CHAPTER 7Inventory

May 2010©Kimberly Lyons

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INVENTORY

Goods purchased or produced for resale Merchandiser (retailer) purchases for resale Manufacturer produces for resale

Raw materials inventory Work-in-process inventory Finished goods inventory

Costs included in inventory Raw materials Labor Manufacturing overhead

All costs are carried as an asset until the time of sale, when they are expensed as “Cost of goods sold”

May 2010©Kimberly Lyons

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ADDITIONAL COSTS IN INVENTORY

Additional costs included in inventory: Delivery costs or “Transportation-in” Taxes Insurances Final delivered cost

Who owns inventory in transit? FOB (Free on Board) destination

Title transfers when the goods reach their destination FOB shipping point

Title transfers when goods are shipped Who owns goods on consignment?

Consignor is the owner Consignee is the seller

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COST OF GOODS AVAILABLE FOR SALE Cost of goods available for sale is the cost of

beginning inventory plus the cost of net purchases

Net purchases+ Purchases- Purchase returns & allowances- Purchase discounts

Cost of goods available must be assigned to either cost of goods sold or ending inventory at the end of the accounting period

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PERPETUAL INVENTORY ACCOUNTING Perpetual is defined as something that is

“continuous” Whenever there is a change in the cost of

inventory on hand, that change is recorded in the inventory account immediately

For example: On 1/3/08 Brewer Co. purchases inventory on

credit for $1,000, terms 2/10, Net 30 On 1/5/08 Brewer returns $300 worth as defective On 1/7/08 Brewer pays for the remaining

inventory On 1/15/08 Brewer sells one half of the remaining

inventory for $600, to customers on credit

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PERPETUAL INVENTORY ACCOUNTINGCONTINUED

Recording these transactions for Brewer Co. using the perpetual method of accounting for inventory:

1/3 Inventory 1,000 Accounts payable 1,000

1/5 Accounts payable 300 Inventory 300

1/7 Accounts payable 700 Inventory 14 Cash 686

1/15 Accounts receivable 600 Revenue 600

Cost of goods sold 343 Inventory 343

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PERIODIC INVENTORY ACCOUNTING

Periodic is defined as something that “occurs occasionally”, or at the end of the period

Whenever there is a change in the cost of inventory on hand, that change is NOT recorded in the inventory account immediately

Instead, we use a variety of temporary accounts to track purchases, purchase returns, and purchase discounts

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PERIODIC INVENTORY ACCOUNTINGCONTINUED

Purchases: a temporary holding account (debit balance)

Purchase returns & allowances and purchase discounts are contra purchases accounts (credit balance)

These accounts are closed at the end of the period to update inventory and record cost of goods sold under the periodic method

These accounts are not used under the perpetual method, where all changes to the inventory account are recorded immediately in inventory

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INVENTORY COST FLOW ASSUMPTIONS Inventory costs flow from the balance sheet

to the income statement There are a variety of choices as to which

costs flow first These cost flow alternatives are independent

of actual goods flow First-in, First-out (FIFO) Last-in, First-out (LIFO) Weighted average cost (WA) Specific identification

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APPLYING COST FLOW ALTERNATIVES:DYNOLD INC. Example: Dynold Inc. had the following

inventory transactions for January of the current year: Units Cost/u Total Cost

Beginning inventory 40 $2 $80

1/15 purchase 10 $3 $30

1/20 purchase 10 $4 $40

1/25 purchase 10 $5 $50

Total available 70 $200

©Kimberly Lyons

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May 2010

FIRST-IN, FIRST-OUT (FIFO)

During the period Dynold sells 30 units Use the data for Dynold to calculate

cost of goods sold and ending inventory FIFO

FIFO CGS: 30u x $2/u = $60 The first cost incurred is the first to

expense FIFO End: $200 - $60 = $140

Of the total cost of goods available, those costs not assigned to cost of goods sold remain in ending inventory

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LAST-IN, FIRST-OUT (LIFO)

