6-1 prepared by coby harmon university of california, santa barbara westmont college copyright...

6-1

Prepared byCoby Harmon

University of California, Santa BarbaraWestmont CollegeCopyright ©2015 Pearson Education Inc. All rights reserved.

6-2

1. Show how to account for inventory

Learning Objective

Learning Objective

Copyright ©2015 Pearson Education Inc. All rights reserved.

6-3 LO 1

SHOW HOW TO ACCOUNT FOR INVENTORY

Exhibit 6-1 | Contrasting a Service Company with a Merchandising Company

Merchandisers have two accounts that service entities don’t need:• Cost of goods sold on the income statement

• Inventory on the balance sheet


6-4 LO 1


Exhibit 6-1 | Contrasting a Service Company with a Merchandising Company

Merchandisers have two accounts that service entities don’t need:• Cost of goods sold on the income statement

• Inventory on the balance sheet


6-5

Exhibit 6-2 |Inventory and Cost of Goods Sold When Inventory Cost Is Constant


Assume Family Dollar

Stores, Inc., has in stock

300 towels that cost $3

each.

Family Dollar Stores

marks each towel up by $2

and sells 200 of the towels

for $5 each.


6-6

The cost of inventory sold shifts from asset to expense when

the seller delivers goods to the buyer


LO 1Copyright ©2015 Pearson Education Inc. All rights reserved.

6-7 LO 1

Sale Price vs. Cost of Inventory

Note the difference

Sales revenue based on sales price of inventory sold

Cost of goods sold based on cost of inventory sold

Inventory based on cost of inventory on hand


6-8 LO 1

Sale Price vs. Cost of Inventory

Number of Units of Inventory

Determined from accounting records

Evidenced by physical count at year-end

Consigned goods:

► Does not include those held for another company

► Does include those out on consignment

In transit goods

► Depends on shipping terms


6-9 LO 1

FOB (free on board) shipping point

FOB (free on board)

destination

Shipping Terms

At the point when the goods leave

the seller’s shipping dock

At the point of delivery to the

customer

Ownership Changes Hands

Number of Units of Inventory

Company with legal title to the goods while in

transit pays the transportation costs


6-10 LO 1

Perpetual Inventory System

Periodic Inventory System

Used for all types of goods

Keeps a running record of

all goods bought, sold, and

on hand

Inventory counted at least

once a year

Used for inexpensive goods

Does not keep a running

record of all goods bought,

sold, and on hand

Inventory counted at least

once a year

Accounting for Inventory in the Perpetual System


6-11 LO 1

Accounting for Inventory in the Perpetual System

How the Perpetual System Works

Optical scanner reads bar code, system

► Records sale

► Updates inventory records

Two entries needed for each sale

► Record revenue and asset received

► Record cost of goods sold and reduction of inventory

Exhibit 6-4 | Bar Code for Electronic Scanner


6-12 LO 1

Recording Transactions (Perpetual System)

Exhibit 6-5 | Recording and Reporting Inventory—Perpetual System

PANEL A—Recording Transactions (amounts assumed)Copyright ©2015 Pearson Education Inc. All rights reserved.

6-13 LO 1



PANEL A—T-accounts (amounts assumed)Copyright ©2015 Pearson Education Inc. All rights reserved.

6-14


PANEL B—Reporting (amounts assumed)



6-15 LO 1


The cost of inventory is the net amount of purchases,

determined as follows (using assumed amounts):


6-16 LO 1


The journal entry to record a purchase return of merchandise

that cost $500 is as follows:

Account Debit Credit

Accounts payable

Inventory

500

500

To record purchase return


6-17 LO 1


The journal entry to record a purchase of $1,000 in

merchandise is as follows:


Inventory

Accounts Payable

1,000

1,000

To record purchase of merchandise


6-18 LO 1


The journal entry to record the payment for merchandise

within 10 days when the discount terms are 2/10, n/30, is as

follows:


Accounts Payable

Inventory

1,000

20

To record payment within discount period

Cash 980

Discount = $1,000 x 2% = $20


6-19

2. Apply and compare various inventory cost

methods

Learning Objective

Learning Objective


6-20

APPLY AND COMPARE VARIOUS INVENTORY COST METHODS

LO 2

Accounting method selected affects the

Profits to be reported

Amount of income tax to be paid

Values of inventory turnover and gross margin percentage

ratios derived from the financial statements


6-21

What Goes into Inventory Cost?

