Chapter 6 - Lecture notes 6 PDF

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Chapter 6: Accounting for Inventory and Cost of Goods Sold (4 inventory cost methods in this class) Four Fundamental Activities 1. Establish goals and strategies 2. Obtain financing 3. Make investments 4. Conduct operations The operations of a retail firm?  Buying and selling inventory The operations of a manufacturing firm?  Producing and selling inventory Inventory of Retail Companies  Purchase goods from suppliers to sell to others at a profit  “Cost of Goods Sold” represents the fundamental expenses incurred in acquiring the goods that are sold during the period – reported on the income statement  “Net Sales” represents the net sales earned related to goods sold during the period – reported on the income statement  Inventory of a retail company is always referred to “finished goods inventory” – reported on the balance sheet Net sales = total sales – (less) sales discount, sales return, sales allowance Revenues minus cost of goods sold = gross profit Multiple-step income statement

Cost of Goods Sold is: a. Reported in the income statement b. Reported in the balance sheet c. A current asset d. The cost of inventory on hand at the end of the period Beginning inventory + purchases = goods available for sale Goods available for sale – ending inventory = cost of goods sold goods available for sale – cost of goods sold = ending inventory Ending inventory + cost of goods sold = goods available for sale Previous years ending inventory is next years beginning inventory Inventory of Manufacturing Firm Three types of inventory: 1. Raw materials – the materials that are put into production to make the finished goods. This is also referred to as “direct materials” 2. Work-in-process inventory (WIP) – this is the account that summarizes the direct materials, the direct labor, and the allocated overhead costs that go into making a finished good 3. Finished good inventory – represents the cost of goods that have been manufactured but not yet sold Which of the following inventory (asset) accounts consists of items for which the manufacturing process is complete? a. Raw materials b. Work-in-process c. Cost of goods sold d. Finished goods Inventory break-down  Merchandise company o Wholesaler o Retailer  Manufacturing company o Raw materials o Work in process o Finished goods

Inventory of Manufacturing Firm what are the components of overhead that eventually get allocated to work in process (WIP) inventory? 1. Indirect labor (supervisor salaries) 2. Supplies used in the factory 3. Depreciation of factory building and equipment 4. Utilities of factory LIFO – FIFO – Weighted Average 1. Take a physical count 2. Apply a cost flow assumption  FIFO – assumes first goods purchased are the first goods sold  LIFO – assumes the last goods purchased are the first goods sold  Weighted Average – assumes an average cost over the accounting period  Don’t forget about **Specific Identification** Inventory Costing and Price Changes LIFO and FIFO  Are both historical cost methods  Allocate costs of inventory differently  Differences arise when costs of inventory change over time Illustrate Inventory Cost Flow Assumptions Many students find it surprising that companies are allowed to report inventory costs using assumed amounts rather than actual amounts. Nearly all companies sell their actual inventory in a FIFO manner, but they are allowed to report it as if they sold it in a LIFO manner. Later, we will see why that’s advantageous. Weighted-Average Cost  Under this method, we assume: o Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale o Each unit of inventory has a cost equal to the weighted-average unit cost of all inventory items o The weighted-average cost is calculated as:  Cost of goods available for sale / (divided by) number of units available for sale  LIFO is lower on the cost of goods sold than FIFO. Weighted average cost is also lower than FIFO with cost of goods sold.

 FIFO method increases out ending inventory under periods of rising prices. FIFO has lower cost of goods sold but higher ending inventory.  LIFO has higher expense but lower ending inventory. This applies when the graph is / - it is the opposite for when the graph is \ Additional details on FIFO and LIFO  FIFO method o Matches physical flow for most companies o Ending inventory reflects current cost o Balance-sheet approach  LIFO method o Cost of goods sold reflects current cost o Income-statement approach  LIFO conformity rule o Companies that use LIFO for tax reporting must also use LIFO for financial reporting Which inventory method or cost flow assumption most closely resembles the actual physical flow of goods? a. FIFO b. LIFO c. Weighted-Average d. FILO Comparison of Inventory Cost Methods, When Costs Are Rising details on LIFO 

The choice of inventory method affects o Reported ending inventory (asset)  Ending inventory (on the balance sheet) affects FIFO, LIFO, and WeightedAverage o Reported cost of goods sold (expense, and therefore profit)  Cost of goods sold affects FIFO, LIFO, and Weighted-Average

