©2008 Pearson Prentice Hall. All rights reserved. 6-1 Accounting for Inventory Chapter 6

©2008 Pearson Prentice Hall. All rights reserved. 6-2 Inventory Items held by the company for re-sale  Current asset on the Balance Sheet Items sold shifted to Cost of Goods Sold  Expense on the Income Statement Sales revenue based on retail price of inventory Cost of Goods Sold based on cost of inventory

©2008 Pearson Prentice Hall. All rights reserved. 6-3 Gross Profit Sales Revenue minus Cost of Goods Sold Also called Gross Margin Represents markup on products “Gross” because expenses have not been deducted

©2008 Pearson Prentice Hall. All rights reserved. 6-4 Learning Objective 1 Account for inventory

©2008 Pearson Prentice Hall. All rights reserved. 6-5 Two Systems Periodic Count items to determine quantity on hand Used for inexpensive items Used by small businesses Low cost Perpetual Running record of inventory kept by computer program Used by large businesses Scanners and bar codes used to record transactions

©2008 Pearson Prentice Hall. All rights reserved. 6-6 Net cost of purchases Purchase price + Freight-in - Purchase returns - Purchase Discounts = Net cost of purchases - Purchase allowances Transportation costs Unsuitable goods returned to seller Reduction in amount owed For early payment

©2008 Pearson Prentice Hall. All rights reserved. 6-7 Discount terms Companies offer incentive for early payment 2/10, n/30  2% discount if bill paid in ten days  Full amount due in 30 days Purchase discounts  Company receives discount if it makes payment early  Reduces cost of inventory Sales discounts  Company offers discount to customers for early payment  Reduces cash received on accounts receivable

©2008 Pearson Prentice Hall. All rights reserved. 6-8 ©2009 Prentice Hall 5-8 Perpetual Entries To record purchases of inventory on account JOURNAL Date Accounts Debit Credit Inventory Accounts payable

©2008 Pearson Prentice Hall. All rights reserved. 6-9 Perpetual Entries To record sale of inventory on account Two entries required JOURNAL DateAccountsDebitCredit Accounts receivable Sales Cost of goods sold Inventory ©2009 Prentice Hall Retail price Cost

©2008 Pearson Prentice Hall. All rights reserved Net Sales Sales revenue - Sales returns - Sales Discounts = Net Sales - Sales allowances Unsuitable goods returned to company Reduction in amount owed For early payment

©2008 Pearson Prentice Hall. All rights reserved Learning Objective 2 Understand the various inventory methods

©2008 Pearson Prentice Hall. All rights reserved Inventory Costing Methods To determine the cost of inventory sold or on hand, the units are multiplied by the unit cost Inventory items are often purchased at different prices throughout the year Company selects a costing method to determine which unit cost to use

©2008 Pearson Prentice Hall. All rights reserved Inventory Costing Methods Specific-unit-cost Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO)

©2008 Pearson Prentice Hall. All rights reserved Specific-unit-cost Each item in inventory can be separately identified Used for unique items  Cars, fine jewelry Too expensive for homogeneous items

©2008 Pearson Prentice Hall. All rights reserved Average-cost An average of inventory costs Cost of goods available Number of units available = Average cost per unit Average cost per unit x units sold = Cost of goods sold Average cost per unit x units on hand = Ending inventory

©2008 Pearson Prentice Hall. All rights reserved FIFO Oldest items assumed to be sold first Ending inventory will consist of most recent items purchased

©2008 Pearson Prentice Hall. All rights reserved LIFO Newest items are assumed to be sold first Ending inventory consists of oldest items in inventory

©2008 Pearson Prentice Hall. All rights reserved E6-15 UnitsCost Beginning inventory5$160$800 Oct. 15 Purchase11$170$1,870 Oct. 26 Purchase5$180$900 Units available21$3,570 Ending inventory8units Units sold ______ units Subtract units in ending inventory from units available

©2008 Pearson Prentice Hall. All rights reserved E6-15 Ending inventory = $160 = $480 $180 = $900 $1,380 Cost of goods sold = $160 = $ 320 $170 = $1,870 $2,190 Specific Unit Cost

©2008 Pearson Prentice Hall. All rights reserved E6-15 Cost of goods available Number of units available = Average cost per unit Average cost per unit x units sold = Cost of goods sold Average cost per unit x units on hand = Ending inventory Average Cost $ = $170 $170 x 13 units = $2,210 $170 x 8 units = $1,360

©2008 Pearson Prentice Hall. All rights reserved E6-15 Ending inventory = $180 = $900 $170 = $540 $1,440 Cost of goods sold = $____ = $_____ $170 = $1,360 $2,160 FIFO Newest items Oldest items Highest ending inventory What is the price of the oldest items?

