Introduction To Financial Accounting


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Introduction To Financial Accounting

  1. 1. Introduction to Financial Accounting, 7th Edition PowerPoint Presentations Developed by: Eddie Metrejean, MTAX, CPA University of Mississippi Images provided by New Vision Technology 1-800-387-0732
  2. 2. Chapter 6 Inventories and Cost of Goods Sold
  3. 3. Learning Objectives <ul><li>After studying this chapter, you should be able to: </li></ul><ul><li>Link inventory valuation to gross profit. </li></ul><ul><li>Use both perpetual and periodic inventory systems. </li></ul><ul><li>Calculate the cost of merchandise acquired. </li></ul><ul><li>Choose one of the four principle inventory valuation methods. </li></ul><ul><li>Calculate the impact on net income of LIFO liquidations. </li></ul>
  4. 4. Learning Objectives <ul><li>After studying this chapter, you should be able to: </li></ul><ul><li>Use the lower-of-cost-or-market method to value inventories. </li></ul><ul><li>Show the effects of inventory errors on financial statements. </li></ul><ul><li>Evaluate the gross profit percentage and inventory turnover. </li></ul>
  5. 5. Gross Profit and Cost of Goods Sold <ul><li>An initial step in assessing profitability is gross profit (profit margin or gross margin), which is the difference between sales revenue and the costs of the goods sold. </li></ul><ul><li>Products being held for resale are reported as inventory, a current asset. </li></ul><ul><ul><li>When the goods are sold, the costs of the inventory become an expense, Cost of Goods Sold. This expense is deducted from sales to determine Gross Profit. </li></ul></ul>
  6. 6. Gross Profit and Cost of Goods Sold Sales Cost of Goods Sold (an expense) Selling and Administrative Expenses Merchandise Inventory Balance Sheet Income Statement Minus Equals Gross Profit Minus Equals Net Income Merchandise Purchases Merchandise Sales
  7. 7. The Basic Concept of Inventory Accounting <ul><li>The key to calculating cost of goods sold is accounting for the remaining inventory. </li></ul><ul><li>Cost valuation - process of assigning specific historical costs to items counted in the physical inventory </li></ul><ul><ul><li>Multiply the number of items in ending inventory times the cost of each item. </li></ul></ul>
  8. 8. Perpetual and Periodic Inventory Systems <ul><li>Two main systems for keeping merchandise inventory records: </li></ul><ul><ul><li>Perpetual inventory system - a system that keeps a running, continuous record that tracks inventories and the cost of goods sold on a day-to-day basis </li></ul></ul><ul><ul><li>Periodic inventory system - the system by which the cost of good sold is computed periodically by relying solely on physical counts without keeping day-to-day records of units sold or on hand </li></ul></ul>
  9. 9. Perpetual and Periodic Inventory Systems <ul><li>A perpetual inventory system helps managers control inventory levels and prepare interim financial statements. </li></ul><ul><ul><li>The inventory amount can be found at any given point in time. </li></ul></ul><ul><li>A physical count of inventory on hand must still be taken at least once a year. This is the process of counting all the items in inventory at a moment in time. </li></ul>
  10. 10. Perpetual and Periodic Inventory Systems <ul><li>In a perpetual system, the journal entries are: </li></ul><ul><li>When inventory is purchased: </li></ul><ul><li>Merchandise inventory xxx </li></ul><ul><li> Accounts payable (or cash) xxx </li></ul><ul><li>When inventory is sold: </li></ul><ul><li>Accounts receivable (or cash) xxx </li></ul><ul><li> Sales revenue xxx </li></ul><ul><li>Cost of goods sold xxx </li></ul><ul><li> Merchandise inventory xxx </li></ul>
  11. 11. Perpetual and Periodic Inventory Systems <ul><li>In a periodic system, no day-to-day inventory records are maintained. </li></ul><ul><li>The physical count allows management to delete damaged or obsolete items and helps to reveal inventory shrinkage - losses from theft, breakage, or loss of inventory </li></ul>
  12. 12. Perpetual and Periodic Inventory Systems <ul><li>Calculations for cost of goods sold start with cost of good available for sale , which is the sum of the beginning inventory plus current year purchases. </li></ul><ul><li>Computation for Cost of Goods Sold: </li></ul><ul><li>Beginning inventory xxx </li></ul><ul><li>Add: Purchases xxx </li></ul><ul><li>Cost of goods available for sale xxx </li></ul><ul><li>Less: Ending inventory xxx </li></ul><ul><li>Cost of goods sold xxx </li></ul><ul><li>======= </li></ul>
