Accounting for Inventory

Accounting for Inventory
Chapter 6 Chapter 6 reviews accounting for inventory. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved.
Inventory Items held by the company for re-sale Current asset on the Balance Sheet Items sold shifted to Cost of Goods Sold Expense on the Income Statement Sales revenue based on retail price of inventory Cost of Goods Sold based on cost of inventory Companies that sell products have inventory. They purchase items and then re-sell them. Inventory is a current asset on the balance sheet. When items are sold, the cost of the items is transferred to an expense account called “Cost of Good Sold”, which is often abbreviated COGS. It’s important to keep in mind that to make a profit, companies must sell inventory for a price higher than its cost. Revenue is based on the selling or retail price of the inventory. Cost of goods sold is the cost of the inventory items to the company that is selling them. ©2008 Pearson Prentice Hall. All rights reserved.

Gross Profit Sales Revenue minus Cost of Goods Sold Also called Gross Margin Represents markup on products “Gross” because expenses have not been deducted Gross profit is an important measure for a company. Another term for gross profit is gross margin .It is computed by subtracting cost of goods sold from sales. It represents the mark up on goods. It is called “gross” profit because the company has yet to deduct all its expenses. ©2008 Pearson Prentice Hall. All rights reserved.

Two Systems Periodic Count items to determine quantity on hand Used for inexpensive items Used by small businesses Low cost Perpetual Running record of inventory kept by computer program Used by large businesses Scanners and bar codes used to record transactions Companies can chose from two systems to account for inventory. Companies that use periodic inventory tend to be smaller businesses that sell inexpensive items. This system requires that inventory items are counted to determine the amount on hand. Periodic is a low cost method of keeping track of inventory. With the advent of scanners, bar codes and computerized registers, more and more companies use perpetual inventory systems. With this system, inventory is updated for every transaction that impacts it – sales, purchases, returns. Most large retailers use perpetual inventory. ©2008 Pearson Prentice Hall. All rights reserved.

Net cost of purchases Purchase price + Freight-in Transportation costs Unsuitable goods returned to seller - Purchase returns Reduction in amount owed - Purchase allowances The cost of purchasing inventory consists of several items – all of which need to be included in the cost of inventory. Freight-in is added to the purchase price of the items. Freight-in is the shipping costs the company paid to get the items sent. Purchase returns and allowances are subtracted. Both involve reductions to the customers’ balances. Purchase returns occur when customers return unwanted goods. With purchase allowances, the goods aren’t physically returned, but the company reduces the amount owed. Purchases discounts are when the company offers a discount if the customer pays the bill within a certain number of days. Purchase Discounts For early payment = Net cost of purchases ©2008 Pearson Prentice Hall. All rights reserved.

Discount terms Companies offer incentive for early payment 2/10, n/30 2% discount if bill paid in ten days Full amount due in 30 days Purchase discounts Company receives discount if it makes payment early Reduces cost of inventory Sales discounts Company offers discount to customers for early payment Reduces cash received on accounts receivable A purchase discount is a decrease in the buyer’s cost of inventory earned by paying quickly. Many companies offer payment terms of “2/10 n/30.” This means the buyer can take a 2% discount for payment within 10 days, with the final amount due within 30 days. Another common credit term is “net 30,” which tells the customer to pay the full amount within 30 days. When the company offers discounts to its customers, it is called a “sales discount”. ©2008 Pearson Prentice Hall. All rights reserved.

Perpetual Entries To record purchases of inventory on account JOURNAL Date Accounts Debit Credit Inventory Accounts payable When a company using the perpetual inventory purchases inventory the above entry is made. 5-8 ©2008 Pearson Prentice Hall. All rights reserved. ©2009 Prentice Hall

Perpetual Entries To record sale of inventory on account Two entries required JOURNAL Date Accounts Debit Credit Accounts receivable Sales Cost of goods sold Inventory Retail price A sale of inventory requires two entries. One to record the sale at retail price. If the customer is purchasing on account, accounts receivable is debited. The second entry has a debit to COGS, which goes to the income statement, and a credit to inventory, which reduces the asset account. This entry is done at the cost of the items. Cost ©2008 Pearson Prentice Hall. All rights reserved. ©2009 Prentice Hall

