LOLS

Chapter 5

Inventory

Learning Objectives

• Understand the basics of recording inventory purchases and sales.

• Understand the typical categories of inventory and their contents.

• Understand how an expanded income statement presentation can enhance reporting usefulness.

• Explain how inventory costs are allocated to inventory and costs of goods sold and the importance of this allocation to income measurement.

• Know how to apply FIFO, LIFO, and moving average inventory-costing assumptions.

• Apply specific identification and lower-of-cost-or-market concepts.

iStock/Thinkstock

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CHAPTER 5Introduction

Chapter Outline

Introduction 5.1 Categories of Inventory

Inventory Costs Freight Consigned Goods Critical Thinking About Inventory Cost

5.2 Cost Assignment 5.3 Perpetual Systems

First-In, First-Out Last-In, First-Out The Average Cost Approach

5.4 Comparing Methods Specific Identification Lower-of-Cost-or-Market Adjustments

5.5 The Importance of Accuracy

Introduction

You may think that since you are working in a healthcare environment and not selling products, you don’t have to worry about inventory costing and management. In real- ity, even the smallest medical office has inventory. Physicians give shots and need to hold inventory of the inoculations that will be given to patients. If your office provides sample medications, you need to track and account for that inventory even if the patients don’t pay for it. Almost everything you do in patient care requires medical supplies that can be directly allocated to each patient. Some things, such as bandages, are not cost effective to bill per patient, but other things, such as medications, will likely be billed on a patient-by- patient basis. In some healthcare settings, such as an oncology practice where expensive medical treatments are done in the office using medications that can cost hundreds, if not thousands, of dollars, inventory management becomes critical.

Therefore, in a medical environment, medications and other items used in patient care are goods to be sold, even if they aren’t being sold in the traditional way. Essentially, they become the costs of services sold. A medical office can’t provide an inoculation without first paying costs of buying that inoculation and having it shipped to the practice.

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CHAPTER 5Introduction

How hard could it be to account for inventory? The basic concept is very simple. When you buy inventory, you record the purchase of the asset, like this:

2-10-XX Inventory 10,000.00

Accounts payable 10,000.00

Purchased $10,000 of inventory on account

Then, when the inventory is resold, two entries are needed—one to record the sales pro- ceeds and another to remove the inventory and charge it to an expense category called Cost of Goods Sold. Cost of Goods Sold is not common in most healthcare environments, but you will see it used in some retail-type environments, such as the sale of medical equipment or pharmaceuticals. In most healthcare environments, the use of inventory is accounted for as a supplies expense. The following example is for an organization that does use Cost of Goods Sold:

3-15-XX Accounts receivable 15,000.00

Sales 15,000.00

Sold merchandise on account

3-15-XX Cost of goods sold 10,000.00

Inventory 10,000.00

To record the cost of merchandise sold

This very basic approach would result in the following income statement results:

Sales $15,000

Cost of goods or services sold 10,000

Gross profit $ 5,000

If the organization uses Supplies Expense to offset its use of Inventory, that the entry would look like this:

3-15-XX Supplies expense

Inventory

To record the use of inventory for patient care

In this the account, “Supplies Expense,” would be in the expense section of the income statement.

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CHAPTER 5Section 5.1 Categories of Inventory

The gross profit is simply the net difference between the cost of inventory that has been sold and the sales proceeds. It is not the net income because it does not reflect all other costs of doing business. Of course, if inventory accounting were only this simple, there would be no need for a separate chapter. So, what issues could possibly arise to compli- cate the accounting for inventory?

For starters, there are issues about what goods are appropriately included in inventory. What is the appropriate moment to conclude that a transaction has resulted in a sale? What costs, in addition to the direct purchase price, are to be placed into the inventory accounts? How do we attach costs to specific units sold when numerous identical units have been purchased at different costs on different dates, and we are not sure which phys- ical units have actually been delivered to a customer? Suddenly, accounting for inventory appears to present a number of vexing challenges. This chapter helps sort out these issues and provides you with a sound understanding of the accounting principles you need to know to answer these types of questions and more.

5.1 Categories of Inventory

The very simple journal entry that opened this chapter contemplated a retail business model. The company bought goods from a supplier and resold those goods to custom- ers at a higher price point. This is traditional retailing, which is a large segment of the economy but not the only segment. Some aspects of a medical practice may work this way. For example, a practice that sells supplements to its patients would operate that aspect of the practice as any retail store would.

More likely, the inventory in a medical practice is sold as part of a treatment or procedure. For example, the medical practice may bill $100 for giving a patient an injection. The sup- plies for the injection may have cost $50 to purchase. So in this very simple example, the amount paid to the practice would be the revenue. The amount paid for the inoculation from the supplier would be the cost of goods or services sold.

Some healthcare entities manufacture their goods, such as pharmaceutical firms or medi- cal equipment providers. These types of companies also carry inventory on their books.

