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Chapter 5: Inventory

2. 1. Acquiring Inventory:. What items 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 transitFOB Shipping Point: belongs to the purchaser while in transit (once invent

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Chapter 5: Inventory

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    1. 1 Chapter 5: Inventory

    2. 2 1. Acquiring Inventory: What items 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). Note: FOB does not indicate who pays the freight. This is indicated by “prepaid’ or “collect”.

    3. 3 Class Problem: Houston Corporation had the following inventory transactions in transit at 12/31/02. Indicate whether the inventory would be included in Houston’s ending inventory at December 31, 2002. 1. Purchased inventory “FOB Shipping Point”; shipped on December 30. YES 2. Sold inventory “FOB Shipping Point”; shipped on December 30. NO

    4. 4 Class Problem - continued: Houston Corporation had the following inventory transactions in transit at 12/31/02. Indicate whether the inventory would be included in Houston’s ending inventory at December 31, 2002. 3. Sold inventory “FOB Destination”; shipped on December 30. YES 4. Purchased inventory “FOB Destination”; shipped on December 30: NO

    5. 5 1. Acquiring inventory - contd. What costs to attach? General rule: all costs associated with purchase or manufacture. Freight-in (transportation-in) adds to the cost of purchases. Purchase returns reduce the cost of purchases (contra) for returned inventory. Purchase allowances reduce the cost of purchases (contra) for reduced prices due to damage or errors. Purchase discounts from early cash payments (contra) reduce the cost of purchases. Purchase discounts recorded using gross or net method. Gross method more popular, but net method is theoretically correct way of reporting of economic events. Illustration after discussion of periodic system.

    6. 6 2. Perpetual or Periodic Method 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 general ledger entries; perpetual used for units.

    7. 7 Illustration Periodic System Purchase of 10 units @ $8: Inventory (or Purchases) 80 Cash 80 Sale of 7 units @ $12: Cash 84 Sales 84 (no COGS entry until the end of the period) December 31 to recognize EI and COGS. Note that there is no BI; EI physical count is 2 cases, valued at $8 each = $16, so COGS is for 8 cases @$8 each.: BI + P - EI = COGS, so 0 + 80 - 16 = COGS = 64) COGS 64 Inventory (or BI and Purch.) 64

    8. 8 Periodic System Note that the periodic system is illustrated in later sections of the text, using the specific components of COGS for the journal entries. These components include: Purchases (+) Freight-in (+) Purchase discounts (-) Purchase returns (-) Purchase allowances (-) Also, when these accounts are used during the period, the balance in the Inventory account remains as the beginning inventory until the AJE at the end of the period is posted. Now work Ex. 5-24.

    9. 9 Periodic System If the component accounts are used to record inventory activity during the accounting period, then the AJE at the end of the period transfers the balances in the component accounts to EI and COGS. The following formulas represent the activity: BI + Purchases (net) - EI = COGS or BI + Purchases (net) = EI + COGS Note that Purchases (net) = Purchases + Freight-in - Purchase Discounts - Purchase Returns - Purchase Allowances

    10. 10 This AJE under periodic system follows the formula for COGS: COGS xx Ending Inventory xx Purch. Discounts xx Purch. Returns xx Purch. Allowances xx Freight-in xx Purchases xx Beginning inventory xx Note that this journal entry closes out BI and Net Purchases, and transfers the balances to EI and COGS. The EI balance will go to the balance sheet, and the COGS balance will go to the income statement.

    11. 11 Purchase Discounts - Gross Method Assume purchase of $100 on account on 6/1/00, terms 2/15, n/30. GJE to record purchase on 6/1/00: Purchases 100 Accounts Payable 100 GJE to record payment, if on or before 6/16/00: Accounts Payable 100 Purchase Discounts 2 Cash 98 GJE to record payment, if after 6/16/00: Accounts Payable 100 Cash 100 (Purch Disc. is contra to Purchases; part of COGS calc.)

