Financial Accounting Chapter 6 Notes Inventories

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1 Financial Accounting Notes Inventories I. Management Issues Associated with Accounting with Inventory. Defining Inventory: 1. Assets held for resale purpose in a normal course of business. (Current Asset) 2. Assets used to produce products for resale purpose Merchandise Firms: Merchandise Manufacturing Firms: Raw material Work-in-process Finished goods A. Applying the Matching Rule to Inventories The proper determination of income through matching Cost and Revenue Why costing inventory properly is so important? Because gross margin has a direct effect on net income. In we calculated Gross Margin as follows: Net Sales $250,000 Cost of Good Sold Beginning Merchandise Inventory 50,000 Net Purchases 150,000 Goods Available for Sale 200,000 Less Merchandise Inventory December ,000 Cost of Good Sold 150,000 Gross Margin 100,000 Assuming that the Goods available for sale remain the same, what will be the gross margin if ending inventory had been calculated to be $75,000, what about $25,000? If ending inventory were $75,000, CGS would be less and, and gross margin will higher. If ending inventory were $25,000, CGS will be higher and the gross margin will be lower. Assessing the Impact of Inventory Decisions: Management has various methods to use when evaluating inventory. The decisions usually result in different amounts of reported net income. Because income is affected, the valuation of inventory may also have a considerable effect on the amount of income taxed paid; and thus cash flow. 1

2 C. Evaluating Inventory Level Inventory level that a company may decide to keep may affect the cost of storage, as well as cost of handling. The optimum levels of inventory will impact sales. Low levels when there is high demand will affect total sales. High levels when there is low demand will affect the cash flow of the company as well as adding the additional cost of storage. D. Measuring Optimum Levels of Inventory Turnover Inventory turnover rate: Inventory Turnover Cost of Good Sold Average Inventory $23,374 (5, ,031)/2 3.9 times This ratio measures how fast inventory is sold. Average Day s Inventory on hand: Average number of days require to sell the inventory on hand Average Days Inv. Number of Days in a year Inventory Turnover 2

3 $ Days 3.9 times In this case this company sales its inventory 3.9 times on an average of 93.6 days. In-Class Exercise SE2 II. Pricing Inventory Under the Periodic Inventory System 1. Costs included in inventory 1. Invoice price less purchase discounts 2. Freight or transportation in, including in insurance 3. Taxes and tariffs Other cost may include storing, ordering and receiving but because the difficulty to closely estimate the amounts are usually considered expenses in the accounting period the inventory was purchase. Merchandise In Transit Who includes inventory in transit, the buyer or the seller? The answer depends on the shipping agreement. FOB Shipping Point -> Is included in the buyers inventory FOB Destination -> Is included in the sellers inventory Merchandise in Consignment Consignment is merchandise placed by its owner (consignor) on the premises of another company (consignee), title of merchandise remains with the consignor. Methods of Pricing Inventory at Cost There are several methods of pricing inventory. A company decides which inventory method may be applicable to their type of business. Pricing inventory is an assumption based on the flow of costs and not about the flow of physical inventory Why is necessary to assume the cost of the ending inventory? Merchandise is bought during the year at different prices 3

4 Identical items are bough and sold and it is impossible to tell from which lot came from. Goods Flow Refers to the actual physical movement of inventory Cost Flow Refers to the association of cost with theirs assumed flow in the operations of a company. Inventory Methods 1. Specific Identification Method 2. Average-cost method 3. First-in First-out (FIFO) 4. Last-in First-Out (LIFO) 4

5 Calculating Ending Inventory using different cost methods under a Periodic Inventory System The following illustrate the transactions recorded in June: Inventory Data June 30 June 1 Inventory 50 $1.00 $50 6 Purchase 50 $ Purchase 150 $ Purchase 100 $ Purchase 150 $ Good available for sale 500 units $625 Sales Ending Inventory (Inventory on hand June 30) 280 units 220 units Illustration of the four methods Periodic Inventory System Specific Identification Method (Used units can be defined) Calculating Units Sold: Calculating Ending Inventory: June 6 50 $1.10 $55 June 1 $1.00 $50 13 $ $ $ $ $ Total 280 $357 Total E.I. 220 $268 Goods available for sale Less: Ending Inventory Cost of Goods Sold $ $357 Average Method (Units are prices at the average cost of goods available for sale during the period) Calculating Units Sold: Calculating Ending Inventory: Average cost of available for sale Items: Units cost $625 / No. of Units 500 = $1.25 per unit. Total Units Sold $1.25 $350 Total Units Reminding $1.25 $275 Total 280 $350 Total E.I. 220 $275 Goods available for sale Less: Ending Inventory Cost of Goods Sold $ $350 In-Class SE4 5

6 First-In First-Out (FIFO) (Assumes that items purchase first are the first items sold) Calculating Units Sold: Calculating Ending Inventory: June 1 50 $1.00 $50 June 20 $1.30 $91 6 $ $ $ $ Total Units Sold 280 $324 Total E.I. 220 $301 Goods available for sale Less: Ending Inventory Cost of Goods Sold $ $324 In-Class SE5 Last-in First-Out (LIFO) (Assumes that items purchase last are the first items sold) Calculating Units Sold: Calculating Ending Inventory: June 25 $1.40 $210 June 1 $1.00 $50 20 $ $ $ $ Total 280 $376 Total E.I. 220 $249 Goods available for sale Less: Ending Inventory Cost of Goods Sold In-Class SE6 $ $376 Comparing the effects of each system on Net Income: Specific Average FIFO LIFO Identification Costing Sales $840 $840 $840 $840 Cost of Good Sold: Beginning inventory Add Purchases Goods available for sale Less: Ending Inventory (268) (275) (301) (249) Cost of Goods Sold Gross Margin Less: Other Operating Expenses Income before tax Income tax 30% Net Income $198 $203 $221 $185 6