Inventory Costs As a general rule, inventory should include all costs that are ordinary and necessary to put the goods in place and in condition for their resale. Inventory therefore includes the invoice price, shipping costs incurred when buying the goods, and similar costs. Costs like interest charges on money borrowed to buy inventory, storage costs, and insurance are not included in inventory accounts because they do not meet the general rule. Those costs are called carrying costs and are to be expensed in the period incurred.

Freight Few people think deeply about how significant freight cost can be to the overall cost of bringing a product to market. It can be expressed in very simple terms. If you drive to the store for a gallon of milk costing $3 and spend $3 on gas to make the trip, how much did

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CHAPTER 5Section 5.1 Categories of Inventory

the milk actually cost? If you were trying to categorize your milk in the refrigerator as an asset on an accounting balance sheet, would your report its cost at $3 or $6? Because of its significance, accountants have been very careful to describe fully a framework for the handling of freight costs. Developing an understanding of this framework begins with specific knowledge about freight terms.

FOB is a common freight nomenclature. It is an abbreviation for “free on board.” What that really means is the point at which the ownership of goods shifts from the seller to the buyer. Thus, goods may be sold FOB shipping point. Once goods are shipped, they are deemed the property of the buyer. Equally important, the buyer must assume responsi- bility for payment of freight to the destination. Conversely, FOB destination means that the seller owns the goods until they are delivered and must bear the cost of shipping. The implications of freight terms should not be underestimated. There are two highly signifi- cant inventory accounting considerations that are directly affected by the FOB terms.

First, goods sold FOB destination do not belong to the purchaser until they arrive at their final destination. Therefore, goods that have been purchased but not yet received would not be carried in the buyer’s balance sheet at the end of the accounting period. Similarly, no liability would be reported for the payment obligation. Conversely, goods purchased FOB shipping point that have been shipped by the seller should be reflected on the buy- er’s balance sheet, even though they may not be in the buyer’s physical possession. In this case, the buyer needs to show both the inventory and related liability on its books. Accountants can face interesting challenges to determine the status of goods in transit at the end of each accounting period.

The second major issue pertains to the freight cost. When the buyer assumes the freight cost (as with FOB shipping point), it is deemed to be an ordinary and necessary cost to put the goods in place and in condition for resale. As such, accountants will add freight-in to the cost of the inventory. Thus, the Inventory account will reflect both the invoice cost of the goods, along with any additional amounts for freight. You should be aware that freight-out incurred by a seller of goods faces a different accounting rule. Freight-out is treated like a sales expense and does not increase the cost of goods sold amount; instead, the freight out is subtracted from gross profit in calculating income.

Consigned Goods On occasion, a supplier may approach a healthcare organization about stocking a par- ticular product. The healthcare organization may be reluctant, not wanting to invest in inventory that may not be used for patient services. This negotiation may result in a con- signment of inventory. A consignment is an agreement whereby the inventory’s owner, the consignor, places it with another party in the hope that the goods will be needed for patient care. The party holding physical possession is the consignee but not the legal owner. It must care for the goods and try to sell them to an end customer. The consignor surrenders physical custody but maintains legal ownership. The consignor would con- tinue to carry the goods in its inventory records.

Consigned goods pose a record-keeping challenge. Because physical custody does not represent ownership, it becomes difficult for both consignees and consignors to main- tain proper accountability over consigned inventory. When the consignee sells consigned

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CHAPTER 5Section 5.1 Categories of Inventory

goods to an end user, the consignee becomes obligated to remit a portion of the final sales price to the consignor. Otherwise, it is understood that the consignee reserves the right to return the inventory without obligation to make payment.

Critical Thinking About Inventory Cost Consider that a business is likely to open a new accounting period with a carryover balance of inventory from the preceding period. This is probably rather obvious. Just because an accounting period has ended does not mean that unsold goods must be dumped. Instead, the ending balance of one period becomes the beginning inventory balance of the next. Figure 5.1 shows how a period’s beginning inventory, plus additional purchases, can be combined to represent the total goods available for sale. Some of the goods available for sale are sold and become cost of goods sold, and the unsold portion represents the ending inventory (which will carry forward into the next accounting period). To simplify word- ing, assume cost of goods or services sold in each instance, but we will simplify the rest of the chapter to just using “cost of goods sold.” In many healthcare environments, when inventory is used, it is offset by showing a “Supplies Expense.” Whether the use of inven- tory will be shown as a “Cost of Goods Sold” or a “Supplies Expense,” the basic concepts of managing inventory costs or expenses are similar.

Figure 5.1: Goods available for sale

Figure 5.1 shows how goods available for sale must be split between ending inventory and cost of goods sold. Though a picture may be worth a thousand words, it is also true that accountants rarely communicate with images. Thus, the drawing is usually converted to a calculation format such as the following (all amounts are assumed for the time being):

Beginning inventory $100,000

Plus: Purchases 450,000

Goods available for sale $550,000

Less: Ending inventory 50,000

Cost of goods sold $500,000

The Cost of Goods Sold may be a Supplies Expense in most healthcare environments. In the drawing, the units appear as physical units, but the natural commingling of homoge- neous inventory sometimes makes it difficult or impossible to truly know which units are

Beginning inventory +

Net purchases

Ending inventory +

Cost of goods sold

Goods available for sale

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CHAPTER 5Section 5.3 Perpetual Systems

which. Accountants therefore express inventory on the balance sheet in units of money rather than physical quantity descriptions.

