Cornerstones of Financial & Managerial Accounting

Cornerstones of Financial & Managerial Accounting Rich/Jones/Heitger/Mowen/Hansen

Chapter 6 Learning Objectives

LO1. Describe the types of inventories held by merchandisers and manufacturers, and understand how inventory costs flow through a company.  Merchandising companies hold one type of inventory termed merchandise inventory.  Manufacturing companies have three types of inventory—raw materials, work-in-process, and finished goods.  When goods are purchased, the cost of the purchase is recorded in merchandise inventory (for merchandisers) or raw materials inventory (for manufacturers). During the production process, manufacturers record the cost (raw materials, labor, and overhead) in work-in-process and then transfer the cost to finished goods inventory when the product is complete.  Once the product is sold, the cost is transferred out of the inventory account (either Merchandise Inventory or Finished Goods) and into Cost of Goods Sold to match it with sales revenue.  The relationship between inventory and cost of goods sold is described by the cost of goods sold model. LO2. Explain how to record purchases and sales of inventory using a perpetual inventory system.  In a perpetual inventory system, purchases of inventory are recorded by increasing the inventory account.  If a purchase discount exists, inventory is reduced by the amount of the discount taken.  When a purchased item is returned (purchase return) or a price reduction is granted by the seller (purchase allowance), the inventory item is reduced by the amount of the purchase return or allowance given.  If transportation costs exist and the shipping terms are F.O.B shipping point, the transportation costs are considered part of the total cost of purchases and the inventory account is increased.  If transportation costs exist and the shipping terms are F.O.B. destination, the seller pays these costs and records them as a selling expense on the income statement.  In a perpetual inventory system, sales are recorded through two journal entries: (1) record the sales revenue, and (2) increase Cost of Goods Sold and decrease the inventory account.  If an item is later returned, two entries must also be made: (1) increase Sales Returns and Allowances (a contra-revenue account), and (2) increase the inventory account and decrease Cost of Goods Sold. LO3. Apply the four inventory costing methods to compute ending inventory and cost of goods sold under a perpetual inventory system.  The four inventory costing methods are: specific identification; first-in, first- out (FIFO); last-in, first-out (LIFO); and average cost.  The specific identification method determines the cost of ending inventory and the cost of goods sold based on the identification of the actual units sold and in inventory.  The other three inventory costing methods allocate cost of goods available for sale between ending inventory and cost of goods sold using the following process. Step 1: Calculate the cost of goods available for sale immediately prior to any sale transaction. Step 2: Apply the inventory costing method to determine ending inventory and cost of goods sold. Step 3: Repeat steps 1 and 2 for all inventory transactions during the period. The sum of the cost of goods sold computed in step 2 is the cost of goods sold for the period. Ending inventory is the amount computed during the final application of step 2 for the period. LO4. Analyze the financial reporting and tax effects of the various inventory costing methods.  If the prices paid for purchased inventory are stable, all inventory costing methods will yield the same amounts for ending inventory and cost of goods sold.  When purchase prices vary, FIFO, LIFO and the average cost methods will produce different amounts for ending inventory, cost of goods sold and, therefore, income.  When prices are rising, the FIFO method produces the highest cost for ending inventory, the lowest cost of goods sold, and the highest gross margin (and net income).  In contrast, the LIFO method produced the lowest cost for ending inventory, the highest cost of goods sold, and, therefore, the lowest gross margin (and net income) of the three methods. Because LIFO results in lower income, it results in the lowest income taxes.  When purchase prices are falling, the situation is reversed.  The average cost method produced amounts for inventory, cost of goods sold, and net income that fell between the FIFO and LIFO extremes. LO5. Apply the lower of cost or market rule to the valuation of inventory.  If the market value of inventory has dropped below its original cost, generally accepted accounting principles permit a departure from the historical cost concept.  A company is allowed to reduce the amount recorded for inventory to its market value, where market value is defined as the current replacement cost.  This lower of cost or market rule is an application of the conservatism principle. LO6. Evaluate inventory management using the gross profit and inventory turnover ratios.  Two useful measures of how successful a company is at managing and controlling its inventory are the gross profit ratio (gross profit ÷ net sales) and the inventory turnover ratio (cost of goods sold ÷ average inventory).  The gross profit ratio indicates how many cents of every dollar are available to cover expenses other than cost of goods sold and to earn a profit. The inventory turnover ratio describes how quickly inventory is purchased (or produced) and sold. LO7. Describe how errors in ending inventory affect income statements and balance sheets.  Inventory errors can arise for a number of reasons, including incorrect counts of inventory, mistakes in costing, or errors in identifying items.  Because the ending inventory of one period is the beginning inventory of the next period, an error in the measurement of ending inventory will affect the cost of goods sold and net income of two consecutive periods.  Inventory errors are self-correcting, therefore, the assets and stockholders’ equity of only the first period are misstated (assuming no other errors are made).