Financial accounting the impact on decision makers 9e chapter 5

Account for Sales of MerchandiseLO 2  Sales revenue: representation of the inflow of assets, either cash or accounts receivable, from the sale of a product during the period Gross Profi

Chapter 5

Inventories and Cost

of Goods Sold

Types of Manufacturing Costs

 Direct materials: also called raw materials

 Ingredients used in making a product

 Direct labor: amounts paid to workers to manufacture the product

 Manufacturing overheads: all other costs that are

related to the manufacturing process but cannot be directly matched to specific units of output

 Example: depreciation of building and salary of

supervisor

Three Forms of Inventory

 Direct materials

 The inventory of a manufacturer before the addition

of any direct labor or manufacturing overhead

 Work in process

 Cost of unfinished products in a manufacturing

company

 Finished goods

 A manufacturer’s inventory that is complete and

ready for sale

Exhibit 5.1 Relationships between Types of

Businesses and Inventory Costs

Account for Sales of Merchandise

LO 2

 Sales revenue: representation of the inflow of assets, either cash or accounts receivable, from the sale of a product during the period

Gross Profit = Net Sales − Cost of Goods Sold Net Sales = Sales − Sales Return and Allowances − Sales Discount

Exhibit 5.3—Net Sales Section of

the Income Statement

Sales Returns and Allowances

 Sales returns and allowances: contra-revenue account used to record refunds to customers and reductions of their accounts

 Sales discounts: contra-revenue account used to

record discounts given to customers for early payment

of their accounts

 Credit terms: firm’s policy for granting credit

 Example: n/30; Net, 10 EOM; 1/10, n/30

Credit Terms and Sales Discounts

 Credit terms: firm’s policy for granting credit

 n/30: the net amount of the selling price is due

within 30 days of the date of the invoice

 Net, 10 EOM: the net amount is due anytime within ten days after the end of the month

 1/10, n/30: the customer can deduct 1% from the selling price if the bill is paid within ten days

 Sales discounts: contra-revenue account used to record discounts given to customers for early

payment of their accounts

Cost of Goods Sold

 Recognition of cost of goods sold as an expense is an excellent example of matching principle

 Sales revenue: inflow of assets, cash or accounts

receivable

 Cost of goods sold: outflow of asset, inventory

 Cost of goods available for sale

 Cost of goods soldBeginning inventory + Cost of goods purchased

Cost of goods available for sale − Ending inventory

LO 3

Exhibit 5.4—Cost of Goods Sold Section of the Income Statement

Exhibit 5.5—Cost of Goods Sold

Model

Inventory Systems: Perpetual and

Periodic

Example 5.3—Recording Cost of Goods

Sold in a Perpetual System

 Daisy’s sells a pair of running shoes that costs $70 In addition to the entry to record the sale, Daisy’s would also record an adjustment as follows:

Exhibit 5.6—Cost of Goods

Purchased

Example 5.4—Recording Purchase

Example 5.5—Recording Purchase

Returns in a Periodic System

 Daisy’s returns $850 of merchandise to Nike for credit

on Daisy’s account The return decreases both

liabilities and purchases Because a return reduces

purchases, it has the effect of reducing expenses and increasing net income and stockholders’ equity

Example 5.6—Recording Purchase Discounts in a Periodic System

 On March 13,there is a purchase of merchandise for

$500, with credit terms of 1/10, n/30

Example 5.6—Recording Purchase

Discounts in a Periodic System (continued)

Purchase Discounts

 A contra-purchases account used to record reductions

in purchase price for early payment to a supplier

Shipping Terms and Transportation

Example 5.7—Recording Transportation-In in a Periodic System

 Assume that on delivery of a shipment of goods, Daisy’s pays an invoice for $300 from Rocky

Mountain Railroad The terms of shipment are

FOB shipping point

Example 5.8—Determining the Effect of Shipping Terms on Purchases and Sales

The Gross Profit Ratio

 Important measure of profitability

 Indicates a company’s ability to cover operating

expenses and earn a profit

 Relationship between gross profit and net sales—

measured by the gross profit ratio—one of the most

important measures to assess the performance of a

company

LO 4

Gross ProfitNet SalesGross Profit Ratio =

The Ratio Analysis Model

1. How much of the sales revenue is used for the cost

of the products, and thus, how much remains to cover other expenses and to earn net income?

2. Gather the information about net sales and cost of

goods sold

3. Calculate the gross profit ratio

4. Compare the ratio with prior years and with

competitors

5. Interpret the ratios—showing increase or decrease

The Business Decision Model

1. If you were an investor, would you buy stock in a

company?