  13. 13. Physical Inventory <ul><li>In both periodic and perpetual inventory systems, a physical count of each item being held in inventory is required. </li></ul><ul><li>The physical count is extremely important in determining net income because inventory is included in the determination of cost of goods sold. </li></ul>
  14. 14. Cost of Merchandise Acquired <ul><li>Regardless of the inventory system used, the basis of inventory accounting is the cost of the merchandise a company purchases for resale. </li></ul><ul><li>What costs are included in the cost of the merchandise? </li></ul><ul><ul><li>The cost of merchandise usually includes only the invoice price plus any directly identifiable transportation charges less any offsetting discounts. </li></ul></ul>
  15. 15. Transportation Charges <ul><li>The major cost of transporting merchandise is usually freight charges from the shipping point of the seller to the receiving point of the buyer. </li></ul><ul><ul><li>If goods are shipped F.O.B. (free on board) destination , the seller pays the costs from the shipping point of the seller to the receiving point of the buyer. </li></ul></ul><ul><ul><li>If goods are shipped F.O.B. shipping point , the buyer pays the freight costs from the shipping point of the seller to the receiving point of the buyer. </li></ul></ul>
  16. 16. Transportation Charges <ul><li>Any costs of transportation borne by the buyer should be added to the cost of the inventory acquired. </li></ul><ul><li>Usually, transportation costs are not easy to trace to specific inventory items, so companies usually use a separate transportation cost account called, Freight In, Transportation In, Inbound Transportation, Inward Transportation, etc. </li></ul>
  17. 17. Transportation Charges <ul><li>Freight in is usually shown in the purchases section on the income statement as an additional cost of the goods acquired. </li></ul><ul><li>Freight out represents the costs borne by the seller and is shown as an expense of selling the merchandise. </li></ul><ul><ul><li>It is included with other selling expenses on the income statement. </li></ul></ul>
  18. 18. Purchases and Purchase Returns <ul><li>The accounting for purchases, purchase returns, purchase allowances, and cash discounts on purchases is just the opposite of the accounting for sales. </li></ul><ul><li>To record the purchase of merchandise: </li></ul><ul><li>Purchases 900,000 </li></ul><ul><li> Accounts payable 900,000 </li></ul><ul><li>To record the return of merchandise: </li></ul><ul><li>Accounts payable 80,000 </li></ul><ul><li> Purchase returns and allowances 80,000 </li></ul>
  19. 19. Gross Profit <ul><li>Gross sales $175,000 </li></ul><ul><li>Deduct: Sales returns and allowances $ 2,000 </li></ul><ul><li> Cash discounts on sales 1,500 3,500 </li></ul><ul><li>Net sales $171,500 </li></ul><ul><li>Deduct: Cost of goods sold: </li></ul><ul><li> Merchandise inventory, 1/1/97 $ 7,500 </li></ul><ul><li> Purchases $120,000 </li></ul><ul><li> Deduct: Purchase returns and allowances $3,000 </li></ul><ul><li> Cash discounts on purchase 1,000 4,000 </li></ul><ul><li> Net purchases $116,000 </li></ul><ul><li> Add: Freight in 10,000 </li></ul><ul><li> Total cost of merchandise acquired 126,000 </li></ul><ul><li> Cost of good available for sale $133,500 </li></ul><ul><li> Deduct: Merchandise inventory, 12/31/97 9,000 </li></ul><ul><li> Cost of good sold 124,500 </li></ul><ul><li>Gross profit $ 47,000 </li></ul><ul><li> ============= </li></ul>
  20. 20. Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems <ul><li>In the perpetual system, purchases of merchandise directly increase the Inventory account, and purchase returns and allowances and sales directly decrease the Inventory account. </li></ul><ul><li>As we have seen, in the periodic system, purchases of merchandise increase a Purchases account, and purchase returns and allowances are placed in separate accounts that are deducted from Purchases. Sales have no effect on the Purchases account. </li></ul>
