Ch08 Fundamental Of Financial Accounting By Edmonds (4th Edition)
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Fundamental Financial Accounting Concepts Fourth Edition by Edmonds, McNair, Milam, Olds PowerPoint® presentation by J. Lawrence Bergin
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Chapter 8
Asset Valuation Accounting for Inventories and Investments (appendix) McGraw-Hill/Irwin
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Inventory Cost Recall that inventory is recorded at the price paid or the consideration given up.
McGraw-Hill/Irwin
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Inventory Cost ◆
The amount recorded for inventory should include: • Invoice price, freight charges, inspection costs, and preparation costs.
◆
Inventory may be tracked with either a periodic or a perpetual inventory system.
McGraw-Hill/Irwin
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Cost of Goods Sold Beginning inventory
$
Add: Purchases, net Goods available for sale $ Less: Ending inventory Cost of Goods Sold
McGraw-Hill/Irwin
$
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Alternative Inventory Cost Flow Methods
FIFO
Weighted Average
McGraw-Hill/Irwin
LIFO Spe c Ide ntif ific icat ion
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Inventory Cost Flow Methods These four inventory costing methods are used to assign the total dollar amount of goods available for sale between ending inventory and cost of goods sold. Ending inventory or CGS??
McGraw-Hill/Irwin
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Inventory Account Inventory Beginning Balance 100 units @ $3 Purchases during the period 150 units $3.10
Units Sold
200 units sold
100 units $3.05 200 units $3.15 Ending Balance
McGraw-Hill/Irwin
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Inventory Account Inventory Beginning Balance 100 units @ $3 Purchases during the period 150 units $3.10 100 units $3.05
Sold 200 units
What is CGS??
200 units $3.15 Ending Balance = 350 units
What is EI?? McGraw-Hill/Irwin
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First-In, First-Out ◆
The cost of the oldest inventory items are charged to cost of goods sold when goods are sold.
◆
The cost of the newest inventory items remain in ending inventory.
◆
The actual physical flow of inventory items may differ from the FIFO cost flow assumptions.
McGraw-Hill/Irwin
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Last-In, First-Out ◆
The cost of the newest inventory items are charged to cost of goods sold when goods are sold.
◆
The cost of the oldest inventory items remain in ending inventory.
◆
The actual physical flow of inventory items may differ from the LIFO cost flow assumptions.
McGraw-Hill/Irwin
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Weighted-Average ◆
Compute cost of goods available for sale: Cost of Beginning Inventory + Net Cost of Purchases
◆
Compute total units available for sale: Units in Beginning Inventory + Units Purchased
McGraw-Hill/Irwin
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Weighted-Average ◆
Compute weighted-average cost per unit: Cost of Goods Available for Sale Total Units Available for Sale
◆
Compute ending inventory: Units in EI × Weighted-Average Cost per Unit
◆
Compute Cost of Goods Sold: Units Sold × Weighted-Average Cost per Unit
McGraw-Hill/Irwin
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Specific Identification ◆
Specific cost of each inventory item is known.
◆
Used with small volume, high dollar inventory. Inventory of Yachts Customer Cost to build Smith $120,000 Jones 80,000 Baker 150,000 Total inventory $350,000
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Applying these inventory costing methods: FIFO, LIFO, and W. Ave. may be applied on either the PERIODIC or PERPETUAL basis. First, let’s apply them using a PERIODIC approach.
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Example: Date 1/1 3/10 6/17 9/15 12/27
McGraw-Hill/Irwin
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
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Inventory Account Inventory Beginning Balance 10 units @ $4 Purchases during the period 12 units @ $7
Sold 18 units
What is CGS??
11 units @ $8 Ending Balance = 15 units
What is EI?? McGraw-Hill/Irwin
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Goods Available for Sale: Begin. Inv. 10 @ $ 4 = $40 Purchases: 12 @ $ 7 = $84 11 @ $ 8 = $88 Total Purchases 172 Goods Available $ 212
FOR SALE
Q: How much of the $212 should be in Cost of Goods Sold expense and how much should be the Ending Inventory balance? McGraw-Hill/Irwin
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Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERIODIC inventory basis it does not matter WHEN the SALES were made. We only care that a TOTAL of 18 units were sold. McGraw-Hill/Irwin
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FIFO:
(Periodic basis) ◆ Cost of Goods Sold: (for the 18 units sold) From Units Price Cost
Ending Inventory: (for 15 units remaining) From Units Price Cost ◆
McGraw-Hill/Irwin
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FIFO: ◆
Cost of Goods Sold:
From 1/1 3/10 Totals ◆
(Periodic basis) Units 10 8 18
Ending Inventory:
From 3/10 9/15 Totals McGraw-Hill/Irwin
Units 4 11 15
(for the 18 units sold)
Price $ 4 7
Cost $ 40 56 $ 96
(for 15 units remaining)
Price $ 7 8
Cost $ 28 88 $116 © The McGraw-Hill Companies, Inc., 2003
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LIFO:
(Periodic basis) ◆ Cost of Goods Sold: (for the 18 units sold) From Units Price Cost
Ending Inventory: (for 15 units remaining) From Units Price Cost ◆
McGraw-Hill/Irwin
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Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERIODIC inventory basis it does not matter WHEN the SALES were made. We only care that a TOTAL of 18 units were sold. McGraw-Hill/Irwin
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LIFO:
(Periodic basis)
Cost of Goods Sold: (for the 18 units sold) From Units Price Cost 9/15 11 $ 8 $ 88 3/10 7 7 49 Totals 18 $137 ◆
Ending Inventory: (for 15 units remaining) From Units Price Cost 3/10 5 $ 7 $ 35 1/1 10 4 40 Totals 15 $ 75 ◆
McGraw-Hill/Irwin
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Weighted Average: (Periodic basis)
Average cost per unit:
Cost of Goods avail. for sale # of units avail. for sale
McGraw-Hill/Irwin
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Weighted Average: (Periodic basis)
Average cost per unit:
Cost of Goods avail. for sale # of units avail. for sale
McGraw-Hill/Irwin
$ 212
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Weighted Average: (Periodic basis)
Average cost per unit:
Cost of Goods avail. for sale # of units avail. for sale
McGraw-Hill/Irwin
$ 212 33 units
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Weighted Average: (Periodic basis)
Average cost per unit:
Cost of Goods avail. for sale # of units avail. for sale
McGraw-Hill/Irwin
$ 212 = $6.42 33 units Per unit
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Weighted Average: (Periodic basis)
Average cost per unit: Cost of GAFS # of units GAFS
$ 212 33
= $6.42/unit
Cost of Goods Sold:
Ending Inventory:
McGraw-Hill/Irwin
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Weighted Average: (Periodic basis)
Average cost per unit: Cost of GAFS # of units GAFS
$ 212 33
= $6.42/unit
Cost of Goods Sold: 18 units sold @ $6.42 cost = $116 (rounded) Ending Inventory:
McGraw-Hill/Irwin
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Weighted Average: (Periodic basis)
Average cost per unit: Cost of GAFS # of units GAFS
$ 212 = $6.42/unit 33
Cost of Goods Sold: 18 units sold @ $6.42 cost = $116 (rounded) Ending Inventory: 15 units remaining @ $6.42 cost = $ 96 (rounded) McGraw-Hill/Irwin
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Income Statements (on Periodic basis) [Given operating expenses of $50 and a 40% tax rate] (15@$14 + 3@$20)=
Sales Cost of G. S. Gross Margin Oper. exp. Pretax Inc. Taxes (40%) Net Income McGraw-Hill/Irwin
FIFO
LIFO
Wt. Avg.
