chapter 8 handout
TRANSCRIPT
MGT 220 Chapter 8
Inventory Classification
• Inventory consists of:- finished goods held for sale in the ordinary course of business
- goods held or consumed in the production of finished goods
• A merchandising concern has one inventory account– Merchandise Inventory
• A manufacturing concern will normally have three inventory accounts:– Raw materials– Work in process– Finished goods
Items to Be Included in Inventory
• Legal title to goods determines inclusion• The following goods are included in the seller’s
inventory:1 Goods in transit
(if seller has title during shipment, e.g., f.o.b. destination)
2 Goods on consignment with seller3 Goods, sold under buyback agreements
(Revenue assumption here?)
4 Goods, sold with high rates of return(Revenue assumption here?)
5 Instalment sales (Don’t worry about this)
COSTS TO INCLUDECOSTS TO INCLUDE
Purchase Discounts (2%10, net 30)
Gross MethodDiscount is revenuePurchase is recorded at 100%
Net MethodPurchase price is 98%
Net MethodPurchase inventory for $1000 (2/10 net 30)
Inventory 980
A/P (or Cash) 980
Pay $500 of invoices within discount period
A/P 490
Cash 490
Pay $500 of invoices outside discount period
A/P 490
Purchase discount lost (E) 10
Cash 500
Inventory Control
• Inventory control is important for:- ensuring availability of inventory items- preventing excessive accumulation of inventory
items
• The perpetual system maintains a continuous record of inventory changes
• The periodic system updates inventory records only periodically
Perpetual SystemJournal Entries
Buy: Inventory 100
A/P (or Cash) 100
Sell: A/R 150
Sales Revenue 150
CGS 100
Inventory 100
Perpetual SystemAt year end,
1. Do a physical count of inventory;
2. Compare count to balance in subsidiary inventory ledger; and,
3. Make any adjustments for differences between the two. These differences posted to a separate account – Inventory Over and Short
Periodic SystemJournal Entries
Buy: Purchases 100
A/P (or Cash) 100
Sell: A/R 150
Sales Revenue 150
Periodic SystemAt year end,
1. Do a physical count of inventory;
2. Make the following journal entry:
Inventory (Based on Ending count) xx
CGS (Plug) xx
Purchases (Close out account) xx
Inventory (Close out begin. balance) xx
Cost Flow AssumptionsPossible cost flow assumptions are:
1. Specific identification (of each item sold)
2. Average cost (assigns average value to the item sold)
3. First-in, First-out (FIFO) (first inventory item bought is the first one sold)
4. Last-in, First-out (LIFO)(last inventory item bought is the first one sold)
Cost Flow Assumptions
Simple Example
• There are five items in inventory:
a) $50 b) $60 c) $70 d) $80 e) $90
• They are exactly the same except for the amount paid for each item.
• You sell item d) for $100 cash
Cost Flow Assumptions
Simple Example (Cont.)
Journal Entry:
Cash $100
Sales $100
CGS $XX
Inventory $XX
What is $XX?
Cost Flow Assumptions
Simple Example (Cont.)
4 possibilities
1. Specific Identification - $80 (Actual cost)
2. FIFO - $50
3. LIFO - $90
4. Average - $70 ([50+60+70+80+90]/5)
Cost Flow Assumptions
• It is not easy, or even possible in many cases, to keep track of the actual cost of inventory items.
• As a result, often we must make some sort of “cost flow assumption”
Cost Flow AssumptionsRemember:Beg Inv + Purchases – CGS = End InvBeg Inv + Purchases = CGAS = CGS + End Inv• The accounting problem is how do we
divide the CGAS into CGS and End Inv amounts.
• Putting more into CGS reduces net income, and reduces the inventory asset (End Inv) on the balance sheet
Cost Flow Assumptions• The objective is to most clearly reflect
periodic income • Cost flow assumptions need not be
consistent with physical flow of goods • Objectives of choosing an inventory
valuation method are to: 1. realistically match expenses against revenue 2. report inventory at a realistic amount 3. minimize income taxes
Specific Identification
• Items sold and purchased are individually identified as to cost
• Works best with items that are unique, high cost, with small numbers held as inventory
• Advantage: – Matches revenues and actual costs
• Disadvantages:– May be costly to implement and maintain– May lead to income manipulation
Advantages of LIFO Method
• LIFO matches more recent costs with current revenues
• Under LIFO, the need to write down inventory to market is minimized
Disadvantages of LIFO Method• LIFO yields the lowest net income (when prices are
rising) and therefore reduced earnings • Under LIFO (when prices are rising), the ending
inventory is understated • LIFO does not approximate the physical flow of
goods except in special situations• LIFO liquidation may result in income that is
overstated• LIFO may cause poor buying habits (because of the
LIFO liquidation layer problem)• Not acceptable for tax purposes
Tax advantages
• Given that LIFO is not acceptable for tax purposes, which method should be chosen to minimize tax expense?