    12. 12 Purchase Discounts - Net Method Assume purchase of $100 on account on 6/1/00, terms 2/15, n/30. GJE to record purchase on 6/1/00: Purchases 98 Accounts Payable 98 GJE to record payment, if on or before 6/16/00: Accounts Payable 98 Cash 98 GJE to record payment, if after 6/16/00: Accounts Payable 98 Purchase Disc. Lost 2 Cash 100 (P.D. Lost is operating expense, like Interest Expense)

    13. 13 Class Problem -Inventory Components Given the following selected information for 2001 and 2002 (in thousands): 2001 2002 Beginning inventory $ 40 $ 55 Purchases 150 160 Freight-in 6 7 Purchase discounts 3 5 Purchase returns & allowances 2 0 Cost of goods available for sale (a) (d) Ending inventory (b) 68 Cost of goods sold (c) (e) Note: Goods available for sale (GAS) = BI + P(net) = EI +COGS 1. Compute the missing numbers. 2. Prepare the adjusting journal entry for 2001 and 2002, assuming the company uses the periodic system.

    14. 14 Solution to Question 1: Part (a) 2001: to find GAS: BI + P(n) = GAS 40 + 150 + 6 - 3 - 2 = GAS = 191 Part (b) 2001 to find EI: EI2001 = BI 2002 = 55 Part (c) 2001 to find COGS: BI + P(n) - EI = COGS or GAS - EI = COGS 191 - 55 = COGS = 136

    15. 15 Solution to Question 1: Part (d) 2002: to find GAS: BI + P(n) = GAS 55 + 160 + 7 - 5 - 0 = GAS = 217 Part (e) 2002: to find COGS: BI + P(n) - EI = COGS or GAS - EI = COGS 217 - 68 = COGS = 149

    16. 16 Solution to Question 2: 2001 AJE at end of year to transfer balances in BI and Purchase components to EI + COGS (in thousands): Inventory (ending) 55 COGS 136 Purchase discounts 3 Purchase returns & allow. 2 Freight-in 6 Inventory (beginning) 40 Purchases 150

    17. 17 Solution to Question 2: 2002 AJE at end of year to transfer balances in BI and Purchase components to EI + COGS (in thousands): Inventory (ending) 68 COGS 149 Purchase discounts 5 Purchase returns & allow. 0 Freight-in 7 Inventory (beginning) 55 Purchases 160 Now work Ex. 5-19.

    18. 18 3. Cost Flow Assumptions Given: BI + P (net) = EI + COGS How to assign costs of inflows [BI + P(net)] to EI and COGS? Methods: Specific identification Average for 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 (Note that we will apply only to periodic systems this semester.)

    19. 19 Class Problem - Cost Flows 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 1/12 30 units 1/24 25 units Ending inventory? BI + P - EI = Units Sold 20 + 70 - EI = 55 so EI =

    20. 20 Costs Flows- Periodic System Cost of goods sold can be calculated at each sale (perpetual system), or at the end of the period (periodic system). The periodic system evaluates the cost layers once, at the end of the period, for all sales during the period. In this example, the total sales of 55 units will be costed out at the end of the period, using the three cost layers for the period: Begin Inventory 20 @ $ 9.00 $180 Purchase 1/10 40 @ 10.00 400 Purchase 1/22 30 @ 11.00 330

    21. 21 FIFO (LISH)- Periodic FIFO for COGS (top down) 55 units 20 @ $9 = $180 35 @ $10 = $350 Total = $530 LISH for EI (bottom up) 35 units 30 @ $11 = $330 5 @ $10 = $ 50 Total $380

    22. 22 LIFO (FISH) - Periodic LIFO for COGS (bottom up) 55 units 30 @ $11 = $330 25 @ $10 = $250 Total = $580 FISH for EI (top down) 35 units 20 @ $ 9 = $180 15 @ $10 = $150 Total = $330

    23. 23 Average - Periodic First calculate average: Goods available cost = $910 Goods available units = 90 units Avg. = $10.11 per unit Now COGS: 55 units x $10.11 per unit = $ 556 Now EI: 35 units x $10.11 per unit = $354

    24. 24 Comparison of FIFO, LIFO, and Average In times of rising prices: highest COGS: lowest COGS highest EI lowest EI highest Net Income lowest Net Income Now work Ex. 5-29.

