PROFESSOR S CLASS NOTES FOR UNIT 8 COB 241 Sections 13, 14, 15 Class on October 3, 2018

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1 PROFESSOR S CLASS NOTES FOR UNIT 8 COB 241 Sections 13, 14, 15 Class on October 3, 2018 Acquisition Cost of Long-Term Assets A video accompanying Unit 6 introduced the concept of Acquisition Cost. To review: Long-Term Assets such as equipment, buildings, warehouses, furniture, fixtures, and factories are put on the accounting records at Acquisition Cost. Acquisition Cost includes every penny it takes to get the asset READY TO USE. This includes the purchase price, as well as all taxes, tariffs, delivery and transportation costs, packaging for transit, transportation insurance, unloading, installation, connection, configuration, programming, -- basically ALL costs of getting the asset in place and ready to use. Acquisition cost is shown on the Balance Sheet as an asset for as long as the asset physically lasts and is owned by the company. Acquisition Cost of Short-Term Assets The same principle holds true for acquiring Short-Term Assets as well, -- assets such as supplies inventory, raw materials inventory, finished goods inventory, and inventory for sale. These inventories are put on the accounting records at their acquisition cost. The acquisition cost of inventory includes every penny it takes to get the asset on the shelf, READY TO USE OR SELL. And as with long-term assets, inventory acquisition cost includes the purchase price of the goods, as well as all taxes, tariffs, delivery and transportation costs, packaging for transit, transportation insurance, unloading, placing on the shelf in the storerooms or warehouse, -- ALL costs of getting the asset in place and ready to use or sell. And like long-term assets, the acquisition cost of inventory is reported on the Balance Sheet as an asset for as long as the inventory is owned by the company.

2 Journal Entry for Acquiring Inventory with Freight-In Costs Example: A company purchases $10,000 worth of goods from a supplier, and also incurs $350 in transportation costs to have those goods delivered. The entire $10,350 is the acquisition cost of the inventory. DATE or ID DEBIT CREDIT 15-Oct Inventory (purchase price) 10,000 Accounts Payable (to the mdse vendor) 10,000 Inventory (freight-in) 350 Accounts Payable (to trucking company) 350 (to record acquisition of inventory, including freight in) Notice that the cost of transporting purchased goods is called Freight In. Materiality Principle A financial amount is said to be material if it will have an effect or influence on any foreseeable decision involving that amount. Material amounts are those which management (or government) believes should be recorded, tracked and accounted for. One of the major applications of the materiality principle is deciding whether to treat supplies as inventory assets, or whether to expense supplies at the time they are purchased. If the amount of supplies actually carried over from one period to another is relatively small, then the entire amount of supplies purchased is often expensed at the time of acquisition. But if the total amount of all supplies left over is expected to be significant (material), then the left-over supplies should be shown as Supplies Inventory on the Balance Sheet. Note that the decision is based on the total amount left over in aggregate, even though any single supply item might itself be insignificant. Example: a company might consider a $1000 threshold as its materiality criteria: any amount over $1000 is considered material. A $20 carton of paperclips by itself is insignificant. But when aggregated with other leftover supplies such as toner, paper, folders, pens, markers, etc., the aggregate of all supplies together might exceed $1000, and thus the company should maintain a Supplies Inventory asset account.

3 Third Major Accounting Equation BB + TI = TO + EB Beginning Balance plus Transfers In, must always equal Transfers Out plus Ending Balance Without noticing it, we have already been using this equation to find the ending balance of each T-account at the end of each period: BB + TI - TO = EB The Periodic Inventory System Another way we ve already used this equation was to make the adjusting entry to the Supplies Inventory account. Remember: supplies were purchased and placed in inventory, and at the end of the period it was determined that a portion of those supplies had been used. By knowing the amount of beginning inventory (BB), tracking the purchases as we acquired additional supplies (TI), then estimating the amount remaining at the end of the period. (EB), we can calculate the amount of supplies to expense (TO). BB + TI - EB = TO Because this process requires a physical count (or estimate) at the end of each period, it is called the Periodic Inventory System. Adjusting Journal Entry under the Periodic Inventory System As an example, assume a company has a beginning balance in their supplies inventory of $4,500. During the present accounting period, the company acquires an additional $10,350 of supplies (including freight-in), and is using the Periodic Inventory System. BB + TI = TO + EB Beginning Balance Transfers In Transfers Out Ending Balance $4,500 + $10,350 =? + $5,000 Solving for TO, we find that TO equals $9,850: $4, ,350-5,000 = $9,850. Thus we make an adjusting entry at the end of the period to show the consumption of $9,850 of Supplies Inventory. DATE or ID DEBIT CREDIT 31-Oct Supplies Expense 9,850 Supplies Inventory 9,850 (adjusting entry to show usage of supplies)

