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Chapter 10--Learning Objectives

Chapter 10--Learning Objectives. 1. Explain the importance of inventory for asset valuation and income measurement. Inventories are a significant asset for many businesses. Inventories affect income. Sales XXX Beginning inventory XXX Purchases XXX Goods available for sale XXX

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Chapter 10--Learning Objectives

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  1. Chapter 10--Learning Objectives 1. Explain the importance of inventory for asset valuation and income measurement

  2. Inventories are a significant asset for many businesses

  3. Inventories affect income Sales XXX Beginning inventory XXX Purchases XXX Goods available for sale XXX Ending inventory XXX Cost of goods sold XXX Gross profit XXX Operating expenses XXX Net income XXX

  4. Chapter 10--Learning Objectives 2. Understand the nature of inventory and what is included in it

  5. Types of inventory 1. Assets held for sale (or resale) in the ordinary course of business 2. Assets used or consumed in the production of goods to be sold in the ordinary course of business

  6. A retail store(Sears, Wal-Mart, Safeway) Has inventory for resale to customers

  7. A manufacturer(Ford, IBM, Exxon) Has inventories used or consumed in the production of goods for sale

  8. A manufacturer’s inventorieswill usually include Raw materials inventory Items used in producing the product Work in process inventory Products started but not yet completed Finished goods inventory Products completed but not yet sold

  9. What about this F.O.B. stuff ? “F.O.B.” means “free on board” and refers to the time and place at which the goods were turned over to the transportation carrier

  10. If you are in Los Angelesand your supplier is in New York City Them You

  11. If you are in Los Angelesand your supplier is in New York City Somebody has to pay for moving the goods across the country Them You

  12. If you are in Los Angelesand your supplier is in New York City And somebody owns the goods while they are moving across the country Them You

  13. The F.O.B. designation determines who that “somebody” is Them You

  14. If the goods are shipped F.O.B. New York(or F.O.B. origin) You will pay the transportation cost and you will own the merchandise once it is turned over to the carrier in NYC Them You

  15. If the goods are shipped F.O.B. Los Angeles(or F.O.B. destination) The supplier will pay the transportation cost and they will own the merchandise until in reaches you in Los Angeles Them You

  16. The owner of the goods Is usually the entity that should include those goods in inventory This applies to goods in transit and to consignment situations But there are exceptions for some special sales agreements

  17. An interesting situation arisesin purchase commitments These are noncancellable, long-term contracts to purchase goods at a set price You might enter into such an agreement to buy a product if you thought its price was about to go up If the price does go up, everything is cool and you will make lots of money But if the price goes down, you have an economic problem and an accounting problem

  18. The Oliver Peck Oil Company(O. Peck for short) Thinking that the price of gas is about to increase Peck signs a contract during 19X1 to purchase 100,000 gallons of gas during 19X2 at $1.00 per gallon

  19. On December 31, 19X1,gas is selling for $.94 Since Peck has agreed to pay $1.00 per gallon, accounting conservatism mandates: December 31, 19X1 Est. Loss on Purch. Commit. 6,000 Est. Liab. on Contract 6,000 This reduces Peck’s income and increases his liabilities

  20. Assume that on the April 1, 19X2, delivery date, gas is selling for $.90 Since Peck has agreed to pay $1.00 per gallon, there is an additional loss: April 1, 19X2 Purchases 90,000 Est. Liab. on Contract 6,000 Loss on Purchase Contract 4,000 Cash 100,000

  21. Now assume that on the April 1, 19X2, delivery date, gas is selling for $.98 Peck must still pay $1.00, but the situation has improved since December 31: April 1, 19X2 Purchases 98,000 Est. Liab. on Contract 6,000 Recovery on Contract 4,000 Cash 100,000

  22. Now assume that on the April 1, 19X2, delivery date, gas is selling for $1.05 This is what Peck was planning on, but the purchase is recorded at $1.00 and lower cost of goods sold will give Peck higher profits when the gas is sold April 1, 19X2 Purchases 100,000 Est. Liab. on Contract 6,000 Recovery on Contract 6,000 Cash 100,000

  23. Chapter 10--Learning Objectives 3. Differentiate between perpetual and periodic inventory measurement systems

  24. In a periodic inventory system Purchases of goods for resale are recorded in a “Purchases” account: Purchases XXX Cash or Accts. Payable XXX

