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8/13/2019 Albrecht Financial Accounting Pp t Chapter 07
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COPYRIGHT 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western aretrademarks used herein under license. 1
Chapter 7
Inventory
Albrecht, Stice, Stice, Swain
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Types of Inventory
Raw materials Materials purchased for use in manufacturing
process.
Work in process Partially completed units in production.
Finished goods
Manufactured products ready for sale. Cost of goods sold
Costs incurred to purchase or manufacturethe merchandise sold during the period.
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Costs Included in Inventory
What costs are included in inventory?
Raw materials
Labor costs Manufacturing overhead
The indirect manufacturing costs associated withproducing inventory.
Freight in costs
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Who Owns the Inventory?
When goods are in transit?Q: Who owns inventory on a truck or railroad car?
A: The party who is paying the shipping costs.
When goods are on consignment?Q: Who owns inventory stocked in a warehouse?
A: The supplier until the inventory is sold. Thewarehouse owner stocks and sells the inventory andreceives a commission on sales as payment forservices rendered.
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Perpetual vs. Periodic Systems
Perpetual inventory system
Detailed records of the number of units andthe cost of each purchase and sale are
prepared THROUGHOUT the period.
Periodic inventory system
System of accounting where cost of goods
sold is determined and inventory is adjustedat the END of the accounting period, not whenmerchandise is purchased or sold.
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Perpetual vs. Periodic Method
Inventory is purchased:Inventory 500
Accounts Payable 500
Transportation costs:Inventory 10
Cash 10
Purchase returns:Accounts Payable 50
Inventory 50
Purchase discounts:Account Payable 450
Inventory 9Cash 441
Inventory is purchased:Purchases 500
Accounts Payable 500
Transportation costs:Freight In 10
Cash 10
Purchase returns:Accounts Payable 50
Purchase Returns 50
Purchase discounts:Accounts Payable 450
Purchase Discounts 9Cash 441
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Perpetual vs. Periodic Method
When inventory is sold:
Accounts Receivable 50Sales 50
Cost of Goods Sold 30
Inventory 30
Closing Entry:
None
When inventory is sold:
Accounts Receivable 50Sales 50
No inventory entry at time of
saleClosing Entries:
Inventory 451Purchase Returns 50
Purchase Discounts 9Freight In 10Purchases 500
Cost of Goods Sold 30
Inventory 30
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Inventory Counts
Inventory counts Necessary under both the periodic and the
perpetual method.
With a periodic system, a physical count isthe only way to get the informationnecessary to compute cost of goods sold.
Under perpetual method, physical counts
allow companies to determine inventoryshrinkage. Shrinkage equals the difference between what
ending inventory should be what the countreveals it is.
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Cost of Goods SoldComputations
Periodic Method
Beginning Inventory
+ Net Purchases
= Cost of GoodsAvailable for Sale
Ending Inventory
= Cost of Good Sold
Perpetual Method
Ending Inventory (frominventory system)
Ending Inventory (frominventory count)
= Inventory Shrinkage
+ Cost of Goods Sold (from
inventory system)= Total Cost of Goods Sold
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Inventory Cost FlowAssumptions
FIFO (first in, first out)
Oldest units sold first.
LIFO (last in, last out)
Newest units sold first.
Average Cost
Average cost per unit is calculated by taking theaverage cost of goods available for sale.
Specific Identification
Each item is specifically identified.
Usually used for large or expensive items (cars).
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Inventory Cost Flow
Rice King buys and sells rice and had thefollowing transactions for the year: June 10 Purchased 10 tons at $6 per ton.
July 28 Purchased 10 tons at $9 per ton.
October 10 Sold 10 tons at $11 per ton. How much did Rice King make during the year?
FIFO LIFO Avg. CostSold Sold Sold
Old Rice New Rice Mixed Rice
Sales ($11 x 10 tons) $110 $110 $110COGS (10 tons) 60 90 75Gross margin $ 50 $ 20 $ 35
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LIFO vs. FIFO
FIFO gives a bettermeasure of inventoryon the balance sheet.
