1 Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso ELS

Chapter 6

3 Chapter 6 Reporting and Analyzing Inventory After studying Chapter 6, you should be able to: zExplain the recording of purchases and sales of inventory under a periodic inventory system. zExplain how to determine cost of goods sold under a periodic inventory system. zDescribe the steps in determining inventory quantities.  Identify the unique features of the income statement for a merchandising company under a periodic inventory system.

4 Chapter 6 Reporting and Analyzing Inventory After studying Chapter 6, you should be able to: zExplain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. zExplain the financial statement and tax effects of each of the inventory cost flow assumptions. zExplain the lower of cost or market basis of accounting for inventories. zCompute and interpret the inventory turnover ratio.  Describe the LIFO reserve and explain its importance for comparing results of different companies.

5 Merchandise Inventory zowned by the company zin form ready to sale to customers

6 Manufacturing Inventory zFinished goods inventory zWork in process zRaw materials

7 Finished Goods Inventory Manufactured items that are complete and ready for sale.

8 Work in Process Manufactured inventory that has been placed into production but is not yet complete.

9 Raw Materials The basic goods that will be used in production, but have not been placed in production.

Key difference between periodic and perpetual inventory… is the point at which the costs of goods sold is computed.

No attempt is made on date of sale to record the cost of merchandise sold... A physical count of inventory is taken at end of period to determine: zCost of merchandise on hand; zCost of goods sold.

Cost of Goods Sold Computed Perpetual Periodic Perpetual Point of SaleItem Sold Inventory Purchased Item SoldPoint of Sale End of Period Comparing Periodic and Perpetual Inventory Systems Inventory Purchased End of Period Page 204 in the book

Businesses that use the periodic method generally do not have sophisticated computer systems required to compute cost of goods sold when sale is made.

14 Merchandise Purchases On May 4 the company bought $ 3,800 worth of merchandise from PW Audio Supply, Inc. Task:Record the purchase by getting information from the Purchase Invoice. The Purchase Invoice is just a copy of the sales invoice.

15 1. Seller 2.Invoice Date 3.Purchaser 4.Salesperson 5.Credit terms 6.Freight terms 7.Goods sold: catalog no.,description, quantity, price per unit 8.Total invoice price Invoice No. 731 Address 125 Main Street Attention o f James Hoover, Purchasing Agent Firm Name: Sauk Stero City Chelsea State Illinois Zip Date 8/4/98 Salesperson Maone Terms 2/10,n/30 Freight Paid by Buyer Catalog No. Description QTY Price Amount Page 206 in book

Merchandise Purchases-Periodic On May 4 the company bought $ 3,800 worth of merchandise from PW Audio Supply, Inc. Purchases Purchase Returns & All. Purchase Discounts Cash Accounts Payable Freight-In May May 4 3,800

Purchases Returns and Allowances - Periodic On May 8 the company returned $300 worth of merchandise to PW Audio Supply, Inc. Purchases Purchase Returns & All. Purchase Discounts Cash Accounts Payable Freight-In May May 4 3,800 May 8 300

18 Freight Costs - On Incoming Inventory

Freight - In Periodic On May 9 the company paid $ 150 to have the merchandise inventory delivered to them. Purchases Purchase Returns & All. Purchase Discounts Cash Accounts Payable Freight-In May May 4 3,800 May May 9 150

20 Purchase Discounts Credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. Credit terms specify the amount of cash discounts and the time period during which it is offered. 2/10,n/30 1/10 EOM

Purchase Discounts On May 14, the company pays the balance due on the account within the discount period Purchases Purchase Returns & All. Purchase Discounts Cash Accounts Payable Freight-In May May 4 3,800 May May 9 150

Purchases Discounts Review - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was paid within the discount period. Original Invoice $3,800 -Returns 300 Amount due before discount $3,500 2% discount 70 Net due $3,430

Purchase Discounts On May 14, the company pays the balance due on the account within the discount period Purchases Purchase Returns & All. Purchase Discounts Cash Accounts Payable Freight-In May May 4 3,800 May May May 14 3,500 May May 14 3,430

24 Sales Revenues - Under a Periodic System zare recorded when earned-revenue recognition principle zmust be supported by a business document- written evidence zONLY 1 entry is made for each sale yone to record sale

25 Sales Returns and Allowances Flip side of purchase returns and allowance On buyer’s books GENERAL JOURNAL Debit Credit May 8 Accounts Payable 300 Purchase Returns and Allowances 300 To record goods returned that were purchased on account On seller’s books GENERAL JOURNAL Debit Credit May 8 Sales Returns and Allowance 300 Accounts Receivable 300 To record return of goods delivered to Sauk Stero

Sales - Under a Periodic System Assume a sale of $ 3,800 on Account Cash Accounts Receivable Merchandise Inventory Cost of Goods Sold Sales Returns & Allowances Sales May 4 3,800

27 What is the Sales Returns and Allowances Account? zContra Revenue Account to sales zUsed to show how much came in on returns and allowances Excessive returns and allowances suggest: zinferior merchandise zinefficiencies in filing orders zerrors in billing customers zmistakes in delivery or shipment of goods

28 What Is the Sales Discount Account? zContra Revenue Account to sales zUsed to disclose amount of cash discounts taken by customers

29 Sales Discounts Flip side of purchase discounts On buyer’s books GENERAL JOURNAL Debit Credit May 14 Accounts Payable 3,500 Cash 3,430 Merchandise Inventory 70 To record payment within discount period On seller’s books GENERAL JOURNAL Debit Credit May 14Cash 3,430 Sales Discounts 70 Accounts Receivable 3500 To record collection within discount period

30 Purchases $325,000 Less: Purchase returns and allowances $ 10,400 Purchase discounts 6,800 17,200 Net purchases307,800 Net Purchases Net Purchases are gross purchases adjusted for returns and discounts.

