Inventory C H A P T E R 8. Learning Objective 1 Identify what items and costs should be included in...

Inventory Inventory

C H A P T E R 8

Learning Objective 1

Identify what items and costs should be included in inventory and cost of goods sold.

Define Inventory and COGS. What are some of their characteristics?

Describe the Time Line of Business.

What is Inventory?

Defined according to type and nature of the company.

Defined according to type and nature of the company.

Merchandising: Manufacturing:

Define Each Manufacturing Inventory• Raw materials

• Work in process

• Finished goods

What Costs are Included in Inventory?

Who Owns the Inventory?

When goods are in transit?

Q: Who owns inventory on a truck or railroad car?

When goods are on consignment?

Q: Who owns inventory stocked in a warehouse?

Ending Inventory & COGS

At period’s end, allocated between

inventory is still remaining (an asset), and

inventory sold during the period (an expense, Cost of Goods Sold).

Cost of goods available for sale

Cost of goods available for sale

Beginning inventoryBeginning inventory

Net purchases

Net purchases= +

The question is where is the inventory that could have been sold this period? Only two choices:


Account for inventory purchases and sales using both a perpetual and a periodic inventory system.

What are the Two Methods for Accounting for Inventory?

Example: Accounting for Inventory Purchases and Sales

Beginning inventory 10 hats @ $10 each = $100

March 1 Purchase 15 hats @ $15 each = $225

March 1 Freight in $10

March 1 Purchase return 3 hats @ $15 each = $ 45

May 2 Purchase 10 hats @ $20 each = $200

May 2 Purchase discount 2/10, n/30

June 30 Sales 20 hats (10 @ $10, 10 @ $15)

July 3 Sales return 1 hat @ $15 = $ 15

Ending inventory 13 hats

Harper’s Hats recorded the following transactions for 2006:

Example: 2006 Inventory

Purchase Sale Balance `Date Units Total Units Total Units Cost TotalJan. 1 10 $10 $100

Mar. 1 15 $225 10 $10 $10015 $15 $225

(3) ($45) 12 $15 $180

May 2 10 $200 10 $10 $10012 $15 $18010 $20 $200

June 30 10 $100 10 $150

2 $15 $ 3010 $20 $200

July 3 (1) ($15) 3 $15 $ 4510 $20 $200

Perpetual & PeriodicJournal Entries

PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries for

COGS

Perpetual

All purchases are added directly to the inventory account.

Periodic

At end of period,

• Inventory balance is updated using inventory count.

• Temporary purchases account balance

is closed to Inventory to compute COGS.

PERPETUAL

PERIODIC

Harper purchased 10 hats at $10 each on January 1. Record the entries for both perpetual and periodic systems.

Example: Journal Entriesfor Purchases


Purchases

Transportation costs

Purchase returnsPurchase discountsSalesSales returnsClosing entries for

COGS

Perpetual

All costs are added directly to the inventory balance.

Periodic

At end of period, temporary freight in account balance is closed to Inventory to compute COGS.

Example: Journal Entriesfor Transportation Cost

PERPETUAL

PERIODIC

Harper hired a trucking company to deliver its March 1 purchase of 15 hats. The trucking company charged $10. Record the entries for both the perpetual and the periodic systems.


PurchasesTransportation costs

Purchase returnsPurchase discountsSalesSales returnsClosing entries for

COGS

Perpetual

Inventory is decreased.

Accounts Payable is decreased by same amount.

Periodic

If merchandise has been paid for, the supplier will reimburse (debit Cash).At end of period, temporary purchase returns account balance is closed to Inventory to compute COGS.

PERPETUAL

PERIODIC

Of the 15 hats delivered on March 1, three were defective and Harper returned them the same day. Record the entries for both the perpetual and the periodic inventory systems.

Example: Journal Entriesfor Purchase Returns


PurchasesTransportation costsPurchase returns

Purchase discounts

SalesSales returnsClosing entries for

COGS

Perpetual

Subtract the discount amount from the inventory account.

Periodic

At end of period, temporary purchase discounts account balance is closed to Inventory to compute COGS.

Example: Journal Entriesfor Purchase Discounts

PERPETUAL

PERIODIC

On May 2, Harper purchased 10 hats at $20 each. The supplier offered terms of 2/10, n/30. Record the entries for both the perpetual and the periodic inventory systems.


PurchasesTransportation costsPurchase returnsPurchase discounts

Perpetual

All adjustments are entered directly in the Inventory account.

