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Chapter 5: Inventory

Chapter 5: Inventory. Introduction & Acquisition of inventory: Costs to capitalize. The inventory formula. Perpetual versus period. Selling inventory: Cost flow assumptions. Journal entries. Inventory errors. Ending inventory: Lower-of-cost-or market valuation. Inventory.

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Chapter 5: Inventory

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  1. Chapter 5: Inventory

  2. Introduction & Acquisition of inventory: Costs to capitalize. The inventory formula. Perpetual versus period. Selling inventory: Cost flow assumptions. Journal entries. Inventory errors. Ending inventory: Lower-of-cost-or market valuation. Inventory

  3. Detailed Multiple Step I/S For the year ended December 31, 2008 Sales revenue $380,000 Less: Sales discounts 9,000 Sales returns and allowances 13,500 Net sales $357,500 Cost of goods sold Beginning inventory $ 20,000 Purchases $240,000 Less: Purchase discounts 7,000 Purchase returns and allowances 12,000 Net purchases $221,000 Add: Transportation in 14,000 Cost of goods purchased 235,000 Cost of goods available for sale $255,000 Less: Ending inventory 36,700 Cost of goods sold 218,300 Gross profit $139,200 Operating expenses: Selling expenses $ 39,950 General and administrative expenses 25,650 65,600 Income from operations $ 73,600 Other revenues and expenses: Interest revenue $ 1,500 Interest expense 16,900 Income before taxes $ 58,200 Income tax expense 17,200 Net income $ 41,000

  4. Net sales = Sales – Sales Discounts – Sales R&A Net Purchases = Purchases – Purch. Disc. – PR&A COGS = BI + Purch. (net) + Transport. In – EI Gross profit (or gross margin) = Sales (net) – COGS Net Income = Sales(net) – COGS – Op. Expenses + Other revenues - Other expenses - Income tax expense Income Statement Formulas

  5. What items or units to include? General rule: (1) held for sale and (2) complete and unrestricted ownership. Consignments: belong to consignor, ownership not based on physical possession. Goods in transit FOB Shipping Point: belongs to the purchaser while in transit (once inventory leaves seller’s facilities). FOB Destination: belongs to seller while in transit (until inventory reaches purchaser’s facilities). 1. Acquiring Inventory

  6. Seller Purchaser Seller Purchaser Goods in Transit FOB Shipping Point Belongs to Purchaser Title Transfers FOB Destination Belongs to Seller Title Transfers

  7. Dallas Company had the following inventory transactions at the end of 2008. Indicate whether Dallas should show the inventory in its financials as of 12/31/08. On 12/28, purchased inventory, FOB Destination. Shipped 12/28, did not arrive until Jan. 2. 2. On Dec. 29, purchased inventory, FOB Shipping Point. Shipped 12/29, did not arrive until Jan. 2. 3. On 12/28, sold inventory to Houston Company, FOB Destination. Shipped 12/28; Houston received on Jan. 2. Class Problem

  8. Dallas Company had the following inventory transactions at the end of 2008. Indicate whether Dallas should show the inventory in its financials as of 12/31/08. 4. On 12/28, sold inventory to Amarillo Company, FOB Shipping Point. Shipped 12/28; Amarillo received on Jan. 2. 5. On 12/28, sold inventory to Amarillo Company, FOB Shipping Point. Shipped 12/28; Amarillo received on Dec. 29. Class Problem

  9. Used to calculate Cost of Goods Sold (COGS) for the Income Statement and Ending Inventory (EI) for the balance sheet. BI + Purchases (net) + TI - EI = COGS Where TI = transportation-in costs Purchases (net) = Purchases (billed cost of inventory purchased) - Purchase Discounts (cash discounts for early payment on account) - Purchase Returns and Allowances (returns reduce inventory when given back to seller; allowances are a negotiated reduction in price of inventory purchased). 2. The Inventory Formula