$270 96 174 50 124 50 $ 74
$270 137 133 50 83 33 $ 50
$ 270 116 154 50 104 42 $ 62
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Q1: Does LIFO always result in the lowest Net Income Statements (Periodic basis) about Income or is there something special [Given expenses of $50 and a 40% tax rate] the operating economic situation here? FIFO
LIFO
Wt. Avg.
Sales $270 $270 $ 270 Cost of G. S. 96 137 116 A1: In a period of RISING prices LIFO charges Gross Margin 174 133 154 out the latest (highest) prices first, resulting Oper. 50lowest Net50Inc. in exp. the highest C50of G S and Pretax Inc. method 124 83select? Why? 104 Q2: Which would YOU Taxes (40%) 50 33 42 Net Income $ 74 $ 50 $ 62 McGraw-Hill/Irwin
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Cashflows from Operating Activities FIFO
Inflows: Sales collected $ Outflows: Purchases paid for Oper. exp. paid Taxes (40%) paid Net cash flow $ McGraw-Hill/Irwin
LIFO
Wt. Avg.
$
$
$
$ © The McGraw-Hill Companies, Inc., 2003
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Cashflows from Operating Activities FIFO
LIFO
Wt. Avg.
Inflows: Sales collected $270 $270 $270 Outflows: Purchases paid for (172) (172) (172) Oper. exp. paid (50) (50) (50) Taxes (40%) paid (50) (33) (42) Net cash flow $ ( 2) $ 15 $ 6 Why is FIFO cash flow $17 less than LIFO’s? The ONLY difference in cash flow is the amount of TAXES paid. McGraw-Hill/Irwin
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Summary: Effects of Cost Flow Assumptions ◆ Effects on financial statements ❐
Income Statement ❐
❐ ❐
❐
cost of goods sold, gross profit & income before taxes taxes net earnings (net income)
Balance Sheet ❐ Inventory ❐ Retained
❐
Earnings (because of Net Income effect)
Cashflow Statement ❐ Cashflows
McGraw-Hill/Irwin
are affected only because of taxes. © The McGraw-Hill Companies, Inc., 2003
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Comparison of Methods ◆
Each of the four methods is acceptable, and an argument can be made for using each.
◆
The choice of an inventory method will depend on management’s incentives, the tax laws, and the reporting company’s particular economic circumstances.
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Consistency Principle Because the choice of an inventory method can significantly affect the financial statements, a company might be inclined to select a new method each year that would result in the most favorable financial statements. However . . .
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Consistency Principle . . . the consistency principle requires that companies use the same accounting methods period after period so the financial statements of succeeding periods will be comparable. comparable
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Alternative Inventory Costing Methods in Practice The LIFO conformity rule states that if LIFO is used for taxes, then LIFO must also be used for financial reporting.
LIFO for taxes
McGraw-Hill/Irwin
LIFO for books
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Example: Periodic vs. Perpetual Using the same data used for the Periodic method, now calculate Cost of Goods Sold and Ending Inventory under FIFO, LIFO and Average Cost using the PERPETUAL method.
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Goods Available for Sale: Begin. Inv. 10 @ $ 4 = $40 Purchases: 12 @ $ 7 = $84 11 @ $ 8 = $88 Total Purchases 172 Goods Available $ 212
FOR SALE
Q: How much of the $212 should be in Cost of Goods Sold expense and how much should be reported on the Bal. Sheet as Ending Inventory? McGraw-Hill/Irwin
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Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERPETUAL inventory basis it DOES matter WHEN the SALES were made. McGraw-Hill/Irwin
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FIFO--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS date units cost $ inv.
McGraw-Hill/Irwin
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FIFO--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS date units cost $ inv. 3/10 12 @ $7 6/17
1/1 1/1 10 @ $4 = $ 40 3/10 5 @ $7 = $ 35 $ 75
3/10
3/10
3/10 7 @ $7 9/15 11 @ $8 3/10 4 @ $7 = $ 28 9/15 11 @ $8 = 88 End. Inv. $116
9/15 11 @ $8 12/27
3 @ $7 = $ 21
Cost of Goods Sold McGraw-Hill/Irwin
1/1 10 @ $4 10 @ $4 3/10 12 @ $7
$ 96
7 @ $7
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LIFO--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS date units cost $ inv.
McGraw-Hill/Irwin
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Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERPETUAL inventory basis it DOES matter WHEN the SALES were made. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
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LIFO--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS date units cost $ inv. 3/10 12 @ $7 6/17
1/1 3/10 12 @ $7 = $ 84 1/1 3 @ $4 = $ 12 $ 96
1/1
9/15
1/1 7 @ $4 9/15 11 @ $8 1/1 7 @ $4 = $ 28 9/15 8 @ $8 = 64 End. Inv. $ 92
9/15 11 @ $8 12/27
3 @ $8 = $ 24
Cost of Goods Sold McGraw-Hill/Irwin
1/1 10 @ $4 10 @ $4 3/10 12 @ $7
$120
7 @ $4
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Weighted Average - Perpetual When weighted average is applied on a perpetual basis it is called a “Moving Average”. Procedures: 1. A new unit average cost must be calculated after every purchase. 2. Units SOLD are “costed out” (that is, charged to Cost of Goods Sold) using the unit average cost of units in inventory at the time of the sale.
McGraw-Hill/Irwin
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Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERPETUAL inventory basis it DOES matter WHEN the SALES were made. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv.
Cost of Goods Sold on the annual Income Statement = Merchandise Inventory on the 12/31 Balance Sheet = McGraw-Hill/Irwin
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS dateunits cost $ inv. 3/10
12 @ $7
1/ 1 1/ 1 3/10 ave.
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ ?? =124.00
Question: What is the average unit cost as of 3/10? Total Inv. Cost divided by Total units in inv. = Unit Cost $124 / 22 = $5.64/unit McGraw-Hill/Irwin
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
12 @ $7
1/ 1 1/ 1 3/10 ave.
