Accounting 101 Chapter 5 Inventories and Cost of Sales

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1 I. Internal Controls of Inventory Accounting 101 Inventory consists of the items a business has for resale to customers in the normal course of business. A. s included in inventory 1. of the merchandise 2. Transportation 3. Insurance 4. Import duties and taxes B. Inventory will always be the largest Current Asset on the Balance Sheet and the of Goods Sold will be the largest expense on the Income Statement. Two primary objectives of Internal Control over inventory are 1. Safeguarding the inventory 2. Properly reporting it on the financial statements II. of Goods Sold Calculation Walberg Associates, antique dealers, purchased the contents of an estate for $75,000. Terms of the purchase were FOB shipping point, and the cost of transporting the goods to Walberg Associates s warehouse was $2,400. Walberg Associates insured the shipment at a cost of $300. Prior to putting the goods up for sale, they cleaned and refurbished them at a cost of $980. Determine the cost of the inventory acquired from the estate.

2 III. Inventory Flow October 1 Purchased 5 $.10 October 5 Sold 2 units October 10 Purchased 5 $.10 October 12 Sold 3 units October 15 Purchased 5 $.10 October 20 Sold 4 units A primary concern for inventory is properly calculating its value for the Balance Sheet and Income Statement. However, often times the inventory consists of identical units of merchandise, which were acquired at different unit costs. When a unit is sold, it is impossible to determine what amount was paid for the particular unit sold. Therefore, the company must assume an Inventory Flow Assumption for use in assigning costs to the inventory on hand and the units sold. Methods allowed for GAAP Reporting: A. First-In, First-Out (FIFO)- Milk. Push old milk forward B. Last-In, First-Out (LIFO) Boxes of Nails at Home Depot. Push them back and put new nails forward. Or use the classic coal bin. C. Weighted Average - Gasoline they fill the reservoir with different priced gas.

3 D. Specific Identification- A car dealer or jewelry retailer may be able to identify the cost specifically of the item being sold. For most companies this isn't practical, it can also be used to manipulate earnings. Example: October 1 Purchased 4 $.10 October 5 Sold 2 $1.00 October 10 Purchased 4 $.12 October 12 Sold $1.00 October 15 Purchased 4 $15 October 20 Sold 3 $1.00

4 Laker Company reported the following January purchases and sales data for its only product. Date Activities Units Acquired at Units Sold at Retail Jan. 1 Beginning inventory 140 $6.00 = $ 840 Jan. 10 Sales 100 $15 Jan. 20 Purchase 60 $5.00 = 300 Jan. 25 Sales 80 $15 Jan. 30 Purchase 180 $4.50 = 810 s 380 units $1, units Required The company uses a perpetual inventory system. Determine the cost assigned to ending inventory and to cost of goods sold using (a) specific identification, (b) weighted average, (c) FIFO, and (d) LIFO. (Round per unit costs and inventory amounts to cents.) For specific identification, ending inventory consists of 200 units, where 180 are from the January 30 purchase, 5 are from the January 20 purchase, and 15 are from beginning inventory FIFO Date Purchases of Goods Sold Inventory

5 LIFO Date Purchases of Goods Sold Inventory Weighted Average Date Purchases of Goods Sold Inventory

6 Use the data above to prepare comparative income statements for the month of January for Laker Company similar to those shown in Exhibit 5.8 for the four inventory methods. Assume expenses are $1,250, and that the applicable income tax rate is 40%. (Round amounts to cents.) 1. Which method yields the highest net income? 2. Does net income using weighted average fall above, between, or below that using FIFO and LIFO? 3. If costs were rising instead of falling, which method would yield the highest net income? Hemming Co. reported the following current-year purchases and sales for its only product. Date Activities Units Acquired at Units Sold at Retail Jan. 1 Beginning inventory 200 $10 = $ 2,000 Jan. 10 Sales 150 $40 Mar. 14 Purchase 350 $15 = 5,250 Mar. 15 Sales 300 $40 July 30 Purchase 450 $20 = 9,000 Oct. 5 Sales 430 $40 Oct. 26 Purchase 100 $25 = 2,500 s 1,100 units $18, units Required Hemming uses a perpetual inventory system. Determine the costs assigned to ending inventory and to cost of goods sold using (a) FIFO and (b) LIFO. Compute the gross margin for method. (Round amounts to cents.)

7 FIFO Date Purchases of Goods Sold Inventory LIFO Date Purchases of Goods Sold Inventory

8 Ending inventory consists of 45 units from the March 14 purchase, 75 units from the July 30 purchase, and all 100 units from the October 26 purchase. Using the specific identification method, compute (a) the cost of goods sold and (b) the gross profit. (Round amounts to cents.) Ming Company uses a perpetual inventory system. It entered into the following purchases and sales transactions for April. (For specific identification, the April 9 sale consisted of 8 units from beginning inventory and 27 units from the April 6 purchase; the April 30 sale consisted of 12 units from beginning inventory, 3 units from the April 6 purchase, and 10 units from the April 25 purchase.) Date Activities Units Acquired at Units Sold at Retail Apr. 1 Beginning inventory 20 $3, per unit Apr. 6 Purchase 30 $3, per unit Apr. 9 Sales 35 $12, per unit Apr. 17 Purchase 5 $4, per unit Apr. 25 Purchase 10 $4, per unit Apr. 30 Sales 25 $14, per unit 65 units 60 units Required 1. Compute cost of goods available for sale and the number of units available for sale. 2. Compute the number of units in ending inventory. 3. Compute the cost assigned to ending inventory using (a) FIFO, (b) LIFO, (c) weighted average, and (d) specific identification. (Round all amounts to cents.) 4. Compute gross profit earned by the company for of the four costing methods in part 3.

9 FIFO Date Purchases of Goods Sold Inventory LIFO Date Purchases of Goods Sold Inventory

10 Weighted Average Specific Identification Valuation of Inventory other than Inventory is normally carried at unless: Market is lower Inventory items are obsolete or damaged Note this violates the Historical Principle: The Historical Principle is abandoned when the future utility of the asset is no longer as great as its original cost. Lower-of--or-Market Accounting principles require that inventory be reported at the market of replacing inventory when the market value is lower than the purchase cost. Example: Unit Unit Market Apple Jacks $1.50 $1.75 Rice Krispies $1.00 $1.35 Frosted Flakes $1.80 $1.42

11 Effect of Errors in Reporting Inventory Beginning Inventory + Net Purchases Ending Inventory = of Goods Sold If ending inventory is reported inaccurately, the following financial statement data are incorrect. On the income statement: 1. of merchandise sold 2. Gross profit 3. Net income On the balance sheet: 1. Ending inventory 2. current assets 3. assets 4. Retained earnings (due to the incorrect net income being added to the retained earnings account) Understate the Physical Inventory: Understate Assets and Net Income Overstate the Physical Inventory: Overstate Assets and Net Income COMPARISON OF INVENTORY METHODS Method Advantages Disadvantages FIFO Ending inventory amount on balance sheetcreates illusory profits during times of hig approximates current replacement costs inflation LIFO Matches current costs against current Ending inventory amount on income statement revenues on income statement may be substantially different from current replacement cost During inflationary periods, reduces income taxes Average Easy to understand Ending inventory amount on income statement may not represent current replacement cost Yields same answer whether prices start at $1 Lose tax advantage and increase to $2 or start available from LIFO when at $2 and decrease to $1 prices are rising