A critical factor in determining income is the allocation of the cost of goods available for sale between ending inventory and cost of goods sold. Accountants have a significant task to assess what cost attaches to ending inventory and what cost attaches to cost of goods sold, especially in light of the fact that the exact physical flow of goods is probably unknown.

5.2 Cost Assignment

It is unlikely that each unit of inventory will have the exact same cost. It can be impractical to trace the exact cost of each unit; even when possible, accountants do not require this association. Instead, accountants use inventory cost flow assumptions. These assump- tions do not need to relate to the physical flow of the inventory. Thus, the inventory cost allocation approach is just a systematic approach for dealing with the question of what cost is to be attached to ending inventory and cost of goods sold.

To illustrate this point, consider the case of Jill’s Medical Supplies. Jill’s Medical Supplies has a storage bin full of gauze rolls. As customers purchase rolls, Jill’s Medical Supplies randomly selects them from the bin. As Jill’s restocks, they dump newly purchased gauze rolls into the bin. The rolls are constantly being mixed up such that Jill’s has no way of knowing the exact purchase date or price of any particular roll remaining in the bin. Dur- ing a recent period, the bin had an opening supply of 500 rolls and was restocked two different times. At each restocking, 500 rolls were added. The rolls in beginning inventory cost $2 per roll. The first restocking had a unit cost of $2.25. The final restocking was at $2.75. The bin was never allowed to empty completely. At the end of the period, the bin contains 125 rolls, probably including some from beginning inventory and each restock- ing event.

What is the cost of the ending inventory? The answer to this important question will directly impact the calculation of not only ending inventory but also cost of goods sold (and therefore income). Jill’s must adopt an inventory-costing method. There are several cost flow assumptions to choose from. One is a first-in, first-out (FIFO) approach. Another is the last-in, first-out (LIFO) approach. The third method reflects a more complex aver- age cost approach. These approaches will be discussed in the next section. The complexity arises because the average cost method is not just the simple average of the per-unit price but instead weights the cost by the number of units purchased at each price point. Thus, it is also known as a weighted-average concept. In the average cost example that follows, the weighted-average cost is recalculated each time there is a new purchase, resulting in a further refinement of its moniker as the moving-average method.

5.3 Perpetual Systems

Before more closely examining the accounting for Jill’s inventory under the FIFO, LIFO, and average cost approaches, it is first necessary to point out that inventory costs can either be accumulated on a real-time perpetual inventory system or occasionally updat- ing via a periodic inventory system. As the name suggests, a perpetual system is one in

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CHAPTER 5Section 5.3 Perpetual Systems

which inventory records are continuously updated for all inventory changes. As inven- tory is purchased, it is added into the Inventory account. As inventory is sold, it is sub- tracted from the Inventory accounts. A periodic system is one in which the Inventory accounts are only updated on designated intervals, such as at the end of each accounting period. At one time, accumulating and assigning costs on a perpetual basis was exceed- ingly difficult because of the extraordinarily tedious record keeping that ensues. Then, companies necessarily resorted to simplifying techniques that only periodically updated inventory records. Modern computers have allowed companies to adopt more sophisti- cated real-time, or perpetual, tracking of inventory. These systems greatly improve asset accountability and business decision making. With a perpetual system, each inventory purchase or sale transaction triggers an update of the inventory records and corporate general ledger. To begin to see how this operates, closely examine the details about Jill’s inventory purchases in Table 5.1.

Table 5.1: Jill’s Medical Supplies inventory purchases

Date Quantity Purchased

Cost per Unit Total Cost

Beginning balance

July 1 500 $2.00 $1,000

Purchase 2 July 15 500 $2.25 $1,125

Purchase 3 July 24 500 $2.75 $1,375

In addition to information about the purchasing activity, we also need detailed informa- tion about Jill’s sales. Table 5.2 provides detailed sales data:

Table 5.2: Jill’s Medical Supplies sales data

Date Quantity Sold Sales Price per Unit

Total Sales

Sale 1 July 9 400 $4.00 $1,600

Sale 2 July 20 550 $4.50 $2,475

Sale 3 July 28 425 $5.00 $2,125

Overall, you will notice that Jill’s had 1,500 units available (500 1 500 1 500) and sold 1,375 units (400 1 550 1 425), leaving the remaining ending inventory on hand at the end of July at 125 units. We mustn’t lose sight of our accounting goals: to determine the total sales, total cost of goods sold, gross profit, and ending inventory balances to report in the financial statements. Making this determination will require an inventory cost flow assumption.

