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					Chapter 5: Inventory
  1. Acquisition    2. Recording
  of Inventory:       Inventory
  What costs to        Activity:
    capitalize?     Which method?

      3. Sell         4. Ending
    Inventory:        Inventory:
  Which cost flow   Lower-of-cost-or-
   assumption?        market rule

  5. Estimation      6. Analysis
  of Inventory       of Inventory
                         Errors
                                        1
1. Acquiring Inventory:
   What items to include?
    – General rule: (1) held for sale and (2) complete and
      unrestricted ownership.
    – Consignments: belong to consignor, ownership not
      based on physical possession.
    – Goods in transit
       • FOB Shipping Point: belongs to the purchaser
         while in transit (once inventory leaves seller’s
         facilities).
       • FOB Destination: belongs to seller while in transit
         (until inventory reaches purchaser’s facilities).
       • Note: FOB does not indicate who pays the freight.
         This is indicated by “prepaid’ or “collect”.


                                                          2
Class Problem: Houston Corporation had
 the following inventory transactions in
 transit at 12/31/02. Indicate whether the
 inventory would be included in Houston’s
 ending inventory at December 31, 2002.

1. Purchased inventory “FOB Shipping
  Point”; shipped on December 30.
   YES
2. Sold inventory “FOB Shipping Point”;
  shipped on December 30.
   NO

                                             3
Class Problem - continued: Houston
 Corporation had the following inventory
 transactions in transit at 12/31/02.
 Indicate whether the inventory would be
 included in Houston’s ending inventory at
 December 31, 2002.

3. Sold inventory “FOB Destination”;
  shipped on December 30.
   YES
4. Purchased inventory “FOB Destination”;
  shipped on December 30:
   NO
                                             4
1. Acquiring inventory - contd.
   What costs to attach? General rule: all costs
    associated with purchase or manufacture.
    – Freight-in (transportation-in) adds to the cost of
      purchases.
    – Purchase returns reduce the cost of purchases
      (contra) for returned inventory.
    – Purchase allowances reduce the cost of purchases
      (contra) for reduced prices due to damage or errors.
    – Purchase discounts from early cash payments
      (contra) reduce the cost of purchases.
       • Purchase discounts recorded using gross or net
         method.
       • Gross method more popular, but net method is
         theoretically correct way of reporting of economic
         events.
       • Illustration after discussion of periodic system.
                                                          5
2. Perpetual or Periodic Method
   Perpetual
    – Up-to-date record in inventory account.
    – Cost of goods sold computed for each sale.
   Periodic
    – Inventory purchases are recorded as incurred.
    – Inventory and cost of goods sold determined at the
      end of each period through physical count.
   Costs and benefits
    – Perpetual requires more bookkeeping but provides
      more useful information.
    – General application: Periodic used for general
      ledger entries; perpetual used for units.