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00
Question: What is the average unit cost as of 3/10? Total Inv. Cost divided by Total units in inv. = Unit Cost $124 / 22 = $5.64/unit McGraw-Hill/Irwin
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00
Now what?! 1. Until another purchase is made, units SOLD are “costed out” at $5.64 each. 2. A new average cost must be calculated when the next purchase is made. McGraw-Hill/Irwin
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60
McGraw-Hill/Irwin
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48
© The McGraw-Hill Companies, Inc., 2003
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60 9/15
11 @ $8
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48 7 @ 5.64 39.48 11 @ 8.00 88.00 18 @ ??? 127.48
Question: What is the new average cost? $127.48 divided by 18 units = $7.08 per unit (rounded) McGraw-Hill/Irwin
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60 9/15
11 @ $8
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48 7 @ 5.64 39.48 11 @ 8.00 88.00 18 @ 7.08 127.48
Question: What is the new average cost? $127.48 divided by 18 units = $7.08 per unit (rounded) McGraw-Hill/Irwin
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60 9/15
11 @ $8
12/27
McGraw-Hill/Irwin
3 @ 7.08=21.24
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48 7 @ 5.64 39.48 11 @ 8.00 88.00 18 @ 7.08 127.48 15 @ 7.08 106.20
© The McGraw-Hill Companies, Inc., 2003
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Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60 9/15
11 @ $8
12/27
3 @ 7.08=21.24
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48 7 @ 5.64 39.48 11 @ 8.00 88.00 18 @ 7.08 127.48 15 @ 7.08 106.20
Cost of Goods Sold for annual income statement = $84.60 + $21.24 = $105.84 Merchandise Inventory on the 12/31 Balance Sheet = $106.20 McGraw-Hill/Irwin
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Summary of FIFO, LIFO, Ave. Cost combined with Periodic and Perpetual Cost of G. S.
End. Invent.
FIFO-Periodic
$ 96
$116
FIFO-Perpetual
$ 96
$116
LIFO-Periodic
$137
$ 75
LIFO-Perpetual
$120
$ 92
Ave.-Periodic
$116
$ 96
Ave.-Perpetual
$106 (rounded)
$106 (rounded)
McGraw-Hill/Irwin
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Summary of LIFO-FIFO combined with Periodic and Perpetual When using FIFO, the C of GS and End. Inv. are the same for both perpetual and periodic. ◆ When using LIFO (and W. Ave), the perpetual and periodic recording methods do not give the same value for C of GS and E. I. ◆
• In a period of rising prices (inventory costs are rising) C of G.S. under LIFO PERIODIC will either be equal to (rarely) or greater than PERPETUAL. © The McGraw-Hill McGraw-Hill/Irwin(usually) Cost of G.S. using LIFO Companies, Inc., 2003
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Summary of LIFO-FIFO combined with Periodic and Perpetual So, if you are using LIFO because of its tax benefits would you apply it on a PERIODIC Basis or a PERPETUAL Basis? Periodic Why? Starting with the very first sale, you would charge Cost of G.S exp. with the cost of the last purchased goods of the year. The resulting higher Cost of Goods Sold (assuming rising prices) means lower profit and, thus, lower taxes. McGraw-Hill/Irwin
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Gross Margin Method of Estimating Inventory Provides an estimate ◆ Not acceptable for GAAP ◆ When to use ◆
• • • •
for interim (any period less than a year) reporting purposes when physical inventory not possible (casualty) a check on the accuracy of the physical count do we have a problem with theft?
McGraw-Hill/Irwin
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Example: Given the following: Beginning Inventory Purchases Sales
$ 1,000 (cost) 9,000 (cost) 12,000 (retail)
Assume that gross margin has been 40% of sales. Estimate the cost of inventory and CGS for the period.
McGraw-Hill/Irwin
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If the Gross Margin rate is 40% what is the Cost of Goods Sold %? Net Sales Less: Cost of G.S. =Gross Margin
100% = 60% X% 40%
Use these %’s and a partial multi-step income statement format to find the “missing” amounts.
McGraw-Hill/Irwin
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Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net Goods Avail. - End. Inv.
$1,000 9,000 10,000 (?)
Cost of Goods Sold Gross Margin
McGraw-Hill/Irwin
(60% x Net Sales)
$
(40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
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Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net Goods Avail. - End. Inv. Cost of Goods Sold Gross Margin
McGraw-Hill/Irwin
$1,000 9,000 10,000 (?) (60% x Net Sales)
$ 4,800 (40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
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Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net Goods Avail. - End. Inv. Cost of Goods Sold Gross Margin
McGraw-Hill/Irwin
$1,000 9,000 10,000 (?) (60% x Net Sales)
$ 4,800 (40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
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Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net Goods Avail. - End. Inv. Cost of Goods Sold
$1,000 9,000 10,000 (?) (7,200) (60% x Net
Sales)
Gross Margin
McGraw-Hill/Irwin
$ 4,800 (40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
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Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net
$1,000 9,000
Goods Avail.
10,000
- End. Inv.
(2,800)
Cost of Goods Sold Gross Margin
McGraw-Hill/Irwin
(7,200) (60% x Net Sales) $ 4,800 (40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
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Use given amounts and known %’s On the right side is an alternative solution format where the estimated inventory is the last line. Sales
$12,000
- C. of Gds. S.
Begin. Inv.
Beg. Inv. $1,000 + Purch.
Alternate Solution Format: $ 1,000
+ Purch., net
9,000
9,000
Goods Avail.
Gds Avl. 10,000
Sales
- End. Inv.(2,800)
$10,000 $12,000
- 40%Est. G.M.
Cost of Gds S. (60%) (7,200) =60%Est. CofGS Gross Margin McGraw-Hill/Irwin
(40%)
$4,800
Est. Ending Inv.
(4,800) (7,200) $ 2,800
© The McGraw-Hill Companies, Inc., 2003
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Lower of Cost or Market
◆
Ending inventory is reported at the lower of cost or market (LCM) applied in 1 of 3 ways. • Item-by-item • Major categories • Total inventory (not acceptable for tax return)
◆
Market refers to the replacement cost of the merchandise, which is what you would pay your supplier if you bought the inventory today.
◆
This practice is in keeping with the generally accepted accounting principle of conservatism.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 73
Lower of Cost or Market Cost
$50
Inventory Loss = $10
Market McGraw-Hill/Irwin
$40
$40 Market Value © The McGraw-Hill Companies, Inc., 2003
8- 74
Lower of Cost or Market Unit Qty. Cost Invent. SideItem Mirrors (a) 50 $(b)5
Unit Mkt.
Total Mkt.
