ACCOUNTING - CLUTCH CH. 5 - INVENTORY.

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2 CONCEPT: MERCHANDISING COMPANY VS MANUFACTURING COMPANY A merchandising company has Inventory account. Merchandisers goods manufactured by others. The Inventory account might also be called Merchandise Inventory XYZ Company purchases goods from its supplier for $10,000 on account. Journal Entry: Assets = Liabilities + Equity A manufacturing company has Inventory accounts. Manufacturers goods and then sell them. Raw Materials Inventory inputs into production; this is what the company from suppliers Work-in-Process Inventory goods that are still in production at the end of the period Finished Goods Inventory the value of the finished product Page 2

3 CONCEPT: PHYSICAL INVENTORY COUNT AND OWNERSHIP OF GOODS Whether using perpetual or periodic inventory systems, all companies must determine Inventory at the end of the period. A physical count involves actually counting and measuring all goods that are still in Inventory. - Perpetual Inventory the count should the inventory balance from the records. > Any discrepancies can be explained by wasted materials, shoplifting, or employee theft. - Periodic Inventory a physical count is We may own some goods that are not in the warehouse. FOB Shipping Point of the goods changes hands at the shipping point - Any FOB Shipping Point in transit belong to the company. Supplier Shipping Company Our Warehouse FOB Destination of the goods changes hands at the destination - Any FOB Destination in transit belong to the company. Our Warehouse Shipping Company Customer We may not own some goods that are in the warehouse. Consigned Goods Goods you are selling, but are owned by another company. - You do not own consigned goods, so they are part of your Inventory. - Generally, you earn some commission upon selling consigned goods. Jan s Boutique sells Sophie s dresses on consignment. Sophie pays Jan $100 for each dress sold. At the beginning of the month, Jan s store displayed five of Sophie s dresses, with a cost of $250 each. Jan sold two dresses during the month for $1,000 each. Record Jan s journal entries related to the consigned goods. Journal Entry: Inventory Balance: Revenue: Liabilities: Page 3

4 CONCEPT: SPECIFIC IDENTIFICATION A company can properly value its cost of goods sold and inventory balance if it can specifically identify each unit sold. EXAMPLE: Specific Identification usually requires goods that are or otherwise easily identified. COGS Price we paid for each unit sold Ending Inventory Price we paid for units left unsold ABC Yacht Company resells yachts and only keeps a few units on hand. The units on hand at the beginning of June were: Yacht A with a value $350,000, Yacht B with a value of $500,000, and Yacht C with a value of $600,000. During June, the company sold Yacht B to a customer for $800,000, half of which was paid in cash. Journalize this sale and note the ending balance in the following accounts. Journal Entry: Inventory Balance: Revenue: COGS: PRACTICE: Unique Robots Company currently has four robots in its factory. Two units of X3ZA, which it purchased for $80,000 each, one unit of EE1C for $60,000, and one unit of C4P0 for $125,000. The company then sold the EE1C model for $140,000. Journalize this sale and note the ending balance in the following accounts.. Journal Entry: Inventory Balance: Revenue: COGS: Page 4

5 CONCEPT: PERIODIC SYSTEM FIFO, LIFO, AND AVERAGE COST When we sell large amounts of units, we can use cost flow assumptions to track COGS and Inventory First In, First Out ( ) the unit is sold first (COGS what you paid for older units) Last In, First Out ( ) the unit is sold first (COGS what you paid for newer units) Average Cost goods are sold at their average cost (COGS average of what you paid) Average Cost = Total Cost Quantity Note: The cost flow assumption does NOT have to be consistent with the flow of goods - In a periodic system, an inventory count reveals the in ending inventory. Beginning Inventory + Purchases = Goods Available for Sale Beginning Inventory + Purchases COGS = Ending Inventory EXAMPLE: A company had the following inventory data for the month of July in its periodic inventory system: Date Activity Units Cost Total Cost of Purchase July 1 Inventory Balance 1,000 $ Purchase 500 $ Purchase 600 $23.30 Total Available for Sale The month-end physical count noted that there were 800 units on hand. Calculate COGS and Ending Inventory. FIFO LIFO Average Cost COGS Ending Inventory Page 5