LO 2

The cost of any asset, such as inventory, is the sum of all

the costs incurred to bring the asset to its intended use,

less any discounts.

Cost includes:

Purchase price

Freight in

Insurance while in transit

Fees or taxes paid to get

the inventory ready to sell

Less returns, allowances,

and discounts


6-22

Apply Various Inventory Costing Methods

LO 2

Accounting uses four generally accepted inventory

methods:

1. Specific unit cost

2. Average cost

3. First-in, first-out (FIFO) cost

4. Last-in, first-out (LIFO) cost

Company can use any of

these methods

Methods can have very

different effects on

reported

profits,

income taxes, and

cash flow


6-23

Average Last-in, first-out

LO 2

Used for businesses with unique inventory items

Automobiles, antique furniture, jewels, and real estate

Businesses cost their inventories at the specific cost of the

particular unit

Too expensive for inventories with common characteristics

Also called the specific identification method

Specific unit


First-in, first-out


6-24

Last-in, first-out

LO 2

Sometimes called the weighted-average method

Based on the average cost of inventory during the period

Specific unit


First-in, first-outAverage


6-25 LO 2

Illustration

Exhibit 6-6 | Inventory Data Used to Illustrate the Various Inventory Costing Methods

In Exhibit 6-6, Family Dollar began the period with 10 lamps that

cost $10 each; the beginning inventory was therefore $100. During

the period, Family Dollar bought 50 more lamps, sold 40 lamps,

and ended the period with 20 lamps.


6-26 LO 2

IllustrationExhibit 6-6


6-27 LO 2

IllustrationExhibit 6-6

Accounting questions are:

1. What is the cost of goods sold for the income statement?

2. What is the cost of the ending inventory for the balance

sheet?Answer depends on

cost method used


6-28 LO 2

Exhibit 6-6

Average Cost

Average cost per unit =Cost of goods available

Number of units available

$900

60= = $15

Number of units sold X Average cost per unit = Cost of good sold

40 units X $15 = $600

Number of units on hand X Average cost per unit = Ending inventory

20 units X $15 = $300


6-29 LO 2

Exhibit 6-6

Average Cost

The following T-account shows the effects of average costing:

Cost of goods sold (40 units@ average cost of $15 per unit) 600

End bal (20 units @ averagecost of $15 per unit) 300


6-30

Average Last-in, first-out

LO 2

First costs into inventory are first costs assigned to cost of

goods sold (oldest items assumed to be sold first)

Ending inventory is based on latest costs incurred

Specific unit


First-in, first-out


6-31 LO 2

FIFO CostInventory (at FIFO cost)

Beg bal (10 units @ $10) 100

Purchases:

No. 1 (25 units @ $14)350No. 2 (25 units @ $18)450

(10 units @$10)100

(25 units @$14)350 (5 units @$18)90

End bal (20 units @ $18) 360

Cost of Good Sold

(10 units @$10)100(25 units @$14)350 (5 units @$18)90

End bal (40 units) 540

40 units sold20 units on hand


6-32

Average

LO 2

Costing is the opposite of FIFO

Last costs into inventory go to cost of goods sold (most

recent items purchased are assumed to be sold first)

Oldest costs in ending inventory

Specific unit


First-in, first-out

Last-in, first-out


6-33 LO 2

LIFO CostInventory (at LIFO cost)

Beg bal (10 units @ $10) 100

Purchases:

No. 1 (25 units @ $14)350No. 2 (25 units @ $18)450

(15 units @$14)210(25 units @$18)450

End bal (10 units @ $10)(10 units @ $14) 240

Cost of Good Sold

(25 units @$18)450(15 units @$14)210


40 units sold20 units on hand


6-34

Illustration

LO 2

Hazelwood Surplus began March with 75 tents that cost $16 each.