  21. 21. Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems <ul><li>Journal entries under the perpetual system: </li></ul><ul><li>To record the purchase of merchandise: </li></ul><ul><li>Inventory 900,000 </li></ul><ul><li> Accounts payable 900,000 </li></ul><ul><li>To record the return of merchandise: </li></ul><ul><li>Accounts payable 80,000 </li></ul><ul><li> Inventory 80,000 </li></ul>
  22. 22. Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems <ul><li>Under the perpetual system, inventory amounts are updated each time an inventory transaction is processed. </li></ul><ul><li>Under a periodic system, the inventory account does not change until the end of the accounting period. </li></ul><ul><ul><li>At that time, a physical inventory is taken to determine the amount of inventory on hand, and an adjusting entry is made to inventory. </li></ul></ul>
  23. 23. Principal Inventory Valuation Methods <ul><li>Four inventory valuation systems have been generally accepted. </li></ul><ul><ul><li>Specific identification </li></ul></ul><ul><ul><li>First in, first out (FIFO) </li></ul></ul><ul><ul><li>Last in, first out (LIFO) </li></ul></ul><ul><ul><li>Weighted average </li></ul></ul>
  24. 24. Principal Inventory Valuation Methods <ul><li>If unit prices and costs did not change, all four inventory valuation methods would show identical results. </li></ul><ul><li>Because prices change, cost of goods sold and inventories are affected which in turn affect income measurement and asset measurement. </li></ul><ul><ul><li>The choice of the inventory valuation method can significantly affect the amount reported as ending inventory. </li></ul></ul>
  25. 25. Specific Identification <ul><li>Specific identification method - concentrates on the physical tracing of the particular items sold </li></ul><ul><ul><li>Used mostly when the physical flow of goods is easy to track </li></ul></ul><ul><ul><li>Relatively easy to use </li></ul></ul><ul><ul><li>Works best for relatively expensive low-volume merchandise, such as automobiles or jewelry </li></ul></ul>
  26. 26. FIFO <ul><li>FIFO (first in, first out) method - assumes that the units acquired earliest are used or sold first </li></ul><ul><ul><li>This might not actually be the actual physical flow of goods within the company. </li></ul></ul><ul><ul><li>Under FIFO, the oldest unit is deemed to be sold, regardless of which unit is actually given to the customer. </li></ul></ul><ul><ul><li>The costs of the newer units in stock are included in ending inventory. </li></ul></ul>
  27. 27. FIFO <ul><li>FIFO uses the most recent cost in ending inventory, so the inventory tends to closely approximate that actual market value of the inventory at the balance sheet date. </li></ul><ul><li>Also, in periods when prices are rising, FIFO leads to higher net income because the costs of the older, lower costing items are included in cost of goods sold. </li></ul>
  28. 28. LIFO <ul><li>LIFO (last in, first out) - assumes that the units acquired most recently are used or sold first </li></ul><ul><ul><li>This might not actually be the actual physical flow of goods within the company. </li></ul></ul><ul><ul><li>Under LIFO, the newest unit is deemed to be sold, regardless of which unit is actually given to the customer. </li></ul></ul><ul><ul><li>The costs of the older units in stock are included in ending inventory. </li></ul></ul>
  29. 29. LIFO <ul><li>LIFO uses the oldest costs to value ending inventory, so that value may be significantly different from the actual market value of the inventory at the balance sheet date. </li></ul><ul><li>In periods when prices are rising, LIFO yields lower net income because the higher costs of more recent purchases are put into cost of goods sold first. </li></ul>
  30. 30. LIFO <ul><li>Because LIFO results in reduced net income, it also results in lower income taxes. </li></ul><ul><ul><li>The Internal Revenue Code requires that if a company uses LIFO to compute its taxable income, the company must also use LIFO to compute its financial net income. </li></ul></ul><ul><ul><li>The result is lower income taxes and lower reported earnings figures to investors. </li></ul></ul>
