Introductory Accounting B

1. Introductory Accounting B B11-A291 / B11-A027 Mark Binder, CA Chapter 7

2. Learning Objectives Identify the items making up merchandise inventory Identify the costs of merchandise inventory Compute inventory in a perpetual system using specific identification, weighted average, FIFO and LIFO Analyze the effects of inventory methods for financial reporting Analyze the effect of inventory errors on current and future financial statements Compute the lower of cost or market value of inventory Apply the gross profit method to estimate inventory.

3. Costs to Include in Inventory Goods in Transit Include if FOB shipping point should be included in ending inventory. Goods on Consignment Consignee gives the goods to the consignee for the consignor to sell. Goods are still the property of the Consignor. Goods Damaged or Obsolete Include in inventory at price which goods can be sold for, their net realizable value (NRV).

4. Physical Count of Inventory Usually companies physically count inventory at the end of the year. This is a necessary step if the company uses a periodic system. Even if the company uses a perpetual system a physical count is done to verify ending inventory amounts.

5. Perpetual vs. Periodic In a Perpetual system inventory quantities and costs are constantly updated. This is rapidly becoming normal for many business This is also the focus of the text and this course Some companies still use periodic systems where the inventory quantity is updated only at the time of an inventory count.

6. Inventory Costing Systems There are four methods used to assign costs to inventory: Specific Identification Weighted average FIFO (first in first out) LIFO (last in first out)

7. Specific Identification In specific identification the system tracks the cost of each item exclusively. When that item is sold the cost of the item is recorded to cost of goods sold. This method is intuitively the most pleasing. Unfortunately it is only practical for inventory systems where the items are both unique and costly such as automobiles.

8. Other Methods of Inventory Costing For most types of inventory it is not practical to track costs of inventory to specific items. Consider the situation of a gasoline station. On Jan 1 it has 5 litres of gasoline in inventory and each litre cost $0.50 On Jan 1 an additional 10 litres of gasoline costing $0.60 are purchased.

9. Other Methods of Inventory Costing On Jan 5 12 litres are sold. The question to answer is which 12 liters were sold and how much did they cost? It is next to impossible to distinguish the $0.50 per litre litres from the $0.60 per litre liters. Any practical method would prove too costly to implement.

10. Other Methods of Inventory Costing According to the handbook it is also unnecessary to determine specifically which goods are the ones sold. The cost of goods does not have to follow the physical flow of goods. The costing assumption should provide the best ‘match’ of costs to related revenues.

11. FIFO Costing In FIFO costing we assume that the first items in are the first units out. This also means that when a sale takes place the items assumed to be sold are the items purchased last. In other words the items sold are assumed to be the oldest items first. Consequently, ending inventory will contain the most recent costs.

12. FIFO Costing

13. FIFO Costing Each purchase must stay separate from all other purchases. This creates ‘cost layers’ in inventory Theoretically there is no limit to how many cost layers their can be.

14. FIFO Costing

15. FIFO Costing Cost of goods sold is $6.70. Ending inventory is 3 litres @ $0.60 = $1.80

16. LIFO Costing In LIFO costing we assume that the last items in are the first units out. This also means that when a sale takes place the items assumed to be sold are the items purchased most recently. In other words the items sold are assumed to be the newest items first. Consequently, ending inventory will have the oldest costs remaining in ending inventory.

17. LIFO Costing

18. LIFO Costing

19. LIFO Costing Cost of goods sold is $7.00. Ending inventory is 3 litres @ $0.50 = $1.50

20. LIFO Costing Each purchase must stay separate from all other purchases. This creates ‘cost layers’ in inventory Theoretically there is no limit to how many cost layers their can be.

21. Weighted Average Costing In Weighted Average costing we assume that the items sold are an average of all items in inventory. The average is not a simple average but it is ‘weighted’ by how many items are in inventory.

