Inventory

1. 8 • C H A P T E R Inventory

2. Learning Objective 1 • Identify what items and costs should be included in inventory and cost of goods sold.

3. Define Inventory and COGS. What are some of their characteristics?

4. Describe the Time Line of Business.

5. What is Inventory? • Defined according to type and nature of the company. Merchandising: • Manufacturing:

6. Define Each Manufacturing Inventory • Raw materials • Work in process • Finished goods

7. What Costs are Included in Inventory?

8. Who Owns the Inventory? When goods are in transit? Q: Who owns inventory on a truck or railroad car? When goods are on consignment? Q: Who owns inventory stocked in a warehouse?

9. Ending Inventory & COGS • At period’s end, allocated between inventory is still remaining (an asset), and inventory sold during the period (an expense, Cost of Goods Sold). Cost of goods available for sale Beginning inventory Net purchases = + The question is where is the inventory that could have been sold this period? Only two choices:

10. Learning Objective 2 • Account for inventory purchases and sales using both a perpetual and a periodic inventory system.

11. What are the Two Methods for Accounting for Inventory?

12. Example: Accounting for Inventory Purchases and Sales Harper’s Hats recorded the following transactions for 2006: Beginning inventory 10 hats @ $10 each = $100 March 1 Purchase 15 hats @ $15 each = $225 March 1 Freight in $10 March 1 Purchase return 3 hats @ $15 each = $ 45 May 2 Purchase 10 hats @ $20 each = $200 May 2 Purchase discount 2/10, n/30 June 30 Sales 20 hats (10 @ $10, 10 @ $15) July 3 Sales return 1 hat @ $15 = $ 15 Ending inventory 13 hats

13. Example: 2006 Inventory Purchase Sale Balance ` DateUnitsTotalUnitsTotalUnitsCostTotal Jan. 1 10 $10 $100 Mar. 1 15 $225 10 $10 $100 15 $15 $225 (3) ($45) 12 $15 $180 May 2 10 $200 10 $10 $100 12 $15 $180 10 $20 $200 June 30 10 $100 10 $150 2 $15 $ 30 10 $20 $200 July 3 (1) ($15) 3 $15 $ 45 10 $20 $200

14. Perpetual All purchases are added directly to theinventory account. • Periodic • At end of period, • Inventory balance is updated using inventory count. • Temporary purchases account balance is closed to Inventory tocompute COGS. Perpetual & PeriodicJournal Entries Purchases Transportation costs Purchase returns Purchase discounts Sales Sales returns Closing entries for COGS

15. Example: Journal Entriesfor Purchases Harper purchased 10 hats at $10 each on January 1.Record the entries for both perpetual and periodic systems. PERPETUAL PERIODIC

16. Perpetual All costs are added directly to the inventory balance. Periodic At end of period, temporary freight in account balance is closed to Inventory to compute COGS. Perpetual & PeriodicJournal Entries Purchases Transportation costs Purchase returns Purchase discounts Sales Sales returns Closing entries for COGS

17. Example: Journal Entriesfor Transportation Cost Harper hired a trucking company to deliver its March 1 purchase of 15 hats. The trucking company charged $10.Record the entries for both the perpetual and the periodic systems. PERPETUAL PERIODIC

18. Perpetual Inventoryis decreased. Accounts Payableis decreased by same amount. Periodic If merchandise has been paid for, the supplier will reimburse (debitCash). At end of period, temporarypurchase returnsaccount balance is closed toInventoryto compute COGS. Perpetual & PeriodicJournal Entries Purchases Transportation costs Purchase returns Purchase discounts Sales Sales returns Closing entries for COGS

19. Example: Journal Entriesfor Purchase Returns Of the 15 hats delivered on March 1, three were defective and Harper returned them the same day.Record the entries for both the perpetual and the periodic inventory systems. PERPETUAL PERIODIC

