Copyright 2003 Prentice Hall Publishing1 Acquisitions/Payment: Inventory and Liabilities Chapter 6

Copyright 2003 Prentice Hall Publishing2 Questions we will answer in this chapter l How does a firm account for inventory? l How are financial statements affected by the purchase of merchandise inventory? l What kinds of liabilities result from the acquisition of inventory and other resources? l How does a firm account for payroll?

Copyright 2003 Prentice Hall Publishing3 Inventory is recorded at the price paid for it. Inventory Cost

Copyright 2003 Prentice Hall Publishing4 l The amount recorded for inventory should include: n Invoice price, freight charges, inspection costs, and preparation costs. l Inventory may be tracked with either a periodic or a perpetual inventory system. Inventory Cost

Copyright 2003 Prentice Hall Publishing5 Beginning inventory Add: Purchases (net) Goods available for sale Deduct: Ending inventory Cost of goods sold Cost of Goods Sold

Copyright 2003 Prentice Hall Publishing6 Inventory l Inventory is tangible property that is held for resale or will be used in producing goods or services. l Inventory is reported on the balance sheet as a current asset. l Types of inventory: Merchandise inventory Raw materials inventory These 3 will Work in process inventory be studied Finished goods inventory in managerial accounting.

Copyright 2003 Prentice Hall Publishing7 Shipping Terms (Sales & Purchases) l F.O.B. shipping point or destination n tells who pays shipping l F.O.B shipping indicates that the title to the goods changes hands at shipping. l F.O.B. destination indicates that the title to the goods changes hands at destination.

Copyright 2003 Prentice Hall Publishing8 l Whoever owns the goods while they are in-transit pays for the shipping. l Shipping costs to get the inventory IN are included as part of the cost of the inventory. l Shipping costs for a sale are part of operating expenses. Shipping Costs

Copyright 2003 Prentice Hall Publishing9 Alternative Inventory Cost Flow Methods FIFO LIFO WeightedAverage SpecificIdentification

Copyright 2003 Prentice Hall Publishing10 Inventory Cost Flow Methods These four inventory costing methods are used to assign the total dollar amount of goods available for sale between ending inventory and cost of goods sold. Ending inventory or CGS??

Copyright 2003 Prentice Hall Publishing11 l The cost of the oldest inventory items are charged to cost of goods sold when goods are sold. l The cost of the newest inventory items remain in ending inventory. l The actual physical flow of inventory items may differ from the FIFO cost flow assumptions. First-In, First-Out

Copyright 2003 Prentice Hall Publishing12 l The cost of the newest inventory items are charged to cost of goods sold when goods are sold. l The cost of the oldest inventory items remain in ending inventory. l The actual physical flow of inventory items may differ from the LIFO cost flow assumptions. Last-In, First-Out

Copyright 2003 Prentice Hall Publishing13 Weighted-Average l Take the average cost of all goods available for sale to value both CGS and Ending Inventory. l BE SURE IT’S WEIGHTED!

Copyright 2003 Prentice Hall Publishing14 Specific Identification l Specific cost of each inventory item is known. l Used with small volume, high dollar inventory.

Copyright 2003 Prentice Hall Publishing15 Example DateEventUnitsPriceTotal 3/1Beg. Inv. 10$ 6$ 60 3/10Purchase /15Purchase /27Sale

Copyright 2003 Prentice Hall Publishing16 FIFO l Cost of Goods Sold: FromUnitsPriceCost l Ending Inventory: FromUnitsPriceCost

Copyright 2003 Prentice Hall Publishing17 Cost of Goods Sold: FromUnitsPriceCost 3/1 10$ 6$ 60 3/ Totals 18$116 l Ending Inventory: FromUnitsPriceCost 3/10 4$ 7$ 28 3/ Totals 15$116 FIFO

Copyright 2003 Prentice Hall Publishing18 l Cost of Goods Sold: FromUnitsPriceCost l Ending Inventory: FromUnitsPriceCost LIFO

Copyright 2003 Prentice Hall Publishing19 l Cost of Goods Sold: FromUnitsPriceCost 3/15 11$ 8$ 88 3/ Totals 18$137 l Ending Inventory: FromUnitsPriceCost 3/10 5$ 7$ 35 3/ Totals 15$ 95 LIFO

Copyright 2003 Prentice Hall Publishing20 Average cost per unit: Cost of GAFS # of units GAFS Weighted Average