22. Weighted Average Costing To calculate the average add the total of all purchases to date and divide by the number of units purchased. In our example the weighted average is $2.50 + $6.00 = $8.50 / 15 = $0.57 (rounded). It is not $0.55 which would be the simple average.

23. Weighted Average Calculation 5 litres @ $0.50 = $2.50 10 litres @ $0.60= $6.00 Total 15 $8.50 Weighted average $8.50 /15 = $0.57 (rounded) Cost of goods sold 12 x $0.57 = $6.84 Ending inventory 3 x $0.57 = $1.71 Note $6.84 + $1.71 = $8.55 which is greater than the total of inventory on hand prior to sale This is clearly a nonsense result caused by rounding. Either ending inventory or cost of goods sold will have to be adjusted for the rounding error.

24. Weighted Average Costing At any time only two pieces of information must be stored, the total value of all purchases of inventory and The total number of items in inventory. There are no cost layers.

25. Summary of Methods All methods are allowed under GAAP in Canada. CCRA however only allows FIFO and Weighted Average. In the US all three methods are allowed for tax.

26. Summary of Methods In times of rising prices LIFO, which uses the most recent costs first, will almost always create the highest cost of goods sold. This in turn will create the lowest Net Income. This explains why CCRA in Canada does not allow this method and why LIFO is so popular in the US where the IRS does allow LIFO. In Canada FIFO and Weighted Average are a virtual tie in terms of popularity.

27. Summary of Methods This was not always the case. Historically FIFO was much more popular. With the advent of computer based systems Weighted Average has become much more popular.

28. Summary of Methods The primary reason for this is system resources: Under FIFO costing each ‘cost layer’ would have to be stored separately Under Weighted average only two items of data need to be stored, total quantity and total cost. Weighted average places far fewer demands on storage and in practice often produces very similar results to FIFO, which explains it recent popularity.

29. Inventory Errors If a company has an error in inventory, this will trigger errors in cost of goods sold, net income, current assets and owner’s equity. Ending inventory in one period is opening inventory in the following period.

30. Inventory Errors Beginning inventory + Cost of goods purchased Ending inventory Cost of Goods Sold Assume Beginning inventory is $10,000 Cost of goods purchased is $50,000 Ending inventory is $10,000

31. Inventory Errors Beginning inventory $10,000 + Cost of goods purchased $50,000 Ending inventory $10,000 Cost of Goods Sold $50,000

32. Inventory Errors Assume that an error in computation underestimated ending inventory by $5,000 Beginning inventory $10,000 + Cost of goods purchased $50,000 Ending inventory $5,000 Cost of Goods Sold $55,000

33. Inventory Errors With understatement of ending inventory cost of goods sold is increased by $5,000. This will cause a decrease in Net income and consequently Owner’s equity of $5,000. The understatement of ending inventory also understates current assets.

34. Inventory Errors Second Year partial income statement Beginning inventory = prior year ending inventory Beginning inventory $5,000 + Cost of goods purchased $50,000 Ending inventory $10,000 Cost of Goods Sold $45,000

35. Inventory Error Cost of Goods Sold in the first year of the error is $55,000. Cost of Goods Sold in the second year after the error is $45,000. The average of the two years is $50,000. Had no error occurred the Cost of Goods Sold would be $50,000.

36. Inventory Errors The effect of the error is to reverse itself out over the two years. These errors are sometimes called self correcting.

37. LCM LCM Lower of Cost or Market Inventory is a highly sensitive number It is usually a very significant part of current assets and potentially total assets

38. LCM Apply the principle of Lower of Cost or Market This means that inventory is carried at the lower of two values: Historical Cost Market Value

39. LCM In applying the principle of LCM can be done one of three ways, all of which are acceptable: Item by item Inventory class Inventory as a whole

40. Item by Item In this method each item is compared to the estimate of market value. The lower of the two amounts is chosen. This will usually yield the lowest possible value of inventory.