Additional details on FIFO and LIFO  Generally, FIFO more closely resembles the actual physical flow of inventory. When inventory costs are rising, FIFO results in higher reported inventory in the balance sheet and higher reported income in the income statement. Conversely, LIFO results in a lower reported inventory and net income, reducing the company’s income tax obligation. During a period of rising prices, which inventory cost flow assumption would result in the highest cost of goods sold, and thereby the lowest net income? A. FIFO

B. LIFO C. Weighted-Average D. FILO Specialized Identifications – is for items of varying components such as jewelry, cars, etc. Perpetual Inventory System and Periodic Inventory System Perpetual Inventory System  Maintains a continual record of inventory  Helps a company better manage inventory levels Periodic Inventory System – we will not be doing anything with the Periodic System  Does not maintain a continual record of inventory  Periodically adjusts for purchase and sale of inventory Record Inventory Transaction Example

LIFO Adjustment

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Companies generally maintain their own inventory records on a FIFO basis To report using LIFO, a year-end adjustment to inventory needs to be made (LIFO Adjustment) The difference in reporting inventory when using LIFO instead of FIFO is commonly referred to as the LIFO reserve Recall that Mario’s ending inventory using FIFO was $2,00 but would have been $1,600 under LIFO

LIFO Reserve  What is a LIFO reserve? o Difference between LIFO cost and the current value of inventory o Must be reported by companies using LIFO  LIFO reserve: FIFO ending inventory cost – (minus) LIFO ending inventory cost Inventory Statement Effects of LIFO versus FIFO  Functions of two factors o Speed and direction of inventory cost changes  If costs increase more slowly, difference between LIFO and FIFO will decrease  If cost decrease, difference between LIFO and FIFO will reverse o Length of time inventory is held  Difference increases with longer holding periods  Effects of changing costs o Management may change selling prices o Lower income taxes result with LIFO when prices are rising Balance Sheet Statement Effects of LIFO versus FIFO  FIFO costing on the balance sheet o Approximates current value o If prices fall, more likely to require lower of cost or market adjustments

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Periods of rising prices o LIFO ending inventories are understated compared to FIFO  Does not represent replacement cost o LIFO reserve can be viewed as an ‘unrealized holding gain’  A gain that results from holding inventory prices are rising

Additional inventory transactions  Freight charges o Freight – in (shipment from suppliers o Freight – out (shipment to customers  Purchase discounts o Discount offered by seller to buyer for quick payment  Purchase returns o Buyer returns unwanted or defective inventory Shipping Terms FOB Shipping Point: title passes at shipping point (when inventory leaves the supplier’s warehouse). Mario records the purchase on April 25. FOB Destination: Title passes at destination (when inventory arrives at Mario’s). Mario records the purchase on April 29. Cost of Goods Sold – this is an expense  The three S’s o Sales o Spoilage o Shrinkage  Thef o Not an S but important – inventory write down Inventory Costing – Lower-of-Cost and Net Realizable Value When the value of inventory is lower than its cost  Companies must “write down” the inventory to its market value in the period in which the price decline occurs  Market Value = replacement cost = net realizable value  Applying lower-of-cost and net realizable value to inventory valuation is an example of accounting conservationism  Also, commonly called lower-of-cost-or-market! LMC During the year: record inventory purchases at cost At the end of the year: which is lower for unsolved inventory?  Cost – specific identification, FIFO, or weighted-average

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o No year-end adjustment needed (report ending inventory at purchase cost Net realizable value – estimated selling price less cost to sell o Reduce inventory from cost to net realizable value (and report to an expense for the reduction)

Inventory Write-Downs Under LCM  Inventory book value is written down to current market value, reducing total assets  Inventory write-down is reflected as an expense on the income statement, reducing current period cross profit, income, and equity – included as part of cost of goods sold Analysis of Inventory Inventory management is a double-edge sword 1. High inventory levels – may incur high carrying cost (e.g., investment, storage, insurance, obsolescence, and damage) 2. Low inventory levels – may lead to stockouts and lost sales Ratios used to analyze inventory Inventory turnover ratio  Shows the number of times the firm sells its average inventory balance during a reporting period o Inventory turnover ratio = cost of goods sold / (divided by) average inventory Average days in inventory  Indicates the approximate number of days the average inventory is held o Average days in inventory = 365 / (divided by) inventory turnover ratio The inventory turnover ratio indicates the approximate number of days the average inventory is held - true or false Additional inventory transactions

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Freight charges o Freight – in (shipments from suppliers Journal entry – debit inventory; credit Accounts payable/cash

The correct journal entry to record freight charges associated with inventory purchase is: a. Debit freight expense; credit cash b. Debit inventory; credit cash c. Debit cash; credit freight expense d. Debit cash; credit inventory...