31 Cost of Goods Purchased Purchases $325,000 Less: Purchase returns and allowances $ 10,400 Purchase discounts 6,800 17,200 Net purchases307,800 Add: Freight-in 12,200 Cost of goods purchased320,000 Cost of goods purchased is net purchases plus freight-in.

32 Companies that use periodic inventory take a physical count to... zdetermine ending inventory zcompute cost of goods sold Companies that use perpetual inventory must take a physical inventory to check accuracy of “book inventory” to actual inventory.

33 Taking a Physical Inventory zCounting, weighting or measuring each type of inventory zDetermining ownership of goods zQuantity of each kind of inventory listed on inventory summary sheets where unit costs are applied

34 Questions Concerning Ownership zDo all the goods included in the count belong to the company? zDoes the company own any goods not included in the count?

35 Goods in Transit These are goods on board a truck, train, ship, or plane at the end of the period.

36 Goods in Transit Who includes these in inventory? zBuyer? zSeller? The Company with Legal Title

Ownership passes to owner here Ownership passes to buyer here Public Carrier Co Public Carrier Co Seller Buyer Page 245 in book FOB Shipping Point FOB Destination Point

38 Shipping Terms zFOB (free on board) shipping point- ownership of goods passes to buyer when public carrier accepts the goods zFOB (free on board) destination- ownership of goods remains with the seller until the goods reach the buyer

39 Consigned Goods Goods in your store that you don’t pay for until they sell… the company does not take ownership.

40 Income Statement Presentation The income statement for a merchandising company is the same whether a periodic or perpetual inventory system is used, except for the cost of goods sold section.

Sales revenues Sales$ 480,000 Less: Sales returns and allowance$12,000 Sales discounts 8,000 20,000 Net sales 460,000 Cost of goods sold 316,000 Gross profit 144,000Operating expenses Store salaries expense45,000 Rent expense19,000 Utilities expense 17,000 Advertising expense 16,000 Depreciation expense 8,000 Freight-out 7,000 Insurance expense 2,000 Total operating expenses114,000 Net Income $ 30,000 PW AUDIO SUPPLY, INC. Income Statement (Perpetual) For the Year Ended December 31, 1998 Page 213 in book

Sales revenues Sale $ 480,000 Less: Sales returns and allowance$12,000 Sales discounts 8,000 20,000 Net sales 460,000 Cost of goods sold Inventory, January 36,000 Purchases $ 325,000 Less: Purchase returns and allowances $10,400 Purchase discounts 6,800 17,200 Net Purchases 307,800 Add: Freight-in 12,200 Cost of goods purchased 320,000 Cost of goods available for sale 356,000 Inventory, December 31 40,000 Cost of goods sold 316,000 Gross profit 144,000 Operating expenses 114,000 Net Income $ 30,000 Page 247 in book Income Statement (Periodic)

Specific Identification An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of ending inventory. Page 248 in book

44 Inventory Costing zSpecific Identification method zAssumed Cost Flow methods yFIFO- First-in, First-Out- earliest goods purchased first to be sold yLIFO- Last-in,First-Out- latest goods purchased the first to be sold yAverage Cost Method- costs are charged on the basis of weighted average unit cost

45 What Makes Cost Flow Assumptions Necessary? Changing Prices

Use of Cost Flow Methods in Major U.S. Companies

The FIFO method assumes the earliest goods purchased are the first to be sold. Page 250 in book

The LIFO method assumes the latest goods purchased are the first to be sold. Page 251 in book

Page 252 in book The average cost method assumes that goods available for sale are homogeneous. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred.

Page 253 in book The average cost method assumes that goods available for sale are homogeneous.

51 Factors Used in Selecting an Inventory Cost Method zIncome statement effects zBalance sheet effects zTax Effects

52 Income Statement Effects zIn periods of increasing prices yFIFO reports the highest net income yLIFO the lowest yaverage cost falls in the middle. zIn periods of decreasing prices y FIFO will report the lowest net income yLIFO the highest yaverage cost in the middle.

53 Balance Sheet Effects In a period of increasing prices costs allocated to ending inventory using: zFIFO will approximate current costs z LIFO will be understated

54 Why Do Companies Use Lifo? zHigher cost of goods sold zLower net income Lower Income Taxes

55 The Lower of Cost or Market Basis of Accounting for Inventories When the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline occurs.

56 Lower of Cost or Market (LCM) zdeparture from cost principle zfollows conservatism concept zcan be used only after one of the cost flow methods ( Specific Identification FIFO, LIFO, or Average Cost)

57 Market Is... CURRENT REPLACEMENT COST

58 How Much Inventory Should a Company Have? yOnly enough for sales needs yExcess inventory costs: xstorage costs xinterest costs xobsolescence - technology, fashion

Inventory Turnover Ratio = Cost of Goods Sold Average Inventory

Days in Inventory = 365 days Inventory Turnover Ratio

61 Lifo Reserve And Its Importance For Comparing Results Of Different Companies zAccounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO. zThis amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods.