chapter 6
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Chapter 6. Inventories. Objectives:. Discuss inventory cost flow assumptions. Apply cost flow assumptions to determine the CGS and the value of ending inventory. Explain the lower-of-cost-or-market (LCM) rule for inventory reporting. - PowerPoint PPT PresentationTRANSCRIPT
ACCT 100
Chapter 6
Inventories
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 2
Objectives:1. Discuss inventory cost flow assumptions.
2. Apply cost flow assumptions to determine the CGS and the value of ending inventory.
3. Explain the lower-of-cost-or-market (LCM) rule for inventory reporting.
4. Discuss the financial effects of the inventory cost flow assumptions.
5. Learn the effects of inventory errors on financial statements.
6. Discuss the inventory turnover rate and the gross margin ratio.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 3
Defining Inventory
1. Assets held for resale purpose in a normal course of business.
2. Assets used to produce products for resale purpose.
Merchandising Firms: merchandise
Manufacturing Firms: raw materialsWork-in-processFinished Goods
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 4
How to Account for Inventory Purchases, Sales and Reporting? Applying either the periodic inventory
system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories.
Both inventory systems require a physical count of inventory at the end of a period to determine the units which can be included in the inventory count.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 5
Inventory Systems
A. Perpetual Inventory System.
B. Periodic Inventory System.
Perpetual vs. Periodic Inventory System
Perpetual system Periodic System At purchase Inventory xxx Purchases xxxA/P xxx A/P xxx
At sale: CGS xxx None Inventory xxxA/R xxx A/R xxxSales xxx Sales xxx
Inventories 6
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 7
Perpetual Inventory System
Inventory account is used for the purchase and sale.
The balance of inventory is available at all time.
A physical count is needed at the end of a period.
Any discrepancy of book balance with physical count should be adjusted to a loss or gain account.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 8
Perpetual Inventory System (contd.)
CGS account is used to record the CGS of a sale.
Therefore, the CGS is also known at all time.
CGS is determined by selecting a cost flow assumption.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 9
Cost Flow Assumptions
In order to apply these assumptions, companies must keep a record of the cost of each inventory unit purchased.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 10
Cost Flow Assumptions (contd.)
1.First-In, First Out (FIFO) method.
2.Last-in, First-Out (LIFO) method.
3.Weighted-Average Cost method.
4.Specific Identification method.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 11
Perpetual Inventory SystemExample The following inventory information is
available for March:
Beginning balance of inventory on 3/1: Beginning balance of 100 units at $5
per unit3/5: Purchased 150 units at $63/7: Sold 200 units at $103/14: Purchased 100 units at $73/28: Sold 30 units at $11
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 12
Perpetual Inventory SystemExample (contd.) The following is a perpetual record using
different cost flow assumptions:Balance
Date Pur. Sold FIFO LIFO W-A3/1(Beg. Bal.) 100 $5 100 $5 100 $5
3/5 150 $6 100 $5 100 $5 250 $5.6150 $6 150 $6
3/7 200 $10 50 $6 50 $5 50 $5.63/14 100 $7 50 $6 50 $5 150 $6.53
100 $7 100 $73/28 30 $11 20 $6 50 $5 120 $6.53
100 $7 70 $7
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 13
Perpetual Inventory SystemExample (contd.)
Inventory (WA)
500 1120900 195.9700784.1
Inventory (FIFO)
500 1100900 180700820
Inventory (LIFO)
500 1150900 210700740
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 14
J. E. for Perpetual (FIFO)
3/5 Inventory 900 Cash 900
3/7 Cash 2,000 Sales Rev. 2,000
Cost of Goods Sold 1,100* Inventory 1,100
3/14 Inventory 700 Cash 700
3/28 Cash 330 Sales Rev. 330
Cost of Good Sold 180**Inventory 180
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 15
J. E. for Perpetual (FIFO) (contd.)
* Cost of goods sold of 200 units on 3/7 is based on a FIFO assumption:
Balance before the sale of 200 units on 3/7
$100 x 5 + 100 x 6 = $1100
Notes:
100 $5150 $6
** Balance before the sale 50 $6of 30 units on 3/28 100 $7
30 x $6 = $180
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 16
If the CGS Is Based on LIFO:
3/7 Cost of good sold* 1,150Inventory
1,150* Balance before the sale: 100 $5
150 $6 $150 x $6 + 50 x $5 = $1,150
3/28 Cost of goods sold** 210Inventory
210** Balance before the sale: 50 $5
100 $7 30 x $7 = $210
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 17
If the CGS Is Based on Weighted-Average Method:3/7 Cost of good sold* 1,120
Inventory1,120
* 200 x $5.6 = $1,120
3/28 Cost of goods sold** 195.90Inventory
195.90
** 30 x 6.53 = $195.90
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 18
CGS (FIFO)1,100 1801,280
The T Accounts of CGS at the End of Period (3/31):
CGS (LIFO)1,150 2001,360
CGS (WA)1,120 195.901,315.90
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 19
End of Period Adjustments
1. Adjustment for lost units
2. Adjustments for LCM (Lower-of-Cost-or-market) valuation
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 20
Adjustment for Lost Units Assuming ending units = 110 units on 3/31.
The lost units on 3/31 are 10.
Cost of 10 lost units (under FIFO)
=> $6 10 = $60
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 21
Adjustment for Lost Units (contd.)
Adjusting Ending:
3/31 Loss from Declining in inventory units
60
Inventory
60Inventory (FIFO)
820 60
760
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 22
Adjustments for LCM Valuation
LCM rule requires that inventory be reported in the statements at the lower of cost or market value (an application of conservatism)
Inventory (FIFO)B.B 500 1,100 900 180 700 820 60 -- 3/31 760
Cost (on 3/31, FIFO) = $760
Assuming market price = $600
LCM = $600.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 23
Allowance
0 -- 3/1
160
160 -- 3/31
2. Adjustments for LCM Valuation (contd.) Adjusting entry ==>Given Allowance for
declining in market value of inventory with a beginning balance of zero.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 24
B/S (3/31)Inventory 760 Allowance (160)Inv. At LCM 600
24
3/31 Loss Due to Market Decline of Inventory
160Allowance to reduceInventory to market
160I/S (for the period ended 3/31) Loss(from declining in units) $ 60Loss (or CGS) $160CGS
$1,280
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 25
Periodic Inventory System Using the example on page 11, the following
entries will be recorded under the periodic inventory system:
3/5 Purchases 900Cash 900
3/7 Cash 2,000Sales Revenue 2,000
3/14 Purchases 700Cash 700
3/28 Cash 330Sales Revenue 330
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 26
Periodic Inventory System (contd.)
At the end of an accounting period, the following steps must be followed to determine the cost of ending inventory and for the cost of goods sold:
1. Do an inventory count.
2. Apply a cost flow assumption to determine the cost of ending inventory.
3. Determine the cost of goods sold using: CGS = Beg. Inv. + Net Pur. - Ending Inv.** No adjusting entries are required for lost units.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 27
Periodic Inventory SystemExample Using the example on Page 11 and assuming
the physical count of inventory indicates 105 units on hand on 3/31, the cost of ending inventory (105 units) would be (given a FIFO cost flow assumption): $7 100 + $6 5 = $730
Inventory Data:Units Cost
3/1 (B.B) 100 $5 3/ 5 Pur 150 $6 3/ 7 Pur 100 $7
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 28
Periodic Inventory SystemExample (contd.) The cost of goods sold (based on a FIFO cost
flow) equals:
Beg. Inv. + Pur - Ending Inv.= 500 + 1,600 - 730= 1,370
If a LIFO cost assumption is used, the cost of ending inventory equals:
The CGS = 500 + 1,600 - 530* = 1,570
* Cost of Ending Inv. = $5 x 100 + 6 x 5 = 530
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 29
Periodic Inventory SystemExample (contd.) A weighted-average cost flow assumption:
WAUC = 100 x 5 + 150 x 6 + 100 x 7 350
= 6
Cost of ending inventory: 6 x 105 = 630
Cost of goods sold = 500 +1600 - 630 = 1470
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 30
Periodic Inventory SystemEnd of Period Adjustments1. No adjustment is needed for lost units
(because the cost of lost units is embedded in the CGS).
2. Adjustment for the LCM valuation assuming FIFO,
cost = $730
Assuming the market price = $600
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 31
Periodic Inventory SystemEnd of Period Adjustments (contd.) Adjusting entry:
Loss Due to Market Value Decline of Inventory (or CGS)
130
Allowance to Reduce Inventory to Market Value
130
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 32
B/S (3/31)Inventory 730 Allowance (130)Inv. At LCM 600
I/S (for the period ended 3/31) Loss Due to Market Value Decline of Inv. (or CGS)
130Cost of Good Sold:
Beginning Inventory $ 500 Net Purchase 1,600
Total Goods Available for Sale $2,100 Ending Inventory (730)
1,370
32
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 33
Periodic Inventory System
End of period entries to update inventory and related cost of goods sold accounts based on a FIFO cost-flow assumption:
a. Transfer the cost of beginning inventory to the CGS account:
CGS 500Inventory (Beg. Balance) 500
b. Transfer the cost of purchase to CGS:
CGS 1,600Purchase 1,600
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 34
Periodic Inventory System (contd.)
c. Record the cost of ending inventory based on a physical count of 105 units and a FIFO cost-flow assumption:
Inventory (ending balance) 730CGS730
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 35
Periodic Inventory System (contd.)
T- accounts: Inventory
B.B 500 a. 500c. 730
Purchase3/5 900 b.
1,6003/14 700
CGSa. 500 c. 730b. 1,600
1,370
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 36
LIFO(matchingcurrent costwith revenue ifthe inventory isnot depleted toearly layers)
Income
Low
Tax
Low
B/S
Unfair
I/S
Fair
FIFO High High Fair Unfair
Comparison of FIFO vs. LIFO
During an Inflation Period
Inventories: Measurement 37
Survey: (Source: Accounting Trends & Techniques and KWW Textbook) a, b,c
Yearl Firms LIF1O FIFO W-A Others1984 1061
100%408 38%
366 30%
225 22%
52 5%
1988 1038 100%
379 36.5%
396 38%
213 20.5%
50 5%
1991 1032 100%
361 35%
421 41%
200 19%
50
5%2000 887
100%
283 32%
386 44%
180 20%
38
4%
2006 802
100%
228
28%
385
48%
159
20%
30
4%2010 666d
100%
176
26.4%
325
49%
147
22%
18
2.6%
Inventories: Measurement 38
Survey: (Source: Accounting Trends & Techniques ) (contd.)a. Sample firms are 600 firms. Most companies
adopt more than one inventory method.b. Due to low inflation, the number of firms
adopting LIFO has declined since mid-1980s.c. IAS No. 2 does not permit LIFO, and
therefore, multinational companies use LIFO for all or most of their domestic inventories while use FIFO or average cost for their foreign subsidiaries.
d. The number of disclosures.
Inventories: Measurement 39
Items to Be Included in Inventory Count Any goods with the legal title transferred to the buyer should be included in the inventory count of the buyer (including goods in transit with a FOB shipping point term).
Consigned Goods: Legal title remained with the consignor (i.e., the manufacturers).
Inventory shipped for an “on approval” sale. Note: FOB shipping point – the ownership transfers to the buyer at the shipping point. FOB destination – the ownership transfers to the buyer at the destination.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 40
Reason of Switching to LIFO
1. Tax savings.
2. Income Manipulation.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 41
Reason of Switching to LIFO
Income Manipulation When LIFO cost flows assumption is
used and price is rising, income maybe subject to management manipulation as follows:
a. Liquidation LIFO (to reduce CGS and therefore increase income)
b. To decrease income by increasing CGS
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 42
Income Manipulation
a. Liquidation LIFO When the inventory is depleted to the
early layers, the CGS would be low and the income would be high.
Strategy: to delay the purchase of inventory so that the cost of inventory would be depleted to the cost of early layers.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 43
Income Manipulationb. To Decrease Income
by Increasing CGS Strategy: order more inventory at the
end of period so that CGS would be high (under LIFO) and income would be low.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 44
Advantages of FIFO
a. Less likely to be subject to management manipulation;
b. Produce higher income during an inflation period;
c. Inventory cost reported on the B/S is close to the replacement cost.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 45
Disadvantage of FIFO
a. Bad match of sales revenue with CGS; match current sales revenue with old costs;
b. Producing higher income during an inflation period results in paying more income tax.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 46
Advantages of LIFO
a. Good match of sales revenue with CGS; match the most recent inventory cost against sales revenue;
b. Produce lower income during an inflation period; result in tax savings (defer income tax).
(This is only true when the inventory level is not decreasing. If inventory is decreasing, there would be liquidation profits).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 47
Disadvantages of LIFO
a. Inventory cost presented on the B/S is not fair.
b. Subject to management.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 48
IRS
1. Does not allow firms to use LCM if firms are using LIFO.
2. If firms are using LIFO for income tax filing purposes, firms must also use LIFO for financial reporting purposes (referred to as LIFO conformity rule).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 49
IRS (contd.)
3. LIFO is not acceptable by the IRS until late 1930’s.
Switch from FIFO to LIFO, firms do not need the approval of the IRS. However, switch from LIFO to FIFO, firms need to receive the approval of the IRS and need to pay back taxes (the cumulative effect).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 50
International Perspective
Many countries do not permit the use of LIFO.
For example, Australia, Singapore, and United Kingdom do not permit the use of LIFO.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 51
Accounting Principles and Theory Related to Inventories
1. Consistency Principle
2. Disclosure Principle
3. Materiality
4. Conservatism
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 52
The Impact of Inventory Errors on the Financial Statements
Year 1:Income CGS Gross Margin = Beg Inv + Net Pur - End Invunder over under under *over under over over ** Year 2:over under over underunder over under over
* either understating the units or understating the value** either overstating the units or the value*** Gross Margin = Sales Revenue - CGS
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 53
Ethical Issues
To artificially inflate the net income, a company may
1. Overstating the ending inventory to decrease the cost of goods sold.
2. Ship the goods to distributors at the end of a period (i.e., 12/20/x1). The goods are later returned but in the next period (I.e., 1/3/x2) (Parking transactions).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 54
Estimating Inventory: Gross Margin Method Reasons: For some companies, inventory
information is needed between accountingperiods. Companies cannot afford to
do physical inventory count every quarter.
Thus, a gross margin method (gross profit method) can be used to estimate value of ending inventory for interim reports.
No physical count of inventory is needed for this method. The value of inventory is based on estimation.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 55
Estimating Inventory: Gross Margin Method (contd.) This method is not acceptable for annual
financial reporting purposes.
This method is acceptable for interim reporting
The insurance companies may use this method to estimate the loss of inventory in case of fire or flood.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 56
Gross Profit Method (Gross margin Method)Data Required
Beginning Inventory (at cost)
Purchase (net) (at Cost)
Sales Price
Gross margin ratio (Gross margin/sales price)
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 57
Example
Beginning Inv. = $60,000
Purchase (net) = $200,000
Sales = $280,000
Gross margin ratio* = 30%
* gross marking ratio is obtained from past years’ experience (assuming the ratio is stable over years)
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 58
Using Gross Profit Method to Estimate the Cost of Ending Inventory
Selling Price Cost Beg, Inv. $60,000Purchase (net) 200,000Goods Avai. For Sale 260,000Sales 280,000 Less: gross margin* (84,000)Sales (at cost) 196,000 **Estimated Inv. (at cost) 64,000
* gross margin = 280,000 x 30%** also equals 280,000 x (1-30%) = 196,000
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 59
Comments for Gross Profit Method
If the relationship between the gross profit and shelling price has been changed, the ratio should be adjusted accordingly.
A separate gross profit ratio should be applied to different type of inventory with different relationship between the gross profit and selling price.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 60
Analyzing Financial Statements
1. Inventory turnover rate
2. Gross margin percentage
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 61
1. Inventory Turnover Rate
Inventory turnover rate
Cost of Goods Sold= ___________________________
Average Inventory
This ratio measures how fast inventory is sold.
Average Inventory = (Beg. Inv. + End Inv.)/2
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 62
2. Gross Margin Percentage
Gross margin percentage
Gross Margin= _______________________________
Net Sales Revenue
This percentage is an indication of profitability. A 40% gross margin means that each dollar of sales generate 40 cents of gross profit.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 63
2. Gross Margin Percentage (contd.)
This percentage varies among industries. In general, the average gross profit is 14.1% for automobile dealers, 22.8% for grocery stores and 55.7% for restaurants.
Sources: Robert Morris Associates’ Annual Statement Studies).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 64
Inventory Control
1. Keeping inventory handles away from the accounting.
2. Physical count of inventory. ( At lease once a year)
3. Keeping perpetual inventory system for high-cost inventory.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 65
Inventory Transaction on the Cash Flow Statement
Cash Flows from Operating Activities:
Collection from Customers $xxx
Cash Payments to Suppliers ($xxx)