4 The Periodic Inventory System is used by most companies for their Supply Inventory. Many companies also use the periodic inventory system for other kinds of inventory, such as Raw Materials or Inventory for Sale. Any time the nature of the inventory makes it impractical to individually track the goods as they are being taken out of inventory, the periodic inventory system is normally used. Example: Restaurants uses the Periodic Inventory System for their food inventory. Rather than tracking the removal of bread, hamburger patties, ketchup, French fries and other inventory every time a sale is made, restaurants use the Periodic Inventory System. They take inventory at the start of the month, keep track of purchases as they arrive, and take inventory again at the end of the month. They then use the formula to determine how much food inventory was used during the month. Perpetual Inventory System In contrast with the Periodic Inventory System, the Perpetual Inventory System keeps a continuous up-to-date inventory value, by recording every removal of inventory as it occurs. With the invention of UPC codes, bar codes, and reliable scanning devices, it became practical for merchandising businesses to capture the actual dollar amount of the goods being taken out of inventory, each and every time something is removed from inventory. Today most businesses use the perpetual inventory system whenever they can. Inventory Shrinkage While the perpetual inventory system does not require a physical count of inventory to determine usage, all companies actually do take a physical count of their inventory at least once a year, and frequently more often. The purpose is not to determine usage, but rather to verify that the ending balance is still correct. During normal operations, many errors, oversights, and mistakes crop in. Also, inventory sometimes disappears, taken out by shoplifters, employee theft, breakage, spoilage, damage, and other hazards encountered in the normal course of business. These problems result in inventory being lost but not recorded in the perpetual inventory system. To correct the records and ensure the inventory account ending balance reflects what is actually in inventory, an adjusting entry is made to reflect this Inventory Shrinkage.

5 Merchandising Businesses Merchandising businesses are companies whose operations consist of buying goods from suppliers, and then selling those goods to customers. Merchandising businesses can be Distributors or Retailers. Distributors purchase from manufacturers, and sell to retailers. Retailers purchase from distributors, and sell to end-users, such as consumers, or businesses who plan to use, rather than re-sell, the product. Inventory in a Merchandising Business Distributors and Retailers both sell goods, rather than providing services. Distributors and Retailers purchase goods, and place the goods in Inventory until they are sold. The account which holds the value of the inventory is sometimes titled, Inventory For Sale, Merchandise Inventory, or Goods Available for Sale. Most simply call it Inventory. Inventory for Sale is a short-term asset. (Companies hope that they will sell their inventory within the coming year.) Acquisition of Inventory For Sale As shown earlier, when goods are purchased, the Inventory account is debited (increased) for the acquisition cost of the merchandise. DATE or ID DEBIT CREDIT 5-Oct Inventory for Sale 23,500 Accounts Payable 23,500 (to record the acquisition of Inventory for Sale) If there are any Freight-In charges for a carrier or seller to deliver the goods from the supplier, the Inventory account will also be debited for Freight-In costs the cost of transportation, packing, and any other charges associated with getting the goods to our business, on the shelf ready to sell.

6 Recording the Sale of Inventory Two simultaneous events occur when goods are sold. First, the goods are removed from inventory and given to the customer. This usage of the asset is expensed. The expense account charged is titled Cost of Goods Sold. The entry results in a debit (increase) to expenses, and a credit (decrease) in assets. Second, a sale is recorded. The sale can be for cash, or on account. This results in a credit (increase) to Revenue, and a debit (increase) to either Cash or Accounts Receivable. To repeat, every sale of merchandise involves two debits and two credits. DATE or ID DEBIT CREDIT 9-Oct Cost of Goods Sold 2,450 inventory for Sale 2,450 Accounts Receivable 4,000 Sales Revenue 4,000 (to record the sale of goods on account) As shown above, the Inventory account is credited (decreased) by $2,450 to show the removal of inventory. The associated expense account is debited (increased). Notice that the expense account is titled Cost of Goods Sold, to separate it from other operating expenses of the business. Second, since a sale has been made, the Sales Revenue account is credited (increased), and either the Cash account or Accounts Receivable account is debited (increased). Gross Margin In the above example, notice that the inventory account is reduced (and expense increased) by the Acquisition Cost of the inventory. And notice that the sale is recorded for the price charged to the customer. The difference between the inventory s acquisition cost, and the sales price charged the customer is called Gross Margin. Gross Margin is not an account. It is simply the difference between the acquisition cost and sales price. Don t confuse Gross Margin with Net Income.

