©2008 pearson prentice hall. all rights reserved. 6-1 accounting for inventory chapter 6

©2008 Pearson Prentice Hall. All rights reserved.

6-1

Accounting for Inventory

Chapter 6


6-2

Inventory

• Items held by the company for re-sale Current asset on the Balance Sheet

• Items sold shifted to Cost of Goods Sold Expense on the Income Statement

• Sales revenue based on retail price of inventory

• Cost of Goods Sold based on cost of inventory


6-3

Gross Profit

• Sales Revenue minus Cost of Goods Sold• Also called Gross Margin• Represents markup on products• “Gross” because expenses have not been

deducted


6-4

Learning Objective 1

Account for inventory


6-5

Two Systems

Periodic• Count items to

determine quantity on hand

• Used for inexpensive items

• Used by small businesses

• Low cost

Perpetual• Running record of

inventory kept by computer program

• Used by large businesses

• Scanners and bar codes used to record transactions


6-6

Net cost of purchasesPurchase price

+ Freight-in

- Purchase returns

- Purchase Discounts

= Net cost of purchases

- Purchase allowances

Transportation costs

Unsuitable goodsreturned to seller

Reduction in amount owed

For early payment


6-7

Discount terms• Companies offer incentive for early payment• 2/10, n/30

2% discount if bill paid in ten days Full amount due in 30 days

• Purchase discounts Company receives discount if it makes payment early Reduces cost of inventory

• Sales discounts Company offers discount to customers for early

payment Reduces cash received on accounts receivable


6-8©2009 Prentice Hall

5-8

Perpetual Entries

To record purchases of inventory on account

JOURNAL

Date Accounts Debit Credit

Inventory

Accounts payable


6-9

Perpetual Entries

• To record sale of inventory on account• Two entries required

JOURNALDate Accounts Debit Credit

Accounts receivable Sales

Cost of goods sold Inventory

©2009 Prentice Hall

Retail price

Cost


6-10

Net Sales

Sales revenue

- Sales returns

- Sales Discounts

= Net Sales

- Sales allowances

Unsuitable goodsreturned to company

Reduction in amount owed

For early payment


6-11


Understand the various inventory methods


6-12

Inventory Costing Methods

• To determine the cost of inventory sold or on hand, the units are multiplied by the unit cost

• Inventory items are often purchased at different prices throughout the year

• Company selects a costing method to determine which unit cost to use


6-13

Inventory Costing Methods

• Specific-unit-cost• Average cost• First-in, first-out (FIFO)• Last-in, first-out (LIFO)


6-14

Specific-unit-cost

• Each item in inventory can be separately identified

• Used for unique items Cars, fine jewelry

• Too expensive for homogeneous items


6-15

Average-cost

• An average of inventory costs Cost of goods available

Number of units available= Average cost per unit

Average cost per unit x units sold = Cost of goods sold

Average cost per unit x units on hand = Ending inventory


6-16

FIFO

• Oldest items assumed to be sold first• Ending inventory will consist of most

recent items purchased


6-17

LIFO

• Newest items are assumed to be sold first• Ending inventory consists of oldest items

in inventory


6-18

E6-15

Units CostBeginning inventory 5 $160 $800 Oct. 15 Purchase 11 $170 $1,870 Oct. 26 Purchase 5 $180 $900 Units available 21 $3,570 Ending inventory 8 unitsUnits sold ______ units

Subtract units in ending inventory

from units available


6-19

E6-15

Ending inventory =

3 @ $160 = $480

5 @ $180 = $900 $1,380

Cost of goods sold =

2 @ $160 = $ 320

11 @ $170 = $1,870$2,190

Specific Unit Cost


6-20

E6-15

Cost of goods available

Number of units available= Average cost per unit

Average cost per unit x units sold = Cost of goods sold

Average cost per unit x units on hand = Ending inventory

Average Cost

$357021

= $170

$170 x 13 units = $2,210

$170 x 8 units = $1,360


6-21

E6-15

Ending inventory =

3 @ $180 = $900

5 @ $170 = $540 $1,440


5 @ $____ = $_____

8 @ $170 = $1,360$2,160

FIFO

Newest items

Oldest items

Highest ending inventory

What is the price of the oldest

items?


6-22

E6-15

Ending inventory =

5 @ $160 = $800

3 @ $170 = $510 $1,310


5 @ $180 = $ 900

8 @ $170 = $1,360$2,260

LIFO

Newest items

Oldest items

Highest Cost of goods Sold


6-23

Increasing Costs

Cost of goods sold• FIFO lowest

Based on older costs• LIFO highest

Based on recent costs

Ending inventory• FIFO highest

Based on recent costs• LIFO lowest

Based on older costs

Opposite relationships exist whencosts are decreasing


6-24

Tax Advantage of LIFO

Assuming inventory costs are increasing

LIFO results in higher COGS

Lower net income results in lower taxes

Lower taxes results in greater cash flow

Higher COGS results in lower net income


6-25

Comparison of Inventory Methods

FIFO• Balance sheet

More recent costs• Income Statement

Does not match current costs with revenue

LIFO• Balance Sheet

Old, outdated costs• Income Statement

Matches current costs with revenue


6-26

Accounting Principles Related to Inventory

• Consistency Companies should use same inventory

method from period to period• Disclosure

Companies should disclosed inventory method used

• Conservatism Companies should “write down” inventory if

market price falls below cost


6-27

Lower-of-Cost-or-Market (LCM)

• Inventory should be reported at whichever is lower – cost or market Market = current replacement cost

• If cost is lower, no adjustment needed• If market is lower,

Inventory is decreased to market value Cost of goods sold is increased


6-29

Gross Profit Percentage

• Key indicator of ability to sell inventory at a profit

Gross profitNet Sales Revenue

Sales – Cost of Goods Sold = Gross profit

= Gross profit

percentage


6-30

Inventory Turnover

• How many times a company sells its average level of inventory

• Compute average inventory

• Inventory turnover

Beginning inventory + Ending inventory 2

Cost of goods soldAverage inventory


6-31


Estimate inventory by the gross profit method


6-32

Estimating Inventory by the Gross Profit Method

Beginning Inventory

+ Purchases

= Goods available

- Ending inventory

= Cost of Goods sold

Cost of goods sold computation - periodic

Beginning Inventory

+ Purchases

= Goods available

- Cost of Goods sold = Ending inventory

Gross profit method

Net sales x (1 – GP%)


6-33

E6-26

Beginning inventory $ 48,000

Net purchases $ 106,000

Goods available $ 154,000

Sales $ 200,000

x Cost ratio _____%

= Estimated COGS $ __________

Estimated ending inventory $ 34,000

Cost ratio = 100% - GP%

Multiply Sales by cost ratio


6-34


Show how inventory errors affect the financial statements


6-35

Effects of Inventory Errors

• Error in ending inventory impacts two periods

• First period Cost of goods sold Gross Profit & Net Income

• Second period Beginning inventory Costs of Goods sold Gross Profit & Net Income

Inverse with error

Direct with error

Direct with error

Direct with error

Inverse with error


6-36

Effects of Inventory Errors

Period 1 Period 2

Inventory error COGS

GP & Net Inc COGS

GP & Net Inc

Period 1 Ending inventory overstated U O O U

Period 2 Ending inventory understated O U U O

O = OverstatedU = Understated

©2008 pearson prentice hall. all rights reserved. 6-1 accounting for inventory chapter 6

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