Net Sales Sales revenue Unsuitable goods returned to company - Sales returns Reduction in amount owed - Sales allowances Just as several amounts go into “net cost of purchases”, three items are deducted to determine “net sales”. Sales revenue is the amount earning by selling products to customers. If items are returned to the company by the customer, sales returns is debited. Sales allowances are similar to returns, except the items are physically returned. The company reduces the customer’s account receivable. Sales discounts are just like purchases discounts with the roles reversed. The company grants the customer a discount if payment is received within a specified number of days. For early payment Sales Discounts = Net Sales ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 2 Understand the various inventory methods
Learning Objective 2 discusses understanding the various inventory methods. Understand the various inventory methods ©2008 Pearson Prentice Hall. All rights reserved.

Inventory Costing Methods
To determine the cost of inventory sold or on hand, the units are multiplied by the unit cost Inventory items are often purchased at different prices throughout the year Company selects a costing method to determine which unit cost to use While companies choose between two inventory systems – periodic and perpetual – they also select an inventory costing method. Inventory items are purchased several times throughout the year. More often than not, the cost of those items differ for each purchase. When computing the cost of goods sold or the dollar amount of ending inventory, a company must choose a cost-flow assumption to assign a dollar amount to the units. ©2008 Pearson Prentice Hall. All rights reserved.

Inventory Costing Methods
Specific-unit-cost Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) The four inventory costing methods are: specific-unit-cost; average cost; first-in, first-out (FIFO); and last-in, last-out (LIFO). ©2008 Pearson Prentice Hall. All rights reserved.

Specific-unit-cost Each item in inventory can be separately identified Used for unique items Cars, fine jewelry Too expensive for homogeneous items Some businesses deal in unique inventory items, such as automobiles, antique furniture, jewels, and real estate. These businesses cost their inventories at the specific cost of the particular unit. The specific-unit-cost method is also called the specific identification method. This method is too expensive to use for inventory items that have common characteristics, such as bushels of wheat, gallons of paint, or auto tires. ©2008 Pearson Prentice Hall. All rights reserved.

Average-cost An average of inventory costs Cost of goods available = Average cost per unit Number of units available Average cost per unit x units sold = Cost of goods sold The average-cost method, as its name implies, averages the cost of inventory items purchased during the year. The cost of goods available is divided by the units available to determine an average cost per unit. The cost of goods available is the dollar amount of beginning inventory plus the net cost of purchases. This average cost per unit is multiplied by either the units sold to determine cost of goods sold, or by the units on hand to determine the amount of ending inventory. Average cost per unit x units on hand = Ending inventory ©2008 Pearson Prentice Hall. All rights reserved.

FIFO Oldest items assumed to be sold first Ending inventory will consist of most recent items purchased FIFO assumes that the company sells the oldest items in inventory first. Therefore, the ending inventory will be made up of the most recent purchases. ©2008 Pearson Prentice Hall. All rights reserved.

LIFO Newest items are assumed to be sold first Ending inventory consists of oldest items in inventory LIFO is the opposite of FIFO. The company assumes that the most recent items purchased are the first to be sold. Therefore, the ending inventory consists of the oldest inventory items. ©2008 Pearson Prentice Hall. All rights reserved.

Subtract units in ending inventory from units available
Cost Beginning inventory 5 $160 $800 Oct. 15 Purchase 11 $170 $1,870 Oct. 26 Purchase $180 $900 Units available 21 $3,570 Ending inventory 8 units Units sold ______ Subtract units in ending inventory from units available E6-15 demonstrates accounting for inventory. ©2008 Pearson Prentice Hall. All rights reserved.

Specific Unit Cost Ending inventory = $160 = $480 $1,380 $180 = $900 Cost of goods sold = Here we determine the specific unit cost. $2,190 $160 = $ 320 $170 = $1,870 ©2008 Pearson Prentice Hall. All rights reserved.

Average Cost Cost of goods available = Average cost per unit Number of units available $3570 = $170 21 Average cost per unit x units sold = Cost of goods sold Now, we determine the average cost. $170 x 13 units = $2,210 Average cost per unit x units on hand = Ending inventory $170 x 8 units = $1,360 ©2008 Pearson Prentice Hall. All rights reserved.

