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Chapter 9: Understanding Inventory and Depreciation Concepts

Inventory Concept (1 of 2)

“Inventory” includes all the items (goods) that an organization has for sale in the normal course of its business.
Inventory is a current asset on the balance sheet, because items in the inventory are expected to be sold within a twelve-month period.

Inventory Concept (2 of 2)

Various healthcare organizations and/or their departments deal with inventory and must account for it, including:
All pharmacies (hospital-based, retail brick-and-mortar, or mail order)
The hospital cafeteria
The hospital gift shop

Interrelationship Between Inventory and Cost of Goods Sold (1 of 2)

The completed inventory item is sold.
That is how an item moves out of inventory and is recognized as cost.
When it is recognized as cost, it then becomes “cost of goods sold” (or “cost of drugs sold,” in the case of the pharmacy).
So it moves out of inventory on the balance sheet and becomes “cost of goods sold” on the statement of income.

Interrelationship Between Inventory and Cost of Goods Sold (2 of 2)

Recording inventory and costs of goods (or drugs) sold is a sequence of events
Record beginning inventory
Record purchases during period
Beginning inventory plus purchases equals “cost of goods (or drugs) available for sale”
Record ending inventory
Cost of goods (or drugs) available for sale less ending inventory equals “cost of goods (or drugs) sold”

Figure 9-1 Recording Inventory in the Accounting Cycle.

Interrelationship Between Inventory and Cost of Goods Sold

“Gross Margin” equals revenue from sales less the cost of goods (or drugs) sold, as follows:

Sales 100%

Cost of goods (drugs) sold – 65%

Gross margin 35%

An organization’s gross margin can readily be compared to industry standards.

Inventory Methods

How is the inventory to be valued? The two most commonly used methods are:
First-In, First-Out (FIFO) inventory method
Last-In, First-Out (LIFO) inventory method

Inventory Methods: FIFO

The FIFO inventory costing method recognizes the first costs placed into inventory as the first costs moved out into cost of goods (or drugs) sold when a sale occurs.
So if costs have risen during the year, under FIFO the ending inventory will be higher (because the oldest less costly inventory items moved out first).

(Exhibit 9-1 illustrates this effect.)

Inventory Methods: LIFO

The LIFO inventory costing method recognizes the latest, or last, costs placed into inventory as the first costs moved out into cost of goods (or drugs) sold when a sale occurs.
So if costs have risen during the year, under LIFO the ending inventory will be lower (because the latest more costly items moved out first, leaving the older less costly items still in inventory).

(Exhibit 9-2 illustrates this effect.)

Other Inventory Methods (1 of 2)

Two other inventory treatments also deserve mention. They are:
Weighted Average inventory method
No Method

Other Inventory Methods (2 of 2)

The weighted average inventory method is based on the weighted average cost of inventory during the period (calculated as cost of goods available for sale divided by number of units available for sale).
If there is no method at all, the inventory is never recognized. In some cases not recognizing inventory can result in misleading financial statements.

Inventory Tracking

The two most typical inventory tracking systems are:
The perpetual inventory system
The periodic inventory system
Two types of adjustments to inventory that usually become necessary include
adjustments for shortages and for obsolete items

Inventory Distribution Systems

Distribution Using Sign-Off Forms
Distribution Using Robotic Technology
Robotic automation
Cost/benefit of a robot

Calculating Inventory Turnover

Inventory turnover is a ratio that shows how fast inventory is sold, or “turns over”:

First compute “Average Inventory” (Beginning Inventory plus Ending Inventory divided by two equals Average Inventory.)

Next compute “Inventory Turnover” (Cost of Goods Sold divided by Average Inventory equals Inventory Turnover)

(Figure 9-2 illustrates the sequence of this computation.)

Figure 9-2 Calculating Inventory Turnover.