Importantly, the cost flow assumption is used to describe the flow of the cost of goods through the accounting system. It is not necessary that a cost flow assumption actually correspond to a physical flow, but it useful to visualize a cost flow assumption by thinking about physical flow. In a healthcare setting, you would likely sell medications on a FIFO

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basis. Medications can become outdated, and you want to use them before they expire. This is logical. On the other hand, if you sold crushed rock that was dumped in large stacks as it was processed and delivered via a loader scooping from the pile as it was sold, you can likely understand the LIFO cost flow concept. We will first perform Jill’s inven- tory calculations using a perpetual FIFO method.

First-In, First-Out Table 5.3 shows the level of detail that is necessary to track the inventory correctly. Study this very carefully. Perhaps you can follow the logic by only tracking amounts in the table; if not, additional explanatory details are provided below the table. Remember, this is a FIFO example. When a sale occurs, the assumption is that the units sold were from the first, or earliest, available units: first-in, first-out.

Table 5.3: FIFO inventory tracking

Date Purchases Sales Cost of Goods Sold

Remaining Inventory Balance

July 1 500 , $2.00 5 $1,000.00

July 9 400 , $4.00 5 $1,600.00

400 , $2.00 5 $800.00

100 , $2.00 5 $ 200.00

July 15 500 , $2.25 5 $1,125.00

100 , $2.00 5 $200.00

500 , $2.25 5 1,125.00

$1,325.00

July 20 550 , $4.50 5 $2,475.00

100 , $2.00 5 $200.00

450 , $2.25 5 1,012.50

$1,212.50

50 , $2.25 5 $112.50

July 24 500 , $2.75 5 $1,375.00

50 , $2.25 5 $112.50

500 , $2.75 5 1,375.00

$1,487.50

July 28 425 , $5.00 5 $2,125.00

50 , $2.25 5 $112.50

375 , $2.75 5 1,031.25

$1,143.75

125 , $2.75 5 $343.75

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Notice that a significant amount of detail is in tracking inventory using a perpetual approach; without computers, this becomes nearly impossible to do correctly when vast inventories and large volumes of transactions are involved. However, given a properly programmed computer, the task is inconsequential. Many businesses have a sufficient level of sophistication that inventory records are being updated as each sale is recorded at a point-of-sale terminal. Jill’s Medical Supplies could have such a terminal.

Be sure to note exactly what is occurring on each date. For example, on July 20, 50 units remain after selling 550 units. This is determined by first noting that 600 units were on hand prior to the sale transaction (consisting of 100 units that are assumed to cost $2.00 each and 500 units that are assumed to cost $2.25 each). After removing 550 units from stock (assumed to consist of 100 units costing $2.00 and 450 units costing $2.25), only 50 remain at an assumed unit cost of $2.25. This cost analysis and allocation process must be repeated with each transaction that results in increasing or decreasing the inventory bal- ance. With FIFO, keep in mind that the layers of inventory assumed to be sold are based on the chronological order in which they were purchased.

The analysis provided within Table 5.3 provides a basis for actually recording the transac- tions into the general journal. Be sure to trace the amounts in the entries back into Table 5.3. Remember, Inventory is debited as purchases occur and credited as sales occur. Fol- lowing are the necessary entries to record July’s activity:

7-9-XX Accounts receivable 1,600.00

Sales 1,600.00

Sold inventory on account

7-9-XX Cost of goods sold 800.00

Inventory 800.00

To record the cost of goods sold

7-15-XX Inventory 1,125.00

Accounts payable 1,125.00

Purchased inventory on account

7-20-XX Accounts receivable 2,475.00

Sales 2,475.00

Sold inventory on account

7-20-XX Cost of goods sold 1,212.50

Inventory 1,212.50

To record the cost of goods sold

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CHAPTER 5Section 5.3 Perpetual Systems

Last-In, First-Out Table 5.4 repeats the preceding facts but with the calculations applied on a LIFO basis. When a sale occurs, the assumption is that the units sold were from the last, or most recent, available units: last-in, first-out.

7-24-XX Inventory 1,375.00

Accounts payable 1,375.00

Purchased inventory on account

7-28-XX Accounts receivable 2,125.00

Sales 2,125.00

Sold inventory on account

7-28-XX Cost of goods sold 1,143.75

Inventory 1,143.75

To record the cost of goods sold

Using selected T-accounts in Exhibit 5.1, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,156.25), and the ending inventory ($343.75).

Exhibit 5.1: T-accounts for sales, cost of goods sold, and inventory (FIFO)

Sales Cost of Goods Sold Inventory

1,000.00

1,600.00 800.00 800.00

1,212.50

2,475.00 1,212.50 1,212.50

1,375.00

2,125.00 1,143.75 1,143.75

6,200.00 3,156.25 343.75

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Table 5.4: LIFO inventory tracking