Item-by-item Lower of
$(c)5 $(a x b) $(a x c) Cost $ or Mkt $ Loss
Tires 38
300 $ 42
$
Batteries
200 $ 35
$ 30
Car Stereos 100 $115
Total Cost
$138 $
$
$
$
SOLUTION: LCM: item-by-item approach =
End. Inv. $
Major category (Auto dept.) =
$
McGraw-Hill/Irwin
Invent. Loss $ $
© The McGraw-Hill Companies, Inc., 2003
8- 75
Lower of Cost or Market Unit Qty. Cost Invent. SideItem Mirrors (a) 50 $(b)5
Unit Mkt.
Total Cost
Total Mkt.
Item-by-item Lower of
b) $(a x 250 c) Cost Mkt $Loss0 $(c)5 $(a x250 $ or250
Tires 38
300 $ 42
$
$12,600 $11,400 $ 7,000 $ 6,000
$11,400 $ 6,000
$1,200 $1,000
Batteries
200 $ 35
$ 30 $11,500 $13,800 $138 $31,350 $31,450
$11,500 $29,150
$ 0 $2,200
Car Stereos 100 $115 SOLUTION:
LCM: item-by-item approach =
End. Inv. $29,150
Major category (Auto dept.) =
$31,350
Invent. Loss $2,200 $
0
Because T. Mkt>T.cost
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 76
Errors in Measuring Ending Inventory ◆
Misstatements in inventory may cause errors in the following areas: • Income Statement –
•
Balance Sheet –
◆
Cost of Goods Sold, Gross Profit, Taxes, Net Income Inventory, Payables, Retained Earnings
Because the ending inventory of one period becomes the beginning inventory of the next period, ending inventory errors affect two accounting periods.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 77
Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1. As Reported Year 1 Year 2 10 11
Sales C of GS: Begin. Inv. 1 +Purchases 7 Gds. Avail. 8 - Ending Inv. =C of G. Sold Gross Margin
As Corrected Year 1 Year 2
2 8 10 2 6 4
4 6 5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 78
Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1. As Reported Year 1 Year 2 10 11
Sales C of GS: Begin. Inv. 1 +Purchases 7 Gds. Avail. 8 - Ending Inv. =C of G. Sold Gross Margin
2 8 10 2 6 4
As Corrected Year 1 Year 2 10
1 7 48 6 3 5
5 5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 79
Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1. As Reported Year 1 Year 2 10 11
Sales C of GS: Begin. Inv. 1 +Purchases 7 Gds. Avail. 8 - Ending Inv. =C of G. Sold Gross Margin
2 8 10 2 6 4
As Corrected Year 1 Year 2 11 10
1 7 48 6 3 5
3 8 11 4 5 5
7 4
What was the effect of the error on the Yr. 1 and Yr. 2 Statements? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 80
What was the effect of understating the Year 1 ending inventory by $1? (ignore taxes) Year 1
Year 2
Sales Begin. Inventory Purchases Goods Avail. for Sale Ending Inventory Cost of Goods Sold Gross Profit Margin Net Income Ret. Earn, end. Bal. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 81
What was the effect of understating the Year 1 ending inventory by $1? (ignore taxes) Year 1
Year 2
Sales Begin. Inventory Purchases Goods Avail. for Sale Ending Inventory Cost of Goods Sold
Compare the Reported amounts for each year with the Corrected amounts.
Gross Profit Margin Net Income Ret. Earn, end. Bal. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 82
Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1. As Reported Year 1 Year 2 10 11
Sales C of GS: Begin. Inv. 1 +Purchases 7 Gds. Avail. 8 - Ending Inv. =C of G. Sold Gross Margin
2 8 10 2 6 4
As Corrected Year 1 Year 2 11 10 Same = No effect 3 1 8 7 11 4 48 7 6 3 5 4 5 5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 83
What was the effect of understating the Year 1 ending inventory by $1? (ignore taxes) Sales
Year 1 No effect
Begin. Inventory
No effect
Purchases
No effect
Year 2
Goods Avail. for Sale No effect Understated $1 Ending Inventory Cost of Goods Sold
Overstated $1
Gross Profit Margin
Understated $1
Net Income
Understated $1
Ret. Earn, end. Bal.
Understated $1
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 84
What was the effect of understating the Year 1 ending inventory by $1? (ignore taxes) Sales
Year 1 No effect
Year 2 No effect
Begin. Inventory
No effect
Understated $1
Purchases
No effect
No effect
Understated $1 Goods Avail. for Sale No effect Understated $1 No effect Ending Inventory Cost of Goods Sold
Overstated $1
Gross Profit Margin
Understated $1 Overstated $1
Net Income
Understated $1 Overstated $1
Ret. Earn, end. Bal.
Understated $1 No effect (why?)
McGraw-Hill/Irwin
Understated $1
© The McGraw-Hill Companies, Inc., 2003
8- 85
Financial Statement Analysis ◆
Inventory Turnover Inventory = Turnover
Cost of Goods Sold $ Inventory*
Often the AVERAGE inventory is used as the denominator.
Ave. Inv =
Beginning Inventory + Ending Inventory 2
This ratio is often used to measure the liquidity (nearness to cash) of the inventory. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 86
Inventory Ratios Inventory Turnover: (A measure of how fast inventory sells. Higher is better.) Cost of Goods Sold $30,000 = = 6.0 times Inventory $ 5,000 Average Days in Inventory: (How many days go by between the time inventory arrives and it is sold?) 365 365 Inventory Turnover = 6.0 = 60.8 days Generally, lower means better. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 87
Length of Operating Cycle Remember from Chapter 6 that a company’s operating cycle is the time it takes to convert inventory to cash by selling it and collecting the receivable. So, the Operating Cycle is: Ave. days to sell inventory + Ave. days to collect receivables Length of Operating Cycle McGraw-Hill/Irwin
60.8 days 36.5 days 97.3 days
© The McGraw-Hill Companies, Inc., 2003
8- 88
Length of Operating Cycle Ave. days to sell inventory + Ave. days to collect receivables Length of Operating Cycle
60.8 days 36.5 days 97.3 days
The longer the operating cycle the more it costs the company for financing, storage and collection costs. Suppose XYZ Co. has a $10,000,000 inventory and pays 10% annual interest to finance operations. Assume XYZ’s operating cycle is 30 days longer than its main competitor’s. How much does the extra 30 days cost XYZ? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 89
Length of Operating Cycle The longer the operating cycle the more it costs the company for financing, storage and collection costs. Suppose XYZ Co. has a $10,000,000 inventory and pays 10% annual interest to finance operations. Assume XYZ’s operating cycle is 30 days longer than its main competitor’s. How much does the extra 30 days cost XYZ? Inventory x Int. rate x Time = Cost $10,000,000 x
10%
x 30/365 =
$82,192
This extra cost is a competitive disadvantage for XYZ Co. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 90
Chapter 8
The Appendix follows. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 91
Chapter 8
APPENDIX Accounting For Investments and Reporting Comprehensive Income
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 92
Investments in Marketable Securities ◆
A company may use some of its extra cash to invest in the debt or equity securities of another company
◆
These investments must be classified as one of three types: • Securities held to maturity • Trading Securities • Securities available for sale
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 93
Securities held to maturity ◆ ◆
◆
◆
Debt securities Intent and ability to hold to maturity Must not be sold in response to changes in interest rates, funding sources, etc.. Measured at cost on the balance sheet
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 94
Trading securities ◆ ◆ ◆ ◆ ◆ ◆
Debt and equity securities Readily determinable fair values Bought and held to sell in the near term Actively and frequently traded (goal: profit!) Measured at fair value and classified as a current asset Unrealized gains and losses, included in determination of net income
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 95
Securities available for sale ◆ ◆ ◆ ◆ ◆ ◆
Debt and equity securities Readily determinable fair values Not classified as either securities held to maturity or trading securities Measured at fair value on balance sheet May be either current or noncurrent May have holding gains or losses, to be reported net, NOT as part of Net Income, but as a component of “other comprehensive income”.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 96
Summary of Reporting Requirements Investm’t. Type of Category Security
Type of Value on Unreal. G/L Cashflow Revenue Bal. Sheet part of NI? Purch/Sale
Held to Maturity
Interest
Amortized Cost
No
Investing Activities
Trading Debt & Securities Equity
Interest & Divid.