FIFO Inventory:
Solution to Assignment 9-1

Assumptions	FIFO Inventory Effect
Sales (Revenue)	900 units @$100 =	$90,000
Cost of Sales:
Beginning inventory	500 units @$50 =	$25,000
Plus: Purchases	400 units @$50 = 20,000 100 units @$65 = 6,500 400 units @$85 = 32,000	58,500
SubTotal	$83,500
Less: Ending inventory	100 units @$65 = 6,500 400 units @$85 = 32,000	38,500
Cost of Sales	[aka “Cost of Goods Sold”	45,000
Gross Profit	$45,000
Cost of Sales %	(45,000 divided by 90,000) =	50%

LIFO Inventory:
Solution to Assignment 9-1

Assumptions	LIFO Inventory Effect
Sales (Revenue)	900 units @$100 =	$90,000
Cost of Sales:
Beginning inventory	500 units @$50 =	$25,000
Plus: Purchases	400 units @$50 = 20,000 100 units @$65 = 6,500 400 units @$85 = 32,000	58,500
SubTotal	$83,500
Less: Ending inventory	500 units @$50 =	25,000
Cost of Sales	[aka “Cost of Goods Sold”]	58,500
Gross Profit	$31,500
Cost of Sales %	(58,500 divided by 90,000) =	65%

LIFO Inventory Turnover:
Solution to Assignment 9-2.1

Average Inventory: $25,000
Inventory Turnover: 2.34

FIFO Inventory Turnover:
Solution to Assignment 9-2.2

Average Inventory: $31,750
Inventory Turnover: 1.41

Depreciation Concept (1 of 2)

Depreciation expense spreads, or allocates, the cost of a fixed asset over the useful life of that asset.
Fixed assets are placed on the balance sheet as long-term assets.
Their cost is recognized each year through depreciation expense.
So the cost is spread, or allocated, over a period of years.

Depreciation Concept (2 of 2)

The useful life of the asset determines the period over which the fixed asset’s cost will be spread.
Salvage value (aka residual value or scrap value) represents any expected cash value of the asset at the end of its useful life. The remaining salvage value is not depreciated, because it is expected to be recovered.

Interrelationship Between Depreciation Expense and the Reserve for Depreciation

Depreciation expense over the years is accumulated into the Reserve for Depreciation. So the two are interrelated:
Depreciation expense for the year is recorded in the Income Statement.
The same amount is also added to the cumulative amount accumulating on the Balance Sheet in the Reserve for Depreciation
The two amounts should balance each other

(The interrelationship is illustrated in Figure 9-3.)

Figure 9-3 Interrelationship of Depreciation Expense and Reserve for Depreciation in the Accounting Cycle.

Net Book Value (1 of 2)

The net book value (aka book value) of a fixed asset:
Is a balance sheet figure that represents the remaining undepreciated portion of the fixed asset cost
The term derives from value recorded on the books—thus “book value”

Net Book Value (2 of 2)

The net book value of a fixed asset is computed as follows:
Determine original cost of fixed asset on the balance sheet
Subtract the reserve for depreciation
The result equals net book value at that point in time

(The computation sequence is illustrated in Figure 9-3.)

Figure 9-4 Net Book Value Computation.

Five Methods of Computing
Book Depreciation

Book Depreciation can be computed in any one of five methods:
Straight-line Depreciation Method
Accelerated Book Depreciation Methods:

Sum-of-the-Year’s Digits (SYD) Method

Double-Declining-Balance (DDB) Method

150% Declining Balance (150% DB) Method

Units of Service or Units of Production (UOP) Method

Depreciation Methods (1 of 2)

Straight-line depreciation assigns an equal or even amount of depreciation expense over each year or period of the asset’s useful life.
Accelerated depreciation writes off more depreciation expense in the first part of the asset’s useful life.
Units-of-Service depreciation assigns a fixed amount of depreciation to each unit of service or output that is produced. (Thus a fixed total units of service over the life of the asset is used instead of number of years of useful life.)

Depreciation Methods (2 of 2)

Straight-line depreciation is illustrated in the following Table 9-1 (with no salvage value) and Table 9-2 (with salvage value). Further details appear in the chapter.
Further details about computations of other methods of book depreciation appear in Appendix 9-A at the end of the chapter.