41. Inventory by Class In this case every ‘class’ or ‘category’ of inventory is compared to it’s market value. The lower of the two amounts is chosen. Commonly we use the estimate of net realizable value (NRV) as estimate for market.

42. Inventory by Class Skis: NRV Cost. Model TK $65 $55. Model A2 $50 $80. Total $115 $135. Since we are comparing by class we compare the totals of $115 to $135. Choose the lower of the two, $115.

43. Inventory by Class Skates: NRV Cost Model AX-1 $90 $110 Model BZ-2 $115 $85 Total $205 $195 In this case the lowest amount is the cost price of $195

44. Inventory by class When evaluating inventory by class or category you look at all the items of inventory that are similar. Only reduce the value if the total market value of all items in the category are less than the cost value of items in that category

45. Inventory as a whole In this case a the total cost of all items in inventory is compared to the total market price of all items. Choose the lower of the two totals.

46. Gross Profit Method In order to accurately produce financial statements it is necessary to determine the actual amount of inventory on hand. This is done through a physical inventory count. In a physical inventory count each item in the inventory is counted.

47. Gross Profit Method The items counted are then compared to the inventory records and adjusted accordingly. The price of each item is also evaluated by comparing the cost to the Net Realizable value. This comparison is done to ensure that inventory is not overstated.

48. Gross Profit Method This is done to ensure that we comply with the Conservatism Principle. The conservativism principle states that under conditions of uncertainty the lowest value for assets and the lowest value for net income should be used. As is clear the taking of inventory is a time consuming and expensive activity.

49. Gross Profit Method For the purposes of internal information or for interim financial statements it is beneficial to find another technique to determine the value of inventory. Different techniques have evolved, one of which is the gross profit method.

50. Gross Profit Method The basis for the gross profit method is the gross profit for a company. Remarkeably, the gross profit for various companies usually is fairly stable. We can use this fact to help determine the value of ending inventory.

51. Gross Profit Method Step 1 – compute the goods available for sale. Recall that goods available for sale is beginning inventory and cost of goods purchased. So if beginning inventory is $20,000 and purchases are $200,000.

52. Gross Profit Method Cost of goods available for sale is therefore $20,000 + $200,000 = $220,000.

53. Gross Profit Method Step 2 : Create an estimate for cost of good sold. To arrive at an estimate of cost of good sold we first determine net sales Net sales = Sales less sales returns Assume sales are $320,000 and sales returns are $20,000

54. Gross Profit Method Net Sales are $320,000 - $20,000 = $300,000 Recall that: Sales Cost of Goods Sold Gross Profit

55. Gross Profit Method Gross Profit % = Gross Profit / Net Sales. If the gross profit is reasonably stable we could multiply the gross profit % x net sales = estimate of gross profit.

56. Gross Profit We could then subtract gross profit from Net Sales to arrive at an estimate of Cost of Goods Sold. However it is far more efficient to simply multiply 1- Gross Profit % to arrive directly at an estimate of Cost of Goods Sold.

57. Gross Profit Assume the gross profit has historically been 35%. 1-35% = 65% An estimate of cost of good sold is then $300,000 (Net Sales) x 65% = $195,000.

58. Gross Profit Recall that: Cost of Goods Available for sale - Ending Inventory Cost of Goods Sold

59. Gross Profit We now know cost of goods available for sale. We also have an estimate of cost of goods sold. Step 3 subtract estimate of cost of goods sold from cost of good available for sale.

60. Gross Profit $220,000 - $195,000 = $25,000. $25,000 is our estimate of ending inventory.

61. Gross Profit Summary of Steps Step 1: Calculate Cost of Goods Available for Sale. Beginning inventory + Net cost of goods purchased. Step 2 : Calculate estimate of Cost of Goods Sold. 1 – GP% x Net Sales (Sales – Sales returns).

62. Gross Profit: Summary of Steps Step 3: Calculate estimate of ending inventory. Cost of goods available for sale – estimate of cost of goods sold. Step 1 – Step 2.