©2008 Pearson Prentice Hall. All rights reserved E6-15 Ending inventory = $160 = $800 $170 = $510 $1,310 Cost of goods sold = $180 = $ 900 $170 = $1,360 $2,260 LIFO Newest items Oldest items Highest Cost of goods Sold

©2008 Pearson Prentice Hall. All rights reserved Increasing Costs Cost of goods sold FIFO lowest  Based on older costs LIFO highest  Based on recent costs Ending inventory FIFO highest  Based on recent costs LIFO lowest  Based on older costs Opposite relationships exist when costs are decreasing

©2008 Pearson Prentice Hall. All rights reserved Tax Advantage of LIFO Assuming inventory costs are increasing LIFO results in higher COGS Lower net income results in lower taxes Lower taxes results in greater cash flow Higher COGS results in lower net income

©2008 Pearson Prentice Hall. All rights reserved Comparison of Inventory Methods FIFO Balance sheet  More recent costs Income Statement  Does not match current costs with revenue LIFO Balance Sheet  Old, outdated costs Income Statement  Matches current costs with revenue

©2008 Pearson Prentice Hall. All rights reserved Accounting Principles Related to Inventory Consistency  Companies should use same inventory method from period to period Disclosure  Companies should disclosed inventory method used Conservatism  Companies should “write down” inventory if market price falls below cost

©2008 Pearson Prentice Hall. All rights reserved Lower-of-Cost-or-Market (LCM) Inventory should be reported at whichever is lower – cost or market  Market = current replacement cost If cost is lower, no adjustment needed If market is lower,  Inventory is decreased to market value  Cost of goods sold is increased

©2008 Pearson Prentice Hall. All rights reserved ©2009 Prentice Hall 5-28 Learning Objective 3 Use gross profit percentage and inventory turnover to evaluate operations

©2008 Pearson Prentice Hall. All rights reserved Gross Profit Percentage Key indicator of ability to sell inventory at a profit Gross profit Net Sales Revenue Sales – Cost of Goods Sold = Gross profit = Gross profit percentage

©2008 Pearson Prentice Hall. All rights reserved Inventory Turnover How many times a company sells its average level of inventory Compute average inventory Inventory turnover Beginning inventory + Ending inventory 2 Cost of goods sold Average inventory

©2008 Pearson Prentice Hall. All rights reserved Learning Objective 4 Estimate inventory by the gross profit method

©2008 Pearson Prentice Hall. All rights reserved Estimating Inventory by the Gross Profit Method Beginning Inventory + Purchases = Goods available - Ending inventory = Cost of Goods sold Cost of goods sold computation - periodic Beginning Inventory + Purchases = Goods available - Cost of Goods sold = Ending inventory Gross profit method Net sales x (1 – GP%)

©2008 Pearson Prentice Hall. All rights reserved E6-26 Beginning inventory $ 48,000 Net purchases $ 106,000 Goods available $ 154,000 Sales $ 200,000 x Cost ratio_____% = Estimated COGS $ __________ Estimated ending inventory $ 34,000 Cost ratio = 100% - GP% Multiply Sales by cost ratio

©2008 Pearson Prentice Hall. All rights reserved Learning Objective 5 Show how inventory errors affect the financial statements

©2008 Pearson Prentice Hall. All rights reserved Effects of Inventory Errors Error in ending inventory impacts two periods First period  Cost of goods sold  Gross Profit & Net Income Second period  Beginning inventory  Costs of Goods sold  Gross Profit & Net Income Inverse with error Direct with error Inverse with error

©2008 Pearson Prentice Hall. All rights reserved Effects of Inventory Errors Period 1Period 2 Inventory errorCOGS GP & Net IncCOGS GP & Net Inc Period 1 Ending inventory overstatedUOOU Period 2 Ending inventory understatedOUUO O = Overstated U = Understated

©2008 Pearson Prentice Hall. All rights reserved End of Chapter Six ©2009 Prentice Hall 5-37