Copyright 2003 Prentice Hall Publishing21 Average cost per unit: Cost of GAFS$ 232 # of units GAFS 33 Cost of Goods Sold: Ending Inventory: = $7.03 Weighted Average

Copyright 2003 Prentice Hall Publishing22 Average cost per unit: Cost of GAFS$ 232 # of units GAFS 33 Cost of Goods Sold: 18 $7.03 = $127 (rounded) Ending Inventory: = $7.03 Weighted Average

Copyright 2003 Prentice Hall Publishing23 Average cost per unit: Cost of GAFS$ 232 # of units GAFS 33 Cost of Goods Sold: 18 $7.03 = $127 (rounded) Ending Inventory: 15 $7.03 = $105 (rounded) = $7.03 Weighted Average

Copyright 2003 Prentice Hall Publishing24 Income Statements FIFOLIFOWt. Avg. FIFOLIFOWt. Avg.SalesCGSGM Oper. exp. Pretax inc. Taxes (40%) Net Income [Given operating expenses of $50 and a 40% tax rate]

Copyright 2003 Prentice Hall Publishing25 FIFOLIFOWt. Avg. Sales$270$270$ 270 CGS GM Oper. exp Pretax inc Taxes (40%) Net Income$ 62$ 50$ 56 Income Statements [Given operating expenses of $50 and a 40% tax rate]

Copyright 2003 Prentice Hall Publishing26 FIFOLIFO Wt. Avg. Inflows: Sales$270$270 $270 Outflows: Purchases Oper. exp Taxes (40%) Net cash flow$ 6$ 15$ 11 Cash Flow from Operations

Copyright 2003 Prentice Hall Publishing27 Summary: Effects of Cost Flow Assumptions l Effects on financial statements p cost of goods sold & gross profit p taxes p net earnings p inventory l Effects on cash flows p cash flows are affected only because of taxes

Copyright 2003 Prentice Hall Publishing28 Comparison of Methods l Each of the four methods is acceptable, and an argument can be made for using each. l The choice of an inventory method will depend on management’s incentives, the tax laws, and the reporting company’s particular economic circumstances.

Copyright 2003 Prentice Hall Publishing29 Consistency Principle Because the choice of an inventory method can significantly affect the financial statements, a company might be inclined to select a new method each year that would result in the most favorable financial statements. However...

Copyright 2003 Prentice Hall Publishing30 consistency principle comparable... the consistency principle requires that companies use the same accounting methods period after period so the financial statements of succeeding periods will be comparable. Consistency Principle

Copyright 2003 Prentice Hall Publishing31 Alternative Inventory Costing Methods in Practice The LIFO conformity rule states that if LIFO is used for taxes, then LIFO must also be used for financial reporting. LIFO for books LIFO for taxes

Copyright 2003 Prentice Hall Publishing32 l 2/10, n/30 (for example) n 2% discount if invoice paid in ten days n tells when and how much must be paid n high interest cost of not taking purchase discounts Terms of Sale and Purchases

Revenues Expenses Net Income Sales Cost of Goods Sold Gross margin Operating Expenses Income before taxes Income Taxes Net income Multistep Income Statement Income Statements

l Cost of goods sold is calculated as the number of units sold during the period multiplied by their unit costs. l Cost of goods sold is a major expense item for most nonservice businesses. l The measurement of cost of goods sold is an excellent example of the application of the matching principle. Costs of Goods Sold

l The inventory account is continuously updated for the following items: n Purchases n Returns & Allowances n Sales l Detailed record-keeping has become much easier with current technology. l A physical count of the inventory is still required at the end of the accounting period to assure accurate inventory records in case of errors or theft. Perpetual Inventory Systems

l The ending inventory is determined at the end of the period by taking a physical count of the goods remaining on hand. l Cost of goods sold is calculated at the end of the accounting period using the ending inventory count. Periodic Inventory Systems

l Because entries are not made to the inventory account during the accounting period, the amount of inventory is not known until the end of the period, when the inventory count is done. l This system is being used less and less due to advancements in technology. Periodic Inventory Systems

The accounting system plays three roles in inventory management: l Provides accurate information for financial statements and tax reports. l Provides up-to-date information on inventory quantities and cost. l Provides information necessary to protect inventory from theft and misuse. Accounting and Inventory Management

l Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover This ratio is often used to measure the liquidity (nearness to cash) of the inventory. Financial Statement Analysis

l Provides an estimate l Not acceptable for GAAP l When to use n for interim reporting purposes n when physical inventory not possible Gross Profit Method of Estimating Inventory

Given the following: Beginning Inventory $ 1,000 (cost) Purchases 9,000 (cost) Sales 12,000 (retail) Historically, gross margin has been 40% of sales. Estimate the cost of inventory and CGS for the period. Example

First estimate cost of goods sold: Sales have been $12,000, and the gross margin has been 40%. If the gross margin is $4,800 (40% of $12,000), then the cost of goods sold must be the remainder, $7,200.