During the month, Hazelwood Surplus made the following purchases

at cost:

March 3 95 tents @ $18 = $1,710

17 165 tents @ $20 = 3,300

23 35 tents @ $21 = 735

Hazelwood Surplus sold 318 tents, and at March 31 the ending

inventory consists of 52 tents. The sale price of each tent was $45.

Requirements

Determine the cost of goods sold and ending inventory amounts for

March under the average cost, FIFO cost, and LIFO cost. Round

average cost per unit to two decimal places.


6-35

Illustration

LO 2

Goods Available


6-36 LO 2

Average CostInventory (at FIFO cost)

Beg bal (75 units @ $16) 1,200

Mar 3 (95 units @ $18) 1,710

Mar 17 (165 units @ $20) 3,300

Mar 23 (35 units @ $21) 735

End bal (370 units) 6,945

318 tents sold52 tents on hand

Average cost per unit

$6,945 ÷ 370 = $18.77

Cost of Good Sold


6-37 LO 2

Average CostInventory (at FIFO cost)

Beg bal (75 units @ $16) 1,200

Mar 3 (95 units @ $18) 1,710

Mar 17 (165 units @ $20) 3,300

Mar 23 (35 units @ $21) 735

End bal (52 units @ $18.77) 976


Average cost per unit

$6,945 ÷ 370 = $18.77

Cost of Good Sold

(318 units @$18.77)5,969

(318 units @$18.77)5,969


6-38 LO 2

FIFO CostInventory (at FIFO cost)

Beg bal (75 units @ $16) 1,200

Mar 3 (95 units @ $18) 1,710

Mar 17 (165 units @ $20) 3,300

Mar 23 (35 units @ $21) 735

(75 units @$16)1,200

(148 units @$20)2,960


Cost of Good Sold

(75 units @$16)1,200(95 units @$18)1,710(148 units @$20)2,960



(95 units @$18)1,710


6-39 LO 2

LIFO CostInventory (at FIFO cost)

Beg bal (75 units @ $16) 1,200

Mar 3 (95 units @ $18) 1,710

Mar 17 (165 units @ $20) 3,300

Mar 23 (35 units @ $21) 735

(23 units @$16)368

(165 units @$20)3,300


Cost of Good Sold

(35 units @$21)735(165 units @$20)3,300(95 units @$18)1,710



(95 units @$18)1,710

(35 units @$21)735

(23 units @$16)368


6-40

Illustration

LO 2

FIFO Average LIFO

Inventory $1,075 $ 976

$ 832

Cost of goods sold 5,870 5,969

6,113

Goods available $6,945 $6,945

$6,945

Inventory Cost Summary by Method


6-41 LO 2

Effects of FIFO, LIFO, and Average Cost

Panel A—When Inventory Costs Are Increasing

Cost of Goods Sold (COGS) Ending Inventory (EI)

FIFO FIFO COGS is lowest because it’s based on the oldest costs, which are low. Gross profit is, therefore, the highest.

FIFO EI is highest because it’s based on the most recent costs, which are high.

LIFO LIFO COGS is highest because it’s based on the most recent costs, which are high. Gross profit is, therefore, the lowest.

LIFO EI is lowest because it’sbased on the oldest costs,which are low.

Exhibit 6-8


6-42 LO 2

Effects of FIFO, LIFO, and Average Cost

Panel B—When Inventory Costs Are Decreasing

Cost of Goods Sold (COGS) Ending Inventory (EI)

FIFO FIFO COGS is highest because it’s based on the oldest costs, which are high. Gross profit is, therefore, the lowest.