7 Advantages and disadvantages of each method: Advantages of FIFO a. Ending Inventory is closest to current balance sheet values and thus give a more realistic view of the current financial assets of he business. b. Produce higher income during an inflation period c. Inventory cost reported on the B/S is close to replacement cost Disadvantages of FIFO a. Bad match of sales revenue with Cost of Good Sold; match current sales revenue with old costs. b. Produced higher income during an inflation period results in paying more income taxes Advantages of LIFO a. Good match of sales revenue with CGS; match the most recent inventory cost against sales revenue b. Produces lower income during an inflation periods; resulting in tax savings Disadvantages of LIFO a. Inventory presented in the balance sheet does not represent the actual units in inventory. IRS Rules: (extra information not included in test) 1. If firms are using LIFO for income tax filing purpose, firms must also use LIFO for financial reporting purposes 2. LIFO was not acceptable by the IRS until late 1930s 3. Switch from FIFO to LIFO, firms do not need the approval of the IRS. However, to switch from LIFO to FIFO, firms must receive the approval of the IRS and need calculate the tax liability for the difference and to pay back taxes. 4. Internationally, many countries do not permit the use of LIFO. Some of these are: Australia, Singapore, and United Kingdom. In-Class Exercise SE7, E5 III. Pricing Inventory Under the Perpetual Inventory System Perpetual inventory pricing of inventory is different from Periodic Inventory because in perpetual inventory a continuous record is kept. Under the Period Inventory only the ending inventory is counted and price. Under the Perpetual Inventory cost of goods sold is accumulated as sales are made and costs are transferred from the Inventory account to Cost of Good Sold. Calculation of Average Cost Method, LIFO and FIFO under Perpetual Inventory. 7

8 PERPETUAL INVENTORY SYSTEM Perpetual Inventory Average Cost Method June 1 Inventory 50 $1.00 $50 June 6 Purchase 50 $1.10 $55 June 6 Balance 100 $1.05 ($105/100Unit s) $105 June 10 Sale 70 $1.05 (73.50) June 10 Balance 30 $1.05 $31.50 June 13 Purchase 150 $ June 20 Purchase 100 $ June 25 Purchase 150 $ June 30 Balance 430 Units $1.28 ($551.50/430 Units) $ June 30 Sale 210 Units $1.28 (268.80) June 30 Inventory 220 Units $1.29 $ Cost of Good ( $ Sold ) To calculate Perpetual Inventory Average Cost method a moving average is computed after each purchase of series of purchases preceding the next sale. Inventory Data June 30 June 1 Inventory 50 $ Purchase 50 $ Sale 70 Units 13 Purchase 150 $ Purchase 100 $ Purchase 150 $ Sale 210 Units 30 Inventory on hand 220 8

9 Perpetual Inventory FIFO Cost Method June 1 Inventory 50 $1.00 $50 June 6 Purchase 50 $1.10 $55 June 10 Sale 50 $1.00 ($50) Sale 20 $1.10 ($22) ($72) June 10 Balance 30 $1.10 $33 June 13 Purchase 150 $ June 20 Purchase 100 $ June 25 Purchase 150 $ June 30 Sale 30 Units $1.10 ($33) Sale 150 Units $1.20 (180) Sale 30 Units $1.30 (39) (252) 30 Inventory 70 Units $1.30 $ Units $ $301 Cost of Good Sold ($ ) $324 The ending inventory under and the cost of good sold will be the same as if it was calculated under the period inventory systems, this occurs because the ending inventory under both systems consists of the same units. Perpetual Inventory LIFO Cost Method June 1 Inventory 50 $1.00 $50 June 6 Purchase 50 $1.10 $55 June 10 Sale 50 $1.10 ($55) Sale 20 $1.00 ($20) ($75) June 10 Balance 30 $1.00 $30 June 13 Purchase 150 $ June 20 Purchase 100 $ June 25 Purchase 150 $ June 30 Sale 150 Units $1.40 ($210) Sale 60 Units $1.30 (78) ($288) 30 Inventory 30 Units $1.00 $30 Cost of Good Sold ($ ) 150 Units $ Units $ $262 $363 9

10 V. Valuing Inventory at the Lower of Cost or Market Lower-of-Cost-or-Market (LMC) Rule Companies at times at faced with inventory that is less than its historical, what they paid. This may be due because of physical deterioration, obsolescence or decline in price level. Take the case of Kmart that because of downturn of the economy found itself with huge amounts of merchandise unable to sale, of course bad management came into play. The company had to marked down about $1 billion dollars in inventory. When the inventory is marked down it affects the balance sheet and income statement. Current assets are lowered and a loss is written down in the income statement which affects net income and the total performance of the company. Valuing inventories by estimation: The Retail Method The retail method is used by merchandising companies and estimates the cost of ending inventory by using the ratio of cost to retail price. The two main reasons for using this method are: 1. Because companies need to prepare financial statements every month, the retail method avoids the time and expense of determining the cost of each item in the inventory. 2. Because retail stores use a bar code and keep the inventory at retail and they can quickly determine the cost by using a ratio. Example: Cost Retail Beginning Inventory 40,000 55,000 Purchases 107, ,000 Freight-in Goods Available for Sale 150, ,000 Ratio of cost to retail price: 150,000 =75% 200,000 Net sales during the period 160,000 Estimating ending inventory at retail $40,000 Ratio of cost to retail 75% Estimated cost of ending inventory 30,000 In-Class Exercise E13 Chapter 8 Homework Assignments: E7, E10 10

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