7 Classification of Expenses Prior to this unit, we have used a single expense account to hold all of the company s expenses. Beginning with Unit 8, we now take a closer look at the categorization of Expenses. Under GAAP rules, costs are classified as either Product Costs or Period Costs. Product Costs Product Costs are all of the costs associated with getting the product on the shelf, ready to sell. In other words, product costs are the product s acquisition cost. Most accountants use the term Acquisition Cost when referring to Long-Term Assets, and the term Product Costs when referring to the cost of acquiring inventory, getting it on the shelf ready to sell. Some major concepts of this learning unit are: Product costs are the acquisition cost of inventory. They include all costs of acquiring the product and getting it on the shelf ready to sell. Product Costs remain on the Balance Sheet as Inventory for as long as the goods remain in the business. When the goods are sold to a customer, Product Costs are then expensed using an expense account titled Cost of Goods Sold. The difference between Product Cost and Sales Price is termed Gross Margin. Other Uses of the Cost of Goods Sold Expense Account Inventory shrinkage is usually expensed to the Cost of Goods Sold account. Example: At year end, a company using the Perpetual Inventory System has an ending balance in their Inventory account of $46,000. However, a physical count of the merchandise at the end of the year reveals that they actually have only $44,000 in inventory on hand. The company must make an adjusting entry so that the balance in the Inventory account reflects what is actually on hand. DATE or ID DEBIT CREDIT 31-Dec Cost of Goods Sold 2,000 Inventory 2,000 (to record Inventory Shrinkage)

8 Period Costs Period Costs are all other operational expenses incurred during the period. Period costs are expensed in the period in which they are incurred. These include expenses such as the usage of office supplies, rent, insurance, interest, depreciation, wages, salaries, utilities, and all other expenses not associated with getting the product on the shelf ready to sell. Costs associated with running the business are classified as one of three types: Selling Expenses, Administrative Expenses, and General Expenses. Selling Expenses Selling expenses are defined as those expenses associated with finding customers, informing them of the company s offerings and prices, convincing the customer to buy, and then servicing the customer s needs (such as warranty service, technical support, etc.) so as to retain the customer s business. Selling expenses include advertising, catalog printing, on-line shopping cart apps, publicity, customer appreciation events, sales reps salaries, sales commissions, warranty service costs, customer support services, and all other costs associated with finding customers, convincing them the buy, and keeping the customer happy. Administrative Expenses Administrative Expenses are defined as those expenses associated with planning, evaluating, and managing the business. Administrative Expenses include gathering, analyzing and providing information, reporting activities (internal, external, governmental), as well as planning and budgeting activities. Administrative expenses include recruiting costs, salaries of the accounting departments, billing, accounts payable clerks, collections agents, controllers, auditors, and other paperwork and record-keeping costs. Administrative expenses also include information technology, computers, telephone, internet, budget analysts, and the cost of most datacollection equipment used by the accounting system. Legal expenses, business licenses, dues and subscriptions to professional organizations such as Chamber of Commerce, and similar costs are usually considered to be administrative expenses.