  25. In a periodic inventory system Recording sales of merchandise is simple: Cash or Accts. Receivable XXX Sales XXX

  26. In a periodic inventory system An adjusting entry closes out the beginning inventory and purchases accounts and records the cost of goods sold and ending inventory Inventory (ending) XXX Cost of Goods Sold XXX Inventory (beginning) XXX Purchases XXX

  27. In a perpetual inventory system Purchases of merchandise for resale are recorded in the “Inventory” account Inventory XXX Cash or Accts. Payable XXX

  28. In a perpetual inventory system Recording sales is more complicated: Cash or Accts. Receivable XXX Sales XXX Cost of Goods Sold XXX Inventory XXX The first entry records the sale at the selling price, just like in a periodic system

  29. In a perpetual inventory system Recording sales is more complicated: Cash or Accts. Receivable XXX Sales XXX Cost of Goods Sold XXX Inventory XXX The second entry removes the cost of the merchandise sold from the “Inventory” account and transfers it to “Cost of Goods Sold”

  30. Inventory XXX In a perpetual inventory system No end-of-period adjustment is required if the actual inventory cost matches the balance in the “Inventory” account:

  31. In a perpetual inventory system If items are missing, an adjustment is made to change the “Inventory” balance to reflect reality: Inventory Shrinkage XXX Inventory XXX “Inventory Shrinkage” is treated as an expense account, but is often included in “Cost of Goods Sold” in practice

  32. Inventory shrinkagecan be a result of Theft Spoilage Accidental breakage Mistakenly thrown away and other causes

  33. Occasionally, a business will have more inventory than the records indicate P e t e ’ s R a b b i t F a r m

  34. Occasionally, a business will have more inventory than the records indicate P e t e ’ s R a b b i t F a r m

  35. Chapter 10--Learning Objectives 4. Record and report inventories for different valuation systems

  36. Inventory cost flow assumptions Picture five items identical except for cost acquired in the order indicated 1 - 2 - 3 - 4 - 5 1 $11 2 $12 3 $13 4 $14 5 $15

  37. Inventory cost flow assumptions The total cost of the five items is $65 ($11 + 12 + 13 + 14 + 15 = $65) Assume that three items are sold for $25 each (total sales revenue = $75) and that two are on hand at the end of the period 1 $11 2 $12 3 $13 4 $14 5 $15

  38. Specific identification The actual items sold are recorded These might be items 1, 3 and 5 Leaving items 2 and 4 in inventory The cost of items 2 and 4 is $26 2 $12 4 $14

  39. Specific identification Sales revenue $75 Goods available for sale $65 Less: Ending inventory 26 Cost of goods sold $39 Gross profit $36 2 $12 4 $14

  40. First-in, first-out ( FIFO ) The first three items would be the items sold--items 1, 2 and 3 Leaving items 4 and 5 The cost of items 4 and 5 is $29 4 $14 5 $15

  41. First-in, first-out ( FIFO ) Sales revenue $75 Goods available for sale $65 Less: Ending inventory 29 Cost of goods sold $36 Gross profit $39 4 $14 5 $15

  42. Last-in, first-out ( LIFO ) The last three items (3, 4 and 5) would be the items sold Leaving items 1 and 2 The cost of items 1 and 2 is $23 1 $11 2 $12

  43. Last-in, first-out ( LIFO ) Sales revenue $75 Goods available for sale $65 Less: Ending inventory 23 Cost of goods sold $42 Gross profit $33 1 $11 2 $12

  44. ? ? Average cost The total cost of the five items is $65 So the average cost per item is $13 It doesn’t matter which items are sold and which remain The cost of the ending inventory is $26

  45. ? ? Average cost Sales revenue $75 Goods available for sale $65 Less: Ending inventory 26 Cost of goods sold $39 Gross profit $36

  46. Note that in this period of rising pricesthe gross profits were: FIFO $ 39 Average 36 LIFO 33 LIFO results in a higher cost of goods sold and a lower gross profit because the higher cost of the last items purchased is being matched against revenues LIFO will also result in a lower income tax in a period of rising prices

  47. Lower of cost or market(LCM) INVENTORY IS PURCHASED AT COST THERE IS NO PROBLEM IF THE VALUE INCREASES

  48. Lower of cost or market(LCM) INVENTORY IS PURCHASED AT COST THERE ARE PROBLEMS IF THE VALUE GOES DOWN

  49. A decline in inventory value... Creates an accounting problem Means that you will lose your shirt Our job is to solve the accounting problem

  50. Any adjustment of inventory value Must be below the ceiling And above the floor

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