Next estimate ending inventory: Goods avail. (1, ,000) - Cost of goods sold Ending inventory $10,000 minus $7,200 = $2,800

First estimate cost of goods sold: Sales12,000 x CGS % (1.0 - GM %) 60% Estimated CGS 7,200 Next estimate ending inventory: Goods avail. (1, ,000)10,000 - Cost of goods sold 7,200 Estimated ending inventory 2,800 Recap

l Ending inventory is reported at the lower of cost or market (LCM). l Market refers to the replacement cost of the merchandise. l This practice is in keeping with the generally accepted accounting principle of conservatism. Lower of Cost or Market

l Misstatements in inventory may cause errors in the following areas: n Income Statement »Cost of Goods Sold, Gross Profit, Net Income n Balance Sheet »Inventory, Payables, Retained Earnings two l Because the ending inventory of one period becomes the beginning inventory of the next period, ending inventory errors affect two accounting periods. Errors in Measuring Ending Inventory

Inventory Errors The ending inventory for CBCR Co. was overstated by $2000 for the year What effect did the error have on n Beginning inventory 2002: n Purchases in 2002: n Goods available for sale in 2002: n Cost of Goods Sold in 2002: n Gross margin in 2002: n Net income in 2002:

Inventory Errors n Beginning inventory 2002: no effect n Purchases in 2002: no effect n Goods available for sale in 2002: no effect n Cost of Goods Sold in 2002: understated n Gross margin in 2002: overstated n Net income in 2002: overstated The ending inventory for CBCR Co. was overstated by $2000 for the year What effect did the error have on

l Beginning inventory 2003: l Purchases for 2003: l Goods available for sale in 2003: l Cost of Goods Sold for 2003: l Gross margin for 2003: l Net income for 2003: The Next Year

l Beginning inventory 2003: overstated l Purchases for 2003: no effect l Goods available for sale in 2003: overstated l Cost of Goods Sold for 2003: overstated l Gross margin for 2003: understated l Net income for 2003: understated The Next Year

Example: Periodic vs. Perpetual l BI15 $20 each l 1/5/95 purchased20 $21 each l 3/6/95 sold10 units l 5/16/95 purchased30 $22 each l 7/5/95 sold20 units l 9/3/95 purchased 10 $23 each Calculate Ending Inventory and Cost of Goods Sold under 1-FIFO perpetual 2-FIFO periodic 3-LIFO perpetual 4-LIFO periodic

Goods Available for Sale l $20 = $300 l $21 = $420 l $22 = $660 l $23 = $230 $1610 FOR SALE SALE

FIFO--Perpetual n Sale on 3/6 of 10 units comes from $20 each n Sale on 7/5 of 20 units comes from BI (5 $20) and from 1/5 purchase (15 $21) n Total CGS = $200 + $100 + $315 = $615 n Ending Inv. = 1/5/95 $21 = 105 $22 = 660 $995 $23 = 230

FIFO--Periodic Total sales of 30 units n Start with the oldest for CGS: 15 units from BI = $ units from 1/5/95 purchase =$315 Total CGS = $615 n Ending Inv. = 1/5/95 $21 = 105 $22 = 660 $995 $23 = 230

LIFO--Perpetual n Sale on 3/6 of 10 units comes from 1/5 purchase (the most recent one at the time of the sale): $210 n Sale on 7/5 of 20 units comes from 5/16 purchase: $440 n Total CGS = $210 + $440 = $650 n Ending Inv. = $20 = $300 $21 = 210 $22 = 220 $960 $23 = 230

LIFO--Periodic Total sales of 30 units n Start with the latest purchases for CGS: 10 units from 9/3/95 purchase =$ units from 5/16/95 purchase =$440 Total CGS =$670 n Ending Inv. $20 =$300 $21 =$420 5/16/95 $22 =$220 $940

l Gross margin %: n gross margin as a percent of sales n Net sales - CGS (=gross margin) Net sales Ratios: Gross Margin Percentage

l Return on sales = Net income Net sales Revenues - expenses Net sales Ratios: Return on Sales

Net Income Assets Return on Assets = Ratios: Return on Assets