3 Chapter 6 Reporting and Analyzing Inventory After studying Chapter 6, you should be able to:Explain the recording of purchases and sales of inventory under a periodic inventory system.Explain how to determine cost of goods sold under a periodic inventory system.Describe the steps in determining inventory quantities.Identify the unique features of the income statement for a merchandising company under a periodic inventory system.3
4 Chapter 6 Reporting and Analyzing Inventory After studying Chapter 6, you should be able to:Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.Explain the financial statement and tax effects of each of the inventory cost flow assumptions.Explain the lower of cost or market basis of accounting for inventories.Compute and interpret the inventory turnover ratio.Describe the LIFO reserve and explain its importance for comparing results of different companies.4
5 Merchandise Inventory owned by the companyin form ready to sale to customers5
6 Manufacturing Inventory Finished goods inventoryWork in processRaw materials6
7 Finished Goods Inventory Manufactured items that are complete and ready for sale.7
8 Work in ProcessManufactured inventory that has been placed into production but is not yet complete.8
9 Raw MaterialsThe basic goods that will be used in production, but have not been placed in production.9
10 Key difference between periodic and perpetual inventory… is the point at which the costs of goods sold is computed.
11 Periodic InventoryNo attempt is made on date of sale to record the cost of merchandise sold...A physical count of inventory is taken at end of period to determine:Cost of merchandise on hand;Cost of goods sold.
12 Comparing Periodic and Perpetual Inventory Systems Inventory PurchasedItem SoldEnd of PeriodPerpetualPerpetualNo EntryRecord Purchase of InventoryRecord Revenue and Cost of Goods SoldEnd of PeriodInventory PurchasedItem SoldPeriodicRecord Purchase of InventoryRecord Revenue OnlyCompute Cost of Goods Sold
13 Businesses that use the periodic method generally do not have sophisticated computer systems required to compute cost of goods sold when sale is made.
14 Merchandise Purchases On May 4 the company bought $ 3,800 worth of merchandise from PW Audio Supply, Inc.Task:Record the purchase by getting information from the Purchase Invoice.The Purchase Invoice is just a copy of the sales invoice.14
15 7.Goods sold: catalog no.,description,quantity, price per unit 1. Seller2.Invoice Date3.Purchaser4.Salesperson5.Credit terms6.Freight terms7.Goods sold: catalog no.,description,quantity, price per unit8.Total invoice priceInvoice No. 731Illustration 5-4Firm Name: Sauk SteroCity Chelsea State Illinois Zip 60915Attention o f James Hoover, Purchasing AgentAddress 125 Main StreetDate 5/4/01 Salesperson Maone Terms 2/10,n/30 Freight Paid by BuyerCatalog No. Description QTY Price AmountIMPORTANT: ALL RETURNS MUST BE MADE WITHIN 10 DAYS TOTAL $3,8001,5003008Production ModelCircuitsA2547Z48
16 Merchandise Purchases-Periodic On May 4 the company bought $ 3,800 worth of merchandise from PW Audio Supply, Inc.PurchasesPurchase Returns & All.Purchase DiscountsMayAccounts PayableFreight-InCashMay 4 3,800
17 Purchases Returns and Allowances - Periodic On May 8 the company returned $300 worth of merchandise to PW Audio Supply, Inc.PurchasesPurchase Returns & All.Purchase DiscountsMayMayAccounts PayableFreight-InCashMay 4 3,800
19 Freight - In PeriodicOn May 9 the company paid $ 150 to have the merchandise inventory delivered to them.Purchase Returns & All.Purchase DiscountsPurchasesMayMayAccounts PayableFreight-InCashMayMayMay 4 3,800
20 Purchase DiscountsCredit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment.Credit terms specify the amount of cash discounts and the time period during which it is offered.2/10,n/301/10 EOM20
21 Purchase DiscountsOn May 14, the company pays the balance due on the account within the discount periodPurchasesPurchase Returns & All.Purchase DiscountsCashAccounts PayableFreight-InMayMay 4 3,800MayMay
22 Amount due before discount $3,500 Purchases DiscountsReview - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was paid within the discount period.Original Invoice $3,800-ReturnsAmount due before discount $3,5002% discountNet due $3,430
23 Purchase DiscountsOn May 14, the company pays the balance due on the account within the discount periodPurchasesPurchase Returns & All.CashAccounts PayableFreight-InMayMay 4 3,800MayMayMayMay 14 3,500MayMay 14 3,430
24 Under a Periodic System Sales Revenues -Under a Periodic Systemare recorded when earned-revenue recognition principlemust be supported by a business document-written evidenceONLY 1 entry is made for each saleone to record sale24
25 Sales Returns and Allowances Flip side of purchase returns and allowanceOn buyer’s booksGENERAL JOURNAL Debit CreditMay 8 Accounts Payable Purchase Returns and AllowancesTo record goods returned that were purchased on accountOn seller’s booksGENERAL JOURNAL Debit CreditMay 8 Sales Returns and Allowance Accounts ReceivableTo record return of goods delivered to Sauk Stero25
26 Merchandise Inventory Sales Returns & Allowances Sales - Under a Periodic SystemAssume a sale of $ 3,800 on AccountCashAccounts ReceivableMerchandise InventoryMay 4 3,800Cost of Goods SoldSales Returns & AllowancesSalesMay 4 3,800
27 What is the Sales Returns and Allowances Account? Contra Revenue Account to salesUsed to show how much came in on returns and allowancesExcessive returns and allowances suggest:inferior merchandiseinefficiencies in filing orderserrors in billing customersmistakes in delivery or shipment of goods27
28 What Is the Sales Discount Account? Contra Revenue Account to salesUsed to disclose amount of cash discounts taken by customers28