                                                      6
Illustration
Periodic System
Purchase of 10 units @ $8:
  Inventory (or Purchases) 80
      Cash                          80
Sale of 7 units @ $12:
  Cash                        84
      Sales                         84
  (no COGS entry until the end of the period)
December 31 to recognize EI and COGS. Note that
  there is no BI; EI physical count is 2 cases, valued at
  $8 each = $16, so COGS is for 8 cases @$8 each.:
      BI + P - EI = COGS, so
       0 + 80 - 16 = COGS = 64)
  COGS                     64
    Inventory (or BI and Purch.) 64
                                                        7
Periodic System
Note that the periodic system is illustrated in
  later sections of the text, using the specific
  components of COGS for the journal entries.
These components include:
  Purchases (+)
  Freight-in (+)
  Purchase discounts (-)
  Purchase returns (-)
  Purchase allowances (-)
Also, when these accounts are used during the
  period, the balance in the Inventory account
  remains as the beginning inventory until the
  AJE at the end of the period is posted.
  Now work Ex. 5-24.
                                                   8
Periodic System
If the component accounts are used to record
   inventory activity during the accounting period,
   then the AJE at the end of the period transfers
   the balances in the component accounts to EI
   and COGS. The following formulas represent
   the activity:
BI + Purchases (net) - EI = COGS          or
BI + Purchases (net) = EI + COGS
Note that Purchases (net) =
Purchases
+ Freight-in
 - Purchase Discounts
 - Purchase Returns
 - Purchase Allowances
                                                  9
This AJE under periodic system follows
the formula for COGS:
COGS                  xx
Ending Inventory      xx
Purch. Discounts      xx
Purch. Returns        xx
Purch. Allowances     xx
     Freight-in                       xx
     Purchases                        xx
     Beginning inventory              xx
Note that this journal entry closes out BI and Net
  Purchases, and transfers the balances to EI and
  COGS. The EI balance will go to the balance sheet,
  and the COGS balance will go to the income
  statement.
                                                       10
Purchase Discounts - Gross Method
Assume purchase of $100 on account on
  6/1/00, terms 2/15, n/30.
GJE to record purchase on 6/1/00:
  Purchases            100
      Accounts Payable       100
GJE to record payment, if on or before 6/16/00:
  Accounts Payable 100
      Purchase Discounts        2
      Cash                    98
GJE to record payment, if after 6/16/00:
  Accounts Payable 100
      Cash                   100
(Purch Disc. is contra to Purchases; part of COGS calc.)
                                                       11
Purchase Discounts - Net Method
Assume purchase of $100 on account on
  6/1/00, terms 2/15, n/30.
GJE to record purchase on 6/1/00:
  Purchases             98
      Accounts Payable        98
GJE to record payment, if on or before 6/16/00:
  Accounts Payable 98
      Cash                    98
GJE to record payment, if after 6/16/00:
  Accounts Payable 98
  Purchase Disc. Lost 2
      Cash                   100
(P.D. Lost is operating expense, like Interest Expense)   12
Class Problem -Inventory Components
Given the following selected information for 2001 and
   2002 (in thousands):
                                    2001         2002
Beginning inventory                $ 40          $ 55
Purchases                            150          160
Freight-in                              6            7
Purchase discounts                      3            5
Purchase returns & allowances           2            0
Cost of goods available for sale       (a)          (d)
Ending inventory                       (b)         68
Cost of goods sold                     (c)          (e)
Note: Goods available for sale (GAS)
       = BI + P(net) = EI +COGS
1. Compute the missing numbers.
2. Prepare the adjusting journal entry for 2001 and 2002,
   assuming the company uses the periodic system.        13
Solution to Question 1:
Part (a) 2001: to find GAS:
           BI + P(n) = GAS
         40 + 150 + 6 - 3 - 2 = GAS = 191

Part (b) 2001 to find EI:
           EI2001 = BI 2002 = 55

Part (c) 2001 to find COGS:
            BI + P(n) - EI = COGS
     or         GAS - EI = COGS
                 191 - 55 = COGS = 136
                                         14
Solution to Question 1:
Part (d) 2002: to find GAS:
       BI +     P(n) = GAS
       55 + 160 + 7 - 5 - 0 = GAS = 217

Part (e) 2002: to find COGS:
       BI + P(n) - EI = COGS
 or         GAS - EI = COGS
             217 - 68 = COGS = 149



                                          15
Solution to Question 2:
2001 AJE at end of year to transfer balances in
  BI and Purchase components to EI + COGS (in
  thousands):

  Inventory (ending)        55
  COGS                     136
  Purchase discounts         3
  Purchase returns & allow. 2
     Freight-in                         6
     Inventory (beginning)             40
     Purchases                        150


                                              16
Solution to Question 2:
2002 AJE at end of year to transfer balances in
  BI and Purchase components to EI + COGS (in
  thousands):

  Inventory (ending)        68
  COGS                     149
  Purchase discounts         5
  Purchase returns & allow. 0
     Freight-in                         7
     Inventory (beginning)             55
     Purchases                        160

Now work Ex. 5-19.
                                              17
3. Cost Flow Assumptions
 Given: BI + P (net) = EI + COGS
 How to assign costs of inflows [BI + P(net)] to
  EI and COGS?
Methods:
 Specific identification