20. Perpetual Subtract the discount amount from the inventory account. Periodic At end of period, temporarypurchase discountsaccount balance is closed toInventoryto compute COGS. Perpetual & PeriodicJournal Entries Purchases Transportation costs Purchase returns Purchase discounts Sales Sales returns Closing entries for COGS

21. Example: Journal Entriesfor Purchase Discounts On May 2, Harper purchased 10 hats at $20 each. The supplier offered terms of 2/10, n/30. Record the entries for both the perpetual and the periodic inventory systems. PERPETUAL PERIODIC

22. Perpetual All adjustments are entered directly in theInventory account. Periodic All adjustments are accumulated in an array of temporary holding accounts: Purchases Freight In Purchase Returns Purchase Discounts The difference in terms of journal entries: Perpetual & PeriodicJournal Entries Purchases Transportation costs Purchase returns Purchase discounts

23. Perpetual Recognize salesand COGSon a transaction-by-transactionbasis. Periodic Only totalsales are known. Perpetual & PeriodicJournal Entries Purchases Transportation costs Purchase returns Purchase discounts Sales Sales returns Closing entries for COGS

24. Example: Journal Entriesfor Sales In June, Harper’s Hats sold 20 hats for $25 each (selling the old ones first).Record the entries for both the perpetual and the periodic systems. PERPETUAL PERIODIC

25. Perpetual Sales for returned items are canceled. Cost of returned inventory is removed fromCOGS and restored to theinventory account. Periodic Salesfor returned items are canceled. No entry is made to adjustCOGS. Perpetual & PeriodicJournal Entries Purchases Transportation costs Purchase returns Purchase discounts Sales Sales returns Closing entries for COGS

26. Example: Journal Entriesfor Sales Returns On July 3, one hat was returned from a late June purchase. Record the entries for both the perpetual and the periodic inventory systems. PERPETUAL PERIODIC

27. Perpetual All journal entries are posted to the ledger. Results in new balances for Inventory and COGS. Numbers are verified by physical count. Periodic Temporary holding accounts are accumulated and added to Inventory. Inventory account balance is reduced by the amount of COGS. Perpetual & PeriodicJournal Entries Purchases Transportation costs Purchase returns Purchase discounts Sales Sales returns Closing entries for COGS

28. Accounting for Inventory Purchases and Sales Harper’s Hats recorded the following transactions for 2006: Beginning inventory 10 hats @ $10 each = $100 March 1 Purchase 15 hats @ $15 each = $225 March 1 Freight in $10 March 1 Purchase return 3 hats @ $15 each = $ 45 May 2 Purchase 10 hats @ $20 each = $200 May 2 Purchase discount 2/10, n/30 June 30 Sales 20 hats (10 @ $10, 10 @ $15) July 3 Sales return 1 hat @ $15 = $ 15 Ending inventory 13 hats

29. Closing Entries for Cost of Goods Sold • Perpetual: the inventory account will have an ending balance of $255. Inventory COGS 6/30 250 7/3 15 Bal. 235 1/1 100 3/1 225 3/1 45 3/1 10 5/2 200 6/30 250 7/3 15 Bal. 255

30. Closing Entries for Cost of Goods Sold • Periodic: the inventory account will be debited by $386, which represents the net purchases for the year. Jul. 31 Inventory. . . . . . . . . . . . . . . . . . . 386 Purchase Returns. . . . . . . . . . . . 45 Purchase Discounts. . . . . . . . . . 4 Freight In. . . . . . . . . . . . . . . . . 10 Purchases. . . . . . . . . . . . . . . . 425

31. Periodic Inventory With a periodic system, a physical count is the only way to get the information necessary to compute COGS: Beginning Inventory, January 1, 2006 + Purchases for the year = Cost of goods available for sale during 2006 – Ending Inventory, December 31, 2006 = Cost of Goods Sold for 2006

32. Learning Objective 3 • Calculate cost of goods sold using the results of an inventory count and understand the impact of errors in ending inventory on reported cost of goods sold.

