Accounting Chapter 5 Review Package V2 PDF

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Chapter 5 review...

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Commerce 1AA3 – October 2020 – Created by Bahman

C o m m e r c e 1 A A 3 – In t r o t o F i n a n c i a l A c c o u n t i n g Chapter 5 – Inventory & Cost of Goods Sold Key Learning Points of Chapter: 1. Account for inventory using perpetual & periodic inventory systems. a) Income Statements – Service vs Merchandising Company

b) Balance Sheet – Service vs Merchandising Company c) Definitions d) Shipping Terms and determining units of inventory e) Comparing the Systems – Perpetual vs Periodic

2. Apply & Compare the three main inventory costing methods. a) Specific Identified Cost Method b) Weighted-Average Cost Method c) FIFO Cost Method d) Summary & Scenarios

3. Explain how accounting standards apply to inventory. a)

Comparability

b)

Lower-of-Cost and Net Realizable Value (LCNRV)

4. Compute & Evaluate gross profit and inventory turnover. a)

Ratios

Legend (if not bolded): Very Important Terms/Names

5. Analyze effects of inventory error. a)

Inventory Errors + Examples

Formulas & Equations

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point One: Account for inventory using perpetual & periodic inventory systems: What does Perpetual & Periodic even mean? Periodic System: inventory system where the firm does not keep continuous record of the inventory on hand Perpetual System: Inventory System where business does keep continuous record for each inventory item The two companies: Service vs Merchandise Service Company – Income Statement

Merchandise Company – Income Statement

Service Company – Balance Sheet

Merchandise Company – Balance Sheet

Will be focusing on the inventory part of a merchandising company

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point One Cont.: Account for inventory using perpetual & periodic inventory systems cont.: Merchandising Company: Inventory

Accounting for Inventory Value of inventory affects 2 accounts: inventory (current asset) on the balance sheet; & cost of

goods sold, shown as an expense on the income statement Sales Price vs Costs of Inventory Sales Revenue: Based on the sale price of the inventory sold. Cost of Goods Sold: Based on the cost of the inventory sold.

Gross profit, also called gross margin Sales revenue minus cost of goods sold

Inventory: Based on the cost of the inventory still on hand. Number of Units of Inventory: the number of units of inventory a business has on hand at a certain point. >> End of Period Inventory = # of Units on Hand (x) Cost per Unit of Inventory -

Determined from accounting records, Evidenced by physical count at year-end. •

•

Consigned goods: •

Does not include those held for another company

•

Does include those out on consignment

Goods in Transit: Can be different number depending on “FOB Shipping Terms” o

FOB Shipping Point = buyer has legal title as soon as it leaves the shipper’s

warehouse o

FOB Destination = seller has legal title until it’s delivered to the buyer.

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point One Cont.: Account for inventory using perpetual & periodic inventory systems cont.: Shipping Terms – Detailed

Back to the inventory accounting systems: Perpetual vs Periodic:

Perpetual Inventory System: Bar codes on products provide information to record •

Sale of item

•

Update of inventory record

Two entries needed for each sale •

Record revenue and asset received (cash or receivables)

•

Record cost of sale and reduction of inventory

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point One Cont.: Account for inventory using perpetual & periodic inventory systems cont.: Summary of Journalizing Under both Methods: Transaction

Perpetual System

Periodic System

1. Purchase of Inventory

Inventory – Debited Cash or A/P – Credited

Purchases – Debited Cash or A/P – Credited

2. Purchase Discounts

A/P – Debited Inventory – Credited (A/P * discount%) Cash – Credited

A/P – Debited Purchase Discounts – Credited (A/P * discount%) Cash – Credited

3. Return of Damaged Goods (Purchase Returns)

Cash or A/P – Debited Inventory – Credited

Cash or A/P – Debited Purchase Returns – Credited and/or Allowances

4. Sale of Merchandise (Inventory)

a. Cash or A/R – Debited Sales Revenue – Credited b. COGS – Debited Inventory - Credited

Cash or A/R – Debited Sales Revenue – Credited

5. Sales Discount:

Cash – Debited Sales Discount – Debited A/R – Credited

Cash – Debited Sales Discount – Debited A/R – Credited

6. Sales Return:

a. Sales Returns – Debited Cash or A/R – Credited b. Inventory – Debited COGS – Credited

Sales Returns – Debited Cash or A/R – Credited

7. Payment for Freight (Seller)

Freight Out – Debited Cash – Credited

Freight Out – Debited Cash – Credited

8. Payment for Freight (Buyer) AKA “Freight IN”

Inventory – Debited Cash – Credited

Freight In – Debited Cash – Credited

Some Definitions: Purchase Returns = Decreases Cost of Purchase because buyer returned the goods to seller. Purchase Allowance = Decrease in Cost of Purchase because buyer got a deduction—often due to merchandise defects Purchase Discount = Decrease in Cost of Purchase that is earned by paying quickly Sales Returns & Allowances = Merchandise returned for credit or refunds for a service provided Sales Discount = Given in this form>> ex: “2/10, N/30” $15/unit

2.

COGS = 40 units sold * WAC = $600

3.

Ending Inv. = 20 units left * WAC = $300 OR 900 – 600 = 300

A useful resource for comparing the two methods (Perpetual vs Periodic WAC) https://accountinginfocus.com/financial-accounting/inventory/weighted-average-inventory/

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point Two Cont.: Apply & Compare the three main inventory costing methods Cont.: Weighted Average Cost (Periodic): -

Very similar to Perpetual, except ending inv. Is calculated slight “easier” way since inventory is counted at the end of the year to see what's left: STEPS: A. Calculate Weighted Average Cost Per-Unit (WAC per unit) = COGAS / Number of Units Available B. Determine COGS = # of units Sold (x) WAC per unit C. Calculate Ending Inventory = # of units left on hand (x) WAC per unit

3.