Periodic

All adjustments are accumulated in an array of temporary holding accounts:

Purchases

Freight In

Purchase Returns

Purchase Discounts

The difference in terms of

journal entries:


PurchasesTransportation costsPurchase returnsPurchase discounts

SalesSales returnsClosing entries for

COGS

Perpetual

Recognize sales and COGS on a transaction-by-transaction basis.

Periodic

Only total sales are known.

Example: Journal Entriesfor Sales

In June, Harper’s Hats sold 20 hats for $25 each (selling the old ones first). Record the entries for both the perpetual and the periodic systems.

PERPETUAL

PERIODIC


PurchasesTransportation costsPurchase returnsPurchase discountsSales

Sales returnsClosing entries for

COGS

Perpetual

Sales for returned items are canceled.

Cost of returned inventory is removed from COGS and restored to the inventory account.

Periodic

Sales for returned items are canceled.

No entry is made to adjust COGS.

PERPETUAL

PERIODIC

Example: Journal Entriesfor Sales Returns

On July 3, one hat was returned from a late June purchase. Record the entries for both the perpetual and the periodic inventory systems.


PurchasesTransportation costsPurchase returnsPurchase discountsSalesSales returnsClosing entries

for COGS

Perpetual

All journal entries are posted to the ledger.

Results in new balances for Inventory and COGS.

Numbers are verified by physical count.

Periodic

Temporary holding accounts are accumulated and added to Inventory.

Inventory account balance is reduced by the amount of COGS.

Accounting for Inventory Purchases and Sales

Beginning inventory 10 hats @ $10 each = $100

March 1 Purchase 15 hats @ $15 each = $225

March 1 Freight in $10

March 1 Purchase return 3 hats @ $15 each = $ 45

May 2 Purchase 10 hats @ $20 each = $200

May 2 Purchase discount 2/10, n/30

June 30 Sales 20 hats (10 @ $10, 10 @ $15)

July 3 Sales return 1 hat @ $15 = $ 15

Ending inventory 13 hats

Harper’s Hats recorded the following transactions for 2006:

6/30 2507/3 15

Bal. 235

Perpetual: the inventory account will have an ending balance of $255.

Closing Entries for Cost of Goods Sold

1/1 1003/1 225 3/1 453/1 105/2 200

6/30 2507/3 15

Bal. 255

Inventory COGS

Periodic: the inventory account will be debited by $386, which represents the net purchases for the year.

Closing Entries for Cost of Goods Sold

Jul. 31 Inventory. . . . . . . . . . . . . . . . . . . 386Purchase Returns. . . . . . . . . . . . 45Purchase Discounts. . . . . . . . . . 4

Freight In. . . . . . . . . . . . . . . . . 10Purchases. . . . . . . . . . . . . . . . 425

Beginning Inventory, January 1, 2006

+ Purchases for the year

= Cost of goods available for sale during 2006

– Ending Inventory, December 31, 2006

= Cost of Goods Sold for 2006

Periodic Inventory

With a periodic system, a physical count is the only way to get the

information necessary to compute COGS:


Calculate cost of goods sold using the results of an inventory count and understand the impact of errors in ending inventory on reported cost of goods sold.

Physical Count of Inventory

PeriodicThe only way to get information necessary to compute COGS:

PerpetualPhysical count either confirms records are accurate or highlights shortages and clerical errors.

• Quantity count.• Inventory costing (assigning a

unit cost to each type of merchandise).

• Ending inventory = quantity of each type x its unit cost.

Essential to maintaining reliable inventory accounting records.

COGS Computation

PerpetualThe accounting records yield the COGS for the period as well as the amount of inventory that should be found with a physical count.

The difference between the records and actual count = inventory lost, stolen, or spoiled.

PeriodicCompany does not know what ending inventory should be.Assumes physical count is the difference between cost of goods available for sale and ending inventory.Cannot tell whether goods were sold, lost, stolen, or spoiled.

What is the Income Effect of an Error in Ending Inventory?

Complete Table of Effects of Inventory Errors

Understate

Ending Inventory

Sales OK

Beginning inventory OKNet purchases OKGoods available OKEnding inventory LOWCost of goods sold HIGH

Gross margin LOWExpenses OKNet income LOW

UnderstatePurchases

UnderstateBeginningInventory

Understate Sales


Apply the four inventory cost flow alternatives: specific identification, FIFO, LIFO, and average cost.

Inventory Cost Flow

Kernel King buys and sells corn and had the following transactions for 2002:June 10 Purchased 10 tons at $6 per ton.July 28 Purchased 10 tons at $9 per ton.October 10 Sold 10 tons at $11 per ton.

How much did Kernel King make in 2002?

