Reposted...Accounting Homework FOUR WK3_Q2
cordova.dhasgify
chapter 5
Inventory
Learning Goals
• Know 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 cost 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, retail, and lower-of-cost-or-market concepts.
Copyright Barbara Chase/Corbis/AP Images
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CHAPTER 5Chapter Outline
Chapter Outline 5.1 Categories of Inventory
Inventory Costs Freight Expanded Income Reporting 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 The Retail Method Lower-of-Cost-or-Market Adjustments
5.5 The Importance of Accuracy
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:
3-15-XX Accounts Receivable 15,000.00
Sales 15,000.00
Sold merchandise on account
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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 sold 10,000
Gross profit $ 5,000
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 was 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. Retailing is a large segment of the economy but not the only segment. The goods must have been manufactured. Therefore, manufacturers also carry inventory on their books.
A manufacturer’s inventory may consist of goods in various stages of development. It may have raw materials consisting of components and parts that will eventually be put into production. The manufacturer may also have work-in-process inventory consisting of goods being manufactured but not yet completed. A third category of inventory is finished goods. These are completed goods awaiting sale. Consider that the manufacturer’s process entails converting raw material into finished goods. During production, raw materials are converted via the addition of labor and other factors of production (such factory costs are called overhead).
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The process for correctly accumulating and attaching these costs to work in process requires substantial skill and is covered in depth in the managerial accounting course. For now, be aware that much more is to be learned about how costs attach to products in a manufacturing environment. Let’s focus just on the general inventory-accounting princi- ples that would be applicable to most businesses, using scenarios involving the purchase and resale of goods.
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 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. To develop 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 responsibil- ity 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.
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CHAPTER 5Section 5.1 Categories of Inventory
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.
Expanded Income Reporting
The foregoing issues begin to show why a merchant’s income statement can be expanded. Merchants and others frequently present a multiple-step income statement. This for- mat divides business results into separate categories. The first category clearly shows the difference between the selling price of the product and its cost. This difference is called gross profit. Following gross profit are the other expenses of doing business. This usu- ally consists of the selling, general, and administrative expenses (SG&A) associated with running the business. These primary categories on the multiple-step income statement relate to the business’s core performance. An investor would closely follow these num- bers, especially noting trends and changes. Investors often compare cost categories to sales on a percentage basis. For instance, cost of goods sold may be 40%, 50%, or 60% of sales. Monitoring this percentage will reveal pricing power and how the potential impact increases or decreases sales.
However, other business events can give rise to income statement effects. It is common for a business to have incidental transactions that contribute to profits and losses. Exam- ples include the sale of corporate assets (not inventory), losses from catastrophes, and similar events. If significant, these items are typically presented after the SG&A section. Although potentially meaningful, the sometimes nonrecurring nature makes it easier to discount their ongoing impacts to the business. Finally, financing costs are frequently broken out from other expense components. The reason is that investors may wish to evaluate financial performance separate and apart from the cost of funds that are used to finance the business. This does not mean interest is not a real expense. Expense is a real cost, but its different character justifies clearly breaking it out within the income state- ment. This provides information needed to fully understand and evaluate the business’s income generation capacity. Table 5.1 is an example an income statement reflecting these special considerations.
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Table 5.1: An example of an income statement that reflects special considerations
INCOME STATEMENT Example Company
For the Month Ending January 31, 20XX
Sales $179,000
Cost of Goods Sold 100,000
Gross Profit $ 79,000
Selling Expenses
Advertising $10,000
Freight-out 8,000
Depreciation 6,000
Salaries 3,000 $ 27,000
General and Administrative
Salaries $14,000
Depreciation 5,000
Rent 2,000
Insurance 1,000 22,000
Other
Loss on Sale of Stock $ 4,000
Interest Expense 6,000 10,000 59,000
Income Before Taxes $20,000
Income tax expense 6,500
Net income $13,500
Consigned Goods
On occasion, a manufacturer may approach a merchant about stocking a particular prod- uct. The merchant may be reluctant, not wanting to invest in inventory that may not sell. This negotiation may result in a consignment of inventory. A consignment is an agree- ment whereby the inventory’s owner, the consignor, places it with another party in the hope that the goods will be resold to an end consumer. The party holding physical pos- session 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 continue 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
Beginning inventory +
Net purchases
Ending inventory +
Cost of goods sold
Goods available for sale
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. Exhibit 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).