2. Gather information from the financial statements

and other sources

3. Compare the company's gross profit ratio with

industry averages and look at trends

4. Buy stock or find an alternative use for the money

5. Monitor the investment periodically

Inventory Valuation and the Measurement of Income

 Value assigned to inventory on balance sheet

determines the amount eventually recognized as an

expense on income statement

 Incorrect ending inventory will affect cost of goods

sold and net income

LO 5

 Cost of insurance when inventory is in transit

 Cost of storing inventory before it is ready to be sold

 Taxes paid—excise and sales taxes

Inventory Costing Methods

with a Periodic System

Specific Identification Method

 Relies on matching unit costs with the actual units sold

 Example 5.10—Determining Ending Inventory and Cost of Goods Sold Using Specific Identification

Example 5.10—Determining Ending Inventory and Cost

of Goods Sold Using Specific Identification (continued)

Weighted Average Cost Method

 Assigns the same unit cost to all units available for sale during the period

Cost of Goods Available for Sale

Units Available for Sale Weighted Average Cost =

Ending inventory = Average CostWeighted × Number of Units inEnding Inventory

Example 5.11—Determining Ending Inventory and Cost of Goods Sold Using Weighted Average

First-In, First-Out Method (FIFO)

 Assigns the most recent costs to ending inventory

 Example 5.12—Determining Ending Inventory and Cost of Goods Sold Using FIFO

Example 5.12—Determining Ending Inventory and Cost of Goods Sold Using FIFO (continued)

Last-In, First-Out Method (LIFO)

 Assigns the most recent costs to cost of goods sold

 Example 5.13—Determining Ending Inventory and Cost of Goods Sold Using LIFO

Example 5.13—Determining Ending Inventory and Cost of Goods Sold Using LIFO (continued)

Selecting an Inventory Costing

 The primary determinant in selecting an inventory

costing method should be the ability of the method to accurately reflect the net income of the period

LO 7

Exhibit 5.7—Income Statements for the

Inventory Costing Methods

Example 5.14—Computing Taxes Saved

by Using LIFO Instead of FIFO

 Assume a 40% tax rate, income tax expense under

LIFO is only $2,000, compared with $2,600 under FIFO,

a savings of $600 in taxes

Result of FIFO and LIFO during a

Period of Raising Prices

LIFO Issues

 LIFO Liquidation

 The result of selling more units than are purchased

during the period

 Negative tax consequences

 LIFO Conformity rule

 If LIFO is used on a tax return, it must also be used in reporting income to stockholders

 LIFO Reserve

 The excess of the value of a company’s inventory stated

at FIFO over the value stated at LIFO

Costing Methods and Inventory

Profits

 Replacement cost: current cost of a unit of inventory

 Inventory profit: the portion of the gross profit that results from holding inventory during a period of

rising prices

Example 5.16—Reconciling the Difference between Gross Profit on a FIFO Basis and on Replacement Cost Basis

Inventory Valuation in Other

Countries

 Valuing inventory differ around the world

 GAAP in the United States allows LIFO

 IASB strictly prohibits the use of LIFO

 Survival of LIFO is not only a matter of convergence with international standards

 LIFO allows companies with rising inventory costs to report lower income

Inventory Errors

 If ending inventory is overstated, cost of goods sold will be

understated and thus net income for the period overstated

 The opposite effects will occur when ending inventory is

understated

 Different types of inventory errors

 Mathematical errors

 Physical count of inventory at year-end

 Cutoff problems—in-transit—at year-end

LO 8

Example 5.17—Analyzing the Effect of an

Inventory Error on Net Income

Example 5.18—Analyzing the Effect of an Inventory Error on Retained Earnings

Example 5.19—Analyzing the Effect of an Inventory Error on the Balance Sheet

Exhibit 5.8—Summary of the Effects

of Inventory Errors

Lower-of-Cost-or Market Rule

 A conservative inventory valuation approach

 Require that inventory be written down at the end of the period if the market value of the inventory is less than its cost

 Can be applied to:

 Entire inventory

 Individual items

 Groups of items

LO 9

• Uses net realizable value with no upper or lower limits

• Write-downs of inventory can be reversed in later periods

Lower-of-Cost-or-Market under International Standards( Continued )

 For example, if cost is $100,000 and market value is

$85,000, the adjustment that can be identified and analyzed as follows:

Inventory Turnover Ratio

 Measures company’s ability to sell its inventory

Number of Days’ Sales in Inventory

 Measures of how long it takes to sell inventory

Number of Days in the Period Inventory Turnover Ratio

=

Number of Days’ Sales

in Inventory

The Ratio Analysis Model

1. How liquid the company is?

2. Gather cost of goods sold from the income statement

and average inventory from balance sheet at the end

of the two most recent years

3. Calculate the inventory turnover ratio

4. Compare the ratio with other ratios

5. Interpret the ratios—measure of how long it takes to

sell inventory

The Business Decision Model

1. If you were an investor, would you buy stock in the

company?

2. Gather information from the financial statements

and other sources

3. Compare trends in inventory turnover ratios, net

income with industry averages

4. Buy stock or find an alternative

5. Monitor your decision periodically

Exhibit 5.10—Inventories and the

Statement of Cash Flows

LO 11

Inventory Costing Methods with the

Use of a Perpetual Inventory System

LO 12

Example 5.20—Determining Ending Inventory

Using FIFO with a Perpetual System

Example 5.21—Determining Ending Inventory

Using LIFO with a Perpetual System

Moving Average

 An average cost method when a weighted average cost assumption is used with a perpetual inventory system

Example 5.22—Determining Ending Inventory Using Moving Average with a Perpetual System

End of Chapter 5