 Average for both COGS and EI

 FIFO - (first-in, first-out) for COGS
    – and LISH (last-in, still here) for EI
   LIFO - (last-in, first-out) for COGS
    – and FISH (first-in, still here) for EI
    (Note that we will apply only to periodic systems this
      semester.)                                         18
Class Problem - Cost Flows
Given the following activity for January:
                              Cost   Total
                  Units     per Unit Cost
Begin Inventory 20           $ 9.00 $180
Purchase 1/10      40          10.00 400
Purchase 1/22      30          11.00 330
Total available    90 units           $910
Sales 1/12         30 units
      1/24         25 units
Ending inventory?
  BI + P - EI = Units Sold
  20 + 70 - EI = 55 so EI = 35 units 19
Costs Flows- Periodic System
  Cost of goods sold can be calculated at each
   sale (perpetual system), or at the end of the
   period (periodic system).
  The periodic system evaluates the cost layers
   once, at the end of the period, for all sales
   during the period.
  In this example, the total sales of 55 units will
   be costed out at the end of the period, using
   the three cost layers for the period:
 Begin Inventory       20 @ $ 9.00 $180
 Purchase 1/10         40 @ 10.00             400
 Purchase 1/22         30 @ 11.00             330


                                                  20
FIFO (LISH)- Periodic
   FIFO for COGS (top down)
    55 units
       20 @ $9 = $180
       35 @ $10 = $350
            Total =         $530
   LISH for EI (bottom up)
    35 units
       30 @ $11 = $330
        5 @ $10 = $ 50
            Total           $380
                                   21
LIFO (FISH) - Periodic
   LIFO for COGS (bottom up)
    55 units
       30 @ $11 = $330
       25 @ $10 = $250
            Total =        $580
   FISH for EI (top down)
    35 units
       20 @ $ 9 = $180
       15 @ $10 = $150
            Total =        $330
                                  22
Average - Periodic
   First calculate average:
    Goods available cost =       $910
    Goods available units =     90 units
                Avg. = $10.11 per unit
   Now COGS:
    55 units x $10.11 per unit = $ 556
   Now EI:
    35 units x $10.11 per unit = $354

                                           23
Comparison of FIFO, LIFO, and
Average
   In times of rising prices:
    LIFO     highest COGS:
    FIFO     lowest COGS
    FIFO     highest EI
    LIFO     lowest EI
    FIFO     highest Net Income
    LIFO     lowest Net Income

    Now work Ex. 5-29.
                                  24
Additional LIFO issues:
   LIFO and taxes
     – Why use LIFO for taxes? Cash flow savings.
     – Why use LIFO for financial statements?
       Required, if used for tax purposes.
   LIFO and market valuation
     – Should market value a company higher or
       lower if they use LIFO? Higher-more cash flow.
   LIFO liquidation
     – What happens to net income with liquidation
       of an old LIFO layer? Goes up - lower COGS.
   LIFO reserve
     – what information is contained in this
       disclosure?
                                                  25
4. Ending Inventory:Applying the
Lower-of-Cost-or-Market Rule
   Based on conservatism, ending inventory
    is valued at cost or market value,
    whichever is lower.
   Problem: can create hidden reserves
     – Recognizes price decreases immediately
     – Defers price increase recognition until
       sold
   Sunbeam (in 1996) wrote inventories down
    to zero, then (in 1997) sold the inventory
    for about half the original value; all of the
    revenue in 1997 was income because
    COGS = 0!
                                               26
5. Inventory Estimation (omit Retail Method)
   Gross Profit (gross margin) Method
   Used to estimate cost of EI and COGS
      – for interim financial reporting (so no physical
        count is required).
      – for lost or damaged inventory (where no
        physical count is possible).
   Can use available information from the general
    ledger (Sales, BI, Purchases).
   Based on history of gross margin to sales and
    the formula:
        Sales - COGS = GM
     If GM is 40% of sales then COGS = 60% of
    sales.
   Still use BI + P(net) - EI = COGS                 27
Class Problem, Inventory Estimation

Given the following information from the
 general ledger:
 Sales, January-March          $600,000
 Inventory, January 1             50,000
 Purchases, January-March 450,000