  31. 31. LIFO <ul><li>If LIFO is such a good deal, why do some companies still use FIFO? </li></ul><ul><li>For several reasons: </li></ul><ul><ul><li>Costs of changing methods can be significant. </li></ul></ul><ul><ul><li>Management may be reluctant to decrease earnings and possibly salaries and bonuses. </li></ul></ul><ul><ul><li>Management might fear that lower income would hurt in loan negotiations with banks. </li></ul></ul><ul><ul><li>Lower earnings will often lower stock prices. </li></ul></ul>
  32. 32. Weighted Average <ul><li>Weighted average method - computes a unit cost by dividing the total acquisition cost of all items available for sale by the number of units available for sale </li></ul>
  33. 33. Weighted Average <ul><li>The averaging in the weighted average must consider not only the price paid, but also the number of units purchased at each price. </li></ul><ul><li>The weighted average method produces a gross profit somewhere between gross profit under FIFO and LIFO. </li></ul>
  34. 34. Weighted Average <ul><li>Smith Corporation purchased 5 units of Product X for $4.00 on Monday and 7 units of Product X for $4.25 on Friday. What is the weighted average cost per unit? </li></ul>= $4.15
  35. 35. Cost Flow Assumptions <ul><li>The accounting profession has determined that companies may choose any of the four methods for valuing inventory. </li></ul><ul><li>The units are all the same, but their costs are different, so tracing the flow or assignment of those costs is more important than tracing where each specific unit actually goes. </li></ul>
  36. 36. Cost Flow Assumptions <ul><li>Because three out of the four methods are not linked to the physical flow of the goods, inventory valuation methods are often called cost flow assumptions . </li></ul><ul><ul><li>No matter which cost flow assumption is picked, the cumulative gross profit over the life of a company remains the same. </li></ul></ul><ul><ul><li>The need to match particular costs to particular revenues makes the choice of cost flow assumptions important. </li></ul></ul>
  37. 37. Inventory Cost Relationships <ul><li>The four cost flow assumptions affect inventory only. They do not affect purchases and liabilities for those purchases. </li></ul><ul><li>Note that in the detailed computation of gross profit, ending inventory affects cost of goods sold. </li></ul><ul><ul><li>The lower the ending inventory, the higher the cost of goods sold. </li></ul></ul><ul><ul><li>The higher the ending inventory, the lower the cost of goods sold. </li></ul></ul>
  38. 38. The Consistency Convention <ul><li>Although companies can choose any cost flow assumption, they have to be consistent over time. </li></ul><ul><li>Consistency - conformity from period to period with unchanging policies and procedures </li></ul><ul><ul><li>Consistency makes year-to-year comparisons of financial information useful. </li></ul></ul><ul><ul><li>Companies can change inventory methods for justifiable reasons, such as changes in market conditions. </li></ul></ul>
  39. 39. Characteristics and Consequences of LIFO <ul><li>LIFO is widely used in the U.S. for reasons stated earlier; however, LIFO is a fairly uncommon inventory method. </li></ul><ul><ul><li>Many countries do not allow its use. </li></ul></ul><ul><li>The most popular method worldwide is weighted average, followed by FIFO. </li></ul>
  40. 40. Holding Gains and Inventory Profits <ul><li>LIFO approximates a replacement cost view of transactions, and measures profit relative to newer costs. </li></ul><ul><ul><li>replacement cost - the cost at which an inventory item could be acquired today </li></ul></ul><ul><li>In contrast, FIFO measures profit relative to older costs. </li></ul>
  41. 41. Holding Gains and Inventory Profits <ul><li>The difference between profit measured under FIFO and LIFO is called a holding gain or inventory profit . </li></ul><ul><ul><li>The holding gain is also the difference between the historical cost under FIFO (older costs) and the historical cost under LIFO (newer costs). </li></ul></ul><ul><ul><li>LIFO ending inventory rarely has holding gains. </li></ul></ul><ul><ul><li>FIFO ending inventory often has holding gains. </li></ul></ul>
  42. 42. LIFO Layers <ul><li>LIFO layer - a separately identifiable additional segment of LIFO inventory </li></ul><ul><ul><li>Ending inventory under LIFO will have one total value, but it may contain prices from many different points in time. </li></ul></ul><ul><ul><li>As a company continues in business, the LIFO layers tend to pile on top of one another over the years. </li></ul></ul>
