health care finance assignment week 3

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Part III: Tools to Analyze Financial Operations

CHAPTER 8: UNDERSTANDING INVENTORY & DEPRECIATION

CONCEPTS

Health Care Finance by Judith J. Baker and R.W. Baker.

• “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

• 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

• 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

• Recording inventory & 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”

Interrelationship Between Inventory and Cost of Goods Sold

Figure 8–1 Recording Inventory in the Accounting Cycle

• “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.

Interrelationship Between Inventory and Cost of Goods Sold

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 8-1 illustrates this effect.

Exhibit 8–1 FIFO Inventory 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 8-2 illustrates this effect.

Exhibit 8–2 LIFO Inventory Effect

Health Care Finance by Judith J. Baker and R.W. Baker.

Other Inventory Methods

• Two other inventory treatments also deserve mention. They are:

• Weighted Average inventory method

• No Method

Other Inventory Methods

• 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.

Calculating Inventory Turnover

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

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

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

• Figure 8-2 illustrates the sequence of this computation.

Figure 8–2 Calculating Inventory Turnover

Health Care Finance by Judith J. Baker and R.W. Baker.

FIFO Inventory: Assignment 8-1 Solution

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: Assignment 8-1 Solution

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: Assignment 8-2.1 Solution

• Average Inventory — $25,000

• Inventory Turnover — 2.34

FIFO Inventory Turnover: Assignment 8-2.2 Solution

• Average Inventory — $31,750

• Inventory Turnover — 1.41

Depreciation Concept

• 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

• 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.

• 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 8-3.

Interrelationship Between Depreciation Expense and the Reserve for Depreciation

Figure 8–3 Interrelationship of Depreciation Expense and Reserve for Depreciation in the

Accounting Cycle.

Net Book Value

• 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

• 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 8-3.

Figure 8–4 Net Book Value Computation

• 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

Five Methods of Computing Book Depreciation

• 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

• Straight-line depreciation is illustrated in the following Table 8-1 (with no salvage value) and Table 8-2 (with salvage value). Further details appear in the chapter.

• Further details about computations of other methods of book depreciation appear in Appendix 8-A at the end of the chapter.

Table 8–1 Straight-Line Depreciation: 5-Year Life with No Salvage Value

Table 8–2 Straight-Line Depreciation: 5-Year Life with Salvage Value

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 8A

• 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 8A: Accelerated

• 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 X 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 8A: Accelerated

• Step 5. Compute the second year’s depreciation expense: $160,000 X 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 8-1.1

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

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

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

Depreciation Concepts: Assignment Exercise 8-3Straight Line:

1a. Lab. Equipment: $300,000 – S or T value of $15,000 = $285,000 / 5 years = $57,000 per year.

1b. Rad. Equipment: $800,000 – S or T value of $80,000 = $720,000 / 7 years = $102,858 per year.

Double declining depreciation for the laboratory equipment

Year Book Value at

Beginning of Year Depreciation Expense

Book Value at

End of Year

300,000

180,000

108,000

64,800

38,880

300,000 X 40% = 120,000

180,000 X 40% = 72,000

108,000 X 40% = 43,200

64,800 X 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

800,000

571,440

408,180

291,563

208,263

148,763

106,262

800,000 X 28.57% = 228,560

571,440 X 28.57% = 163,260

408,180 X 28.57% = 116,617

291,563 X 28.57% = 83.300

208,263 X 28.57% = 59,500

148,763 X 28.57% = 42,501

106,262 X 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 8-5(a) Depreciation Compensation

Cost (to be Depreciated)

Units-of-Service per Year

X 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 8-5(b) Solution

Cost (to be Depreciated)

Units-of-Service per Year

X Depreciati on per Unit

Annual Depreciatio n 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