Inventory

1. 7 C H A P T E R Inventory

2. Learning Objective 1 Identify what items and costs should be included in inventory and cost of goods sold.

3. Define Inventory and COGS. What are some of their characteristics? Goods either manufactured or purchased for resale. • Inventory is reported on balance sheet as an asset. • When sold, inventory is reported on income statement as an expense (cost of goods sold). • COGS: the cost of inventory sold during the period.

4. BUY raw materials or goods for resale SELL finished inventory ADD value COMPUTE ending inventory cost of goods sold Describe the Time Line of Business.

5. What is Inventory? Defined according to type and nature of the company. Merchandising: Items to be resold. For a supermarket, food is inventory, the shopping cart is not. • Manufacturing: • raw materials • work in process • finished goods

6. Define Each Manufacturing Inventory • Raw materials • Goods acquired in a relatively undeveloped state. • Eventually will compose a major part of the finished product. • Work in process • Partly finished products. • Manufacturing plant contains work- in-process inventory. • Finished goods • Completed products waiting for sale.

7. Costs NOT included in inventory costs: • sales effort • general non-factory administrative costs What Costs are Included in Inventory? • Costs incurred in buying inventory and preparing it for sale. • Cost of raw materials. • Cost of work-in-process inventory. • Cost of finished goods.

8. Who Owns the Inventory? When goods are in transit? Q: Who owns the inventory on a truck or railroad car? A: The party who is paying the shipping costs. When goods are on consignment? Q: Who owns inventory stocked in a warehouse? A: The supplier until the inventory is sold. The warehouse owner stocks and sells the inventory and receives a commission on sales as payment for services rendered.

9. Ending Inventory & COGS Cost of goods available for sale Beginning inventory Net purchases At period’s end, is allocated between • inventory still remaining (an asset), and • inventory sold during the period (an expense, Cost of Goods Sold). = + The question is where is the inventory that could have been sold this period? Only two choices:

10. Learning Objective 2 Account for inventory purchases and sales using both a perpetual and a periodic inventory system.

11. Perpetual Records are updated when a purchase or sale is made. Records reflect total items in inventory or sold at any given time. Most often used when each item has a relatively high value, or the cost of running out of or overstocking an item is expensive. Periodic Records are not updated when a purchase or a sale is made. Only the dollar amount of the sale is recorded. Used when inventory is composed of a large number of diverse items, each with a relatively low value. 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 2001: Beginning inventory 10 hats @ $10 each = $100 March 1 Purchase 15 hats @ $15 each = $225 March 1 Freight in $10 March 1 Purchase return 3 hats @ $15 each = $ 45 May 2 Purchase 10 hats @ $20 each = $200 May 2 Purchase discount 2/10, n/30 June 30 Sales 20 hats (10 @ $10, 10 @ $15) July 3 Sales return 1 hat @ $15 = $ 15 Ending inventory 13 hats

13. Example: 2001 Inventory Purchase Sale Balance ` DateUnitsTotalUnitsTotalUnitsCostTotal Jan. 1 10 $10 $100 Mar. 1 15 $225 10 $10 $100 15 $15 $225 (3) ($45) 12 $15 $180 May 2 10 $200 10 $10 $100 12 $15 $180 10 $20 $200 June 30 10 $100 10 $150 2 $15 $ 30 10 $20 $200 July 3 (1) ($15) 3 $15 $ 45 10 $20 $200

14. Perpetual All purchases are added directly to the inventory account. • Periodic • At end of period, • Inventory balance is updated using inventory count. • Temporary purchases account balance is closed to Inventory to compute COGS. Perpetual & PeriodicJournal Entries • Purchases • Transportation costs • Purchase returns • Purchase discounts • Sales • Sales returns • Closing entries for COGS

15. Jan. 1 Inventory . . . . . . . . . . . . . . . . 100 Accounts Payable. . . . . . . 100 Purchased 10 hats @ $10. Jan. 1 Purchases . . . . . . . . . . . . . . . 100 Accounts Payable. . . . . . . 100 Purchased 10 hats @ $10. Example: Journal Entriesfor Purchases Harper purchased 10 hats at $10 each on January 1. Record the entries for both the perpetual and the periodic systems. PERPETUAL PERIODIC

