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Intermediate Accounting November 22 nd , 2010

Intermediate Accounting November 22 nd , 2010. General Course Questions Return Discussion Question #4 Revenue Recognition Turn in Columbia Sportswear Annual Report Projects Discuss Final Group Project Chapter 8 Inventory (using assigned homework) A . When is it Inventory (Ex 1, 3, 5)

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Intermediate Accounting November 22 nd , 2010

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  1. Intermediate AccountingNovember 22nd, 2010 • General Course Questions • Return Discussion Question #4 Revenue Recognition • Turn in Columbia Sportswear Annual Report Projects • Discuss Final Group Project • Chapter 8 Inventory (using assigned homework) A. When is it Inventory (Ex 1, 3, 5) B. Inventory Errors (BE 4 and exercise 5) C. Inventory Costing Methods (Specific Identification, FIFO, LIFO, Weighted/Moving Average) ?12,13,16. BE 5,6,7, P 6 D. Other Inventory Topics (? 3 , 5, 10) E. Dollar Value LIFO, LIFO effect, LIFO reserve (Ex 21)

  2. What is Included in Inventory? A company should record purchases when it obtains legal title to the goods. Ex 1, 3 and 5

  3. What is Included in Inventory? Report inventory units at the lower of cost or market (conservatism). What is included in cost for: - Retailer: - Manufacturing Company:

  4. What is Included in Inventory? Report inventory units at the lower of cost or market (conservatism). What is included in cost for: - Merchandiser: items held for sale (Finished Goods) - Manufacturing Company: items held for sale (Finished Goods) goods to be used in production (Raw Materials) goods in production (Work in Process)

  5. Inventory – Cost FlowMerchandiser vs. Manufacturing Co.

  6. Costs Included in Inventory? • Product Costs - costs directly connected with bringing the goods to the buyer’s place of business and converting such goods to a salable condition. • Period Costs – generally selling, general, and administrative expenses. • Purchase Discounts – Gross vs. Net Method (? 10) • Product Financing (Question 5)

  7. Purchase Discounts: Gross or Net Illustration 8-11 ** * * $4,000 x 2% = $80 Solution on notes page ** $10,000 x 98% = $9,800 Question 10

  8. Purchase Discounts: Gross or Net Illustration 8-11 ** * $4,000 x 2% = $80 Solution on notes page ** $10,000 x 98% = $9,800

  9. Inventory – Cost FlowPerpetual vs. Periodic System

  10. Purchases are debited to Inventory account Freight-in, Purchases Returns & Allowances and Purchase Discounts are recorded in the Inventory account. Debit COGS and credit Inventory account for each sale. Purchases are debited to Purchases account. Freight-in, Purch. R & A and Purch. Disc. are recorded in their respective accounts. COGS is computed only periodically: Cost of Goods Available – Ending Inventory = Cost of Goods Sold Perpetual vs. Periodic System Perpetual Method Periodic Method The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold. Ending Inventory is determined only by physical count at the end of the period.

  11. Inventory System - Perpetual Purchase of Inventory: Dr. Inventory 1,000 Cr. A/P, Cash, etc. 1,000 Purchase Returns, Purchases Discounts Dr. A/P 100 Cr. Inventory 100 Transportation In Dr. Inventory 100 Cr. A/P, Cash, etc. 100 Sale of Inventory: Dr. Cost of Goods Sold 1,000 Cr. Inventory 1,000 Dr. Cash, A/R, etc. 1,500 Cr. Sales Revenue 1,500 At Year-End: no j/e required, unless errors are found in inventory count (physical inventory = perpetual inventory, than adjust to physical

  12. Inventory System - Periodic Purchase of Inventory: Dr. Purchases 1,000 Cr. A/P, Cash, etc. 1,000 Purchase Returns, Purchases Discounts Dr. A/P 100 Cr. Purchases Returns or Purchases Discounts 100 Transportation In Dr. Transportation In 100 Cr. A/P, Cash, etc. 100 Sale of Inventory: Dr. Cash, A/R, etc. 1,500 Cr. Sales Revenue 1,500 At Year-End: Dr. Ending Inventory (determined by count) 38,000 Dr. Cost of Sales (plug) 283,000 Dr. Purchase Returns and Purchase Discounts (close balance) Cr. Purchases (also close Transportation In) 286,000 Cr. Opening Inventory (carried forward from prior year) 35,000

  13. Inventory Control – Physical Count All companiesneed periodic verification of the inventory records by actual count, weight, or measurement, with the counts compared with the detailed inventory records. Companies should take the physical inventory near the end of their fiscal year, to properly report inventory quantities in their annual accounting reports. Question 3

