8 Who Owns the Inventory? When goods are in transit? Q: Who owns inventory on a truck or railroad car?When goods are on consignment?Q: Who owns inventory stocked in a warehouse?
9 Ending Inventory & COGS Cost of goods available for saleBeginning inventoryNet purchases=+The question is where is the inventory that could have been sold this period? Only two choices:At period’s end, allocated betweeninventory is still remaining (an asset), andinventory sold during the period (an expense, Cost of Goods Sold).
10 Learning Objective 2Account for inventory purchases and sales using both a perpetual and a periodic inventory system.
11 What are the Two Methods for Accounting for Inventory?
12 Example: Accounting for Inventory Purchases and Sales Harper’s Hats recorded the following transactions for 2006:Beginning inventory 10 $10 each = $100March 1 Purchase 15 $15 each = $225March 1 Freight in $10March 1 Purchase return 3 $15 each = $ 45May 2 Purchase 10 $20 each = $200May 2 Purchase discount 2/10, n/30June 30 Sales 20 hats $10, $15)July 3 Sales return 1 $15 = $ 15Ending inventory 13 hats18
13 Example: 2006 Inventory Purchase Sale Balance ` Date Units Total Units Total Units Cost TotalJan $10 $100Mar $ $10 $ $15 $225 (3) ($45) 12 $15 $180May 2 10 $ $10 $ $15 $ $20 $200June $ $ $15 $ $20 $200July 3 (1) ($15) 3 $15 $ $20 $20019
14 Perpetual & Periodic Journal Entries All purchases are added directly to the inventory account.PeriodicAt end of period,Inventory balance is updated using inventory count.Temporary purchases account balance is closed to Inventory to compute COGS.PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries for COGS
15 Example: Journal Entries for Purchases Harper purchased 10 hats at $10 each on January 1. Record the entries for both perpetual and periodic systems.PERPETUALPERIODIC22
16 Perpetual & Periodic Journal Entries PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries for COGSPerpetualAll costs are added directly to the inventory balance.PeriodicAt end of period, temporary freight in account balance is closed to Inventory to compute COGS.
17 Example: Journal Entries for Transportation Cost Harper hired a trucking company to deliver its March 1 purchase of 15 hats. The trucking company charged $10. Record the entries for both the perpetual and the periodic systems.PERPETUALPERIODIC22
18 Perpetual & Periodic Journal Entries Inventory is decreased.Accounts Payable is decreased by same amount.PeriodicIf merchandise has been paid for, the supplier will reimburse (debit Cash).At end of period, temporary purchase returns account balance is closed to Inventory to compute COGS.PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries for COGS
19 Example: Journal Entries for Purchase Returns Of the 15 hats delivered on March 1, three were defective and Harper returned them the same day. Record the entries for both the perpetual and the periodic inventory systems.PERPETUALPERIODIC22
20 Perpetual & Periodic Journal Entries PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries for COGSPerpetualSubtract the discount amount from the inventory account.PeriodicAt end of period, temporary purchase discounts account balance is closed to Inventory to compute COGS.
21 Example: Journal Entries for Purchase Discounts On May 2, Harper purchased 10 hats at $20 each. The supplier offered terms of 2/10, n/30. Record the entries for both the perpetual and the periodic inventory systems.PERPETUALPERIODIC22
22 Perpetual & Periodic Journal Entries PurchasesTransportation costsPurchase returnsPurchase discountsPerpetualAll adjustments are entered directly in the Inventory account.PeriodicAll adjustments are accumulated in an array of temporary holding accounts:PurchasesFreight InPurchase ReturnsPurchase DiscountsThe difference in terms of journal entries:
23 Perpetual & Periodic Journal Entries PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries for COGSPerpetualRecognize sales and COGS on a transaction-by-transaction basis.PeriodicOnly total sales are known.
24 Example: Journal Entries for Sales In June, Harper’s Hats sold 20 hats for $25 each (selling the old ones first). Record the entries for both the perpetual and the periodic systems.PERPETUALPERIODIC22
25 Perpetual & Periodic Journal Entries PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries for COGSPerpetualSales for returned items are canceled.Cost of returned inventory is removed from COGS and restored to the inventory account.PeriodicSales for returned items are canceled.No entry is made to adjust COGS.