33. Essential to maintaining reliable inventory accounting records. Physical Count of Inventory Perpetual Physical count either confirms records are accurate or highlights shortages and clerical errors. Periodic The only way to get information necessary to compute COGS: • Quantity count. • Inventory costing (assigning a unit cost to each type of merchandise). • Ending inventory = quantity of each type x its unit cost.

34. COGS Computation • Perpetual The accounting records yield the COGS for the period as well as the amount of inventory that should be found with a physical count. The difference between the records and actual count = inventory lost, stolen, or spoiled. Periodic Company does not know what ending inventory should be. Assumes physical count is the difference between cost of goods available for sale and ending inventory. Cannot tell whether goods were sold, lost, stolen, or spoiled.

35. What is the Income Effect of an Error in Ending Inventory?

36. Understate Beginning Inventory Understate Ending Inventory Sales OK Beginning inventory OK Net purchases OK Goods available OK Ending inventory LOW Cost of goods sold HIGH Gross margin LOW Expenses OK Net incomeLOW Understate Purchases Understate Sales Complete Table of Effects of Inventory Errors

37. Learning Objective 4 • Apply the four inventory cost flow alternatives: specific identification, FIFO, LIFO, and average cost.

38. Inventory Cost Flow Kernel King buys and sells corn and had the following transactions for 2002: June 10 Purchased 10 tons at $6 per ton. July 28 Purchased 10 tons at $9 per ton. October 10 Sold 10 tons at $11 per ton. How much did Kernel King make in 2002? Case #1Case #2Case #3 Sold Sold Sold Old CornNew CornMixed Corn Sales ($11 x 10 tons) COGS (10 tons) Gross margin

39. Specific Identification Cost Flow Specifically identify the cost of each unit sold. The individual cost of each unit is charged against revenue as COGS. To compute COGS and ending inventory, a firm must know each unit sold and its cost.

40. Inventory Cost Flow Methods • LIFO • The newest units are sold and the oldest units remain in inventory. • The cost of the most recent units purchased is transferred to COGS. • Average Cost • An average cost is computed for all inventory available for sale during the period. • COGS is computed by multiplying the number of units sold by the average cost per unit. • FIFO The oldest units are sold and the newest units remain in inventory. The cost of the oldest units purchased is transferred to COGS.

41. CompareInventory Methods • LIFO gives a better reflection of COGS in the income statement. • Therefore, LIFO is a better measure of income. FIFO gives a better measure of inventory on the balance sheet. Therefore, FIFO is a better measure of inventory value.

42. Learning Objective 5 • Use financial ratios to evaluate a company’s inventory level.

43. Why Use JIT Inventory Management?

44. Cost of goods sold Average inventory 365 days Inventory turnover Evaluating Inventory Levels • Inventory Turnover • Measures how many times a company turns over (or replenishes) its inventory. • Average inventory = average of the beginning and ending inventory balances. • Number of Days’ Sales in Inventory

45. Evaluating Inventory Management Buster Boots had cost of goods sold of $60,000 during 2002. The inventory account decreased by $1,000 to $4,000 during the same time.Calculate the inventory turnover ratio and number of days’ sales in inventory. Inventory turnover ratio Number of days’ sales in inventory

46. Expanded MaterialLearning Objective 6 • Analyze the impact of inventory errors on reported cost of goods sold. ? ?

47. What Is the Effect of These Inventory Errors? • If a sale is recorded but the merchandise remains in inventory and is counted in ending inventory, • If a sale is not recorded, but inventory is shipped and not counted in ending inventory,

48. Expanded MaterialLearning Objective 7 • Describe the complications that arise when LIFO or average cost is used with a perpetual inventory system.

49. Using Average Cost or LIFO with a Perpetual System Using average cost or LIFO with perpetual leads to complications. The average cost of units available for sale changes every time a purchase is made. The identification of the “last in” units also changes with every purchase. With periodic, One overall average cost is used for all goods available for sale during the period. The “last in” units are identified at the end of the period.

50. Describe the Similarities of Using FIFO for Perpetual and Periodic Systems.