Date Purchases Sales Cost of Goods Sold

Remaining Inventory Balance

July 1 500 , $2.00 5 $1,000.00

July 9 400 , $4.00 5 $1,600.00

400 , $2.00 5 $800.00

100 , $2.00 5 $200.00

July 15 500 , $2.25 5 $1,125.00

100 , $2.00 5 $200.00

500 , $2.25 5 1,125.00 $1,325.00

July 20 550 , $4.50 5 $2,475.00

500 , $2.25 5 $1,125.00

50 , $2.00 5 100.00

$1,225.00

50 , $2.00 5 $ 100.00

July 24 500 , $2.75 5 $1,375.00

50 , $2.00 5 $100.00

500 , $2.75 5 1,375.00

$1,475.00

July 28 425 , $5.00 5 $2,125.00

425 , $2.75 5 $1,168.75

50 , $2.00 5 $100.00

75 , $2.75 5 206.25

$306.25

Again, carefully observe the action on each date. For example, the 50 remaining units on July 20 consist of those from the very beginning stock (at $2.00 each) because it is assumed under LIFO that goods from the recent purchases are the ones being sold. With LIFO, the layers of inventory assumed to be sold are based on the reverse order in which they were purchased. Following are the necessary entries to record July’s LIFO-based activity:

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CHAPTER 5Section 5.3 Perpetual Systems

7-9-XX Accounts receivable 1,600.00

Sales 1,600.00

Sold inventory on account

7-9-XX Cost of goods sold 800.00

Inventory 800.00

To record the cost of goods sold

7-15-XX Inventory 1,125.00

Accounts payable 1,125.00

Purchased inventory on account

7-20-XX Accounts receivable 2,475.00

Sales 2,475.00

Sold inventory on account

7-20-XX Cost of goods sold 1,225.00

Inventory 1,225.00

To record the cost of goods sold

7-24-XX Inventory 1,375.00

Accounts payable 1,375.00

Purchased inventory on account

7-28-XX Accounts receivable 2,125.00

Sales 2,125.00

Sold inventory on account

7-28-XX Cost of goods sold 1,168.75

Inventory 1,168.75

To record the cost of goods sold

Using selected T-accounts in Exhibit 5.2, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,193.75), and the ending inventory ($306.25).

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(continued)

Exhibit 5.2: T-accounts for sales, cost of goods sold, and inventory (LIFO)

Sales Cost of Goods Sold Inventory

1,000.00

1,600.00 800.00 800.00

1,225.00

2,475.00 1,225.00 1,212.50

1,375.00

2,125.00 1,168.75 1,168.75

6,200.00 3,193.75 306.25

The Average Cost Approach If Jill’s had instead applied the average cost approach, its cost allocation would appear as shown in Table 5.5. In reviewing this data, be sure to notice how the average cost of the total remaining supply of inventory must be recalculated with each purchase of inventory. The decimals associated with the pennies can become very important because the aver- age unit cost is often multiplied times thousands of units (so don’t round significantly!). Another important aspect of these calculations is that you cannot just average the three unit cost values ($2.00, $2.25, and $2.75) because that would fail to weight the cost by the number of units acquired or held at each cost point.

Table 5.5: Cost allocation

Date Purchases Sales Cost of Goods Sold

Remaining Inventory Balance

July 1 500 , $2.00 5 $1,000.00

500 , $2.00 5 $1,000.00

July 9 400 , $4.00 5 $1,600.00

400 , $2.00 5 $ 800.00

100 , $2.00 5 $ 200.00

July 15 500 , $2.25 5 $1,125.00

100 , $2.00 5 $ 200.00

500 , $2.25 5 1,125.00

$1,325.00

$1,325.00/600 units 5 $2.2083 average

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Table 5.5: Cost allocation (continued)

Date Purchases Sales Cost of Goods Sold

Remaining Inventory Balance

July 20 550 , $4.50 5 $2,475.00

500 , $2.2083 5 $1,214.56

50 , $2.083 5 $110.4217

July 24 500 , $2.75 5 $1,375.00

50 , $2.2083 5 $110.4217

500 , $2.7500 5 1,375.00

$1,485.42

$1,485.42/550 units 5 $2.7008 average

July 28 425 , $5.00 5 $2,125.00

425 , $2.7008 5 $1,147.82

125 , $2.7008 5 $337.60

Following are the revised journal entries necessary to reflect the average cost flow assump- tion. The account titles are not changed, only the amounts.

7-9-XX Accounts receivable 1,600.00

Sales 1,600.00

Sold inventory on account

7-9-XX Cost of goods sold 800.00

Inventory 800.00

To record the cost of goods sold

7-15-XX Inventory 1,125.00

Accounts payable 1,125.00

Purchased inventory on account

7-20-XX Accounts receivable 2,475.00

Sales 2,475.00

Sold inventory on account

7-20-XX Cost of goods sold 1,214.58

Inventory 1,214.58

To record the cost of goods sold

7-24-XX Inventory 1,375.00

Accounts payable 1,375.00

Purchased inventory on account

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CHAPTER 5Section 5.4 Comparing Methods

7-28-XX Accounts receivable 2,125.00

Sales 2,125.00

Sold inventory on account

7-28-XX Cost of Goods Sold 1,147.82

Inventory 1,147.82

To record the cost of goods sold

Using selected T-accounts in Exhibit 5.3, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,162.40), and the ending inventory balances ($337.60). Let’s see how these entries impact certain ledger accounts and the resulting financial statements.

