Federal Taxes Income Averaging

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					  Merchandise Inventory



Electronic Presentations for Chapter 7
Key Points
   Inventory and how it affects the financial statements.
   Four issues that must be addressed when accounting for
    inventory.
   General rules for including items in inventory and
    attaching costs to these items.
   Differences between the perpetual and periodic methods
    and trade-offs involved in choosing between them.
   The three cost flow assumptions - average, FIFO, and
    LIFO.
   The lower-of-cost-or-market rule.
Inventory as a % of Assets
(Industry Averages)
 Industry             Inventory/      Inventory/
                     Total Assets   Current Assets
 Manufacturing:
 Motor Vehicles          .37             .51
 Petroleum and Gas       .02             .04

 Retail:                 .47             .62
 Department Stores
 Retail:                 .58             .71
 Hobby, Toy, Games
 General Services:       .07             .19
 Eating Places
 General Services:       .02             .05
 Telephone Comm.
Inventory as a % of Assets
(Industry Averages)
 Industry               Inventory/      Inventory/
                       Total Assets   Current Assets
 Manufacturing:
 Motor Vehicles            .37             .51
 Petroleum and Gas         .02             .04

 Retail:
 Department Stores         .47             .62
 Hobby, Toy, & Games       .58             .71

 General Services:         .07             .19
 Eating Places
 General Services:         .02             .05
 Telephone Comm.
Inventory as a % of Assets
(Industry Averages)
 Industry               Inventory/      Inventory/
                       Total Assets   Current Assets
 Manufacturing:
 Motor Vehicles            .37             .51
 Petroleum and Gas         .02             .04

 Retail:
 Department Stores         .47             .62
 Hobby, Toy, & Games       .58             .71

 General Services:
 Eating Places             .07             .19
 Telephone Comm.           .02             .05
Important Issues
    Acquisition of
     Inventory:
    What costs to
     capitalize?
Important Issues
    Acquisition of      Carry
     Inventory:       Inventory:
    What costs to
     capitalize?     Which method?
Important Issues
    Acquisition of       Carry
     Inventory:        Inventory:
    What costs to
     capitalize?      Which method?



    Sell Inventory:
    Which cost flow
     assumption?
Important Issues
    Acquisition of         Carry
     Inventory:          Inventory:
    What costs to
     capitalize?      Which method?


                          Ending
    Sell Inventory:
                        Inventory:
    Which cost flow
                      Lower-of-cost-or-
     assumption?
                        market rule
Acquiring Inventory:
What Costs to Capitalize?
   What items or units to include?
    – General rule
    – Consignments
    – Goods in transit
   What costs to attach?
    – General rule
    – Cash discounts
   Determining the costs of manufacturing
    inventories
Carrying Inventory: The
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
   Costs and benefits
    – Perpetual requires more bookkeeping but provides
      more useful information
Selling Inventory:
Which Cost Flow Assumption?
   Specific identification
   Averaging
   FIFO - First-in, first-out
   LIFO - Last-in, first-out
   Effects on financial statements
   Effects on federal income taxes
   Trade-offs
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging    LIFO
  Sales                   $525      $525      $525
  Cost of goods sold    . 155      . 179     . 205
  Gross profit            $370      $346      $320
                     Expenses      . 150     . 150
                         . 150
  Net income
   before taxes           $220      $196     $170
  Federal income taxes . 75        . 67        58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold      155        179      205
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging   LIFO
  Sales                   $525      $525     $525
  Cost of goods sold     . 155       179      205
  Gross profit            $370      $346     $320
                     Expenses      . 150      150
                           150
  Net income
   before taxes           $220      $196     $170
  Federal income taxes . 75           67       58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold    . 155        179      205
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging   LIFO
  Sales                  $525       $525     $525
  Cost of goods sold      155        179      205
  Gross profit           $370       $346     $320
                     Expenses        150      150
                          150
  Net income
   before taxes          $220       $196     $170
  Federal income taxes      75        67       58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold      155        179      205
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging    LIFO
  Sales                  $525       $525      $525
  Cost of goods sold      155      . 179       205
  Gross profit           $370       $346      $320
                     Expenses        150     . 150
                          150
  Net income
   before taxes          $220       $196     $170
  Federal income taxes      75        67       58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold    . 155        179      205
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging   LIFO
  Sales                  $525       $525     $525
  Cost of goods sold      155        179      205
  Gross profit           $370       $346     $320
                     Expenses        150      150
                          150
  Net income
   before taxes          $220       $196     $170
  Federal income taxes      75        67       58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold      155      . 179      205
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging   LIFO
  Sales                  $525       $525     $525
  Cost of goods sold      155        179      205
  Gross profit           $370       $346     $320
                     Expenses        150      150
                          150
  Net income
   before taxes          $220       $196     $170
  Federal income taxes      75        67       58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold      155        179      205
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging   LIFO
  Sales                  $525       $525     $525
  Cost of goods sold      155        179      205
  Gross profit           $370       $346     $320
                     Expenses        150      150
  150
  Net income
   before taxes          $220       $196     $170
  Federal income taxes      75        67       58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold      155        179      205
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging   LIFO
  Sales                  $525       $525     $525
  Cost of goods sold      155        179      205
  Gross profit           $370       $346     $320
                     Expenses        150      150
  150
  Net income
   before taxes          $220       $196     $170
  Federal income taxes      75        67       58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold      155        179      205
Effects of the Three Inventory
Cost Flow Assumptions
                         FIFO    Averaging   LIFO
  Sales                  $525       $525     $525
  Cost of goods sold      155        179      205
  Gross profit           $370       $346     $320
                     Expenses        150      150
  150
  Net income
   before taxes          $220       $196     $170
  Federal income taxes      75        67       58
  Net income after taxes $145       $129     $112