9 General Expenses General Expenses are all other costs directly associated with the day-to-day operations of the business. General Expenses include the costs of hiring, training, supervising, and overseeing the workforce, with the exception of the administrative and clerical staff. General expenses include maintenance and repair costs, housekeeping, janitorial, property insurance, liability insurance, as well as property taxes on the warehouse, factory, or other operational facilities. Some also include employee benefits. Other (Non-Operational) expenses Selling, General, and Administrative expenses are sometimes called Operating Expenses, and are considered to be under the control and purview of current management. In contrast, management has relatively little control over several other types of expenses. To make the Income Statement more useful to stockholders in judging the performance of management, many companies sometimes report four other, non-operational, expenses separately on their Income Statement. These include: Interest: Interest is the cost of borrowing money. Interest is frequently reported separately on the Income Statement. This is because if the company had obtained more capital from Owners, it would not have been required to borrow money. So it is sometimes useful to show how much expense the company incurred from borrowing, separate from operating expenses. Thus interest expense is often reported separately on the Income Statement. A few companies consider interest to be an Administrative expense and do not report it separately but including it in SG&A (operating) expenses. Taxes: Compared to most other expenses, management has relatively little control over how much Tax the governments levy. Thus Tax is almost always reported separately. Depreciation: Depreciation is the decrease in value of a long-term asset over time. Current management has relatively little control over the passage of time or the assets acquired under former management, Plus, depreciation is an expense that did not necessarily use up cash during the current period, nor even the recent former period(s). Therefore, Depreciation is often reported separately. A few companies consider depreciation to be a General Expense and do not report it separately, but include it in SG&A expenses. Amortization: Amortization is the reduction in value of an intangible asset, connected with time rather than under the control of management. For this reason, amortization is often reported separately on the Income Statement. If not, it is considered to be a General Expense.

10 The Multi-Step Income Statement Breaking expenses into the categories discussed above permits users of the Income Statement to identify more details about a company s Results of Operations than the can be done gtom a simple Revenue minus Expenses display of Net Income. (Like expenses, Revenue has some complexities that will be dealt with in later units. So for now, a single Revenue account will be used.) Below is the model of the Multi-Step Income Statement. If a company habitually has a zero balance in an account or set of accounts, those accounts can be omitted from the statement. (Values shown below in bold italics are not account balances, but merely subtotals or totals.) Revenue $348,000 Less Cost of Goods Sold (*) 187,000 Gross Margin $161,000 Less Expenses Selling Expenses $ 21,000 Administrative Expenses 16,000 General Administrative Expenses 72,000 Total SG&A (**) Expenses $109,000 Earnings Before Interest, Tax, Depreciation, Amortization (***) $ 52,000 Interest Expense $ 6,000 Tax Expense 9,000 Depreciation Expense 15,000 Amortization Expense 1,000 Total Int/Tax/Depre/Amort $31,000 Gains and/or Losses (****) 0 NET INCOME $21,000

11 (*) Cost of Goods Sold includes not only the cost our company paid for the merchandise, but also the Freight-In, tariffs, delivery, and all other costs of having acquired the goods that were then sold during the present period. (**) Selling, General, and Administrative expenses are often totaled together and reported as SG&A Expenses. Since they are considered to be under control of management, they are often called Operating Expenses. Reporting a single total for SG&A Expenses is acceptable under GAAP. But SG&A expenses must always be reported separately from Cost of Goods Sold expense. (***) Earnings Before Interest, Tax, Depreciation and Amortization is sometimes abbreviated EBITDA. This is used by many company outsiders to judge how well or how poorly management is performing their duty to maximize the owner s wealth. As explained earlier, many companies consider Depreciation and Amortization to be part of their normal operations, and thus include Depreciation expense and Amortization expense as a General Expense. In these cases, this subtotal would be Earnings Before Interest and Tax, often abbreviated as EBIT. (****) We have not yet covered Gains and Losses. Gains and losses are caused by selling Long-Term Assets for more or less than their Net Book Value (depreciated or amortized value). Flexibility in Categorization When Product Costs are expensed, they must always be reported on the Income Statement as Cost of Goods Sold. All other operating expenses must be reported separately from Cost of Goods Sold. GAAP does not require that SG&A expenses be broken down by individual category on the Income Statement. Most companies, however, do report separate figures for Selling, Administrative, and General expenses. Most small companies even report specific types of expenses under these categories GAAP also offers flexibility on whether Interest expense, Tax expense, Depreciation expense, and Amortization expense are considered as operating or non-operating expenses. Some companies consider Interest and Depreciation/Amortization to be Administrative or General expenses. Others do not. Under GAAP, either is acceptable. EBIT is not a required subtotal under GAAP, nor is EBITDA. However, most companies do report those subtotals because they give a clearer picture of management performance regarding the expenses under management control.