6 CONCEPT: PERPETUAL SYSTEM FIFO, LIFO, AND AVERAGE COST When we sell large amounts of units, we can use cost flow assumptions to track COGS and Inventory First In, First Out ( ) the unit is sold first (COGS what you paid for older units) Last In, First Out ( ) the unit is sold first (COGS what you paid for newer units) Average Cost goods are sold at their average cost (COGS average of what you paid) - A perpetual system features a moving average; the average is updated after each Average Cost = Total Cost Quantity Note: The cost flow assumption does NOT have to be consistent with the flow of goods EXAMPLE: A company had the following inventory data for the month of July: Date Activity Units Cost Units Balance Total Cost July 1 Inventory Balance 1,000 $ $ Purchase 500 $ $ $ Purchase 600 $23.30 Calculate COGS and Ending Inventory assuming the company uses a perpetual inventory system. July 5: FIFO LIFO Average Cost July 5: July 5: July 23: July 23: July 23: COGS July 29: July 29: July 29: Total: Total: Total: Ending Inventory Page 6

7 CONCEPT: FINANCIAL STATEMENT EFFECTS OF COSTING METHODS The choice between FIFO, LIFO, and Average Cost leads to differences in the following accounts/calculations: COGS Gross Profit = Sales Revenue COGS Net Income = Gross Profit Other Expenses/Revenues Ending Merchandise Inventory = Beginning Inventory + Purchases Ending Inventory Excerpts from periodic inventory example FIFO LIFO Average Cost Sales 39,000 39,000 39,000 COGS 26,720 29,180 27,968 Gross Profit Inventory Balance, July 31 18,460 20,000 17,212 The differences in these values are dependent on whether prices are generally rising or declining over the period. Rising Price Environment COGS Gross Profit Net Income Ending Inventory Falling Price Environment COGS Gross Profit Net Income Ending Inventory FIFO FIFO LIFO LIFO Rising FIFO Rising LIFO Falling FIFO Falling LIFO $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Note: Companies reporting in LIFO must also show what Inventory would be under FIFO using a LIFO reserve. Page 7

8 CONCEPT: LOWER OF COST OR MARKET The rule of conservatism tells us to be looser with recording losses than gains. If an asset has lost value, we generally take an expense/loss in the period of the change in value If an asset has gained value, we generally take a revenue/gain until it is The Inventory account should be marked to the lower of cost or market - Cost The historical cost of the inventory (what you paid for it) - Market the net realizable value of the inventory or the current replacement cost Net realizable value = Estimated Selling Price Disposal Costs - If the Inventory is marked down, we take a loss from write-down of inventory EXAMPLE: Obsocorp purchased inventory four years ago for $84,000. In the current year, Obsocorp estimated it could sell this inventory for $86,000 while incurring selling expenses of $7,000. In its financial statements, Obsocorp should report this inventory at: a. $77,000 b. $79,000 c. $84,000 d. $86,000 PRACTICE: Using the following data, determine the value of inventory at the lower of cost or market. Apply lower of cost or market to each inventory item. Assume expenses of $2 per unit are expected to be incurred in selling the inventory. Item Inventory Quantity Cost per Unit Estimated Selling Price TR $39 $42 QT314 7 $110 $100 a. $1,160 b. $1,120 c. $1,086 d. $1,076 Page 8

9 CONCEPT: INVENTORY ERRORS Inventory errors correct themselves after years. If it is the first year, there is an overstatement/understatement. EXAMPLE: On January 1, Year 1, a company had a balance in Inventory of $50,000. During the year, purchases of $75,000 were made. On December 31, Year 1, an error in the inventory count caused a final balance in Inventory of $35,000, when the correct amount would have been $30,000. During Year 2, the company purchased $60,000 of Inventory and the year-end physical count found the correct balance of $40,000. Y1 COGS Y1 Ending Inventory Y2 COGS Y2 Ending Inventory Total COGS from Both Years Correct Incorrect PRACTICE: A company had an ending inventory that was overstated by $5,000 due to a miscount during the year-end inventory count. The amounts reflected in the end of the period balance sheet are: Assets Equity a. Overstated Overstated b. Correct Correct c. Understated Understated d. Overstated Correct Page 9

10 PRACTICE: A company had a beginning inventory that was understated by $4,000 because the ending inventory in the previous period was understated by $4,000. The amounts reflected in the current end of period balance sheet are: Assets Equity a. Overstated Overstated b. Correct Correct c. Understated Understated d. Overstated Correct Page 10