    25. 25 Additional LIFO issues: LIFO and taxes Why use LIFO for taxes? Why use LIFO for financial statements? LIFO and market valuation Should market value a company higher or lower if they use LIFO? LIFO liquidation What happens to net income with liquidation of an old LIFO layer? LIFO reserve what information is contained in this disclosure?

    26. 26 4. Ending Inventory:Applying the Lower-of-Cost-or-Market Rule 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 Sunbeam (in 1996) wrote inventories down to zero, then (in 1997) sold the inventory for about half the original value; all of the revenue in 1997 was income because COGS = 0!

    27. 27 5. Inventory Estimation (omit Retail Method) Gross Profit (gross margin) Method Used to estimate cost of EI and COGS for interim financial reporting (so no physical count is required). for lost or damaged inventory (where no physical count is possible). Can use available information from the general ledger (Sales, BI, Purchases). Based on history of gross margin to sales and the formula: Sales - COGS = GM If GM is 40% of sales then COGS = 60% of sales. Still use BI + P(net) - EI = COGS

    28. 28 Class Problem, Inventory Estimation Given the following information from the general ledger: Sales, January-March $600,000 Inventory, January 1 50,000 Purchases, January-March 450,000 If the gross margin has historically been 30 percent of sales, calculate the estimated ending inventory at March 31.

    29. 29 Solution First, estimate COGS: If GM% = 30%, then COGS = 70% So Sales x 70% = COGS Then, estimate EI: BI + P (net) - EI = COGS Now work Ex. 5-30 and 5-42.

    30. 30 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.

    31. 31 Class Problem: Assume that, at the end of 2001, Xeron Corporation neglected to include $1,000 of goods in transit to the company when it performed the annual inventory count. This error went undetected through 2002. What effect would this error have on the financial statements for 2001 and 2002? To analyze, use the inventory formula and the balance sheet formula.

    32. 32 Class Problem: BI + P - EI = COGS | NI | A = L + SE (EI) (RE) 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.

    33. 33 Class Problem: Analysis (ignore the amount, it is the same throughout the analysis): BI + P - EI = COGS | NI | A = L + SE

    34. Ex. 5-24 Periodic System (assume BI = 3 dozen @ $2 per dozen) Purchase of 15 dozen @ $2: Purchases 30 Cash 30 Sale of 14 dozen @ $3: Cash 42 Sales 42 December 31 AJE to transfer BI and Purchases to EI and COGS. Since EI = $2 x 3 dozen (physical count) = $6, COGS must be: BI + P - EI = COGS $6 + $30 - $6 = $30 AJE: COGS 30 EI 6 Purchases 30 BI 6

    35. Ex. 5-19 First, you may need the following additional formulas: (1)Sales - COGS = Gross Margin (or Gross Profit) S - COGS = GP (note that net sales = S - SD - SR - SA = Sales - Sales Disc. - Sales Returns - Sales Allow.) (2) S- COGS - Operating Expenses = NI S - COGS - Op.Ex. = NI

    36. Ex. 5-19 To find Sales, you first need to find COGS: BI + P(net) - EI = COGS 10,350 + 50,200 - 9,350 = COGS 51,200 = COGS Now: S - COGS - Op.Ex. = NI S - 51,200 - 9,300 - 1,500 - 700 = 12,000 S = 74,700

    37. Ex. 5-29 (a) Highest COGS: LIFO (b) Highest NI: FIFO (c) Since first year, no difference. BI = 0 and Purchases = same. (d) Decreasing prices reverse the relationship, so part (a) is FIFO and part (b) is LIFO.

    38. Ex. 5-30 First, estimate COGS: If GM% = 20%, then COGS = 80% So Sales x 80% = COGS 100,000 x .8 = COGS = 80,000 Then, estimate EI: BI + P (net) - EI = COGS 20,000 + 90,000 - EI = 80,000 30,000 = EI

    39. Ex. 5-42 First, estimate COGS: If GM% = 34%, then COGS = 66% So Sales (net) x 66% = COGS (50,000 - 6,000) x .66 = COGS = 29,040 Then, estimate EI: BI + P (net) - EI = COGS 32,700 + 24,000 + 575 - 900 - 200 - EI = 29,040 27,135 = EI

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