FIFO EI is lowest because it’s based on the most recent costs, which are low.

LIFO LIFO COGS is lowest because it’s based on the most recent costs, which are low. Gross profit is, therefore, the highest.

LIFO EI is highest because it’s based on the oldest costs, which are high.

Exhibit 6-8


6-43

Keeping Track of Perpetual Inventories

LO 2

► Impossible to apply LIFO unit costs to units purchased

and sold as transactions are happening

► Weighted-average cost can be quite challenging,

requiring sophisticated computer software

► Many companies track only inventory quantities during

the period, making adjusting journal entries at the end

of the period to apply either LIFO or weighted-average


6-44 LO 2

When prices are rising

Results in lowest taxable income

Results in lowest income taxes

Increases cash available

The Tax Advantage of LIFO


6-45 LO 2

Cost of Goods Sold Ending Inventory

LIFO provides more

realistic net income figure

Most recent costs are

assigned to Cost of Goods

Sold

FIFO provides a more up-to-

date inventory cost

More recent costs on the

Balance Sheet

Comparing FIFO and LIFO


6-46 LO 2

Allows manipulation of net income

► When inventory prices are rising, large quantities

purchased at end of year to lower taxes

Liquidation can occur

► Quantities decrease from last year, companies must

“dip into” older inventory layers

Not allowed under International Financial Reporting

Standards (IFRS)

LIFO and Managing Reported Income


6-47

3. Explain and apply underlying GAAP for inventory

Learning Objective

Learning Objective


6-48 LO 3

Accounting Principles Relevant to Inventory

Financial statement should report enough information for

outsiders to make informed decisions

Disclosure

UNDERLYING GAAP FOR INVENTORY

Representational Faithfulness

Consistency


6-49 LO 3


Company should report relevant and representationally

faithful information about itself

Properly disclosing

► Inventory accounting methods

► Substance of all material transactions impacting

inventory

Disclosure Consistency




6-50


LO 3


Requires the use of comparable methods for consistency

of presentation from period to period

Financial statements contain a footnote describing

► Inventory costing method used

► Inventory was valued at the lower of the costing

method or market

Disclosure Consistency



6-51 LO 3

Lower-of-Cost-or-Market Rule

Requires that inventory be reported in the financial

statements at whichever is lower

Inventory’s historical cost or

Market value

► Generally means current replacement cost

► If replacement cost is below historical cost, inventory is

written down to market value

► Ending inventory is reported at LCM value on the

balance sheet


6-52 LO 3

Lower-of-Cost-or-Market Rule

Suppose Family Dollar, Inc., paid $3,000 for inventory on June 26.

By August 25, its fiscal year-end, the inventory can be replaced for

$2,000. Family Dollar’s year-end balance sheet must report this

inventory at the LCM value of $2,000. An LCM write-down

decreases Inventory and increases Cost of Goods Sold:


Cost of Goods Sold

Inventory

1,000

1,000

Wrote inventory down to market value


6-53 LO 3

Lower-of-Cost-or-Market RuleExhibit 6-9 | Lower-of-Cost-or-Market (LCM) Effects on Inventory and Cost of Goods Sold


6-54 LO 3

Under IFRS, “market” is always defined as “net

realizable value,” which, for inventories, is current

market value.

Under U.S. GAAP, once the LCM rule is applied to write

inventories down to current replacement cost, the write-downs

may never be reversed. In contrast, under IFRS, some LCM

write-downs may be reversed, and inventory may be

subsequently written up again, not to exceed original cost.