  43. 43. LIFO Layers <ul><li>Many companies show inventories that have LIFO layers dating as far back as 1940. These inventories are probably far below the true market value or replacement cost of the inventory. </li></ul><ul><li>LIFO presents an economic reality on the Income Statement, but FIFO presents a more up-to-date valuation on the Balance Sheet. </li></ul>
  44. 44. LIFO Inventory Liquidations <ul><li>As stated before, in periods of rising prices, LIFO will produce a higher cost of goods sold and lower gross profit than FIFO. </li></ul><ul><li>Sometimes companies must “liquidate” some of their LIFO layers. </li></ul><ul><ul><li>In such a case, cost of goods sold decreases because very old costs are now included in cost of goods sold. When cost of goods sold decreases, gross profit increases. </li></ul></ul>
  45. 45. LIFO Inventory Liquidations <ul><li>Security analysts often like to keep track of the effect of choosing LIFO over FIFO because the effect on net income can be significant. </li></ul><ul><li>LIFO reserve - the difference between a company’s inventory valued at LIFO and what it would be under FIFO </li></ul><ul><ul><li>The balance in the LIFO reserve indicates the cumulative affect on gross profit over all prior years due to LIFO. </li></ul></ul>
  46. 46. Lower-of-Cost-or-Market Method (LCM) <ul><li>Lower-of-cost-or-market (LCM) method - the imposition of a market-price test on an inventory cost method </li></ul><ul><ul><li>The current market price is compared with historical cost of inventory under one of the valuation methods. </li></ul></ul><ul><ul><li>The lower of the two values is selected as the basis for the valuation of goods at a specific inventory date. </li></ul></ul><ul><ul><ul><li>When the market value is lower and is used for valuing ending inventory, cost of goods sold is effectively increased. </li></ul></ul></ul>
  47. 47. Lower-of-Cost-or-Market Method (LCM) <ul><li>LCM is an example of conservatism , which means selecting the methods of measurement that yield lower net income, lower assets, and lower stockholders’ equity. </li></ul><ul><ul><li>Erring in the direction of conservatism is better than erring in the direction of overstating assets and net income. </li></ul></ul>
  48. 48. Role of Replacement Cost <ul><li>The concept of replacement cost assumes that as replacement costs decline, selling prices also decline. </li></ul><ul><ul><li>If this is the case , the inventory must be written down to the replacement cost (market value), and the replacement cost is regarded as the “new historical cost.” </li></ul></ul><ul><li>Loss on write-down (or cost of goods sold) xxx </li></ul><ul><li> Inventory xxx </li></ul>
  49. 49. Conservatism in Action <ul><li>Cumulative net income is never lower and is usually higher under the strict cost method than under the LCM method. </li></ul><ul><ul><li>The LCM method affects how much income is reported in each year, but not the total income over the company’s life. </li></ul></ul>
  50. 50. Effects of Inventory Errors <ul><li>An undiscovered inventory error usually affects two accounting periods. </li></ul><ul><ul><ul><ul><ul><li>Amounts are affected in the period in which the error occurred, but the effects will be counterbalanced by identical offsetting amounts in the following period. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>The net effect on retained income is zero. </li></ul></ul></ul></ul></ul>
  51. 51. Effects of Inventory Errors <ul><li>A handy rule of thumb: </li></ul><ul><ul><li>If ending inventory is understated, retained income is understated because cost of good sold will be overstated. </li></ul></ul><ul><ul><li>If ending inventory is overstated, retained income is overstated because cost of goods sold will be understated. </li></ul></ul>
  52. 52. Cutoff Errors and Inventory Valuation <ul><li>Cutoff errors - failure to record transactions in the correct time period </li></ul><ul><li>The general approach to recording purchases and sales is keyed to the legal transfer of ownership. </li></ul><ul><ul><li>Inventory is counted only if it is owned by the company. </li></ul></ul>
  53. 53. The Importance of Gross Profit <ul><li>Gross profit percentage - gross profit as a percentage of sales </li></ul>
