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Chapter 6
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Define accounting principles related to inventory
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Consistency◦ Businesses should use the same accounting
methods from period to period Disclosure
◦ Companies should report enough information for outsiders to make decisions about the company
Materiality◦ Companies must follow accounting rules for
significant items Significant – cause a user to change decision
Conservatism◦ Exercise caution in financial reporting
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Define inventory costing methods
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Each inventory item is identified by its specific cost
Used by business that sell unique, easily identified items◦ Examples: Cars, fine jewelry real estate
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Assumes oldest items are sold first
Oldest Oldest CostsCosts
Oldest Oldest CostsCosts
Cost of Goods Cost of Goods SoldSold
Cost of Goods Cost of Goods SoldSold
Cost of Goods Cost of Goods SoldSold
Cost of Goods Cost of Goods SoldSold
Therefore, newest items are on hand
Recent Recent CostsCosts
Recent Recent CostsCosts
Ending Ending InventoryInventoryEnding Ending
InventoryInventory
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Recent Recent CostsCosts
Recent Recent CostsCosts
Cost of Goods Cost of Goods SoldSold
Cost of Goods Cost of Goods SoldSold
Oldest Oldest CostsCosts
Oldest Oldest CostsCosts
Ending Ending InventoryInventoryEnding Ending
InventoryInventory
Assumes newest items are sold first
Therefore, oldest items are on hand
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The average cost of each unit in inventory is assigned to cost of goods sold
Average CostCost of Inventory
on HandNumber of Units
on Hand÷ =
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Account for perpetual inventory by the three most common costing methods
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$10 $10 $10
Beginning Inventory
$12 $12 $12 $12 $12
Purchase 5 shirts
Then we sell 4 shirts for $20 each.What costs should be assigned to Cost of goods sold?
First-In, First-Out
Cost of good sold = $42Inventory = $48
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GENERAL JOURNALDATE DESCRIPTION REF DEBIT CREDIT
Accounts receivable ($20 x 4) 80
Sales revenue 80
To record sales on account
Cost of goods sold 42
Inventory 42
To record cost of sales
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Sales $80
Cost of goods sold 42
Gross profit $38
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$10 $10 $10
Beginning Inventory
$12 $12 $12 $12
Purchase 5 shirts
Then we sell 4 shirts for $20 each.What costs should be assigned to Cost of goods sold?
Last-In, First-Out
Cost of good sold = $48Inventory = $42
$12
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GENERAL JOURNALDATE DESCRIPTION REF DEBIT CREDIT
Accounts receivable ($20 x 4) 80
Sales revenue 80
To record sales on account
Cost of goods sold 48
Inventory 48
To record cost of sales
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Sales $80
Cost of goods sold 48
Gross profit $32
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$10 $10 $10
Beginning Inventory
$12 $12 $12 $12
Purchase 5 shirts
Then we sell 4 shirts for $20 each.What costs should be assigned to Cost of goods sold?
Compute the Average CostUnits Cost
Beginning inventory 3 $30Purchases 5 60 Total 8 $90
Average = $90/8 = $11.25
Cost of good sold = $11.25 x 4 = $45Inventory = $11.25 x 4 = $45
$12
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GENERAL JOURNALDATE DESCRIPTION REF DEBIT CREDIT
Accounts receivable ($20 x 4) 80
Sales revenue 80
To record sales on account
Cost of goods sold 45
Inventory 45
To record cost of sales
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Sales $80
Cost of goods sold 45
Gross profit $35
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Compare the effects of the three most common costing methods
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LIFO31%
FIFO46%
Other3%
Avg20%
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FIFO LIFO Average
Sales $80 $80 $80
Cost of goods sold
$42 $48 $45
Gross profit $38 $32 $35
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Highest gross profit;
highest net
income
Lowest gross profit; lowest
net income
If inventory prices are increasing
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High income attracts
investors
High income attracts
investors
“Middle ground”“Middle ground”
Lower income = Less taxes
Lower income = Less taxes
Last-In, First-Out
First-In, First-Out
AverageCost
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Apply the lower-of-cost-or market rule to inventory
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Example of Accounting Conservatism Inventory is reported at lower of:
◦ Historical cost or ◦ Market value (current replacement cost)
If market is lower than cost, write down inventory value:
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Date AccountsPost Ref Debit Credit
Cost of goods sold Inventory
GENERAL J OURNAL
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Date AccountsPost Ref Debit Credit
Cost of goods sold Inventory
GENERAL J OURNAL
$25,000 $25,00
0
#1
Current assets:Inventory, (at lower-of-cost-or-market) 80,000$
L and M ElectronicsBalance Sheet
December 30, 2012#2
$105,000 - $25,000
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Cost of goods sold $430,000
L and M ElectronicsIncome Statement
Year ended December 31, 2012#3
$405,000 + $25,000
#4 ConservatismConservatism
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Measure the effects of inventory errors
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Estimate ending inventory by the gross profit method
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Method to estimate ending inventory using the gross profit percent
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Beginning inventory $15,000
Net purchases 70,000
Cost of goods available 85,000
Estimated cost of goods sold:
Sales revenue $100,000
Less: Estimated gross profit of 35%
(35,000)
Estimated cost of goods sold (65,000)
Estimated cost of ending inventory
$20,000
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Beginning inventory $47,000
Net purchases 30,300
Cost of goods available 77,300
Estimated cost of goods sold:
Sales revenue $63,000
Less: Estimated gross profit of 35%
(22,050)
Estimated cost of goods sold (40,950)
Estimated cost of ending inventory
$36,350
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