  14. Effect of Inventory Errors Error in Effect on Effect on Ending Income Balance sheet Inventory Items Items Under- COGS (over) Inventory (under) stated Net income (under) Retained Earn (under) Over- COGS (under) Inventory (over) stated Net income (over) Retained Earn (over)

  15. Effect of Inventory Errors (U/S Ending)

  16. Cost Flow Assumptions Cost flow assumptions DO NOT Need to be consistent with physical flow of goods. The objective is to most clearly reflect periodic income. The cost flow assumptions are: • Specific identification • Average cost • First-in, first-out (FIFO) and • Last-in, first-out (LIFO) (prohibited under IFRS)

  17. Cost Flow Assumptions: Example Spaworld reports the following transactions for 2010 (assume no opening inventory): Date Purchases Cost/Unit Purchase Cost May 12 100 units @ $10/unit = $1,000 Aug 14 200 units @ $11/unit = 2,200 Sep 18 120 units @ $15/unit = 1,800 420 units $5,000 On December 31, the company had 20 units on hand and uses the periodic inventory system. What is the cost of goods sold? What is the cost of ending inventory?

  18. Average Cost Method Date Purchases Cost May 12 100 units $1,000 Aug 14 200 units $2,200 Sep 18 120 units$1,800 420 units $5,000 Dec. 31 Ending inventory 20 units • Steps: • Calculate per unit average cost: use four places to right of decimal • Apply this per unit average cost to units sold to get COGS: round to nearest dollar • Apply the per unit average cost to units remaining in inventory to determine Ending inventory: round to nearest dollar

  19. Average Cost Method Date Purchases Cost May 12 100 units $1,000 Aug 14 200 units $2,200 Sep 18 120 units$1,800 420 units $5,000 Dec. 31 Ending inventory 20 units • Calculate per unit average cost: use four places to right of decimal • Cost per unit: $5000/420 = 11.9047 per unit • Apply this per unit average cost to units sold to get COGS: round to nearest dollar • 11.9047 x 400 = $4,762 COGS • Apply the per unit average cost to units remaining in inventory to determine Ending inventory: round to nearest dollar • 11.9047 x 20 = $238 ending inventory

  20. Year End Entry – Average Cost Journal Entry (Periodic Inventory): 20

  21. Year End Entry – Average Cost Journal Entry: Dr. Ending Inventory 238 Dr. Cost of Sales 4,762 Cr. Purchases 5,000 Cr. Opening Inventory 0 21

  22. GAFS $5,000 COGS EI First-In, First-Out (FIFO) Method Given data: Date Purchases Cost May 12 100 units @ $10 $1,000 Aug 14 200 units @ $11 $2,200 Sep 18 120 units @ $15 $1,800 420 $5,000 Ending Inventory 20 units Ending Inventory (FIFO) Cost of goods sold (FIFO) “Count” from one direction and “plug” the other

  23. GAFS $4,700 $5,000 COGS $300 EI First-In, First-Out (FIFO) Method Given data: Date Purchases Cost May 12 100 units @ $10 $1,000 Aug 14 200 units @ $11 $2,200 Sep 18 120 units @ $15 $1,800 420 $5,000 Ending Inventory 20 units Ending Inventory (FIFO) 20 x $15 = $300 Cost of goods sold (FIFO) 100 units @ $10 $1,000 200 units @ $11 $2,200 100 units @ $15 $1,500 “Count” from one direction and “plug” the other

  24. GAFS $5,000 COGS EI Last-In, First-Out (LIFO) Method Given data: Date Purchases Cost May 12 100 units @ $10 $1,000 Aug 14 200 units @ $11 $2,200 Sep 18 120 units @ $15 $1,800 420 $5,000 Ending Inventory 20 units Ending Inventory (FIFO) Cost of goods sold (FIFO) “Count” from one direction and “plug” the other

  25. GAFS $5,000 COGS EI Last-In, First-Out (LIFO) Method Given data: Date Purchases Cost May 12 100 units @ $10 $1,000 Aug 14 200 units @ $11 $2,200 Sep 18 120 units @ $15 $1,800 420 $5,000 Ending Inventory 20 units Ending Inventory (FIFO) 20 x $10 = $200 Cost of goods sold (FIFO) 80 units @ $10 $ 800 200 units @ $11 $2,200 120 units @ $15 $1,800 “Count” from one direction and “plug” the other $4,800 $200

  26. Cost Flow Assumptions: Notes • The ending inventory in units is the same in all three methods: the cost is different • The cost of goods available is the same for all methods • The cost of goods sold and the cost of ending inventory are different • In periods of rising prices, LIFO would result in the smallest reported net income.