  10. Perpetual Up-to-date record in inventory account. Cost of goods sold computed for each sale. Periodic Inventory purchases are recorded as incurred. Inventory and cost of goods sold determined at the end of each period through physical count. Costs and benefits Perpetual requires more bookkeeping but provides more useful information. General application: Periodic used for external reporting, particularly LIFO; perpetual used for internal tracking of units. 3. Perpetual or Periodic Method

  11. Given: BI + P (net) +TI = EI + COGS How to assign costs of inflows [BI + P(net) + TI] to EI and COGS? Methods: Specific identification Averagefor both COGS and EI FIFO- (first-in, first-out) for COGS and LISH (last-in, still here) for EI LIFO - (last-in, first-out) for COGS and FISH (first-in, still here) for EI 4. Cost Flow Assumptions

  12. Given the following activity for January: Cost Total Units per Unit Cost Begin Inventory 20 $ 9.00 $180 Purchase 1/10 40 10.00 400 Purchase 1/22 30 11.00 330 Total available 90 units $910 Sales -55 units Ending inventory? Class Problem - Cost Flows

  13. Note that, for illustrative purposes, only the periodic system is shown here. The perpetual system give similar results, but is more cumbersome to illustrate. In fact, using the FIFO method, the perpetual and periodic systems yield exactly the same results. Class Problem - Cost Flows

  14. FIFO for COGS (top down) LISH for EI (bottom up) FIFO(LISH)

  15. LIFO for COGS (bottom up) FISH for EI (top down) LIFO(FISH)

  16. First calculate average: Now COGS: Now EI: Average

  17. In times of rising prices: highest COGS: lowest COGS highest EI lowest EI highest Net Income lowest Net Income Comparison of FIFO, LIFO, and Average

  18. 1. When inventory purchased: Purchases xx Cash or A/P xx 2. Pay transportation on inventory: Transportation-in xx Cash xx 3. If purchase discount is taken: A/P xx Purchase discount xx 4. If inventory returned: A/P xx Purch. Returns & Allow. xx 5. Journal Entries - Periodic System

  19. 5. Journal Entries - Periodic System Note that Purchase and Transportation-in are created with Debits. Purchase Discounts, Returns and Allowances are created with a credit (contra to purchases). At the end of the period, the balances in all of these accounts (along with Beginning Inventory) are transferred to Ending Inventory and COGS (adjusting journal entry): Cost of Goods Sold xx (based on FIFO,LIFO,Avg.) Inventory - Ending xx (based on FIFO,LIFO,Avg.) Purchase Discounts xx Purchase Rt. & Allow. xx Purchases xx Transportation-in xx Inventory - Beginning xx 19

  20. 5. Journal Entries - Periodic System Example - assume the following balance in the Unadjusted Trial Balance of Raider Co.: DR CR Merch. Inv. (1/1/08) 2,600 Purchases 12,000 Transportation-in 500 Purchase Discounts 900 Purchase R & A 1,400 At the end of 2008, Raider calculated its ending inventory to be $1,900, based on the FIFO technique. 20

  21. 5. Journal Entries - Periodic System Part 1: What is the value of Cost of Goods Sold? BI + P (net) + TI = EI + COGS Part 2, AJE: 21

  22. 6. Inventory Errors Inventory errors are unique in financial reporting because they involve multiple accounts and multiple periods. Because of the carryover nature of inventory, some inventory errors reverse out by the end of the second year involved. To analyze, use basic inventory formula. 22

  23. Assume that the ending inventory of 2007 was undervalued by $9,000. If the error goes undetected in 2008, what effect would the error have on the balance sheet and income statement accounts for 2007 and 2008. Analyze using the following relationships: BI + P - EI = COGS NI A = L + SE Note that the asset account in inventory error analysis is ending inventory, and the equity effect is retained earnings, specifically the effect on net income. Class Problem-Inventory Error

  24. Analysis (O = overstated, U = understated): BI + P - EI = COGS NI A = L + SE Class Problem 07: 08:

  25. Based on conservatism, ending inventory is valued at cost or market value, whichever is lower. Problem: can create hidden reserves Recognizes price decreases immediately Defers price increase recognition until sold 7. Ending Inventory:Applying the Lower-of-Cost-or-Market Rule

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