Market Value
Yes
Operating Activities
Available Debt & Equity for sale Securities
Interest & Divid.
Market Value
No (in “Other Comprehensive Income”)
Investing Activities
McGraw-Hill/Irwin
Debt
© The McGraw-Hill Companies, Inc., 2003
8- 97
What is Comprehensive Income? All changes in Owners’ Equity except owners’ capital investments and distributions to owners. Includes Net Income and “Other Comprehensive Income.” Other Comprehensive Income includes: -Unrealized gains/losses on Available for Sale Securities. and the following 3 items discussed in higher level courses:
-A type of pension plan accounting adjustment. -Certain gains/losses on “derivative” securities. -Translation adjustments from converting the financial statements of its foreign operations into U.S. dollars.
How is Comprehensive Inc. reported?? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 98
Comprehensive Income Reporting Options Bottom of Income Statement: Income Statement Revenue $100 - Expenses 40 Net Income 60 Other Comp. Inc.(Loss) $(10) Comprehensive Income $ 50 The third option (used by most companies) is to report the current period’s Other Comprehensive Income as a separate section on the Statement of Changes in Stk. Equity. McGraw-Hill/Irwin
Separate Statements Income Statement Revenue $100 - Expenses 40 Net Income $ 60
Statem’t of Comprehensive Inc. Net Income $ 60 Other Comp. Inc. (Loss) (10) Comprehensive Income $ 50 © The McGraw-Hill Companies, Inc., 2003
8- 99
Reporting Comprehensive Income Statement of Changes in Stk. Equity Option Bal., 1/1/X1 Comp. Inc.
Comp. Common Ret. Accumulated Inc. Stock Earn. Other Comp. Inc. Total $100 $205 $30 $335 $60
Net Inc.
60
60 Other Comp. Inc. Unreal. Loss Compreh. Inc.
Own. Invest. Distribution Bal. 12/31/X1
(10) $50
(10)
(10)
$20
20 (5) $400
20 $120
(5) $260
Accumulated Other Comprehensive Income balance is always reported in the Stockholders’ Equity section of the Balance Sheet. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 100
Additional Types of Equity Investments
“Significant Influence” investments
A company (investor) owning 20-50% of another company’s stock is presumed to have significant influence over it (the “investee”). These investments are valued using the equity method which is based on the book value of the investee, rather than cost or market value of the investment.
“Controlling Interest” investments A company owning more than 50% of another company’s stock has the controlling interest. The company owning the controlling interest is the PARENT, the other company is the SUBSIDIARY. CONSOLIDATED financial statements must be issued combining the results of the Parent and all its subsidiaries. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 101
Chapter 8
The End McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 2
Chapter 8
Asset Valuation Accounting for Inventories and Investments (appendix) McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 3
Inventory Cost Recall that inventory is recorded at the price paid or the consideration given up.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 4
Inventory Cost ◆
The amount recorded for inventory should include: • Invoice price, freight charges, inspection costs, and preparation costs.
◆
Inventory may be tracked with either a periodic or a perpetual inventory system.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 5
Cost of Goods Sold Beginning inventory
$
Add: Purchases, net Goods available for sale $ Less: Ending inventory Cost of Goods Sold
McGraw-Hill/Irwin
$
© The McGraw-Hill Companies, Inc., 2003
8- 6
Alternative Inventory Cost Flow Methods
FIFO
Weighted Average
McGraw-Hill/Irwin
LIFO Spe c Ide ntif ific icat ion
© The McGraw-Hill Companies, Inc., 2003
8- 7
Inventory Cost Flow Methods These four inventory costing methods are used to assign the total dollar amount of goods available for sale between ending inventory and cost of goods sold. Ending inventory or CGS??
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 8
Inventory Account Inventory Beginning Balance 100 units @ $3 Purchases during the period 150 units $3.10
Units Sold
200 units sold
100 units $3.05 200 units $3.15 Ending Balance
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 9
Inventory Account Inventory Beginning Balance 100 units @ $3 Purchases during the period 150 units $3.10 100 units $3.05
Sold 200 units
What is CGS??
200 units $3.15 Ending Balance = 350 units
What is EI?? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 10
First-In, First-Out ◆
The cost of the oldest inventory items are charged to cost of goods sold when goods are sold.
◆
The cost of the newest inventory items remain in ending inventory.
◆
The actual physical flow of inventory items may differ from the FIFO cost flow assumptions.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 11
Last-In, First-Out ◆
The cost of the newest inventory items are charged to cost of goods sold when goods are sold.
◆
The cost of the oldest inventory items remain in ending inventory.
◆
The actual physical flow of inventory items may differ from the LIFO cost flow assumptions.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 12
Weighted-Average ◆
Compute cost of goods available for sale: Cost of Beginning Inventory + Net Cost of Purchases
◆
Compute total units available for sale: Units in Beginning Inventory + Units Purchased
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 13
Weighted-Average ◆
Compute weighted-average cost per unit: Cost of Goods Available for Sale Total Units Available for Sale
◆
Compute ending inventory: Units in EI × Weighted-Average Cost per Unit
◆
Compute Cost of Goods Sold: Units Sold × Weighted-Average Cost per Unit
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 14
Specific Identification ◆
Specific cost of each inventory item is known.