26 Example: Journal Entries for Sales Returns On July 3, one hat was returned from a late June purchase. Record the entries for both the perpetual and the periodic inventory systems.PERPETUALPERIODIC22
27 Perpetual & Periodic Journal Entries PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries for COGSPerpetualAll journal entries are posted to the ledger.Results in new balances for Inventory and COGS.Numbers are verified by physical count.PeriodicTemporary holding accounts are accumulated and added to Inventory.Inventory account balance is reduced by the amount of COGS.
28 Accounting for Inventory Purchases and Sales Harper’s Hats recorded the following transactions for 2006:Beginning inventory 10 $10 each = $100March 1 Purchase 15 $15 each = $225March 1 Freight in $10March 1 Purchase return 3 $15 each = $ 45May 2 Purchase 10 $20 each = $200May 2 Purchase discount 2/10, n/30June 30 Sales 20 hats $10, $15)July 3 Sales return 1 $15 = $ 15Ending inventory 13 hats18
29 Closing Entries for Cost of Goods Sold Perpetual: the inventory account will have an ending balance of $255.InventoryCOGS1/1 1003/ /1 453/1 105/2 2006/30 2507/3 15Bal. 2556/30 2507/3 15Bal. 235
30 Closing Entries for Cost of Goods Sold Periodic: the inventory account will be debited by $386, which represents the net purchases for the year.Jul. 31 InventoryPurchase ReturnsPurchase DiscountsFreight InPurchases
31 Periodic InventoryWith a periodic system, a physical count is the only way to get the information necessary to compute COGS:Beginning Inventory, January 1, 2006+ Purchases for the year= Cost of goods available for sale during 2006– Ending Inventory, December 31, 2006= Cost of Goods Sold for 200630
32 Learning Objective 3Calculate cost of goods sold using the results of an inventory count and understand the impact of errors in ending inventory on reported cost of goods sold.
33 Physical Count of Inventory Essential to maintaining reliable inventory accounting records.PerpetualPhysical count either confirms records are accurate or highlights shortages and clerical errors.PeriodicThe only way to get information necessary to compute COGS:Quantity count.Inventory costing (assigning a unit cost to each type of merchandise).Ending inventory = quantity of each type x its unit cost.
34 COGS Computation Perpetual The accounting records yield the COGS for the period as well as the amount of inventory that should be found with a physical count.The difference between the records and actual count = inventory lost, stolen, or spoiled.PeriodicCompany does not know what ending inventory should be.Assumes physical count is the difference between cost of goods available for sale and ending inventory.Cannot tell whether goods were sold, lost, stolen, or spoiled.
35 What is the Income Effect of an Error in Ending Inventory? 8
36 Complete Table of Effects of Inventory Errors Understate EndingInventorySales OKBeginning inventory OKNet purchases OKGoods available OKEnding inventory LOWCost of goods sold HIGHGross margin LOWExpenses OKNet income LOWUnderstatePurchasesBeginningUnderstate Sales12
37 Learning Objective 4Apply the four inventory cost flow alternatives: specific identification, FIFO, LIFO, and average cost.
38 Inventory Cost FlowKernel King buys and sells corn and had the following transactions for 2002:June 10 Purchased 10 tons at $6 per ton.July 28 Purchased 10 tons at $9 per ton.October 10 Sold 10 tons at $11 per ton.How much did Kernel King make in 2002?Case #1 Case #2 Case #3Sold Sold SoldOld Corn New Corn Mixed CornSales ($11 x 10 tons)COGS (10 tons)Gross margin
39 Specific Identification Cost Flow Specifically identify the cost of each unit sold.The individual cost of each unit is charged against revenue as COGS.To compute COGS and ending inventory, a firm must know each unit sold and its cost.
