4 Gross Profit (Gross Margin) Sales Revenue-Cost of Goods Sold=Gross Profit- Operating ExpensesNet Income
5 Learning Objective 1Account for inventory transactions.
6 Inventory Accounting Systems Periodic (a.k.a. physical inventory) systems do not keep a continuous record of inventory on hand:Inventory quantities can only be determined based upon a 100% physical count, usually annuallyQuantities x relevant prices = inventory valuationPerpetual systems maintain a running record to show the inventory on hand at all times.
7 Recording Transactions in the Perpetual System Purchase price of the inventory $600,000+ Freight-in 4,000– Purchase returns – 25,000– Purchase allowances – 5,000– Purchase discounts – 14,000= Net purchases of inventory $560,000
10 Recording Transactions and the T-Accounts InventoryCost of Goods Sold540,000Beg. 100,000560,000120,000540,000
11 Reporting in the Financial Statements Income Statement (partial)Sales revenue $900,000Cost of goods sold ,000Gross profit $360,000Ending Balance Sheet (partial)Current assets:Cash $ XXXShort-term investments XXXAccounts receivable, net XXXInventory ,000Prepaid expenses XXX
12 Reporting in the Financial Statements Net purchasesPurchases+ Freight-in– Purchase returns & allowances– Purchases discountNet salesSales revenue– Sales returns & allowances– Sales discounts
13 Learning Objective 2Analyze the various inventory costing methods.
14 What Goes Into Inventory Cost? Sum of all costs incurred to bring asset to its intended useAcceptable nventory costing methods:Specific unit costWeighted-average costFirst-in, first-out (FIFO)Last-in, first-out (LIFO)
15 Illustrative Data (Text Exhibit 6-6) Beginning inventory (10 $10) $ 100No. 1 (25 $14 per unit) $350No. 2 (25 $18 per unit) 450Total purchasesCost of goods available for sale $ 900Ending inventory: unitsCost of goods sold (60 avail left) units
16 Specific Unit Cost 5 Units @ $10 Cost of Goods Sold $ 50 350 180 $580 $ 50350180$58025 $1410 $18$900 – $580 = $320
17 Weighted-Average $900 total cost ÷ 60 units = $15/unit Ending inventory = 20 × $15 = $300Cost of goods sold = 40 × $15 = $600
18 First-In, First-Out Ending Inventory Cost: Available units 60 units Less units sold 40Ending inventory 20 units20 units × $18 per unit = $360
19 First-In, First-Out 10 Units @ $10 Cost of Goods Sold $100 350 90 $540
20 Last-In, First-Out Ending Inventory Cost: Available units 60 units Less units sold 40Ending inventory 20 units10 units × 10 = $10010 units × 14 = 140Total $240
21 Last-In, First-Out 25 Units @ $18 Cost of Goods Sold $450210$66025 $18(All of Last batch)15 $14
23 Learning Objective 3Identify the income and the tax effects of the inventory methods.
24 The Tax Advantages of LIFO Gross profit $460 $340Operating expensesIncome before taxes $200 $ 80Income tax expense (40%) $ $ 32FIFO LIFOThe most attractive feature of LIFO is lowincome tax payments when prices areincreasing.
26 Comparison of Inventory Methods FIFO produces “inventory profits” during periods of inflation, but you are eating your seed cornLIFO can allow managers to manipulate net income by purchasing more costly inventories, which will be associated with revenueLIFO liquidation:when old LIFO balance sheet layers are associated with current revenuesIf the liquidated layers are 10 or 20 years old, those old inventory costs might be a fiction compared to current costs, artificially inflating profits
27 Why do 50% More Public Companies Use FIFO vs. LIFO? [Re: Slide no. 25] FIFO is easier to account for, and a more natural cost flow assumptionPublic companies will pay the price of higher taxes to report better earnings than LIFO would, in a period of rising pricesThat’s all we’ve had since the 1930’s!
28 Consistency Principle Use the same accounting methods and principles from one period to the nextCannot change accounting principles whimsicallyMay change inventory methods, but must:be able to demonstrate that the new inventory costing method is preferable to the old methoddisclose the effects of the change on net income in the financial statement footnotes
29 Disclosure PrincipleFinancial statements should report enough information to enable an outsider to make knowledgeable decisions about the companyAll material facts must be fully and fairly disclosed
30 ConservatismThe least favorable figures are presented in the financial statements
31 Lower-of-Cost-or-Market Rule is an Example of Conservatism Report inventory at the lower of its historical cost or market (replacement) valueIf the replacement cost falls below its historical cost, write down the value of the inventoryHowever, never write up inventories to market if it higher than cost
32 Learning Objective 4Use the gross profit percentage and inventory turnover to evaluate business.
33 Using the Financial Statements for Decision Making Gross profit percentage= Gross profit÷ Net sales revenueInventory turnover= Cost of goods sold÷ Average inventory
34 Learning Objective 5 Estimate inventory by the gross profit method Gross profit method can be used:To estimate inventories for quarterly balance sheets so physical count not needed, orTo estimate value of inventories lost in a fire or other catastrophe for insurance indemnification, orTo test reasonableness of a physical count of inventories
35 Estimating InventoryGross profit method - based on computation of cost-of-goods-soldBeginning inventory+ Purchases= Cost of goods available for sale– Ending inventory= Cost of goods sold- Est’d Cost of goods sold= Est’d Ending inventory
36 An Example Using Gross Profit Method to Estimate Inventories Mav Co. has a fire, losing all inventoriesAssume usual gross profit is 25% [$.25 of every sales dollar is gross profit]Therefore, usual CGS percent would be 75% [$.75 of every sales dollar is inventory cost]Assume Beg inventory = $10,000Purchases to date of fire = $60,000Therefore goods available = $70,000Sales to date of fire = $55,000
37 An Example Using Gross Profit Method (con.) Goods available (last slide) $70,000Est’d CGS ($55,000 x 75%) ,250Est’d inventory lost to fire ,750
38 Objective 6Show how inventory errors affect cost of goods sold and income.
39 Effects of Inventory Errors An error in the ending inventory creates errors for cost of goods sold and gross profit:Income will be overstated by exact amount of an inventory overstatement, becauseCGS will be understated by exact amount of the inventory overstatement (CGS=Beg+Purchs-Ending)The current year’s ending inventory becomes next year’s beginning inventory:Income will be understated by that same amountCGS will be overstated by that same amountThat is, the error washes out over two periods