◆
Used with small volume, high dollar inventory. Inventory of Yachts Customer Cost to build Smith $120,000 Jones 80,000 Baker 150,000 Total inventory $350,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 15
Applying these inventory costing methods: FIFO, LIFO, and W. Ave. may be applied on either the PERIODIC or PERPETUAL basis. First, let’s apply them using a PERIODIC approach.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 16
Example: Date 1/1 3/10 6/17 9/15 12/27
McGraw-Hill/Irwin
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
© The McGraw-Hill Companies, Inc., 2003
8- 17
Inventory Account Inventory Beginning Balance 10 units @ $4 Purchases during the period 12 units @ $7
Sold 18 units
What is CGS??
11 units @ $8 Ending Balance = 15 units
What is EI?? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 18
Goods Available for Sale: Begin. Inv. 10 @ $ 4 = $40 Purchases: 12 @ $ 7 = $84 11 @ $ 8 = $88 Total Purchases 172 Goods Available $ 212
FOR SALE
Q: How much of the $212 should be in Cost of Goods Sold expense and how much should be the Ending Inventory balance? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 19
Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERIODIC inventory basis it does not matter WHEN the SALES were made. We only care that a TOTAL of 18 units were sold. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 20
FIFO:
(Periodic basis) ◆ Cost of Goods Sold: (for the 18 units sold) From Units Price Cost
Ending Inventory: (for 15 units remaining) From Units Price Cost ◆
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 21
FIFO: ◆
Cost of Goods Sold:
From 1/1 3/10 Totals ◆
(Periodic basis) Units 10 8 18
Ending Inventory:
From 3/10 9/15 Totals McGraw-Hill/Irwin
Units 4 11 15
(for the 18 units sold)
Price $ 4 7
Cost $ 40 56 $ 96
(for 15 units remaining)
Price $ 7 8
Cost $ 28 88 $116 © The McGraw-Hill Companies, Inc., 2003
8- 22
LIFO:
(Periodic basis) ◆ Cost of Goods Sold: (for the 18 units sold) From Units Price Cost
Ending Inventory: (for 15 units remaining) From Units Price Cost ◆
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 23
Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERIODIC inventory basis it does not matter WHEN the SALES were made. We only care that a TOTAL of 18 units were sold. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 24
LIFO:
(Periodic basis)
Cost of Goods Sold: (for the 18 units sold) From Units Price Cost 9/15 11 $ 8 $ 88 3/10 7 7 49 Totals 18 $137 ◆
Ending Inventory: (for 15 units remaining) From Units Price Cost 3/10 5 $ 7 $ 35 1/1 10 4 40 Totals 15 $ 75 ◆
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 25
Weighted Average: (Periodic basis)
Average cost per unit:
Cost of Goods avail. for sale # of units avail. for sale
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 26
Weighted Average: (Periodic basis)
Average cost per unit:
Cost of Goods avail. for sale # of units avail. for sale
McGraw-Hill/Irwin
$ 212
© The McGraw-Hill Companies, Inc., 2003
8- 27
Weighted Average: (Periodic basis)
Average cost per unit:
Cost of Goods avail. for sale # of units avail. for sale
McGraw-Hill/Irwin
$ 212 33 units
© The McGraw-Hill Companies, Inc., 2003
8- 28
Weighted Average: (Periodic basis)
Average cost per unit:
Cost of Goods avail. for sale # of units avail. for sale
McGraw-Hill/Irwin
$ 212 = $6.42 33 units Per unit
© The McGraw-Hill Companies, Inc., 2003
8- 29
Weighted Average: (Periodic basis)
Average cost per unit: Cost of GAFS # of units GAFS
$ 212 33
= $6.42/unit
Cost of Goods Sold:
Ending Inventory:
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 30
Weighted Average: (Periodic basis)
Average cost per unit: Cost of GAFS # of units GAFS
$ 212 33
= $6.42/unit
Cost of Goods Sold: 18 units sold @ $6.42 cost = $116 (rounded) Ending Inventory:
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 31
Weighted Average: (Periodic basis)
Average cost per unit: Cost of GAFS # of units GAFS
$ 212 = $6.42/unit 33
Cost of Goods Sold: 18 units sold @ $6.42 cost = $116 (rounded) Ending Inventory: 15 units remaining @ $6.42 cost = $ 96 (rounded) McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 32
Income Statements (on Periodic basis) [Given operating expenses of $50 and a 40% tax rate] (15@$14 + 3@$20)=
Sales Cost of G. S. Gross Margin Oper. exp. Pretax Inc. Taxes (40%) Net Income McGraw-Hill/Irwin
FIFO
LIFO
Wt. Avg.
$270 96 174 50 124 50 $ 74
$270 137 133 50 83 33 $ 50
$ 270 116 154 50 104 42 $ 62
© The McGraw-Hill Companies, Inc., 2003
8- 33
Q1: Does LIFO always result in the lowest Net Income Statements (Periodic basis) about Income or is there something special [Given expenses of $50 and a 40% tax rate] the operating economic situation here? FIFO
LIFO
Wt. Avg.
Sales $270 $270 $ 270 Cost of G. S. 96 137 116 A1: In a period of RISING prices LIFO charges Gross Margin 174 133 154 out the latest (highest) prices first, resulting Oper. 50lowest Net50Inc. in exp. the highest C50of G S and Pretax Inc. method 124 83select? Why? 104 Q2: Which would YOU Taxes (40%) 50 33 42 Net Income $ 74 $ 50 $ 62 McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 34
Cashflows from Operating Activities FIFO
Inflows: Sales collected $ Outflows: Purchases paid for Oper. exp. paid Taxes (40%) paid Net cash flow $ McGraw-Hill/Irwin
LIFO
Wt. Avg.
$
$
$
$ © The McGraw-Hill Companies, Inc., 2003
8- 35
Cashflows from Operating Activities FIFO
LIFO
Wt. Avg.
Inflows: Sales collected $270 $270 $270 Outflows: Purchases paid for (172) (172) (172) Oper. exp. paid (50) (50) (50) Taxes (40%) paid (50) (33) (42) Net cash flow $ ( 2) $ 15 $ 6 Why is FIFO cash flow $17 less than LIFO’s? The ONLY difference in cash flow is the amount of TAXES paid. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 36
Summary: Effects of Cost Flow Assumptions ◆ Effects on financial statements ❐
Income Statement ❐
❐ ❐
❐
cost of goods sold, gross profit & income before taxes taxes net earnings (net income)
Balance Sheet ❐ Inventory ❐ Retained
❐
Earnings (because of Net Income effect)
Cashflow Statement ❐ Cashflows
McGraw-Hill/Irwin
are affected only because of taxes. © The McGraw-Hill Companies, Inc., 2003
8- 37
Comparison of Methods ◆
Each of the four methods is acceptable, and an argument can be made for using each.