Exhibit 5.3: T-accounts for sales, cost of goods sold, and inventory (average costing)

Sales Cost of Goods Sold Inventory

1,000.00

1,600.00 800.00 800.00

1,125.00

2,475.00 1,214.58 1,214.58

1,375.00

2,125.00 1,147.82 1,147.82

6,200.00 3,162.40 337.60

5.4 Comparing Methods

At this juncture, it is essential to see that alternative accounting methods result in differ-ent reported results for specific periods. With FIFO, Jill’s would report a gross profit of $3,043.75 ($6,200.00 sales 2 $3,156.25). With LIFO, Jill’s would report a gross profit of $3,006.25 ($6,200.00 sales 2 $3,193.75). With average costing, the gross profit amounted to $3,037.60 ($6,200.00 sales 2 $3,162.40). This outcome is consistent with a general rule of thumb that states LIFO will produce the lowest profits during a period of rising prices. Obviously, income is being charged with higher recent costs. Thus, many companies prefer to use LIFO because it reduces income on which taxes may be assessed. You will probably find it interesting to note that many countries outside of the United States do not permit the LIFO method. Few healthcare settings use LIFO because older inventory would likely expire, if inventory most recently bought was sold first.

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CHAPTER 5Section 5.4 Comparing Methods

Some may find fault with allowing accounting choices of this nature. Before reaching a conclusion, consider that these differences in income are usually only temporary. If and when the inventory is completely liquidated, the differences will reverse, and the life- time income of the firm will equal out between the methods. For Jill’s, the annual income difference is not very material; in some cases, accounting methods produce significantly different results, and sometimes they do not. The takeaway message is that a financial statement user should clearly examine financial statements and related disclosures to determine the methods in use. This is particularly important when trying to compare the performance of two firms, especially when each uses a different set of accounting meth- ods and assumptions.

Specific Identification In lieu of an inventory cost flow assumption like FIFO or weighted average, some busi- nesses may instead elect to use the specific identification method. The business must be able to match each unit of inventory with its actual cost. The item’s cost remains in the Inventory account until it is sold, at which point it is assigned to Cost of Goods Sold. You can immediately discern that specific identification requires tedious record keeping and would be useful only for inventories with a fairly high per-unit cost and unique identify- ing characteristics. For example, a medical equipment supplier may use this method if each piece of equipment must be customized to patient needs.

Lower-of-Cost-or-Market Adjustments Notwithstanding the cost flow assumption or other inventory valuation technique in use, it is imperative that a company not overstate the reported inventory value on the bal- ance sheet. Sometimes a company may find that it is holding inventory that it cannot sell for its reported value. Obsolescence, defects, cost declines, and similar issues can impair the realizable value of selected inventory items. Accountants are required to periodically assess inventory on hand to ensure that it is not reported for more than its market value.

This testing is known as a lower-of-cost-or-market method review. In other words, although accountants normally report assets at cost, they also avoid reporting them at more than their market value. That is, the accounting principle is to report the asset at the lower of its original cost or current market value. If the accountant finds that inventory is being carried in the accounting records at more than market value, a downward reduc- tion in recorded valuations may be in order. These so-called write downs, or impairments, from the recorded cost to the lower market value would be made by crediting the Inven- tory account and debiting a Loss for Reduction in Market Value. This loss reduces income. A healthcare institution may find this necessary if supplies become outdated.

In the context of inventory testing, market value is generally but not always considered to be the cost that it would take to replace the goods. This is not the same as expected selling price. Basically, if the inventory on hand can be replaced for a new investment amount that is below reported cost, an impairment reduction is in order. Once a reduction has been recorded, subsequent recoveries in value are not recognized. In essence, the reduced value becomes the new accounting amount to carry in inventory going forward.

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CHAPTER 5Section 5.5 The Importance of Accuracy

Case Study: Jack’s Medical Supply Company

Jack’s Medical Supply Company began business on January 1 of the current year. Owner, Jack Welsh, is trying to determine which inventory method would be the most appropriate for his business. He asks his accountant, Laurie Gordon, to review the purchases and sales to determine how best to present his inventory value on the Balance Sheet in preparation for his year-end financial reports.

Purchases of walkers were as follows:

1/3: 100 walkers , $125 3/17: 50 walkers , $130 5/9: 246 walkers , $140 7/3: 400 walkers , $150 10/23: 74 walkers , $160

Jack’s Medical Supply sold 710 walkers at an average price of $250 per walker. The company uses a periodic inventory system.

(continued)

5.5 The Importance of Accuracy

What is the effect of a company’s failure to reduce the carrying value of impaired inventory? Or, what is the effect of failing to adjust inventory records for goods that are shown to exist but cannot be physically located? In general, why does it matter that inventory records accurately reflect the goods on hand, as measured under gener- ally accepted accounting principles? The general rule is that overstatements of ending inventory cause overstatements of income, whereas understatements of ending inventory cause understatements of income. Before giving consideration to offsetting tax effects, this offset is “dollar for dollar.” In other words, if inventory is overstated by $1, so is income for that year. Remember, the total cost of goods available for sale is ultimately allocated either to Cost of Goods Sold or Inventory (i.e., if the cost is not in Inventory, then it must be assigned to Cost of Goods Sold, thereby reducing income).