What is the price of the oldest items?
FIFO Ending inventory = Highest ending inventory Newest items $180 = $900 $1,440 $170 = $540 What is the price of the oldest items? Cost of goods sold = This slide shows how to use the FIFO method. $2,160 Oldest items $____ = $_____ $170 = $1,360 ©2008 Pearson Prentice Hall. All rights reserved.

LIFO Ending inventory = Oldest items $160 = $800 $1,310 $170 = $510 Cost of goods sold = This slide shows how to use the LIFO method. Highest Cost of goods Sold $2,260 Newest items $180 = $ 900 $170 = $1,360 ©2008 Pearson Prentice Hall. All rights reserved.

Increasing Costs Cost of goods sold FIFO lowest LIFO highest
Based on older costs LIFO highest Based on recent costs Ending inventory FIFO highest Based on recent costs LIFO lowest Based on older costs In periods of inflation, FIFO will result in the lowest cost of goods sold (and thus higher net income) and the highest balance in inventory on the balance sheet. Since FIFO assumes the oldest items are sold first, these items would based on the older, lower cost items and ending inventory would be the newer, more expensive items. Conversely, LIFO will result in the highest cost of goods sold (and thus lower net income) and the lowest balance in inventory on the balance sheet. If prices are decreasing, the opposite would be true. LIFO would have the highest ending inventory and lowest cost of goods sold. Opposite relationships exist when costs are decreasing ©2008 Pearson Prentice Hall. All rights reserved.

Tax Advantage of LIFO Assuming inventory costs are increasing
LIFO results in higher COGS Higher COGS results in lower net income Why would a company choose LIFO if it results in lower net income and lower asset value on the balance sheet? To pay less income taxes. Assuming increasing prices, LIFO results in higher COGS. Higher COGS results in lower net income. Less income means less taxes. This can result in greater cash flow for the company. Lower net income results in lower taxes Lower taxes results in greater cash flow ©2008 Pearson Prentice Hall. All rights reserved.

Comparison of Inventory Methods
FIFO Balance sheet More recent costs Income Statement Does not match current costs with revenue LIFO Balance Sheet Old, outdated costs Income Statement Matches current costs with revenue When comparing FIFO and LIFO, both have strengths and weaknesses. FIFO gives a more accurate balance sheet number as inventory is made up the most recent costs. However, it matches old inventory costs with current revenues. LIFO results in a less accurate balance sheet number. However, on the income statement, the COGS amount is good match with the revenue. ©2008 Pearson Prentice Hall. All rights reserved.

Accounting Principles Related to Inventory
Consistency Companies should use same inventory method from period to period Disclosure Companies should disclosed inventory method used Conservatism Companies should “write down” inventory if market price falls below cost The consistency principle states that businesses should use the same accounting methods and procedures from period to period. Consistency enables investors to compare a company’s financial statements from one period to the next. The consistency principle does not mean that a company is not permitted to change its accounting methods. However, a company making an accounting change must disclose the effect of the change on net income. The disclosure principle holds that a company’s financial statements should report enough information for outsiders to make informed decisions about the company. The company should report relevant, reliable, and comparable information about itself. That means disclosing inventory accounting methods. Without knowledge of the accounting method, a financial statement use could make an unwise decision. Conservatism in accounting means reporting financial statement amounts that paint the gloomiest immediate picture of the company. What advantage does conservatism give a business? Many accountants regard conservatism as a brake on management’s optimistic tendencies. The goal is to present reliable data. Conservatism appears in accounting guidelines such as “anticipate no gains, but provide for all probable losses” and “if in doubt, record an asset at the lowest reasonable amount and report a liability at the highest reasonable amount.” Conservatism directs accountants to decrease the accounting value of an asset if it appears unrealistically high. For inventory, conservatism comes into play with the principle that requires a company to “write down” inventory if its market value falls below cost. ©2008 Pearson Prentice Hall. All rights reserved.