◆
The choice of an inventory method will depend on management’s incentives, the tax laws, and the reporting company’s particular economic circumstances.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 38
Consistency Principle Because the choice of an inventory method can significantly affect the financial statements, a company might be inclined to select a new method each year that would result in the most favorable financial statements. However . . .
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 39
Consistency Principle . . . the consistency principle requires that companies use the same accounting methods period after period so the financial statements of succeeding periods will be comparable. comparable
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 40
Alternative Inventory Costing Methods in Practice The LIFO conformity rule states that if LIFO is used for taxes, then LIFO must also be used for financial reporting.
LIFO for taxes
McGraw-Hill/Irwin
LIFO for books
© The McGraw-Hill Companies, Inc., 2003
8- 41
Example: Periodic vs. Perpetual Using the same data used for the Periodic method, now calculate Cost of Goods Sold and Ending Inventory under FIFO, LIFO and Average Cost using the PERPETUAL method.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 42
Goods Available for Sale: Begin. Inv. 10 @ $ 4 = $40 Purchases: 12 @ $ 7 = $84 11 @ $ 8 = $88 Total Purchases 172 Goods Available $ 212
FOR SALE
Q: How much of the $212 should be in Cost of Goods Sold expense and how much should be reported on the Bal. Sheet as Ending Inventory? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 43
Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERPETUAL inventory basis it DOES matter WHEN the SALES were made. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 44
FIFO--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS date units cost $ inv.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 45
FIFO--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS date units cost $ inv. 3/10 12 @ $7 6/17
1/1 1/1 10 @ $4 = $ 40 3/10 5 @ $7 = $ 35 $ 75
3/10
3/10
3/10 7 @ $7 9/15 11 @ $8 3/10 4 @ $7 = $ 28 9/15 11 @ $8 = 88 End. Inv. $116
9/15 11 @ $8 12/27
3 @ $7 = $ 21
Cost of Goods Sold McGraw-Hill/Irwin
1/1 10 @ $4 10 @ $4 3/10 12 @ $7
$ 96
7 @ $7
© The McGraw-Hill Companies, Inc., 2003
8- 46
LIFO--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS date units cost $ inv.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 47
Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERPETUAL inventory basis it DOES matter WHEN the SALES were made. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 48
LIFO--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS date units cost $ inv. 3/10 12 @ $7 6/17
1/1 3/10 12 @ $7 = $ 84 1/1 3 @ $4 = $ 12 $ 96
1/1
9/15
1/1 7 @ $4 9/15 11 @ $8 1/1 7 @ $4 = $ 28 9/15 8 @ $8 = 64 End. Inv. $ 92
9/15 11 @ $8 12/27
3 @ $8 = $ 24
Cost of Goods Sold McGraw-Hill/Irwin
1/1 10 @ $4 10 @ $4 3/10 12 @ $7
$120
7 @ $4
© The McGraw-Hill Companies, Inc., 2003
8- 49
Weighted Average - Perpetual When weighted average is applied on a perpetual basis it is called a “Moving Average”. Procedures: 1. A new unit average cost must be calculated after every purchase. 2. Units SOLD are “costed out” (that is, charged to Cost of Goods Sold) using the unit average cost of units in inventory at the time of the sale.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 50
Example: Date 1/1 3/10 6/17 9/15 12/27
Event Beg. Inv. Purchase Sale Purchase Sale
Units 10 12 15 11 3
Price $ 4 7 14 8 20
Total $ 40 84 210 88 60
When applying FIFO, LIFO, W. Ave. on a PERPETUAL inventory basis it DOES matter WHEN the SALES were made. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 51
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv.
Cost of Goods Sold on the annual Income Statement = Merchandise Inventory on the 12/31 Balance Sheet = McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 52
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGS dateunits cost $ inv. 3/10
12 @ $7
1/ 1 1/ 1 3/10 ave.
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ ?? =124.00
Question: What is the average unit cost as of 3/10? Total Inv. Cost divided by Total units in inv. = Unit Cost $124 / 22 = $5.64/unit McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 53
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
12 @ $7
1/ 1 1/ 1 3/10 ave.
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00
Question: What is the average unit cost as of 3/10? Total Inv. Cost divided by Total units in inv. = Unit Cost $124 / 22 = $5.64/unit McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 54
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00
Now what?! 1. Until another purchase is made, units SOLD are “costed out” at $5.64 each. 2. A new average cost must be calculated when the next purchase is made. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 55
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60
McGraw-Hill/Irwin
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48
© The McGraw-Hill Companies, Inc., 2003
8- 56
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60 9/15
11 @ $8
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48 7 @ 5.64 39.48 11 @ 8.00 88.00 18 @ ??? 127.48
Question: What is the new average cost? $127.48 divided by 18 units = $7.08 per unit (rounded) McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 57
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60 9/15
11 @ $8
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48 7 @ 5.64 39.48 11 @ 8.00 88.00 18 @ 7.08 127.48
Question: What is the new average cost? $127.48 divided by 18 units = $7.08 per unit (rounded) McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 58
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60 9/15
11 @ $8
12/27
McGraw-Hill/Irwin
3 @ 7.08=21.24
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48 7 @ 5.64 39.48 11 @ 8.00 88.00 18 @ 7.08 127.48 15 @ 7.08 106.20
© The McGraw-Hill Companies, Inc., 2003
8- 59
Weighted (Moving) Ave.--Perpetual IN OUT BALANCE # unit # unit # unit date units cost date units cost CofGSdate units cost $ inv. 3/10
1/ 1 1/ 1 3/10 ave.
12 @ $7
6/17 15 @ 5.64=84.60 9/15
11 @ $8
12/27
3 @ 7.08=21.24
10 @ 4.00 40.00 10 @ 4.00 40.00 12 @ 7.00 84.00 22 @ 5.64 124.00 7 @ 5.64 39.48 7 @ 5.64 39.48 11 @ 8.00 88.00 18 @ 7.08 127.48 15 @ 7.08 106.20
Cost of Goods Sold for annual income statement = $84.60 + $21.24 = $105.84 Merchandise Inventory on the 12/31 Balance Sheet = $106.20 McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 60
Summary of FIFO, LIFO, Ave. Cost combined with Periodic and Perpetual Cost of G. S.
End. Invent.