Computing Tax Depreciation

Tax depreciation is beyond the scope of this book. We merely recognize that it is computed for tax purposes and at this time includes the following methods:
Modified Accelerated Cost Recovery System (MACRS)
General Depreciation System (GDS)
Alternative Depreciation System (ADS)

Depreciation Concepts: Example 9A

Straight Line:

Step 1: Compute the cost net of salvage or trade-in value: 200,000 less 10 percent (S or T value) = $180,000
Step 2: Divide by expected life years (aka estimated useful life) = $18,000 depreciation per year for 10 years

Depreciation Concepts:
Example 9A: Accelerated (1 of 2)

Step 1: Compute the straight-line rate:
1 divided by 10 equals 10 percent.

Step 2: Double the rate (as in double declining method): 10 percent times 2 equals 20 percent.

Step 3: Compute the first year’s depreciation expense: $200,000 × 20% = $40,000.

Step 4: Compute the carry-forward book value at the beginning of year two:

$200,000 – 40,000 = $160,000.

Depreciation Concepts:
Example 9A: Accelerated (2 of 2)

Step 5: Compute the second year’s depreciation

expense: $160,000 × 20% = $32,000.

Step 6: Compute the carry-forward book value at the beginning of year three:
$160,000 – 32,000 = $128,000.

Continue until the asset’s salvage or trade-in value has been reached.

Depreciation Concepts: Practice Exercise 9-1.1

Straight-line depreciation would amount to $18,000 per year for 10 years.

Compute cost net of salvage value or trade-in (S or T): ($600,000 less $60,000 equals $540,000)

Divide result by expected life: ($540,000 divided by 10 equals $54,000 depreciation/year for 10 years)

Depreciation Concepts:
Assignment Exercise 9-3

Double declining depreciation for the laboratory equipment
Year	Book Value at Beginning of Year	Depreciation Expense	Book Value at End of Year
1 2 3 4 5	300,000 180,000 108,000 64,800 38,880	300,000 × 40% = 120,000 180,000 × 40% = 72,000 108,000 × 40% = 43,200 64,800 × 40% = 25,920 38,880 – 15,000 = 23,880	300,000 – 120,000 = 180,000 180,000 – 72,000 = 108,000 108,000 – 43,200 = 64,800 64,800 – 25,920 = 38,880 38,880 – 23,880 = 15,000

Double declining depreciation for the radiology equipment
Year	Book Value at Beginning of Year	Depreciation Expense	Book Value at End of Year
1 2 3 4 5 6 7	800,000 571,440 408,180 291,563 208,263 148,763 106,262	800,000 × 28.57% = 228,560 571,440 × 28.57% = 163,260 408,180 × 28.57% = 116,617 291,563 × 28.57% = 83.300 208,263 × 28.57% = 59,500 148,763 × 28.57% = 42,501 106,262 × 28.57% = 26,262	800,000 – 228,560 = 571,440 571,440 – 163,260 = 408,180 408,180 – 116,617 = 291,563 291,563 – 83,300 = 208,263 208,263 – 59,500 = 148,763 148,763 – 42,501 = 106,262 106,252 – 26,262 = 80,000

Units-of-Service Depreciation: Assignment 9-5(a) Depreciation Compensation

Cost (to be Depreciated)	Units-of-Service per Year	×	Depreciation per Unit	=	Annual Depreciation Expense	Accumulated Depreciation (Reserve for Depreciation)	Net Remaining Undepreciated Cost (Net Book Value)
$50,000
Year 1	2,200	$5.00*	$11,000	$11,000	$39,000
Year 2	2,100	5.00	10,500	21,500	28,500
Year 3	2,300	5.00	11,500	33,000	17,000
Year 4	2,200	5.00	11,000	44,000	6,000
Year 5	1,200	5.00	6,000	50,000	-0-
Total Units	10,000

Units-of-Service Depreciation: Assignment 9-5(b) Solution

Cost (to be Depreciated)	Units-of-Service per Year	×	Depreciation per Unit	=	Annual Depreciation Expense	Accumulated Depreciation (Reserve for Depreciation)	Net Remaining Undepreciated Cost (Net Book Value)
$50,000 less $5,000
Year 1	2,200	$4.50*	$9,900	$ 9,900	$40,100
Year 2	2,100	4.50	9,450	19,350	30,650
Year 3	2,300	4.50	10,350	29,700	20,300
Year 4	2,200	4.50	9,900	39,600	10,400
Year 5	1,200	4.50	5,400	45,000	5,000
Total Units	10,000