  Ending inventory       $255       $231     $205
  Cost of goods sold      155        179      205
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.
   Hidden reserves
    – Recognizes price decreases immediately
    – Defers price increase recognition until sold
Review Problem
   Dec. 1 - Jane Lee, owner, contributed $1,000.
   Dec. 7 - Purchased 300 lbs. of rice for
    $1.00/lb.
   Dec. 25 - Sold 250 lbs. of rice for $5.00/lb.
   Dec. 27 - Purchased 150 lbs. of rice for
    $1.40/lb.
   Dec. 28 - Sold 50 lbs. of rice for $5.00/lb.
   Dec. 29 - Paid cash expenses of $400.
   Dec. 31 - Paid income tax liability.
Income Statement:
Periodic FIFO Assumption
 Sales (300 lb. x $5)   $1,500
Income Statement:
Periodic FIFO Assumption
  Sales (300 lb. x $5)                  $1,500
  Cost of goods sold                       300 *
  Gross profit                          $1,200




* Beginning inventory                   $    0
  + Purchases ($300 + $210)                510
  - Ending inventory (150 lb x $1.40)    (210)
  = Cost of goods sold                  $ 300
Income Statement:
Periodic FIFO Assumption
  Sales (300 lb. x $5)                  $1,500
  Cost of goods sold                       300*
  Gross profit                          $1,200
  Expenses                                 400
  Net income before taxes               $ 800
  Income tax expense ($800 x .30)          240
  Net income after taxes                $ 560


* Beginning inventory                   $    0
  + Purchases ($300 + $210)                510
  - Ending inventory (150 lb x $1.40)    (210)
  = Cost of goods sold                  $ 300
Balance Sheet:
Periodic FIFO Assumption
 Cash                               $1,350 *




* Cash =
 Capital contribution - Purchases + Sales - Expenses - Taxes
 $1,000 - ($300 + $210) + $1,500 - $400 - $240 = $1,350
Balance Sheet:
Periodic FIFO Assumption
 Cash                               $1,350 *
 Inventory (150 lbs. x $1.40)          210




* Cash =
 Capital contribution - Purchases + Sales - Expenses - Taxes
 $1,000 - ($300 + $210) + $1,500 - $400 - $240 = $1,350
Balance Sheet:
Periodic FIFO Assumption
 Cash                               $1,350 *
 Inventory (150 lbs. x $1.40)          210
 Total assets                       $1,560

 Common stock                       $1,000
 Retained earnings                     560
 Total liabilities and
  stockholders’ equity              $1,560

* Cash =
 Capital contribution - Purchases + Sales - Expenses - Taxes
 $1,000 - ($300 + $210) + $1,500 - $400 - $240 = $1,350
Income Statement:
Periodic LIFO Assumption
 Sales (300 lb. x $5)   $1,500
Income Statement:
Periodic LIFO Assumption
  Sales (300 lb. x $5)                  $1,500
  Cost of goods sold                       360 *
  Gross profit                          $1,140




* Beginning inventory                   $    0
  + Purchases ($300 + $210)                510
  - Ending inventory (150 lb x $1.00)    (150)
  = Cost of goods sold                  $ 360
Income Statement:
Periodic LIFO Assumption
  Sales (300 lb. x $5)                  $1,500
  Cost of goods sold                       360 *
  Gross profit                          $1,140
  Expenses                                 400
  Net income before taxes               $ 740
  Income tax expense ($740 x .30)          222
  Net income after taxes                $ 518


* Beginning inventory                   $    0
  + Purchases ($300 + $210)                510
  - Ending inventory (150 lb x $1.00)    (150)
  = Cost of goods sold                  $ 360
Balance Sheet:
Periodic LIFO Assumption
 Cash                               $1,368 *




* Cash =
 Capital contribution - Purchases + Sales - Expenses - Taxes
 $1,000 - ($300 + $150) + $1,500 - $400 - $222 = $1,368
Balance Sheet:
Periodic LIFO Assumption
 Cash                               $1,368 *
 Inventory (150 lbs. x $1.00)          150




* Cash =
 Capital contribution - Purchases + Sales - Expenses - Taxes
 $1,000 - ($300 + $150) + $1,500 - $400 - $222 = $1,368
Balance Sheet:
Periodic LIFO Assumption
 Cash                               $1,368 *
 Inventory (150 lbs. x $1.00)          150
 Total assets                       $1,518

 Common stock                       $1,000
 Retained earnings                     518
 Total liabilities and
  stockholders’ equity              $1,518

* Cash =
 Capital contribution - Purchases + Sales - Expenses - Taxes
 $1,000 - ($300 + $150) + $1,500 - $400 - $222 = $1,368

				
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