Chapter 5 inventory

OPEN UNIVERSITY HCMC MBA PREPARATORY COURSE Principles of Financial Accounting Chapter Inventories and Cost of Goods Sold Learning Objectives After studying this chapter, you should be able to:      Link inventory valuation to gross profit Use both perpetual and periodic inventory systems Calculate the cost of merchandise acquired Choose one of the four principal inventory valuation methods Calculate the impact on net income of LIFO liquidations Learning Objectives After studying this chapter, you should be able to:    Use the lower-of-cost-or-market method to value inventories Show the effects of inventory errors on financial statements Evaluate the gross profit percentage and inventory turnover Gross Profit and Cost of Goods Sold  An initial step in assessing profitability is gross profit (profit margin or gross margin), which is the difference between sales revenues and the costs of the goods sold  Products being held for resale are reported as inventory, a current asset  When the goods are sold, the costs of the inventory become an expense, Cost of Goods Sold This expense is deducted from Net Sales to determine Gross Profit Gross Profit and Cost of Goods Sold Balance Sheet Income Statement Sales Merchandise Purchases Merchandise Inventory Merchandise Sales Minus Cost of Goods Sold (an expense) Equals Gross Profit Minus Selling and Administrative Expenses Equals Net Income The Basic Concept of Inventory Accounting  The key to calculating cost of goods sold is accounting for the remaining inventory at the end of the year  Cost valuation - process of assigning specific historical costs to items counted in the physical inventory  Multiply the number of items in ending inventory times the cost of each item Perpetual and Periodic Inventory Systems  Two main systems for keeping merchandise inventory records:   Perpetual inventory system - a system that keeps a running, continuous record that tracks inventories and the cost of goods sold on a day-to-day basis Periodic inventory system - a system in which the cost of good sold is computed periodically by relying solely on physical counts without keeping day-to-day records of units sold or on hand Perpetual and Periodic Inventory Systems  A perpetual inventory system helps managers control inventory levels and prepare interim financial statements   The inventory amount can be found at any given point in time Inventory items must be counted at least once a year to ensure correct valuation  Physical count - the process of counting all the items in inventory at a moment in time Perpetual and Periodic Inventory Systems  In a perpetual system, the journal entries are: When inventory is purchased: Merchandise inventory xxx Accounts payable (or Cash) When inventory is sold: Accounts receivable (or Cash) Sales revenue xxx Cost of goods sold xxx Merchandise inventory xxx xxx xxx LIFO  If LIFO is such a good deal, why companies still use FIFO?  For several reasons:     some The costs of changing methods can be significant Management may be reluctant to decrease earnings and possibly salaries and bonuses Management might fear that lower income would hurt in loan negotiations with banks Lower earnings will often lower stock prices Weighted Average  Weighted-average method - computes a unit cost by dividing the total acquisition cost of all items available for sale by the number of units available for sale Cost of goods available for sale Weighted average = Units available for sale Weighted Average  The averaging in the weighted average must consider not only the price paid, but also the number of units purchased at each price  The weighted-average method produces a gross profit somewhere between gross profit under FIFO and LIFO Weighted Average Smith Corporation purchased units of Product X for $4.00 on Monday and units of Product X for $4.25 on Friday What is the weightedaverage cost per unit? (5 x $4.00) + (7 x $4.25) Weighted average = 12 $49.75 = 12 = $4.15 Inventory Cost Relationships  The four cost flow assumptions affect inventory only; they not affect purchases and liabilities for those purchases  Note that in the detailed computation of gross profit, ending inventory affects cost of goods sold   The lower the ending inventory, the higher the cost of goods sold The higher the ending inventory, the lower the cost of goods sold Holding Gains and Inventory Profits  LIFO approximates a replacement cost view of transactions, and measures profit relative to newer costs   Replacement cost - the cost at which an inventory item could be acquired today In contrast, FIFO measures profit relative to older costs Holding Gains and Inventory Profits  The difference between profit measured under FIFO and LIFO is called a holding gain or an inventory profit    The holding gain is also the difference between the historical cost under FIFO (older costs) and the historical cost under LIFO (newer costs) LIFO ending inventory rarely has holding gains FIFO ending inventory often has holding gains LIFO Layers  LIFO layer - a separately identifiable additional segment of LIFO inventory   Ending inventory under LIFO will have one total value, but it may contain prices from many different points in time As a company continues in business, the LIFO layers tend to pile on top of one another over the years LIFO Layers  Many companies show inventories that have LIFO layers dating as far back as 1940, when LIFO was first used   These inventories are probably far below the true market value or replacement cost of the inventory LIFO presents an economic reality on the income statement, but FIFO presents a more up-to-date valuation on the balance sheet LIFO Inventory Liquidations  As stated before, in periods of rising prices, LIFO will produce a higher cost of goods sold and lower gross profit than FIFO  Sometimes companies must “liquidate” some of their LIFO layers, that is, units in the older LIFO layers are sold  In such a case, cost of goods sold decreases because