Exhibit 5.1: Goods available for sale
Exhibit 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 pictures. 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
In the drawing, the units appear as physical units, but the natural commingling of homog- enous inventory sometimes makes it difficult or impossible to truly know which units are 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.
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CHAPTER 5Section 5.3 Perpetual Systems
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 Umps Baseball Supply. Umps maintains a stor- age bin full of balls. As customers purchase balls, Umps randomly selects them from the bin. As Umps restocks, they dump newly purchased balls into the bin. The balls are con- stantly being mixed up such that Umps has no way of knowing the exact purchase date or price of any particular ball remaining in the bin. During a recent period, the bin had an opening supply of 500 balls and was restocked two different times. At each restocking, 500 balls were added. The balls in beginning inventory cost $2 per ball. The first restock- ing 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 balls, probably including some from beginning inventory and each restocking 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). Umps 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 com- plex average cost approach. 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 num-ber of units purchased at each price point. Thus, it is also known as a weighted- average cost 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 Umps’s inventory under the FIFO, LIFO, and average cost approaches, it is first necessary to point out that inventory costs can be accumulated on either a real-time perpetual inventory system or occasional updating via a periodic inventory system. As the name suggests, a perpetual system is one in which inventory records are continuously updated for all inventory changes. As inventory is purchased, it is added into the Inventory account. As inventory is sold, it is subtracted 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 recordkeeping 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
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general ledger. To begin to see how this operates, closely examine the details about Umps’s inventory purchases in Table 5.2.
Table 5.2: Umps’s 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 Umps’s sales. Table 5.3 provides detailed sales data:
Table 5.3: Umps’s 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 Umps had 1,500 units available (500 500 500) and sold 1,375 units (400 550 425), 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. To make 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 visual a cost flow assumption by thinking about physical flow. If you owned a convenience store, you would probably sell milk on a FIFO basis. To minimize spoilage, you would sell the oldest milk first. 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 Umps’s inventory calcula- tions using a perpetual FIFO method.
First-In, First-Out
Table 5.4 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.
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Table 5.4: 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
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.
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 5.4 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 5.4. Remember, Inventory is debited as purchases occur and credited as sales occur. Fol- lowing are the necessary entries to record July’s activity:
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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
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 Table 5.5, 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).
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Table 5.5: 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
1,125.00 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
Last-In, First-Out
Table 5.6 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.
Table 5.6: 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 are 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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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 Table 5.7, 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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CHAPTER 5Section 5.3 Perpetual Systems
Table 5.7: 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
1,125.00 2,475.00 1,212.50 1,225.00
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 Umps had instead applied the average cost approach, its cost allocation would appear as shown in Table 5.8. 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 5.8: Cost allocation
Date Beginning Inventory
Purchases Sales Cost of Goods Sold Remaining Inventory Balance
July 1 500 @ $2.00 500 @ $2.00 = $1,000.00
500 @ $2.00 = $1,000.00
July 9 400 @ $4.00 = $1,600.00
400 @ $2.00 = $800.00 100 @ $2.00 = $200.00
July 15 500 @ $2.25 = $1,125.00
100 @ $2.00 = $200.00 500 @ $2.25 = 1,125.00
$1,325.00 $1,325.00/600 units
=$2.2083 average
July 20 550 @ $4.50 = $2,475.00
550 @ $2.2083 = 1,214.58
50 @ $2.2083 =$110.4217
July 24 500 @ $2.75 = $1,375.00
50 @ $2.2083 = $ 110.42 500 @ $2.7500 = 1,375.00
$1,485.42 $1,458.42/550 units
= $2.7008 average
July 28 425 @ $5.00 = $2,125.00
425 @ $2.7008 = $1,147.82
125 @ $2.7008 =$337.60
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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 1,214.57
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
7-28-XX Accounts Receivable 2,125.00
Sales 2,125.00
Sold inventory on account
7-28-XX Cost of Goods Sold 1,147.84
Inventory 1,147.82
To record the cost of goods sold
Using selected T-accounts in Table 5.9, 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:
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Table 5.9: 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 1,214.57 1,375.00
2,125.00 1,147.82 1,147.84
6,200.00 3,162.40 337.59
5.4 Comparing Methods
At this juncture, it is essential to see that alternative accounting methods result in dif-ferent reported results for specific periods. With FIFO, Umps would report a gross profit of $3,043.75 ($6,200.00 sales 2 $3,156.25). With LIFO, Umps 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.
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 (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 Umps 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 iden- tifying characteristics. For example, an automobile dealership might find the technique practical and useful.
