In this chapter we continue our study of assets by investigating the measurement and reporting inventories and the related expense – cost of goods sold. Inventory refers to the assets a company (1) intends to sell in the normal course of business, (2) has in production for future sale, or (3) uses currently in the production of goods to be sold.
Chapter INVENTORIES: MEASUREMENT © 2013 The McGraw-Hill Companies, Inc Recording and Measuring Inventory Types of Inventory Merchandise Inventory Goods acquired for resale 8-2 Manufacturing Inventory •Raw Materials •work-in-progress •Finished Goods Manufacturing Inventories Raw Materials Work in Progress $XX Finished Goods $XX Direct Labor Manufacturing Overhead 8-3 Cost of Goods Sold $XX Raw materials purchased Direct labor incurred Manufacturing overhead incurred Raw materials used Direct labor applied Manufacturing overhead applied Work in progress transferred to finished goods Finished goods sold Inventory Systems Two accounting systems are used to record transactions involving inventory: 8-4 Perpetual Perpetual Inventory Inventory System System Periodic Periodic Inventory Inventory System System The The inventory inventory account account is is continuously continuously updated updated as as purchases purchases and and sales sales are are made made The The inventory inventory account account is is adjusted adjusted at at the the end end of of aa reporting reporting cycle cycle Perpetual Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2013 with $120,000 in inventory During the period it purchases on account $600,000 of merchandise for resale to customers 2013 Inventory Accounts payable 600,000 600,000 Purchase of merchandise inventory on account Returns of inventory are credited to the inventory account Discounts on inventory purchases can be recorded using the gross or net method 8-5 Perpetual Inventory System During 2013, LWBC sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to customers 2013 Inventory Accounts payable 600,000 600,000 Purchase of merchandise inventory on account 2013 Accounts receivable Sales revenue 820,000 820,000 Record sales on account Cost of goods sold Inventory Record cost of goods sold 8-6 540,000 540,000 Periodic Inventory System The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory Cost of goods sold is calculated, using the schedule below, after the physical inventory count at the end of the period Beginning Inventory + Net Purchases Cost of Goods Available for Sale - Ending Inventory = Cost of Goods Sold 8-7 Periodic Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2013 with $120,000 in inventory During the period it purchases on account $600,000 of merchandise for resale to customers 2013 Purchases Accounts payable Purchase of merchandise inventory on account 8-8 600,000 600,000 Periodic Inventory System During 2013, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540,000 2013 Accounts receivable Sales revenue 820,000 820,000 Record sales on account No entry is made to record Cost of Goods Sold A physical count of Ending Inventory shows a balance of $180,000 Let’s calculate Cost of Goods Sold at the end of 2013 8-9 Periodic Inventory System Calculation of Cost of Goods Sold Beginning inventory Plus: Purchases Cost of goods available for sale Less: Ending inventory Cost of goods sold $ 120,000 600,000 720,000 (180,000) $ 540,000 We need the following adjusting entry to record cost of good sold December 31, 2013 Cost of goods sold Inventory (ending) Inventory (beginning) Purchases 540,000 180,000 120,000 600,000 To adjust inventory, close purchases, and record cost of goods sold - 10 Inventory Management Gross profit ratio = The higher the ratio, the higher is the markup a company is able to achieve on its products Gross profit Net sales Inventory turnover ratio = Designed to evaluate a company’s effectiveness in managing its investment in inventory - 43 Cost of goods sold Average inventory (Beginning inventory + Ending inventory Quality of Earnings Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income) Many believe that manipulating income reduces earnings quality because it can mask permanent earnings Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings - 44 LIFO Reserves Cause: Different inventory cost flow assumptions between internal records (non-LIFO) and external reporting (LIFO) (Optional) adjustment at end of accounting period to internal records gives rise to LIFO reserves - 45 Adjustment: Difference between inventory value under the non-LIFO and LIFO assumption brought to LIFO reserves, a contrainventory account Corresponding account is the cost of goods sold Supplemental LIFO Disclosures Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost The conversion from FIFO or average cost to LIFO takes place at the end of the period The conversion may look like this: Total inventories at FIFO Less: LIFO allowance Inventories, at LIFO cost - 46 2013 2012 $ 15,429 (1,508) $ 13,921 $ 15,387 (1,525) $ 13,862 LIFO Liquidation When prices rise LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions If inventory declines, these “out of date” costs may be charged to current earnings - 47 This LIFO liquidation results in “paper profits.” Methods of Simplifying LIFO LIFO Inventory Pools The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation For example, a glass company might group its various grades of window glass into a single window pool Other pools might be auto glass and sliding door glass A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately - 48 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) DVL inventory pools are viewed as layers of value, rather than layers of similar units DVL simplifies LIFO record-keeping DVL minimizes the probability of layer liquidation - 49 At the end of the Example period, we determine if The inventory replacement a new layer inventory differs was added byfrom the old inventory on comparing ending hand We to just create a inventory beginning new layer inventory Methods of Simplifying LIFO Dollar-Value LIFO (DVL) We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase in inventory 1a Compute a Cost Index for the year - 50 Cost index in layer = year Cost in layer year ÷ Cost in base year Methods of Simplifying LIFO Dollar-Value LIFO (DVL) 1b Deflate the ending inventory value using the cost index 1c Compare ending inventory (at base year cost) to beginning inventory - 51 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Next, identify the layers in ending inventory and the years they were created Convert each layer’s base year cost to layer year cost by multiplying to the cost index - 52 Sum all the layers to arrive at Ending Inventory at DVL cost Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price information Let’s look at the solution to this example - 53 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price information 12/31 2012 Ending inventory $ 150,000 Price index 100% Inventory at base-year prices $ 150,000 2013 168,000 105% 160,000 168,000 ÷ 1.05 = 160,000 - 54 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) First, determine the LIFO layer for the current year - 55 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) At the LIFO layer at end of period prices to the ending LIFO inventory from last period - 56 End of Chapter ... rounded rounded - 20 Perpetual Average Cost Date Purchased Beg Inv 1,200 x $ 22.00 = 9-3 900 x 24.00 = 9-1 5 550 x 25.00 = 9-1 5 2,650 9-2 1 600 x 27.00 = 9-2 2 9-2 9 800 x 28.00 = 9-3 0 Average Cost... 400 -1 20 $ 280 Inventory Cost Flow Assumptions •• Specific Specific identification identification •• Average Average cost cost •• First-in, First-in, first-out first-out (FIFO) (FIFO) •• Last-in,... rounded - 19 23,300.00 Balance $ 26,400.00 48,000.00 61,750.00 38,450.00 Perpetual Average Cost Date Purchased Beg Inv 1,200 x $ 22.00 = 9-3 900 x 24.00 = 9-1 5 550 x 25.00 = 9-1 5 2,650 9-2 1 600