Dynold sells 30 units Use the data for Dynold to calculate cost of

goods sold and ending inventory LIFO LIFO CGS: 30u 10u x $5 = $50

10u x $4 = $4010u x $3 = $30

$120 Last cost incurred is the first to cost of goods sold

LIFO End: $200 – 120 = $80 Beginning inventory costs remain in ending

inventory

May 2010©Kimberly Lyons

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WEIGHTED AVERAGE

Dynold sells 30 units Use the data for Dynold to calculate cost of goods

sold and ending inventory WA Calculate a weighted average cost per unit

Total cost of goods available/Total units available=Avg. cost/u

$200/70u = $2.8571/u Assign the average cost per unit to the number of

units sold and the number of units in ending inventory WA CGS: 30u x $2.8571 = $85.71 (rounded)

WA End: 40u x $2.8571 = $114.29 (rounded)

Or $200 – 85.71 = 114.29

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COST FLOWS VS. GOODS FLOWS

In the preceding examples, we assigned cost to 30 units sold without identifying which units were sold

The only time the specific units sold is relevant is when we use the specific identification method

Under this method, the actual cost would be traced to the actual unit that was sold

Otherwise, cost flows are independent of goods flows

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EFFECT OF INVENTORY ALTERNATIVES ON NET INCOME

FIFO WA LIFO

Sales revenue $1,000 $1,000 $1,000

Less: Cost of goods sold (60) (85.71) (120)

Gross Profit $940 $914.29 $880

Less: Operating expenses (200) (200) (200)

Income before tax $740 $714.29 $680

Less: Income tax exp. @ 30%

(222) (214.29) (204)

Net Income $518 $500 $476

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EFFECT OF INVENTORY ALTERNATIVES ON NET INCOMECONTINUED

In a period of rising prices (inflation) LIFO results in

Higher cost of goods sold Lower net income Lower taxes Lower ending inventory

FIFO results in Lower cost of goods sold Higher net income Higher taxes Higher ending inventory

Weighted average numbers are in between In a period of declining prices, the opposite is true If prices are stable or unchanging, there is no

difference

May 2010©Kimberly Lyons

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EFFECT OF INVENTORY ALTERNATIVES ON NET INCOMECONTINUED

The effect on net income of inventory alternatives is arbitrary

All actual costs incurred were the same either way

Sales and sales revenue were the same either way

The real “cash consequence” is the income tax effect

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LOWER OF COST OR MARKET

Inventory should be reported at no more than its “net realizable value”

Net realizable value (NRV) =selling price – cost to sell

When NRV drops below recorded cost (FIFO, LIFO, etc.), the inventory is written down and the loss recorded immediately

Assets are not reported at amounts that exceed their future economic benefits

Inventory should not be written down below NRV less normal profit margin

May 2010©Kimberly Lyons

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INVENTORY SHRINKAGE

With a perpetual inventory accounting system the value of ending inventory can be determined at any time

When this value does not match the physical count, a loss may exist due to lost, damaged, or stolen goods

The inventory account must be adjusted by

Inventory Shrinkage XXX Inventory XXX

If the amount of loss is relatively small, it may be reported as part of cost of goods sold

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REVIEW FOR EXAM

What types of costs, other than purchase price, are included in inventory?

Who is a consignor? Consignee? Who owns goods in transit FOB destination? Who owns goods in transit FOB shipping point? Record inventory transactions using the

perpetual method Calculate net purchases Calculate cost of goods available for sale Calculate cost of goods sold: FIFO, LIFO, & WA Calculate ending inventory: FIFO, LIFO, & WA

May 2010©Kimberly Lyons

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REVIEW FOR EXAMCONTINUED

Understand the effect of rising (falling) prices on FIFO, LIFO, & Weighted average: Cost of goods sold Ending inventory Net Income Income taxes

Prepare a basic income statement illustrating these differences

What is the lower of cost or market rule (LCM)? Estimate the value of ending inventory using

the gross profit percentage Account for inventory shrinkage

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