PRINCIPLES OF FINANCIAL ACCOUNTING

CHAPTER 6

INVENTORY SYSTEMS Periodic Inventory System

No attempt is made to account for the cost of the merchandise at the time of sale.

Cost of goods sold is computed only at period end.

Perpetual Inventory System Cost of goods sold is accounted for

every time a sale is recorded.

Periodic Inventory Entry to record the purchase of an item

that cost $500 on account + Purchases (dr) 500 + Accounts Payable (cr) 500

Entry to record the sale of that item for $800. +Accounts Receivable (dr) 800 +Sales (cr) 800 Note – no entry is made for the cost of goods

sold at this time.

Periodic Inventory (cont) To calculate the cost of goods sold for

the period a physical inventory must be taken.

Calculation: Beginning Merchandise Inventory Plus Net Purchases Plus Freight In Minus Ending Merchandise Inventory

Refer to example on page 253

Perpetual Inventory Entry to record the purchase of a item for

$500 on account: Merchandise Inventory (dr) 500 Accounts Payable (cr) 500

Entries to record the sale of the item for $800 Accounts Receivable (dr) 800 Sales (cr) 800 Cost of goods sold (dr) 500 Merchandise Inventory (cr) 500

Cost Flow Assumptions(Periodic) FIFO (refer to example on page 256)

In times of steady price increases: Net income will be higher than the other methods Asset valuation on the balance sheet will be

higher

LIFO (refer to example on page 257) In times of steady price increases:

Net income will be lower than the other methods Asset valuation on the balance sheet will be

lower.

Cost Flow Assumptions (Cont)(Periodic) Average cost (also called weighted

average) Refer to example on page 259 In times of steady rising or falling

prices Net income will fall between LIFO and

FIFO Asset valuation on the balance sheet will

fall between LIFO and FIFO

Advantage of LIFO Lower reported earnings means

lower taxable income reported, hence lower taxes (temporarily).

Closer matching of current cost with current revenues.

Disadvantages of LIFO Lower reported earnings –

shareholder’s may be dissatisfied with management.

Lower asset valuation causes a lower current ratio and working capital.

LIFO layer erosion could cause earnings catch up at a bad time or can permit manipulation of income.

LOWER OF COST OR MARKET Departs from the Cost Principle. The conservatism concept dictates

that “when in doubt, avoid overstating assets and income.”

Therefore, if inventory has lost value below cost, then you must write down the inventory to the price you believe you can sell the item.

Inventory Ratios Inventory Turnover Ratio:

Cost of Goods sold/Average inventory

Days in inventory 365/Inventory turnover ratio

Appendix 6A Perpetual cost flow

FIFO the same whether using perpetual or periodic

LIFO Must analyze the date of each sale and purchase Refer example on page 273

Average cost (also called moving average) Must recompute the average cost per item every

time you have a purchase. Refer to example on page 273