40 Inventory Cost Flow Methods FIFOThe oldest units are sold and the newest units remain in inventory.The cost of the oldest units purchased is transferred to COGS.LIFOThe newest units are sold and the oldest units remain in inventory.The cost of the most recent units purchased is transferred to COGS.Average CostAn average cost is computed for all inventory available for sale during the period.COGS is computed by multiplying the number of units sold by the average cost per unit.
41 Compare Inventory Methods LIFO gives a better reflection of COGS in the income statement.Therefore, LIFO is a better measure of income.FIFO gives a better measure of inventory on the balance sheet.Therefore, FIFO is a better measure of inventory value.
42 Learning Objective 5Use financial ratios to evaluate a company’s inventory level.
44 Evaluating Inventory Levels Cost of goods soldAverage inventoryInventory TurnoverMeasures how many times a company turns over (or replenishes) its inventory.Average inventory = average of the beginning and ending inventory balances.Number of Days’ Sales in Inventory365 daysInventory turnover58
45 Evaluating Inventory Management Buster Boots had cost of goods sold of $60,000 during The inventory account decreased by $1,000 to $4,000 during the same time. Calculate the inventory turnover ratio and number of days’ sales in inventory.Inventory turnover ratioNumber of days’ sales in inventory22
46 Expanded Material Learning Objective 6 Analyze the impact of inventory errors on reported cost of goods sold.??
47 What Is the Effect of These Inventory Errors? If a sale is recorded but the merchandise remains in inventory and is counted in ending inventory,If a sale is not recorded, but inventory is shipped and not counted in ending inventory,
48 Expanded Material Learning Objective 7 Describe the complications that arise when LIFO or average cost is used with a perpetual inventory system.
49 Using Average Cost or LIFO with a Perpetual System Using average cost or LIFO with perpetual leads to complications.The average cost of units available for sale changes every time a purchase is made.The identification of the “last in” unitsalso changes with every purchase.With periodic,One overall average cost is used for all goods available for sale during the period.The “last in” units are identified at the end of the period.
50 Describe the Similarities of Using FIFO for Perpetual and Periodic Systems.
51 Expanded Material Learning Objective 8 Apply the lower-of-cost-or-market method of accounting for inventory.
53 When Do You Report Inventory at Net Realizable Value (NRV)?
54 Lower of Cost or Market (LCM) Ceiling: the maximum market amount at which inventory can be carried on the books; equal to net realizable value (selling price less estimated selling costs).LCM: A basis for valuing inventory at the lower of original cost or current market value.Floor: the minimum market amount at which inventory can be carried on the books; equal to net realizable value less a normal profit.
55 Example: LCMMarketInventory Replacement NRVItem Cost Floor Cost CeilingABCDDefine market value as:replacement cost, if it falls between the ceiling and the floor.the floor, if the replacement cost is less than the floor.the ceiling, if the replacement cost is higher than the ceiling.When replacement cost, ceiling, and floor are compared, market is always the middle value.Compare the defined market value with the original cost and choose the lower amount.110
56 Expanded Material Learning Objective 9 Explain the gross margin method of estimating inventories.
57 Gross Margin MethodThere are times when a physical count of inventory is either impossible or impractical.If perpetual is used, the inventory account balance is assumed to be correct.If periodic is used, an estimate of the inventory balance must be made.Gross margin method.COGS and ending inventory areestimated using available information:beginning inventorypurchaseshistorical gross margin percentage
58 Gross Margin Method Example Payson Brick has net sales for 1/1 to 3/31 of $100,000 and net purchases of $65,000. Inventory on 1/1 was $15,000 and a historic gross profit percentage of 40%.Dollars % of salesNet sales revenue $100, %Cost of goods sold:Beginning inventory $15,000Purchases ,000Total available for sale $80,000Ending Inventory (3) 20,000Cost of goods sold (2) , %Gross margin (1) $ 40, %$100,000 X .40 (2) $100,000 - $40, (3) $80,000 - $40,000
59 Everything Should Be Made as Simple as Possible and Not Chapter 8 is FinishedEverything Should Be Made asSimple as Possible and NotOne Bit SimplierAlbert Einstein