16. Perpetual All costs are added directly to the inventory balance. Periodic At end of period, temporary freight in account balance is closed to Inventory to compute COGS. Perpetual & PeriodicJournal Entries • Purchases • Transportation costs • Purchase returns • Purchase discounts • Sales • Sales returns • Closing entries for COGS

17. Mar. 1 Inventory . . . . . . . . . . . . . . . . 10 Cash. . . . . . . . . . . . . . . . . . 10 Delivery charge on 15 hats. Mar. 1 Freight In. . . . . . . . . . . . . . . . 10 Cash. . . . . . . . . . . . . . . . . . 10 Delivery charge on 15 hats. Example: Journal Entriesfor 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. PERPETUAL PERIODIC

18. Perpetual Inventory is decreased. Accounts Payable is decreased by same amount. Periodic If 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. Perpetual & PeriodicJournal Entries • Purchases • Transportation costs • Purchase returns • Purchase discounts • Sales • Sales returns • Closing entries for COGS

19. Mar. 1 Accounts Payable (or Cash) 45 Inventory . . . . . . . . . . . . . . 45 Returned 3 hats @ $15. Mar. 1 Accounts Payable (or Cash) 45 Purchase Returns. . . . . . . 45 Returned 3 hats @ $15. Example: Journal Entriesfor 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. PERPETUAL PERIODIC

20. Perpetual Subtract the discount amount from the inventory account. Periodic At end of period, temporary purchase discounts account balance is closed to Inventory to compute COGS. Perpetual & PeriodicJournal Entries • Purchases • Transportation costs • Purchase returns • Purchase discounts • Sales • Sales returns • Closing entries for COGS

21. May 2 Accounts Payable (or Cash) 200 Inventory . . . . . . . . . . . . . . 4 Cash . . . . . . . . . . . . . . . . . . 196 Purchase discount on 10 hats. May 2 Accounts Payable (or Cash) 200 Purchase Discounts . . . . . 4 Cash . . . . . . . . . . . . . . . . . . 196 Purchase discount on 10 hats. Example: Journal Entriesfor 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. PERPETUAL PERIODIC

22. Perpetual All adjustments are entered directly in the Inventory account. Periodic All adjustments are accumulated in an array of temporary holding accounts: Purchases Freight In Purchase Returns Purchase Discounts The difference in terms of journal entries: Perpetual & PeriodicJournal Entries • Purchases • Transportation costs • Purchase returns • Purchase discounts

23. Perpetual Recognize sales and COGS on a transaction-by-transaction basis. Periodic Only total sales are known. Perpetual & PeriodicJournal Entries • Purchases • Transportation costs • Purchase returns • Purchase discounts • Sales • Sales returns • Closing entries for COGS

24. Jun. 30 Accounts Receivable (or Cash) 500 Sales . . . . . . . . . . . . . . . . . . . . 500 Sold 20 hats @ $25. Jun. 30 Cost of Goods Sold . . . . . . . . . . 250 Inventory (10 @ $10; 10 @ $15) 250 Record cost of goods sold. Jun. 30 Accounts Receivable (or Cash) 500 Sales . . . . . . . . . . . . . . . . . . . . 500 Sold 20 hats @ $25. No entry. Example: Journal Entriesfor 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. PERPETUAL PERIODIC

25. Perpetual Sales for returned items are canceled. Cost of returned inventory is removed from COGS and restored to the inventory account. Periodic Sales for returned items are canceled. No entry is made to adjust COGS. Perpetual & PeriodicJournal Entries • Purchases • Transportation costs • Purchase returns • Purchase discounts • Sales • Sales returns • Closing entries for COGS

26. Jul. 3 Sales Returns. . . . . . . . . . . . . . . 25 Accounts Receivable. . . . . . . 25 1 hat returned from June purchase. Jul. 3 Inventory. . . . . . . . . . . . . . . . . . . 15 Cost of Goods sold . . . . . . . . 15 Placed returned hat back into inventory. Jul. 3 Sales Returns. . . . . . . . . . . . . . . 25 Accounts Receivable. . . . . . . 25 1 hat returned from June purchase. No entry. Example: Journal Entriesfor 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. PERPETUAL PERIODIC

27. Perpetual All journal entries are posted to the ledger. Results in new balances for Inventory and COGS. Numbers are verified by physical count. Periodic Temporary holding accounts are accumulated and added to Inventory. Inventory account balance is reduced by the amount of COGS. Perpetual & PeriodicJournal Entries • Purchases • Transportation costs • Purchase returns • Purchase discounts • Sales • Sales returns • Closing entries for COGS