If the gross margin has historically been 30
   percent of sales, calculate the estimated
   ending inventory at March 31.
                                           28
Solution
First, estimate COGS:
 If GM% = 30%, then COGS = 70%
  So Sales x 70% = COGS
       600,000 x .7 = COGS = 420,000
Then, estimate EI:
 BI + P (net) - EI = COGS
50,000 + 450,000 - EI = 420,000
               80,000 = EI
Now work Ex. 5-30 and 5-42.
                                       29
6. Inventory Errors
   Inventory errors are unique in financial
    reporting because they involve multiple
    accounts and multiple periods.
   Because of the carryover nature of
    inventory, some inventory errors reverse out
    by the end of the second year involved.
   To analyze, use basic inventory formula.




                                               30
 Class Problem:
Assume that, at the end of 2001, Xeron
 Corporation neglected to include $1,000 of
 goods in transit to the company when it
 performed the annual inventory count.
 This error went undetected through 2002.
 What effect would this error have on the
 financial statements for 2001 and 2002?

To analyze, use the inventory formula and
 the balance sheet formula.
                                            31
 Class Problem:


BI + P - EI = COGS | NI    | A = L + SE
                              (EI)      (RE)
Note that the asset account in inventory
 error analysis is ending inventory, and
 the equity effect is retained earnings,
 specifically the effect on net income.



                                           32
Class Problem:
Analysis (ignore the amount, it is the same
 throughout the analysis):
    BI + P - EI = COGS | NI | A = L + SE
01:          U      O     U    U          U
02: U               U     O X             X
  Why no effect on 2002 ending SE?
    NI 2001 understated by $1,000
    NI 2002 overstated by $1,000
 Both closed to RE, so no net effect at end.
           (end of Chapter 5)             33
  Ex. 5-24
Periodic System (assume BI = 3 dozen @ $2 per dozen)
Purchase of 15 dozen @ $2:
  Purchases                  30
      Cash                         30
Sale of 14 dozen @ $3:
  Cash                       42
      Sales                        42
December 31 AJE to transfer BI and Purchases to EI and
  COGS. Since EI = $2 x 3 dozen (physical count) = $6,
  COGS must be: BI + P - EI = COGS
                  $6 + $30 - $6 = $30
AJE: COGS                    30
      EI                       6
            Purchases              30
            BI                      6
Ex. 5-19
First, you may need the following additional
  formulas:
(1)Sales - COGS = Gross Margin
                       (or Gross Profit)
    S - COGS = GP
  (note that net sales = S - SD - SR - SA =
  Sales - Sales Disc. - Sales Returns - Sales Allow.)
(2) S- COGS - Operating Expenses = NI
     S - COGS - Op.Ex.        = NI
Ex. 5-19
To find Sales, you first need to find COGS:
BI + P(net) - EI = COGS
10,350 + 50,200 - 9,350 = COGS
                51,200       = COGS
Now:
 S - COGS - Op.Ex. = NI
 S - 51,200 - 9,300 - 1,500 - 700 = 12,000
 S = 74,700
Ex. 5-29
(a) Highest COGS: LIFO
(b) Highest NI: FIFO
(c) Since first year, no difference.
    BI = 0     and Purchases = same.
(d) Decreasing prices reverse the
    relationship, so part (a) is FIFO and
    part (b) is LIFO.
Ex. 5-30
   First, estimate COGS:
    If GM% = 20%, then COGS = 80%
     So Sales x 80% = COGS
           100,000 x .8 = COGS = 80,000
   Then, estimate EI:
     BI + P (net) - EI = COGS
   20,000 + 90,000 - EI = 80,000
                   30,000 = EI
Ex. 5-42
First, estimate COGS:
 If GM% = 34%, then COGS = 66%
  So Sales (net) x 66% = COGS
   (50,000 - 6,000) x .66 = COGS = 29,040
Then, estimate EI:
  BI            + P (net)       - EI = COGS
32,700 + 24,000 + 575 - 900 - 200 - EI = 29,040
                              27,135 = EI

				
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