Therefore, FIFO is abetter measure ofinventory value.
LIFO gives a betterreflection of COGS onthe income statement.
Therefore, LIFO is abetter measure of netincome.
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Managing Inventory
Its a balance!
Avoid tying up
resources in
inventory.
Vs.
Maintainingsufficient inventoryfor smooth businessoperations.
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Measuring the Management ofInventory
Inventory Turnover
How many times during the year a companysells all of its inventory.
Cost of Goods Sold
Average Inventory
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Measuring the Management ofInventory
Number of Days Sales in Inventory
How many days worth of sales the companyhas in inventory.
365
Inventory TurnoverCalculated as cost of goods
sold divided by averageinventory. (Shown in
previous slide).
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Managing the Operating Cycle
Number of Days Purchases in Accounts Payable
How many days worth of inventory the company hasin accounts payable.
365
Purchases / Average Account Payable
Days Purchases in
Accounts Payable
External Financing
Days Sales in
InventoryAverage Collection
Period
30 Days 80 Days
38 Days 72 Days
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Inventory Errors
Inventory errors
Beginning inventory
Purchases
Ending inventory
Affects
Cost of goods sold
Gross margin
Net income
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Inventory Errors
UnderstateEnding
Inventory
Sales OK
Beginning inventory OKNet purchases OKGoods available OKEnding inventory LOW
Cost of goods sold HIGH
Gross margin LOWExpenses OKNet income LOW
UnderstatePurchases
UnderstateBeginningInventory
UnderstateSales
OK
OKLOWLOWOK
LOW
HIGHOKHIGH
OK
LOWOKLOWOK
LOW
HIGHOKHIGH
LOW
OKOKOKOK
OK
LOWOKLOW
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Perpetual LIFO and AverageCost
Complications arise because the last inand average cost change with every newpurchase. The cost of goods sold for each sale needs to
be recomputed after a new purchase is made.
This means a lot more work.
These complications do not occur withFIFO because the first in will always bethe same.
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Net Realizable Value
Net Realizable Value
Selling price less selling costs.
Used to value inventory when it is damaged,
used, or obsolete.
When inventory needs to be wri t ten down :
Loss on Write-down of Inventory . . . . . . 200Inventory . . . . . . . . . . . . . . . . . . . . . . . 200
To w ri te down o f inventory to its net real izable value.
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Lower of Cost or Market
Lower of cost or market
A basis for valuing inventory at the lower of originalcost or current market value.
Determining market value Ceiling
Maximum amount (net realizable value).
Replacement Cost
What inventory could currently be purchased for.
Floor Minimum amount (net realizable value minus a normal profit).
Market value is the middle of these three values.
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Using LCM
LCM can be applied in three ways.
By computing cost and market figures foreach item of inventory and using the lower of
the two figures in EACH case. By computing cost and market figures for the
total inventory and then applying the LCM rule
to that TOTAL. By applying the LCM rule to categories ofinventory.
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Gross Margin Method
Gross Margin Method
Used when a physical count of inventory isimpossible or impractical.
Cost of goods sold and ending inventory areestimated using available information:
Beginning inventory.
Purchases. Historical gross margin percentage.
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Gross Margin Method Example
Orem Industries has net sales for January 1 to March31 of $100,000 and net purchases of $65,000.Inventory on January 1 was $15,000 and the companyhas a historic gross profit percentage of 40%.
Dollars % of salesNet sales revenue $100,000 100%Cost of goods sold:Beginning inventory $15,000Purchases 65,000
Total available for sale $80,000Ending Inventory (3) 20,000Cost of goods sold (2) 60,000 60%Gross margin (1) $ 40,000 40%
(1) $100 000 X 40 (2) $100 000 - $40 000 (3) $80 000 - $40 000