6-55

4. Compute and evaluate gross profit (margin)

percentage and inventory turnover

Learning Objective

Learning Objective


6-56

COMPUTE AND EVALUATE GROSS PROFIT (MARGIN) PERCENTAGE AND INVENTORY TURNOVER

LO 4

Gross profit—sales minus cost of goods sold—key

indicator of a company’s ability to sell inventory at a profit

Markup stated as a percentage of sales

Watched carefully by managers and investors

Gross Profit Percentage

Gross profit percentage =Gross profit

Net sales revenue


6-57

Inventory Turnover

LO 4

Ratio of cost of goods sold to average inventory

Indicates how rapidly inventory is sold

Varies from industry to industry

Inventory turnover =


6-58

Illustration

LO 4

Cola Company made sales of $35,376 million during 2014. Cost of

goods sold for the year totaled $15,437 million. At the end of 2013,

Cola’s inventory stood at $1,672 million, and Cola ended 2014 with

inventory of $1,908 million. Compute Cola’s gross profit percentage

and rate of inventory turnover for 2014.

Gross profit percentage =Gross profit

Net sales revenue

Gross profit percentage =$35,376 - $15,437

$35,376= 56.4%


6-59

Illustration

LO 4

Cola Company made sales of $35,376 million during 2014. Cost of

goods sold for the year totaled $15,437 million. At the end of 2013,

Cola’s inventory stood at $1,672 million, and Cola ended 2014 with

inventory of $1,908 million. Compute Cola’s gross profit percentage

and rate of inventory turnover for 2014.

Inventory turnover =Cost of goods sold

Average inventory

= 8.6 timesInventory turnover =$15,437

($1,672 + $1,908) ÷ 2

Every 42.4 days (365 days ÷ 8.6 times)Copyright ©2015 Pearson Education Inc. All rights reserved.

6-60

5. Use the cost-of-goods-sold (COGS) model to

make management decisions

Learning Objective

Learning Objective


6-61

USE THE COGS MODEL TO MAKE MANAGEMENT DECISIONS

LO 5

Exhibit 6-13 | The Cost-of-Goods-Sold-Model

Beginning inventory $2,100

+ Purchases 6,300

= Cost of goods available for sale 7,500

- Ending inventory -1,500

= Cost of goods sold $6,000

COGS model is used by all companies regardless of their

accounting systems


6-62

Rearrange the COGS formula using amounts from Exhibit 6-13

Cost of goods sold (based on the plan for the next period) $6,000

+ Ending inventory (based on the plan for the next period) 1,500

= Cost of goods available as planned 7,500

- Beginning inventory (actual amount left over from prior period)

-1,200

= Purchases (how much inventory the manager needs to buy)$6,300Manager should buy $6,300 of merchandise to work his plan for

the upcoming period

Computing Budgeted Purchases


6-63 LO 5

Gross profit method

Also known as gross margin method

Widely used to estimate ending inventory

Uses COGS model

Estimating Inventory by the Gross Profit Method


6-64 LO 5

Exhibit 6-14 shows the calculations for the gross profit method,

with new amounts assumed for the illustration.

Gross Profit Method

Exhibit 6-14


6-65 LO 5Advance slide in presentation mode to reveal answers.

Beginning inventory is $70,000, net purchases total

$365,000, and net sales are $500,000. With a normal gross

profit rate of 40% of sales (cost of goods sold = 60%), how

much is ending inventory?

Beginning inventory $ 70,000

Net purchases 365,000

Cost of goods available 435,000

Less estimated cost of goods sold (.60 x $500,000) - 300,000

Estimated cost of ending inventory $ 135,000

Answer


6-66

6. Analyze effects of inventory errors

Learning Objective

Learning Objective


6-67

ANALYZE EFFECTS OF INVENTORY ERRORS

LO 6

Error in ending inventory creates errors for two accounting

periods

Inventory errors counterbalance in two consecutive

periods

Beginning inventory and ending inventory have opposite

effects on cost of goods sold

► Beginning inventory is added; ending inventory is

subtracted

► After two periods an inventory error counterbalances


6-68

EFFECTS OF INVENTORY ERRORS


6-69

EFFECTS OF INVENTORY ERRORS


6-72

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6-1 prepared by coby harmon university of california, santa barbara westmont college copyright...

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