  27. Periodic vs. Perpetual • FIFO: COGS and EI numbers are exactly the same under either periodic or perpetual systems • BUT – LIFO, Weighted Average will give you different numbers • Under perpetual LIFO, with each sale, you cut into only existing layers (so you must stop and calculate the cost of goods sold at each sale) • Under perpetual Weighted Average (more accurately, Moving Average), you stop and calculate a new average cost for every sale

  28. Same Example - Perpetual Basis

  29. Same Example - Perpetual Basis

  30. Advantages of LIFO Method • LIFO matches more recent costs with current revenues. • With increasing prices: • LIFO yields the lowest taxable income (assuming inventory does not decrease). • Under LIFO, there is less need to write down inventory down to market

  31. Special Issues Related to LIFO: Setting up a LIFO Reserve • LIFO Reserve (Allowance) account is used, when: • LIFO is used for tax & external financial reporting purposes • FIFO, average cost, or standard cost system for internal reporting purposes. • Reasons: • Pricing decisions • Record keeping easier • Profit-sharing or bonus arrangements • LIFO troublesome for interim periods • SEC reporting requirements – disclose the difference between LIFO and current cost of inventory reported on the Balance Sheet which is the LIFO RESERVE

  32. Dr. Cost of goods sold $30,000 Cr. Allowance to Reduce Inventory to LIFO $30,000 LIFO Reserve: Example Jeppo Inc reports the following balances: Inventory (FIFO basis) on Dec 31, 2004: $50,000 Inventory (LIFO basis) on Dec 31, 2004: $20,000 Adjust the cost of ending inventory to the LIFO basis Balance Sheet (Assets): Inventory (FIFO) $50,000 less: Allowance to Reduce Inventory ($30,000) Inventory (LIFO) basis $20,000

  33. LIFO Layers • Under the LIFO approach, a business may build up layers of inventory from prior periods. A layer liquidation occurs, when: • Earlier costs are matched against current sales due to a reduction of quantities of inventory during a period (results in “costing” items at older prices) • Such matching results in distorted income.

  34. Disadvantages of LIFO Method • LIFO yields the lowest net income and therefore reduced earnings (with increasing prices) • Under LIFO, the ending inventory is understated relative to current costs • LIFO liquidation (reduction of quantities of inventory during a period – results in “costing” items at older prices): • May result in income that is detrimental from a tax view • May cause poor buying habits (because of the layer liquidation problem) • LIFO Conformity Rule: if you use LIFO for tax purposes, you must use it for financial reporting also.

  35. Dollar Value LIFO • Dollar value LIFO applies LIFO procedures to pools of similar goods based on dollars rather than units • Used for external purposes (i.e., financial statements and taxes) • Advantages over regular LIFO: • Reduces record keeping (maximum of one layer per year). • Mitigates likelihood of eroding old layers (some decreases in goods in the pool are offset by increases in other goods in the pool). • Price index – a measure of the change in prices from a base year (the year dollar value LIFO is adopted in this case) to the current year • Internal = Ending inventory quantities X current year costs Ending inventory quantities X base year costs • External – calculated by the Bureau of Labor Statistics

  36. Dollar Value LIFO Calculation Steps Compare ending inventory at base year prices to beginning of year inventory, also at base year prices – if there is an increase – we add a new LIFO layer at Current Year prices: • Calculate Ending Inventory at current year costs (FIFO) • Calculate or locate the current year price index. • Convert the ending inventory at current cost to inventory at base-year cost by dividing the current year cost by the current price index (1 / 2 ) • Split the ending inventory at current cost into layers depending on the year the items were acquired by comparing current inventory at base prices to prior inventory at base prices. If there is an increase add an additional layer. If there is a decrease deduct from the most recently purchased layer. Once a layer is eliminated (peeled off), it can not be rebuilt. • Multiply each layer by the appropriate price index (price index of the year of acquisition) to obtain the quantity in ending inventory at dollar-value LIFO cost.

  37. Dollar Value LIFO: Example Given: Base layer (Dec 31, 2009): $20,000 Inventory (current prices) Dec 31, 2010: $26,400 Prices increased 20% during 2010. Determine dollar value LIFO at Dec 31,2010

  38. At base $: $22,000 $26,400 / 1.20 At EOY prices: $26,400 Dollar value LIFO Inventory Net increase at base $: Restate at current $: $2,400 (layer added) $20,000 plus $2,400 = $22,400 $22,000 less $20,000 $2,000 * 1.20 Dollar Value LIFO: Example Price increase, 20% Dec 31, 2009 Dec 31, 2010

  39. Dollar Value LIFO: Notes When the ending inventory (at base year prices) is less than the beginning inventory (at base year prices) (i.e. in the example above if EI at base year prices was < $20,000): • the decrease must be subtracted from the most recently added layer. • Once a layer is eliminated (peeled off), it cannot be rebuilt.

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