FIFO (First-in-first-out method) a.

Oldest items assumed to be sold first

b.

Ending inventory consists of most recent purchase costs

Going back to example 2 – “Leon”

Ending Inv. Cost = 20 units left * $18 (why 18 instead of the older $14? Because they were sold) = $360 COGS =

a) Sold 40 units: 10 from the beginning balance (now we have 30 left) b) Still need to “sell” 30 more, take 25 from next group, then 5 from group after.

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point Two Cont.: Apply & Compare the three main inventory costing methods Cont.: FIFO – Example cont.: COGS =

a) Sold 40 units: 10 from the beginning balance (now we have 30 left) b) Still need to “sell” 30 more, take 25 from next group, then 5 from group after.

Another Quick Example:

Summary of Costing Methods – Given Revenue:

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point Two Cont.: Apply & Compare the three main inventory costing methods Cont.: Summary of Costing Methods – What Ifs:

Comparing the Methods: 1. Results in the most realistic net income figure: Weighted Average, because it combines all costs (old costs & recent costs). In contrast, FIFO uses old inventory costs against revenue (less realistic). 2. Method that reports the most up-to-date inventory cost on the balance sheet: FIFO reports the most current inventory cost on the balance sheet. 3. Effects on Taxes: If costs are rising, FIFO results in higher income taxes. Weighted Average will give lower because it combines all costs which leads to lower profits, therefore lower income tax.

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point Three: Explain how accounting standards apply to inventory. Comparability Principle from Chapter One of the most important for this chapter: •

Investors want to compare a company’s financial statements from one period to the next

•

Therefore, must use the same accounting method for inventory from one period to the next

•

If a change in accounting method can be justified, a change can be made, but prior statements need to be adjusted

The Lower of Cost and Net Realizable Value (LCNRV) Rule: •

Rule exists because some inventory can become obsolete or damaged or its selling price can decline.

•

IFRS & ASPE require inventory to be reported at whichever is lower—the inventory’s cost or its net realizable value (NRV)

o

NRV = amount the business could get if it sold the inventory, less any costs incurred to sell it.

•

If the NRV of inventory falls below its historical cost (cost purchased at), the business must write down the value of its goods to the value of the NRV.

On the balance sheet, the business reports ending inventory at its LCNRV. In short: Inventory is reported at the lower of (use whatever number turns out lower): Cost or Net Realizable Value (Usually replacement cost) **If market is lower, inventory is written down

***Any inventory written down should be reviewed each period, because if the NRV has increased, the previous write-down should be reversed up to the new NRV*** >> Next Page

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point Three Cont.: Explain how accounting standards apply to inventory Cont.: The Lower of Cost and Net Realizable Value (LCNRV) Rule Cont.: Continuing from previous example: Assume whichever was lower ended up being 1000 for the last example (in this case NRV), now assume NRV increased in value by 400, so you adjust.

Learning Point Four: Compute & Evaluate gross profit and inventory turnover:

Gross Profit % =

Gross profit Net sales revenue

Inventory Turnover: •

faster the sales, the higher the company’s income

•

the slower the sales, the lower the company’s income.

•

Inventory turnover (ratio of COGS to average inventory) indicates how rapidly inventory is sold. •

Inventory turnover shows how many times a company sold its average inventory during a year.

>> How long it takes to Sell = 365 days / Inventory Turnover (left side)

Inventory turnover:

Cost of Goods Sold Average Inventory

Commerce 1AA3 – October 2020 – Created by Bahman

Learning Point Five: Analyze effects of inventory error: Effects of Mistakes Summarized: ERROR in Inventory or Purchase Record

EFFECT ON COGS

EFFECT ON Net Income (N.I.)

EFFECT ON Retained Earnings (R.E)

EFFECT ON Assets or Other

End. Inv. (U)

COGS (O)

N.I. (U)

R.E (U)

Assets (U)

End. Inv. (O)

COGS (U)

N.I. (O)

R.E (O)

Assets (O)

Beg. Inv. (U)

COGS (U)

N.I. (O)

R.E (N)

Assets (N)

Beg. Inv. (O)

COGS (O)

N.I. (U)

R.E (N)

Assets (N)

Purchases (U)

COGS (U)

N.I. (O)

R.E (O)

A/P (U)

Numerical Example:

Estimating Ending Inventory Inventory = Beg. Inv. (+) Purchases (–) *estimated COGS *estimated COGS Estimated COGS: Given: Sales = 200k, beg inv = 4500, purchases = 150k, GP% = 30% Estimated COGS = Sales (x) [1 (–) GP %] = 200k x 0.70 = 140k >>>> End Inv = 4500 + 150k – 140k = 14500

Commerce 1AA3 – October 2020 – Created by Bahman

Financial Statements: Perpetual vs Periodic: Key Formulae (Perpetual): COGS = # of units sold (x) cost per unit of inventory

GP = Sales - COGS

Key Formulae (Periodic): 1. Net Sales Revenue = Sales Revenue (–) Sales Returns & Allowances (–) Sales Discounts 2. COGS = Beg. Inventory (+) Cost of Goods Purchased (COGP or Net Purchases) (–) End Inv.

Cost of Goods Available for Sale (COGAS) 3. Net Purchases = Purchases (–) Purchase Returns & Allowances (–) Purchase Discounts (+) Freight In 4. Ending A/P = Beg. A/P (+) Purchases (-) Payments

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