Chapter 6. Define accounting principles related to inventory

Chapter 6

Define accounting principles related to inventory

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Consistency◦ Businesses should use the same accounting

methods from period to period Disclosure

◦ Companies should report enough information for outsiders to make decisions about the company

Materiality◦ Companies must follow accounting rules for

significant items Significant – cause a user to change decision

Conservatism◦ Exercise caution in financial reporting

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Define inventory costing methods

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Each inventory item is identified by its specific cost

Used by business that sell unique, easily identified items◦ Examples: Cars, fine jewelry real estate

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Assumes oldest items are sold first

Oldest Oldest CostsCosts

Oldest Oldest CostsCosts

Cost of Goods Cost of Goods SoldSold

Cost of Goods Cost of Goods SoldSold

Cost of Goods Cost of Goods SoldSold

Cost of Goods Cost of Goods SoldSold

Therefore, newest items are on hand

Recent Recent CostsCosts

Recent Recent CostsCosts

Ending Ending InventoryInventoryEnding Ending

InventoryInventory

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Recent Recent CostsCosts

Recent Recent CostsCosts

Cost of Goods Cost of Goods SoldSold

Cost of Goods Cost of Goods SoldSold

Oldest Oldest CostsCosts

Oldest Oldest CostsCosts

Ending Ending InventoryInventoryEnding Ending

InventoryInventory

Assumes newest items are sold first

Therefore, oldest items are on hand

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The average cost of each unit in inventory is assigned to cost of goods sold

Average CostCost of Inventory

on HandNumber of Units

on Hand÷ =

Account for perpetual inventory by the three most common costing methods

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$10 $10 $10

Beginning Inventory

$12 $12 $12 $12 $12

Purchase 5 shirts

Then we sell 4 shirts for $20 each.What costs should be assigned to Cost of goods sold?

First-In, First-Out

Cost of good sold = $42Inventory = $48

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GENERAL JOURNALDATE DESCRIPTION REF DEBIT CREDIT

Accounts receivable ($20 x 4) 80

Sales revenue 80

To record sales on account

Cost of goods sold 42

Inventory 42

To record cost of sales

Sales $80

Cost of goods sold 42

Gross profit $38

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$10 $10 $10

Beginning Inventory

$12 $12 $12 $12

Purchase 5 shirts

Then we sell 4 shirts for $20 each.What costs should be assigned to Cost of goods sold?

Last-In, First-Out

Cost of good sold = $48Inventory = $42

$12

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GENERAL JOURNALDATE DESCRIPTION REF DEBIT CREDIT

Accounts receivable ($20 x 4) 80

Sales revenue 80

To record sales on account

Cost of goods sold 48

Inventory 48

To record cost of sales

Sales $80

Cost of goods sold 48

Gross profit $32

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$10 $10 $10

Beginning Inventory

$12 $12 $12 $12

Purchase 5 shirts

Then we sell 4 shirts for $20 each.What costs should be assigned to Cost of goods sold?

Compute the Average CostUnits Cost

Beginning inventory 3 $30Purchases 5 60 Total 8 $90

Average = $90/8 = $11.25

Cost of good sold = $11.25 x 4 = $45Inventory = $11.25 x 4 = $45

$12

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GENERAL JOURNALDATE DESCRIPTION REF DEBIT CREDIT

Accounts receivable ($20 x 4) 80

Sales revenue 80

To record sales on account

Cost of goods sold 45

Inventory 45

To record cost of sales

Sales $80

Cost of goods sold 45

Gross profit $35

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Compare the effects of the three most common costing methods

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LIFO31%

FIFO46%

Other3%

Avg20%

FIFO LIFO Average

Sales $80 $80 $80

Cost of goods sold

$42 $48 $45

Gross profit $38 $32 $35

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Highest gross profit;

highest net

income

Lowest gross profit; lowest

net income

If inventory prices are increasing

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High income attracts

investors

High income attracts

investors

“Middle ground”“Middle ground”

Lower income = Less taxes

Lower income = Less taxes

Last-In, First-Out

First-In, First-Out

AverageCost

Apply the lower-of-cost-or market rule to inventory

Example of Accounting Conservatism Inventory is reported at lower of:

◦ Historical cost or ◦ Market value (current replacement cost)

If market is lower than cost, write down inventory value:

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Date AccountsPost Ref Debit Credit

Cost of goods sold Inventory

GENERAL J OURNAL

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Date AccountsPost Ref Debit Credit

Cost of goods sold Inventory

GENERAL J OURNAL

$25,000 $25,00

0

#1

Current assets:Inventory, (at lower-of-cost-or-market) 80,000$

L and M ElectronicsBalance Sheet

December 30, 2012#2

$105,000 - $25,000

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Cost of goods sold $430,000

L and M ElectronicsIncome Statement

Year ended December 31, 2012#3

$405,000 + $25,000

#4 ConservatismConservatism

Measure the effects of inventory errors

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Estimate ending inventory by the gross profit method

Method to estimate ending inventory using the gross profit percent

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Beginning inventory $15,000

Net purchases 70,000

Cost of goods available 85,000

Estimated cost of goods sold:

Sales revenue $100,000

Less: Estimated gross profit of 35%

(35,000)

Estimated cost of goods sold (65,000)

Estimated cost of ending inventory

$20,000

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Beginning inventory $47,000

Net purchases 30,300

Cost of goods available 77,300

Estimated cost of goods sold:

Sales revenue $63,000

Less: Estimated gross profit of 35%

(22,050)

Estimated cost of goods sold (40,950)

Estimated cost of ending inventory

$36,350