Despite a company’s best efforts to maintain an accurate perpetual inventory accounting system, errors and discrepancies will invariably creep into the accounting system. Goods may be lost, damaged, or stolen, or transactions may be recorded incorrectly. Therefore, a company should physically examine its inventory on hand at least once each year. This is a highly significant point. Perhaps you have worked for a company and been involved in taking the physical inventory. A physical inventory is the process of actually count- ing and valuing the inventory on hand. Discrepancies should be investigated, and the accounting records should be updated to reflect the balance that is finally determined to be correct—thus the need for accuracy. Employees are often unaware of the connection between a careful count and the final measure of a firm’s income.

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CHAPTER 5Key Terms

average cost A cost flow assumption.

cost flow assumptions Inventory-costing methods such as first-in, first-out; last-in, last-out; or average cost.

first-in, first-out (FIFO) An inventory- costing method; the assumption is that the units are sold from the first, or earliest, available units.

FOB (free on board) A common freight nomenclature indicating the point at which the ownership of goods shifts from the seller to the buyer.

FOB destination A common freight nomenclature indicating that the seller owns goods until they are delivered and must bear the cost of shipping.

FOB shipping point A common freight nomenclature indicating that once goods are shipped, they are deemed the buyer’s property and the buyer must bear the cost of shipping.

last-in, first-out (LIFO) When a sales occurs, the assumption is that the units sold were from the last, or most recent, available.

lower-of-cost-or-market method A method whereby inventories are accounted for at acquisition cost or market value, whichever is lower.

periodic inventory system An updating system in which inventory accounts are only updated on designated intervals, such as at the end of each accounting period.

perpetual inventory system An updat- ing system in which inventory records are continuously updated for all inventory changes.

physical inventory The process of actu- ally counting and valuing inventory on hand.

specific identification The method in which a business must match each unit of inventory with its actual cost.

Key Terms

Case Study: Jack’s Medical Supply Company (continued)

Case Study Exercises

1. Calculate the cost of goods sold, ending inventory, and gross profit under each of the following inventory valuation methods.

a. First-in, first-out b. Last-in, first-out c. Weighted average

2. Which of the three methods would be chosen if management’s goal is to a. produce an up-to-date inventory valuation on the balance sheet? b. approximate the physical flow of basic medical supplies? c. report low earnings (for tax purposes) for a separate medical equipment company

that has been experiencing declining purchase prices?

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CHAPTER 5Review Questions

Review Questions

The following questions relate to several issues raised in the chapter. Test your knowl- edge of these issues by selecting the best answer. (The odd-numbered answers appear in the answer appendix.)

1. Because of a mathematical error, the 20X8 ending inventory included goods at a $170 figure that had actually cost $710. As a result of this error,

a. net income for 20X8 is overstated. b. net income for 20X8 is understated. c. operating expenses for 20X8 are understated. d. total liabilities at the end of 20X8 are overstated.

2. The inventory cost flow assumption in which the oldest costs incurred become part of cost of goods sold when units are sold is

a. LIFO. b. FIFO. c. the weighted average. d. retail.

3. The LIFO inventory valuation method

a. is acceptable only if a company sells its newest goods first. b. will result in higher income levels than FIFO in periods of rising prices. c. will result in a match of fairly current inventory costs against recent selling

prices on the income statement. d. cannot be used with a periodic inventory system.

4. Stanley Medical Supply Company sells two different products. The following information is available at year-end:

Inventory Item Units

Cost per Unit

Market Value per Unit

A 100 $4 $6

B 200 5 3

Applying the lower-of-cost-or-market rule to each item, what will be Stanley’s ending inventory balance?

a. $1,000 b. $1,200 c. $1,400 d. some other amount

5. Which of the following accounting systems maintains a running (continuous) record of merchandising purchases and sales by inventory item?

a. perpetual b. gross profit c. periodic d. retail

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CHAPTER 5Exercises

6. What items are reported as inventory for (a) merchandising companies and (b) manufacturing companies?

7. The Potter Medical Supply Company purchased the following merchandise on December 28:

Supplier Terms Amount

Pax Medical Supply Company FOB destination $1,800

James Manufacturing FOB shipping point 2,500

Both purchases were shipped December 30, but neither had been received by December 31. Should the purchases be included in Potter’s December 31 ending inventory? Explain.

8. Why is it necessary to take a physical count of inventory at the end of each accounting period?

9. Why is the specific identification method of inventory valuation used infrequently?

10. In a period of rising prices, which inventory valuation method (LIFO or FIFO) tends to result in the following?

a. highest cost of goods sold b. lowest inventory valuation c. highest income taxes

11. Discuss the advantages of a perpetual inventory system when compared with a periodic system.

Exercises

1. Inventory errors and income measurement. The income statements of Keagle Medical Equipment Company for 20X3 and 20X4 follow.