28. Example: Accounting for Inventory Purchases and Sales Harper’s Hats recorded the following transactions for 2001: Beginning inventory 10 hats @ $10 each = $100 March 1 Purchase 15 hats @ $15 each = $225 March 1 Freight in $10 March 1 Purchase return 3 hats @ $15 each = $ 45 May 2 Purchase 10 hats @ $20 each = $200 May 2 Purchase discount 2/10, n/30 June 30 Sales 20 hats (10 @ $10, 10 @ $15) July 3 Sales return 1 hat @ $15 = $ 15 Ending inventory 13 hats

29. Example: Closing Entries for Cost of Goods Sold Perpetual: the inventory account will have an ending balance of $255. Inventory COGS 6/30 250 7/3 15 Bal. 235 1/1 100 3/1 225 3/1 45 3/1 10 5/2 200 6/30 250 7/3 15 Bal. 255

30. Example: 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 Inventory. . . . . . . . . . . . . . . . . . . 386 Purchase Returns. . . . . . . . . . . . 45 Purchase Discounts. . . . . . . . . . 4 Freight In. . . . . . . . . . . . . . . . . 10 Purchases. . . . . . . . . . . . . . . . 425

31. Periodic Inventory With a periodic system, a physical count is the only way to get the information necessary to compute COGS: Beginning Inventory, January 1, 2001 + Purchases for the year = Cost of goods available for sale during 2001 – Ending Inventory, December 31, 2001 = Cost of Goods Sold for 2001

32. Learning Objective 3 Calculate 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. Perpetual Physical count either confirms records are accurate or highlights shortages and clerical errors. Periodic The 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 • Periodic • Company 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. 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.

35. What is the Income Effect of an Error in Ending Inventory? Any uncorrected error will affect the financial statements for two years. An error in inventory results in COGS being overstated or understated. The inventory error has the opposite effect on gross margin and net income.

36. Understate Beginning Inventory UnderstateEnding Inventory Sales OK Beginning inventory OK Net purchases OK Goods available OK Ending inventory LOW Cost of goods sold HIGH Gross margin LOW Expenses OK Net income LOW Understate Purchases Understate Sales Effects of Inventory Errors OK OK LOW LOW OK LOW HIGH OK HIGH OK LOW OK LOW OK LOW HIGH OK HIGH LOW OK OK OK OK OK LOW OK LOW

37. Learning Objective 4 Apply the four inventory cost flow alternatives: specific identification, FIFO, LIFO, and average cost.

38. Inventory Cost Flow • Kernel 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 #1Case #2Case #3 Sold Sold Sold Old CornNew CornMixed Corn Sales ($11 x 10 tons) $110 $110 $110 COGS (10 tons) 60 90 75 Gross margin$ 50 $ 20 $ 35

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 • LIFO • The newest units are sold and the oldest units remain in inventory. • The cost of the most recent units purchased is transferred to COGS. • Average Cost • An 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. FIFO • The oldest units are sold and the newest units remain in inventory. • The cost of the oldest units purchased is transferred to COGS.

41. Comparison ofInventory 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 5 Use financial ratios to evaluate a company’s inventory level.

43. Why Use JIT Inventory Management? • Money tied up in inventory cannot be used for other purposes. • JIT attempts to have exactly enough inventory arrive “just in time” for sale. • Its purpose is to minimize investment in inventories while at the same time having enough inventory on hand to meet customer demand.

44. Cost of goods sold Average inventory 365 days Inventory turnover Evaluating Inventory Levels • Inventory Turnover • Measures 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 Inventory

45. Cost of goods sold Average inventory $60,000 $4,500 = = 13.33 365 days Inventory turnover 365 13.33 = = 27.38 Example: Evaluating Inventory Management Buster Boots had cost of goods sold of $60,000 during 2002. 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 ratio Number of days’ sales in inventory

46. Expanded MaterialLearning 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, > COGS Ô understated > gross margin Ô overstated > net income Ô overstated If a sale is not recorded, but inventory is shipped and not counted in ending inventory, > COGS Ô overstated > gross margin Ô understated > net income Ô understated

48. Expanded MaterialLearning 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” units also 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. • No complications arise as no matter when sales occur, the “first in” units are always the same in both systems. • FIFO periodic and FIFO perpetual yield the same numbers for COGS and ending inventory.