Number of units available for sale Moving Weighted Average Method Average cost per unit =

SAP 2007 / SAP University Alliances Introductory Accounting Moving Weighted Average — Example The opening inventory consists of 10 $91/unit.

SAP 2007 / SAP University Alliances Introductory Accounting Moving Weighted Average — Example Additional units are $106/unit. This results in an average cost of $100/unit. (10 x $91) + (15 x $106) 25 units

SAP 2007 / SAP University Alliances Introductory Accounting Moving Weighted Average — Example These 20 units are sold at the average cost of $100/unit.

SAP 2007 / SAP University Alliances Introductory Accounting Moving Weighted Average — Example This leaves 5 units remaining at an average cost of $100/unit.

SAP 2007 / SAP University Alliances Introductory Accounting Financial Reporting Because prices change, the choice of an inventory method is important.

SAP 2007 / SAP University Alliances Introductory Accounting Advantages of Each Method First-In, First-Out Ending inventory approximates current replacement cost. Weighted Average Smoothes out purchase price changes. Last-In, First-Out Better matches current costs in cost of goods sold with revenues. Financial Reporting

Reporting A company is required to use the same accounting methods from period to period (consistency principle). A change is only acceptable when it improves financial reporting. The costing method used must be disclosed in the notes to the financial statements (full-disclosure principle). SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting Lower of Cost or Market Inventory must be reported at market value when market is lower than cost (conservatism principle). Market may be defined as: Net realizable value Current replacement cost

SAP 2007 / SAP University Alliances Introductory Accounting Lower of Cost or Market May be applied in one of three ways: Separately to each item. To major categories of items. To the inventory as a whole.

SAP 2007 / SAP University Alliances Introductory Accounting Inventory Errors Errors in the computation of or physical count of inventory will cause a misstatement of: Cost of goods sold Gross profit Net income Current assets Owner’s equity

SAP 2007 / SAP University Alliances Introductory Accounting Inventory Errors — Effects on the Income Statement

SAP 2007 / SAP University Alliances Introductory Accounting Inventory Errors — Effects on the Balance Sheet

SAP 2007 / SAP University Alliances Introductory Accounting Gross Profit Method Ending inventory is estimated by applying gross profit ratio to net sales. It is used: when inventory has been destroyed, lost, or stolen. for testing the reasonableness of the physical inventory count.

SAP 2007 / SAP University Alliances Introductory Accounting Retail Inventory Method Occasionally used for interim period reporting. Needed information includes: Beginning inventory at cost and retail. Net purchases at cost and retail. Net sales.

SAP 2007 / SAP University Alliances Introductory Accounting Ratios Merchandise Turnover Ratio Measures how many times a company turns its inventory over each period. The ratio will vary from industry to industry.

SAP 2007 / SAP University Alliances Introductory Accounting Ratios Days’ Sales in Inventory Used to estimate how many days it will take to convert inventory to cash or receivables. Used to assess if inventory levels can meet sales demand.