20X3 20X4

Sales $100,000 $109,000

Cost of goods sold 62,000 74,000

Gross profit $ 38,000 $ 35,000

Expenses 26,000 22,000

Net income $ 12,000 $ 13,000

A recent review of the accounting records discovered that the 20X3 ending inven- tory had been understated by $4,000.

a. Prepare corrected 20X3 and 20X4 income statements. b. What is the effect of the error on ending owner’s equity for 20X3 and 20X4?

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CHAPTER 5Problems

2. Inventory valuation methods: basic computations. The January beginning inven- tory of the White Medical Supply consisted of 300 units costing $40 each. During the first quarter, the company purchased two batches of goods: 700 units at $44 on February 21 and 800 units at $50 on March 28. Sales during the first quarter were 1,400 units at $75 per unit. White Medical Supply uses a periodic inventory system.

Using the White Medical Supply data, fill in the following chart to compare the results obtained under the FIFO, LIFO, and weighted-average inventory methods.

FIFO LIFO Weighted Average

Goods available for sale $ $ $

Ending inventory, March 31

Cost of goods sold

3. Analysis of LIFO versus FIFO. Indicate whether LIFO or FIFO best describes each of the following:

a. gives highest profits when prices fall. b. yields lowest income taxes when prices rise. c. generates an ending inventory valuation that somewhat approximates

replacement cost. d. matches recent costs against current selling prices on the income statement. e. comes closest to approximating the physical flow of goods of a fruit and

vegetable dealer. f. results in lowest cost of goods sold in inflationary periods.

Problems

1. Inventory errors. The income statements of Duty Medical Supply Company for the years ended December 31, 20X1 and 20X2, follow.

20X1 20X2

Net sales $ 440,000 $483,000

Cost of goods sold

Beginning inventory $ 95,000 $109,000

Add: Net purchases 380,000 404,000

Goods available for sale $ 475,000 $513,000

Less: Ending inventory 109,000 127,000

Cost of goods sold 366,000 386,000

Gross profit $ 74,000 $ 97,000

Operating expenses 58,000 67,000

Net income $ 16,000 $ 30,000

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CHAPTER 5Problems

Duty uses a periodic inventory system. A detailed review of the accounting records disclosed the following:

• A review of 20X1 purchase invoices revealed that a clerk had incorrectly re- corded a $12,600 purchase as $1,260.

• A $4,800 purchase was made on December 30, 20X2, terms FOB shipping point. The invoice was not recorded in 20X2, nor were the goods included in the 20X2 ending physical inventory count. Both the goods and invoice were received in early 20X3, with the invoice being recorded at that time.

• Goods costing $3,000 were accidentally excluded from the 20X1 ending physi- cal inventory count. These goods were sold during 20X2, and all aspects of the sale were properly recorded.

Instructions

a. Prepare corrected income statements for 20X1 and 20X2. b. Determine the impact of the preceding errors on the December 31, 20X2,

owner’s equity balance.

2. Inventory valuation methods: computations and concepts. Jack’s Medical Supply Company began business on January 1 of the current year. Purchases of walkers were as follows:

1/3: 100 walkers , $125

3/17: 50 walkers , $130

5/9: 246 walkers , $140

7/3: 400 walkers , $150

10/23: 74 walkers , $160

Jack’s Medical Supply sold 710 walkers at an average price of $250 per walker. The company uses a periodic inventory system.

Instructions

a. Calculate cost of goods sold, ending inventory, and gross profit under each of the following inventory valuation methods:

• First-in, first-out • Last-in, first-out • Weighted average

b. Which of the three methods would be chosen if management’s goal is to

(1) produce an up-to-date inventory valuation on the balance sheet? (2) approximate the physical flow of basic medical supplies? (3) report low earnings (for tax purposes) for a separate medical equipment

company that has been experiencing declining purchase prices?

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CHAPTER 5Problems

3. Lower-of-cost-or-market method. Davenport Opticians began business on Sep- tember 1 of the current year. The following purchases were made during the first few months of operation:

Reading Glasses Sunglasses Contact Lenses

9/2 1,000 , $20 450 , $10 2,500 , $5

10/15 750 , $22 200 , $15 2,000 , $6

12/6 300 , $25 1,500 , $7

The December 31 physical inventory count revealed the following items on hand: 650 reading glasses, 400 sunglasses, and 1,000 contact lenses. Total sales through year-end were $85,000, and operating expenses (excluding cost of goods sold) totaled $17,800. Davenport uses the FIFO inventory valuation method coupled with a periodic inventory system.

Instructions

a. Compute the company’s inventory as of December 31. In addition, calculate cost of goods sold and net income through the end of the year.

b. Assume that the manufacturer of contact lenses announced a price decrease to $6.50. Determine the impact of the announcement on the firm’s ending inven- tory valuation.

c. Prepare the journal entry necessary to value the inventory at the lower-of-cost- or-market value.

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