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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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:
Learning Objective 2
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
Perpetual & PeriodicJournal Entries
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.
Perpetual & PeriodicJournal Entries
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
Perpetual & PeriodicJournal Entries
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.
Perpetual & PeriodicJournal Entries
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:
Perpetual & PeriodicJournal 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
Perpetual & PeriodicJournal Entries
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.
Perpetual & PeriodicJournal Entries
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:
Learning Objective 3
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
Learning Objective 4
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.
Learning Objective 5
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,
Expanded MaterialLearning Objective 7
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.
Expanded MaterialLearning Objective 8
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.
Expanded MaterialLearning Objective 9
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