Case #1 Case #2 Case #3Sold Sold Sold

Old Corn New Corn Mixed Corn

Sales ($11 x 10 tons)COGS (10 tons)Gross margin

Specific Identification Cost Flow

Specifically identify the cost of each unit sold.

The individual cost of each unit is charged against revenue as COGS.

To compute COGS and ending inventory, a firm must know each unit sold and its cost.

Inventory Cost Flow Methods

FIFO

The oldest units are sold and the newest units remain in inventory.

The cost of the oldest units purchased is transferred to COGS.

• LIFO

• The newest units are sold and the oldest units remain in inventory.

• The cost of the most recent units purchased is transferred to COGS.

• Average Cost

• An average cost is computed for all inventory available for sale during the period.

• COGS is computed by multiplying the number of units sold by the average cost per unit.

CompareInventory Methods

LIFO gives a better reflection of COGS in the income statement.

Therefore, LIFO is a better measure of income.

FIFO gives a better measure of inventory on the balance sheet.

Therefore, FIFO is a better measure of inventory value.


Use financial ratios to evaluate a company’s inventory level. %%

Why Use JIT Inventory Management?

Evaluating Inventory Levels

Inventory Turnover

• Measures how many times a company turns over (or replenishes) its inventory.

• Average inventory = average of the beginning and ending inventory balances.

Number of Days’ Sales in Inventory

Cost of goods sold

Average inventory

365 days

Inventory turnover

Evaluating Inventory Management

Buster Boots had cost of goods sold of $60,000 during 2002. The inventory account decreased by $1,000 to $4,000 during the same time. Calculate the inventory turnover ratio and number of days’ sales in inventory.

Inventory turnover

ratio

Number of days’ sales

in inventory

Expanded MaterialLearning Objective 6

Analyze the impact of inventory errors on reported cost of goods sold. ??

What Is the Effect of These Inventory Errors?

If a sale is recorded but the merchandise remains in inventory and is counted in ending inventory,

If a sale is not recorded, but inventory is shipped and not counted in ending inventory,


Describe the complications that arise when LIFO or average cost is used with a perpetual inventory system.

Using Average Cost or LIFO with a Perpetual System

Using average cost or LIFO with perpetual leads to complications.The average cost of units available for sale

changes every time a purchase is made.The identification of the “last in” units also changes with every purchase.

With periodic,One overall average cost is used for all

goods available for sale during the period.The “last in” units are identified at the

end of the period.

Describe the Similarities of Using FIFO for Perpetual and

Periodic Systems.


Apply the lower-of-cost-or-market method of accounting for inventory.

When Do You Report Inventory Below Cost?

When Do You Report Inventory at Net Realizable Value (NRV)?

Floor: the minimum market amount at which inventory can be carried on the books; equal to net realizable value less a normal profit.

Lower of Cost or Market (LCM)

LCM: A basis for valuing inventory at the lower of original cost or current market value.

Ceiling: the maximum market amount at which inventory can be carried on the books; equal to net realizable value (selling price less estimated selling costs).

Example: LCM

Market Inventory Replacement NRV Item Cost Floor Cost Ceiling A 34 20 32 30 B 42 32 36 46 C 52 44 42 62 D 38 50 32 68

• Define market value as:• replacement cost, if it falls between the ceiling and the floor.• the floor,, if the replacement cost is less than the floor.• the ceiling,, if the replacement cost is higher than the ceiling.• When replacement cost, ceiling, and floor are compared,

market is always the middle value.

Compare the defined market value with the original cost and choose the lower amount.


Explain the gross margin method of estimating inventories. ??

There are times when a physical count of inventory is either impossible or impractical.

If perpetual is used, the inventory account balance is assumed to be correct.If periodic is used, an estimate of the inventory balance must be made.

Gross margin method.COGS and ending inventory are estimated using available information:beginning inventorypurchaseshistorical gross margin percentage

Gross Margin Method

Gross Margin Method ExamplePayson Brick has net sales for 1/1 to 3/31 of

$100,000 and net purchases of $65,000. Inventory on 1/1 was $15,000 and a historic gross profit percentage of 40%.

Dollars % of salesNet sales revenue $100,000 100%Cost of goods sold: Beginning inventory $15,000 Purchases 65,000 Total available for sale $80,000 Ending Inventory (3) 20,000Cost of goods sold (2) 60,000 60%Gross margin (1) $ 40,000 40%

(1) $100,000 X .40 (2) $100,000 - $40,000 (3) $80,000 - $40,000

Chapter 8 is Finished

Inventory C H A P T E R 8. Learning Objective 1 Identify what items and costs should be included in...

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