very old costs are now included in cost of goods sold When cost of goods sold decreases, gross profit increases LIFO Inventory Liquidations  Security analysts often like to keep track of the effect of choosing LIFO over FIFO because the effect on net income can be significant  LIFO reserve - the difference between a company’s inventory valued at LIFO and what it would be under FIFO  The balance in the LIFO reserve indicates the cumulative effect on gross profit over all prior years due to LIFO The Importance of Gross Profit  Management and investors are interested in gross profit and how it changes over time  The inventory method chosen might have a significant affect on a company’s gross profit, so gross profit is often expressed as a percentage of sales Gross profit Gross Profit % = Sales Gross Profit Percentage  Often the nature of the business of a company affects the gross profit as compared to other types of companies   Wholesaler - an intermediary that sells inventory items to retailers and incurs few selling costs - often have low gross profit percentages Retailer - a company that sells items to the final users, individuals Gross Profit Percentage and Turnover  Retailers often lower their gross profit margins and selling prices and hope that the lower selling prices will increase sales volume enough to compensate for the lower gross profit  One measure of sales level is inventory turnover, which tells how fast inventory is sold Cost of goods sold Inventory = Turnover Average inventory held during the period Gross Profit Percentage and Turnover  Industries with higher gross profit percentages tend to have the lowest inventory turnover   Inventory turnover is especially effective for assessing companies in the same industry A higher inventory turnover indicates an ability to use smaller inventory levels to attain a high sales level References: Horngren, Introduction to financial accounting [...]... Merchandise inventory, 1/1/2002 Purchases Deduct: Purchase returns and allowances $3,000 Cash discounts on purchase 1,000 Net purchases Add: Freight in Total cost of merchandise acquired Cost of good available for sale Deduct: Merchandise inventory, 12/31/2002 Cost of good sold Gross profit $1 75, 000 $ 2,000 1 ,50 0 3 ,50 0 $171 ,50 0 $ 7 ,50 0 $120,000 4,000 $116,000 10,000 126,000 $133 ,50 0 9,000 124 ,50 0 $ 47,000... profit under FIFO and LIFO Weighted Average Smith Corporation purchased 5 units of Product X for $4.00 on Monday and 7 units of Product X for $4. 25 on Friday What is the weightedaverage cost per unit? (5 x $4.00) + (7 x $4. 25) Weighted average = 12 $49. 75 = 12 = $4. 15 Inventory Cost Relationships  The four cost flow assumptions affect inventory only; they do not affect purchases and liabilities for those... sales level is inventory turnover, which tells how fast inventory is sold Cost of goods sold Inventory = Turnover Average inventory held during the period Gross Profit Percentage and Turnover  Industries with higher gross profit percentages tend to have the lowest inventory turnover   Inventory turnover is especially effective for assessing companies in the same industry A higher inventory turnover...Physical Inventory  In both periodic and perpetual inventory systems, a physical count of each item being held in inventory is required  The physical count is extremely important in determining net income because inventory is included in the determination of cost of goods sold Cost of Merchandise Acquired  Regardless of the inventory system used, the basis of inventory accounting is... gross profit, ending inventory affects cost of goods sold   The lower the ending inventory, the higher the cost of goods sold The higher the ending inventory, the lower the cost of goods sold Holding Gains and Inventory Profits  LIFO approximates a replacement cost view of transactions, and measures profit relative to newer costs   Replacement cost - the cost at which an inventory item could... sold, regardless of which units are actually given to the customer The costs of the newer units in stock are included in ending inventory FIFO  FIFO includes the most recent costs in ending inventory, so the inventory tends to closely approximate that actual market value of the inventory at the balance sheet date  Also, in periods when prices are rising, FIFO leads to higher net income because the costs... to older costs Holding Gains and Inventory Profits  The difference between profit measured under FIFO and LIFO is called a holding gain or an inventory profit    The holding gain is also the difference between the historical cost under FIFO (older costs) and the historical cost under LIFO (newer costs) LIFO ending inventory rarely has holding gains FIFO ending inventory often has holding gains... $116,000 10,000 126,000 $133 ,50 0 9,000 124 ,50 0 $ 47,000 Principal Inventory Valuation Methods  Four inventory valuation systems have been generally accepted     Specific identification First in, first out (FIFO) Last in, first out (LIFO) Weighted average Principal Inventory Valuation Methods  If unit prices and costs did not change, all four inventory valuation methods would show identical results ... sold, regardless of which units are actually given to the customer The costs of the older units in stock are included in ending inventory LIFO  LIFO uses the oldest costs to value ending inventory, so that value may be significantly different from the actual market value of the inventory at the balance sheet date  In periods when prices are rising, LIFO yields lower net income because the higher costs... LIFO (newer costs) LIFO ending inventory rarely has holding gains FIFO ending inventory often has holding gains LIFO Layers  LIFO layer - a separately identifiable additional segment of LIFO inventory   Ending inventory under LIFO will have one total value, but it may contain prices from many different points in time As a company continues in business, the LIFO layers tend to pile on top of one another