  54. 54. Gross Profit Percentage <ul><li>Often the nature of the business of the firm affects the gross profit as compared to other types of firms. </li></ul><ul><ul><li>Wholesaler - an intermediary that sells inventory items to retailers - incur few selling costs </li></ul></ul><ul><ul><li>Retailer - a company that sells items to the final users, individuals </li></ul></ul>
  55. 55. Estimating Intraperiod Gross Profit and Inventory <ul><li>The gross profit percentage is very useful in estimating inventory amounts when related information is unavailable. </li></ul><ul><ul><li>Companies that prepare interim financial statements cannot take physical inventories each period. </li></ul></ul><ul><ul><li>They must rely on gross profit percentage or ratios to estimate inventory amounts. </li></ul></ul>
  56. 56. Gross Profit Percentage and Turnover <ul><li>Retailers often lower gross profit margins and selling prices and hope that the lower selling prices will increase sales volume enough to compensate for the lower gross profit. </li></ul><ul><li>One measure of sales level is inventory turnover - cost of goods sold divided by the average inventory held during the period. </li></ul><ul><ul><li>It tells how fast inventory is sold. </li></ul></ul>
  57. 57. Gross Profit Percentage and Turnover <ul><li>Industries with higher gross profit percentages tend to have the lowest inventory turnover. </li></ul><ul><ul><li>Inventory turnover is especially effective for assessing companies in the same industry. </li></ul></ul><ul><ul><li>A higher inventory turnover indicates an ability to use smaller inventory levels to attain a high sales level. </li></ul></ul>
  58. 58. Adjusting from LIFO to FIFO <ul><li>The LIFO reserve can answer two questions: </li></ul><ul><ul><li>The change in the LIFO reserve from one year to another answers the question “How much did this year’s LIFO cost of goods sold differ from the FIFO cost of goods sold?” </li></ul></ul><ul><ul><li>The end of year level of the LIFO reserve answers the question “What has the total cumulative effect been on cost of goods sold over the years that LIFO has been used?” </li></ul></ul>
  59. 59. Internal Control of Inventories <ul><li>Inventories are more easily accessible than cash in many instances, so internal controls must be in place to protect inventory. Retail merchants must contend with shoplifting and theft. </li></ul><ul><li>Internal controls over inventory: </li></ul><ul><ul><li>Alert employees at the point of sale </li></ul></ul><ul><ul><li>Sensitized tags on merchandise that set off an alarm as the item leaves the store </li></ul></ul><ul><ul><li>Surveillance cameras </li></ul></ul>
  60. 60. Shrinkage in Perpetual and Periodic Inventory Systems <ul><li>In perpetual systems, shrinkage is simply the difference between the cost of inventory identified by a physical count and the clerical inventory balance. </li></ul><ul><li>The entries to record the shrinkage: </li></ul><ul><li>Inventory shrinkage xxx </li></ul><ul><li> Inventory xxx </li></ul><ul><li>Cost of goods sold xxx </li></ul><ul><li> Inventory shrinkage xxx </li></ul>
  61. 61. Shrinkage in Perpetual and Periodic Inventory Systems <ul><li>In periodic systems, no clerical balance of inventory exists. </li></ul><ul><li>Inventory shrinkage is automatically included in cost of goods sold. </li></ul><ul><ul><li>Beginning inventory plus purchases less ending inventory measures all inventory that has flowed out, whether it was sold, stolen, or damaged. </li></ul></ul>
  62. 62. Inventory in a Manufacturing Environment <ul><li>When a company manufactures products, the cost of inventory is a combination of the cost of raw materials, the wages paid to workers who make the product, and an allocation of costs of space, energy, and equipment used by the workers to make the product. </li></ul>
  63. 63. Inventory in a Manufacturing Environment <ul><li>Manufacturing firms have three types of inventory, each of which is in a different stage of completion. </li></ul><ul><li>Raw materials inventory - includes the cost of materials held for use in the manufacturing of a product </li></ul><ul><li>Work in process inventory - includes the cost incurred for partially completed items, including costs of raw materials, labor, and other costs </li></ul><ul><li>Finished goods inventory - the accumulated costs of manufacturing for goods that are complete and ready for sale </li></ul>