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PRINCIPLES OF FINANCIAL ACCOUNTING . CHAPTER 6. INVENTORY SYSTEMS. Periodic Inventory System No attempt is made to account for the cost of the merchandise at the time of sale. Cost of goods sold is computed only at period end. Perpetual Inventory System
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PRINCIPLES OF FINANCIAL ACCOUNTING CHAPTER 6
INVENTORY SYSTEMS • Periodic Inventory System • No attempt is made to account for the cost of the merchandise at the time of sale. • Cost of goods sold is computed only at period end. • Perpetual Inventory System • Cost of goods sold is accounted for every time a sale is recorded.
Periodic Inventory • Entry to record the purchase of an item that cost $500 on account • + Purchases (dr) 500 • + Accounts Payable (cr) 500 • Entry to record the sale of that item for $800. • +Accounts Receivable (dr) 800 • +Sales (cr) 800 • Note – no entry is made for the cost of goods sold at this time.
Periodic Inventory (cont) • To calculate the cost of goods sold for the period a physical inventory must be taken. • Calculation: • Beginning Merchandise Inventory • Plus Net Purchases • Plus Freight In • Minus Ending Merchandise Inventory • Refer to example on page 253
Perpetual Inventory • Entry to record the purchase of a item for $500 on account: • Merchandise Inventory (dr) 500 • Accounts Payable (cr) 500 • Entries to record the sale of the item for $800 • Accounts Receivable (dr) 800 • Sales (cr) 800 • Cost of goods sold (dr) 500 • Merchandise Inventory (cr) 500
Cost Flow Assumptions(Periodic) • FIFO (refer to example on page 256) • In times of steady price increases: • Net income will be higher than the other methods • Asset valuation on the balance sheet will be higher • LIFO (refer to example on page 257) • In times of steady price increases: • Net income will be lower than the other methods • Asset valuation on the balance sheet will be lower.
Cost Flow Assumptions (Cont)(Periodic) • Average cost (also called weighted average) • Refer to example on page 259 • In times of steady rising or falling prices • Net income will fall between LIFO and FIFO • Asset valuation on the balance sheet will fall between LIFO and FIFO
Advantage of LIFO • Lower reported earnings means lower taxable income reported, hence lower taxes (temporarily). • Closer matching of current cost with current revenues.
Disadvantages of LIFO • Lower reported earnings – shareholder’s may be dissatisfied with management. • Lower asset valuation causes a lower current ratio and working capital. • LIFO layer erosion could cause earnings catch up at a bad time or can permit manipulation of income.
LOWER OF COST OR MARKET • Departs from the Cost Principle. • The conservatism concept dictates that “when in doubt, avoid overstating assets and income.” • Therefore, if inventory has lost value below cost, then you must write down the inventory to the price you believe you can sell the item.
Inventory Ratios • Inventory Turnover Ratio: • Cost of Goods sold/Average inventory • Days in inventory • 365/Inventory turnover ratio
Appendix 6A • Perpetual cost flow • FIFO the same whether using perpetual or periodic • LIFO • Must analyze the date of each sale and purchase • Refer example on page 273 • Average cost (also called moving average) • Must recompute the average cost per item every time you have a purchase. • Refer to example on page 273