29 Flip side of purchase discounts Sales DiscountsFlip side of purchase discountsOn buyer’s booksGENERAL JOURNAL Debit CreditMay 14 Accounts Payable , Cash ,430 Merchandise InventoryTo record payment within discount periodOn seller’s booksGENERAL JOURNAL Debit CreditMay 14 Cash , Sales Discounts Accounts ReceivableTo record collection within discount period29
30 Net PurchasesPurchases $ 325,000Less: Purchase returns and allowances $ 10,400Purchase discounts 6, ,200Net purchases 307,800Net Purchases are gross purchases adjusted for returns and discounts.30
31 Cost of Goods Purchased Illustration 6-3Cost of Goods PurchasedPurchases $ 325,000Less: Purchase returns and allowances $ 10,400Purchase discounts 6, ,200Net purchases 307,800Add: Freight-in 12,200Cost of goods purchased 320,000Cost of goods purchased is net purchases plus freight-in.31
32 Companies that use periodic inventory take a physical count to... determine ending inventorycompute cost of goods soldCompanies that use perpetual inventory must take a physical inventory to check accuracy of “book inventory” to actual inventory.32
33 Taking a Physical Inventory Determining inventory quantities by counting, weighting or measuring each type of inventory.Determining ownership of goods, including goods in transit,consigned goods.Quantity of each kind of inventory is listed on inventory summary sheets where unit costs are applied.33
34 Questions Concerning Ownership Do all the goods included in the count belong to the company?Does the company own any goods not included in the count?34
35 Goods in TransitThese are goods on board a truck, train, ship, or plane at the end of the period.35
36 The Company with Legal Title Goods in TransitWho includes these in inventory?Buyer?Seller?The Company with Legal Title36
37 Shipping TermsFOB (free on board) shipping point- ownership of goods passes to buyer when public carrier accepts the goodsFOB (free on board) destination- ownership of goods remains with the seller until the goods reach the buyer38
38 Ownership passes to owner here Illustration 6-4FOB Shipping PointPublicCarrierCoSellerBuyerOwnershippasses tobuyer hereFOB Destination PointPublicCarrierCoSellerBuyer
39 Consigned GoodsGoods in your store that you don’t pay for until they sell…the company does not take ownership.39
40 Income Statement Presentation The income statement for a merchandising company is the same whether a periodic or perpetual inventory system is used, except for thecost of goods sold section.40
41 Select Buy, INC. Income Statement (Perpetual) For the Year Ended December 31, 2001 Illustration 5-3Sales revenuesSales $ 480,000 Less: Sales returns and allowance $12,000Sales discounts , ,000Net sales ,000Cost of goods sold ,000Gross profit $ 144,000 Operating expensesSelling expenses:Store salaries expense $45,000Advertising expense ,000Depreciation expense ,000Freight-out ,000Total selling expenses $76,000Administrative expensesSalaries expense $19,000Utilities expense ,000Insurance Expense ,000Total administrative expenses ,000Total operating expenses ,000Income from operations $ 30,000
42 Income Statement (Periodic) Illustration 6-6Sales revenuesSale $ 480,000Less: Sales returns and allowance $12,000Sales discounts , ,000Net sales ,000Cost of goods soldInventory, January ,000Purchases $ 325,000Less: Purchase returns andallowances $10,400Purchase discounts , , Net Purchases ,800Add: Freight-in ,200Cost of goods purchased 320,000Cost of goods available for sale ,000Inventory, December ,000Cost of goods sold ,000Gross profit ,000Operating expenses ,000Net Income $ 30,000
43 Specific Identification Illustration 6-7Specific IdentificationCost of goods sold = $700 + $800An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of ending inventory.
44 Inventory Costing Specific Identification method Cost Flow Assumptions FIFO- First-in, First-Out- earliest goods purchased first to be soldLIFO- Last-in,First-Out- latest goods purchased the first to be soldAverage Cost Method- costs are charged on the basis of weighted average unit cost44
45 What Makes Cost Flow Assumptions Necessary? Changing Prices45
46 Illustration 6-9The FIFO method assumes the earliest goods purchased are the first to be sold.
47 Illustration 6-11The LIFO method assumes the latest goods purchased are the first to be sold.
48 Illustration 6-13The average cost method assumes that goods available for sale are homogeneous. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred.
49 Illustration 6-14The average cost method assumes that goods available for sale are homogeneous.
50 Factors Used in Selecting an Inventory Cost Method Income statement effectsBalance sheet effectsTax Effects51
51 Income Statement Effects In periods of increasing pricesFIFO reports the highest net incomeLIFO the lowestaverage cost falls in the middle.In periods of decreasing pricesFIFO will report the lowest net incomeLIFO the highestaverage cost in the middle.52
52 Balance Sheet EffectsIn a period of increasing prices costs allocated to ending inventory using:FIFO will approximate current costsLIFO will be understated53
53 Why Do Companies Use Lifo? Higher cost of goods soldLower net incomeLower Income Taxes54
54 The Lower of Cost or Market Basis of Accounting for Inventories When the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline occurs.55
55 Lower of Cost or Market (LCM) departure from cost principlefollows conservatism conceptcan be used only after one of the cost flow methods ( Specific Identification FIFO, LIFO, or Average Cost)56
56 CURRENT REPLACEMENT COST Market Is...CURRENT REPLACEMENT COST57
57 How Much Inventory Should a Company Have? Only enough for sales needsExcess inventory costs:storage costsinterest costsobsolescence - technology, fashion58
58 Inventory Turnover Ratio = Cost of Goods SoldAverage Inventory
59 Inventory Turnover Ratio Days in Inventory =365 daysInventory Turnover Ratio
60 Lifo Reserve And Its Importance For Comparing Results Of Different Companies Accounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO.This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods.61