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CHAPTER 5Section 5.5 The Importance of Accuracy
The Retail Method
A particular variation of the specific identification logic can be employed by retailers. It is known as the retail method. First and foremost, the retail method relies on an assump- tion that a company’s markup is constant across all items of inventory. If this is true, the process for determining the cost of ending inventory would be to physically count all goods on hand at the end of the accounting period and determine their retail selling value (perhaps by simple reference to their marked selling prices). Then the total inventory at retail would be multiplied by the cost-to-retail percentage. The amount so determined would represent the cost of the inventory and establish the amount to report as inventory at the end of the accounting period.
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 down- ward reduction 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 Inventory account and a debiting a Loss for Reduction in Market Value. This loss reduces income.
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.
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
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CHAPTER 5Concept Check
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.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.)
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.
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CHAPTER 5Critical Thinking Questions
4. Stanley 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
Critical Thinking Questions
1. What items are reported as inventory for (a) merchandising companies and (b) manufacturing companies?
2. The Potter Company purchased the following merchandise on December 28:
Supplier Terms Amount Pax 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.
3. What are goods on consignment? Who has title to goods on consignment? 4. Why is it necessary to take a physical count of inventory at the end of each account-
ing period? 5. Why is the specific identification method of inventory valuation used infrequently? 6. Discuss the difference between the physical flow of goods and a cost flow assumption. 7. 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
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CHAPTER 5Key Terms
8. Discuss the advantages of a perpetual inventory system when compared with a periodic system.
9. Which type of inventory system, periodic or perpetual, is increasing in popularity? Briefly explain.
10. Why are two journal entries required to record a sale under a perpetual inventory system?
Key Terms
average cost A cost flow assumption.
consignment of inventory An agreement whereby the owner of inventory places it with another party in the hope that it will resell the goods to an end consumer.
cost flow assumptions Inventory-costing methods such as first-in, first-out; last-in, last-out; or average cost.
FIFO See first-in, first-out.
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.
lower-of-cost-or-market method A method whereby inventories are accounted for at acquisition cost or market value, whichever is lower.
multiple-step income statement A state- ment format that divides business results into separate categories.
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.
retail method An inventory-costing method that relies on the assumption that a company’s markup is constant across all items of inventory.
specific identification The method in which a business must match each unit of inventory with its actual cost.
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CHAPTER 5Exercises
Exercises
1. Inventory errors and income measurement. The income statements of Keagle 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?
2. Specific identification method. Boston Galleries uses the specific identification method for inventory valuation. Inventory information for several oil paintings follows.
Painting Cost
1/2 Beginning inventory Woods $11,000
4/19 Purchase Sunset 21,800
6/7 Purchase Earth 31,200
12/16 Purchase Moon 4,000
Woods and Moon were sold during the year for a total of $35,000. Determine the firm’s
a. cost of goods sold. b. gross profit. c. ending inventory.
3. Inventory valuation methods: basic computations. The January beginning inven- tory of the White Company 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. The White Company uses a periodic inventory system.
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CHAPTER 5Exercises
Using the White Company 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
4. 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 replace-
ment 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 veg-
etable dealer. f. Results in lowest cost of goods sold in inflationary periods.
5. Perpetual inventory system: journal entries. At the beginning of 20X3, Beehler Company implemented a computerized perpetual inventory system. The first transactions that occurred during 20X3 follow.
Purchases on account: 500 units , $4 5 $2,000
Sales on account: 300 of the above units 5 $2,550
Returns on account: 75 of the above unsold units
The company president examined the computer-generated journal entries for these transactions and was confused by the absence of a Purchases account.
a. Duplicate the journal entries that would have appeared on the computer printout. b. Calculate the balance in the firm’s Inventory account. c. Briefly explain the absence of the Purchases account to the company president.
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CHAPTER 5Problems
Problems
1. Inventory errors. The income statements of Diamond 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
Diamond 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 recorded 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 physical 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. Wave Riders Surfboard Company began business on January 1 of the current year. Purchases of surfboards were as follows:
1/3: 100 boards , $125
3/17: 50 boards , $130
5/9: 246 boards , $140
7/3: 400 boards , $150
10/23: 74 boards , $160
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CHAPTER 5Problems
Wave Riders sold 710 boards at an average price of $250 per board. 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 a sand and gravel dealer?
(3) report low earnings (for tax purposes) for a separate electronics company that has been experiencing declining purchase prices?
3. Lower-of-cost-or-market method. Davenport Opticians began business on Septem- ber 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) to- taled $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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