Lower-of-Cost-or-Market (LCM)
Inventory should be reported at whichever is lower – cost or market Market = current replacement cost If cost is lower, no adjustment needed If market is lower, Inventory is decreased to market value Cost of goods sold is increased The lower-of-cost-or-market rule (abbreviated as LCM) is based on accounting conservatism. LCM requires that inventory be reported in the financial statements at whichever is lower—its historical cost or its market value. Applied to inventories, market value generally means current replacement cost (that is, how much the business would have to pay now to replace its inventory). If the replacement cost of inventory falls below its historical cost, the business must write down the value of its goods to market value. The business reports ending inventory at its LCM value on the balance sheet. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 3 Learning Objective 3 shows how to use gross profit percentage and inventory turnover to evaluate operations. Use gross profit percentage and inventory turnover to evaluate operations 5-28 ©2008 Pearson Prentice Hall. All rights reserved. ©2009 Prentice Hall 28

Gross Profit Percentage
Key indicator of ability to sell inventory at a profit Sales – Cost of Goods Sold = Gross profit Gross profit = Gross profit percentage Gross profit—sales minus cost of goods sold—is a key indicator of a company’s ability to sell inventory at a profit. Merchandisers strive to increase gross profit percentage, also called the gross margin percentage. Gross profit percentage is markup stated as a percentage of sales Net Sales Revenue ©2008 Pearson Prentice Hall. All rights reserved.

Inventory Turnover How many times a company sells its average level of inventory Compute average inventory Inventory turnover Beginning inventory + Ending inventory 2 A company strives to sell its inventory as quickly as possible because the goods generate no profit until they’re sold. The faster the sales, the higher the income. Inventory turnover, the ratio of cost of goods sold to average inventory, indicates how rapidly inventory is sold. Cost of goods sold Average inventory ©2008 Pearson Prentice Hall. All rights reserved.

Estimating Inventory by the Gross Profit Method
Cost of goods sold computation - periodic Gross profit method Beginning Inventory + Purchases = Goods available - Ending inventory = Cost of Goods sold Beginning Inventory + Purchases = Goods available - Cost of Goods sold = Ending inventory Often a business must estimate the value of its goods. A fire may destroy inventory, and the insurance company requires an estimate of the loss. In this case, the business must estimate the cost of ending inventory because it was destroyed. The gross profit method, also known as the gross margin method, is widely used to estimate ending inventory. This method uses the familiar cost-of-goods-sold model. However, instead of deducting ending inventory from goods available to determine COGS, cost of goods sold is deducted to estimate ending inventory. An estimate of COGS is computed by multiplying net sales by the cost ratio. The cost ratio is one minus the gross profit percentage. Net sales x (1 – GP%) ©2008 Pearson Prentice Hall. All rights reserved.

Multiply Sales by cost ratio
Beginning inventory $ ,000 Net purchases $ ,000 Goods available $ ,000 Sales $ 200,000 x Cost ratio _____% = Estimated COGS $ __________ Estimated ending inventory $ ,000 Cost ratio = 100% - GP% Exercise E6-26 shows how we determine estimated ending inventory. Multiply Sales by cost ratio ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 5 Learning Objective 5 shows how inventory errors affect the financial statements. Show how inventory errors affect the financial statements ©2008 Pearson Prentice Hall. All rights reserved.

Effects of Inventory Errors
Error in ending inventory impacts two periods First period Cost of goods sold Gross Profit & Net Income Second period Beginning inventory Costs of Goods sold Inverse with error Direct with error An error in ending inventory impacts two periods. In the period of the error, COGS is impacted (remember ending inventory is deducted from goods available to compute Cost of Goods Sold). Since ending inventory is subtracted, the relationship is inverse, that is if ending inventory is understated, COGS will be overstated. The error in gross profit and net income will be the “same way” as the inventory error. So if ending inventory is understated, so will Gross Profit and Net Income. Ending inventory of one period becomes the beginning inventory of the next. Since beginning inventory increases COGS, there is a direct relationship between the inventory error and COGS. Since COGS is subtracted from Net Sales to determine Gross Profit, there is an inverse relationship between the error and Gross Profit and Net Income. Direct with error Direct with error Inverse with error ©2008 Pearson Prentice Hall. All rights reserved.

Effects of Inventory Errors
Period 1 Period 2 Inventory error COGS GP & Net Inc Ending inventory overstated U O Ending inventory understated The table above summarizes the impact of inventory errors (both under and overstated). O = Overstated U = Understated ©2008 Pearson Prentice Hall. All rights reserved.

Accounting for Inventory

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