FIFO-Periodic
$ 96
$116
FIFO-Perpetual
$ 96
$116
LIFO-Periodic
$137
$ 75
LIFO-Perpetual
$120
$ 92
Ave.-Periodic
$116
$ 96
Ave.-Perpetual
$106 (rounded)
$106 (rounded)
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 61
Summary of LIFO-FIFO combined with Periodic and Perpetual When using FIFO, the C of GS and End. Inv. are the same for both perpetual and periodic. ◆ When using LIFO (and W. Ave), the perpetual and periodic recording methods do not give the same value for C of GS and E. I. ◆
• In a period of rising prices (inventory costs are rising) C of G.S. under LIFO PERIODIC will either be equal to (rarely) or greater than PERPETUAL. © The McGraw-Hill McGraw-Hill/Irwin(usually) Cost of G.S. using LIFO Companies, Inc., 2003
8- 62
Summary of LIFO-FIFO combined with Periodic and Perpetual So, if you are using LIFO because of its tax benefits would you apply it on a PERIODIC Basis or a PERPETUAL Basis? Periodic Why? Starting with the very first sale, you would charge Cost of G.S exp. with the cost of the last purchased goods of the year. The resulting higher Cost of Goods Sold (assuming rising prices) means lower profit and, thus, lower taxes. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 63
Gross Margin Method of Estimating Inventory Provides an estimate ◆ Not acceptable for GAAP ◆ When to use ◆
• • • •
for interim (any period less than a year) reporting purposes when physical inventory not possible (casualty) a check on the accuracy of the physical count do we have a problem with theft?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 64
Example: Given the following: Beginning Inventory Purchases Sales
$ 1,000 (cost) 9,000 (cost) 12,000 (retail)
Assume that gross margin has been 40% of sales. Estimate the cost of inventory and CGS for the period.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 65
If the Gross Margin rate is 40% what is the Cost of Goods Sold %? Net Sales Less: Cost of G.S. =Gross Margin
100% = 60% X% 40%
Use these %’s and a partial multi-step income statement format to find the “missing” amounts.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 66
Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net Goods Avail. - End. Inv.
$1,000 9,000 10,000 (?)
Cost of Goods Sold Gross Margin
McGraw-Hill/Irwin
(60% x Net Sales)
$
(40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
8- 67
Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net Goods Avail. - End. Inv. Cost of Goods Sold Gross Margin
McGraw-Hill/Irwin
$1,000 9,000 10,000 (?) (60% x Net Sales)
$ 4,800 (40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
8- 68
Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net Goods Avail. - End. Inv. Cost of Goods Sold Gross Margin
McGraw-Hill/Irwin
$1,000 9,000 10,000 (?) (60% x Net Sales)
$ 4,800 (40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
8- 69
Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net Goods Avail. - End. Inv. Cost of Goods Sold
$1,000 9,000 10,000 (?) (7,200) (60% x Net
Sales)
Gross Margin
McGraw-Hill/Irwin
$ 4,800 (40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
8- 70
Use given amounts and known %’s Sales
$12,000
Less: Cost of Goods Sold: Beg. Inv. + Purchases, net
$1,000 9,000
Goods Avail.
10,000
- End. Inv.
(2,800)
Cost of Goods Sold Gross Margin
McGraw-Hill/Irwin
(7,200) (60% x Net Sales) $ 4,800 (40% x Net Sales)
© The McGraw-Hill Companies, Inc., 2003
8- 71
Use given amounts and known %’s On the right side is an alternative solution format where the estimated inventory is the last line. Sales
$12,000
- C. of Gds. S.
Begin. Inv.
Beg. Inv. $1,000 + Purch.
Alternate Solution Format: $ 1,000
+ Purch., net
9,000
9,000
Goods Avail.
Gds Avl. 10,000
Sales
- End. Inv.(2,800)
$10,000 $12,000
- 40%Est. G.M.
Cost of Gds S. (60%) (7,200) =60%Est. CofGS Gross Margin McGraw-Hill/Irwin
(40%)
$4,800
Est. Ending Inv.
(4,800) (7,200) $ 2,800
© The McGraw-Hill Companies, Inc., 2003
8- 72
Lower of Cost or Market
◆
Ending inventory is reported at the lower of cost or market (LCM) applied in 1 of 3 ways. • Item-by-item • Major categories • Total inventory (not acceptable for tax return)
◆
Market refers to the replacement cost of the merchandise, which is what you would pay your supplier if you bought the inventory today.
◆
This practice is in keeping with the generally accepted accounting principle of conservatism.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 73
Lower of Cost or Market Cost
$50
Inventory Loss = $10
Market McGraw-Hill/Irwin
$40
$40 Market Value © The McGraw-Hill Companies, Inc., 2003
8- 74
Lower of Cost or Market Unit Qty. Cost Invent. SideItem Mirrors (a) 50 $(b)5
Unit Mkt.
Total Mkt.
Item-by-item Lower of
$(c)5 $(a x b) $(a x c) Cost $ or Mkt $ Loss
Tires 38
300 $ 42
$
Batteries
200 $ 35
$ 30
Car Stereos 100 $115
Total Cost
$138 $
$
$
$
SOLUTION: LCM: item-by-item approach =
End. Inv. $
Major category (Auto dept.) =
$
McGraw-Hill/Irwin
Invent. Loss $ $
© The McGraw-Hill Companies, Inc., 2003
8- 75
Lower of Cost or Market Unit Qty. Cost Invent. SideItem Mirrors (a) 50 $(b)5
Unit Mkt.
Total Cost
Total Mkt.
Item-by-item Lower of
b) $(a x 250 c) Cost Mkt $Loss0 $(c)5 $(a x250 $ or250
Tires 38
300 $ 42
$
$12,600 $11,400 $ 7,000 $ 6,000
$11,400 $ 6,000
$1,200 $1,000
Batteries
200 $ 35
$ 30 $11,500 $13,800 $138 $31,350 $31,450
$11,500 $29,150
$ 0 $2,200
Car Stereos 100 $115 SOLUTION:
LCM: item-by-item approach =
End. Inv. $29,150
Major category (Auto dept.) =
$31,350
Invent. Loss $2,200 $
0
Because T. Mkt>T.cost
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 76
Errors in Measuring Ending Inventory ◆
Misstatements in inventory may cause errors in the following areas: • Income Statement –
•
Balance Sheet –
◆
Cost of Goods Sold, Gross Profit, Taxes, Net Income Inventory, Payables, Retained Earnings
Because the ending inventory of one period becomes the beginning inventory of the next period, ending inventory errors affect two accounting periods.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 77
Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1. As Reported Year 1 Year 2 10 11
Sales C of GS: Begin. Inv. 1 +Purchases 7 Gds. Avail. 8 - Ending Inv. =C of G. Sold Gross Margin
As Corrected Year 1 Year 2
2 8 10 2 6 4
4 6 5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 78
Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1. As Reported Year 1 Year 2 10 11
Sales C of GS: Begin. Inv. 1 +Purchases 7 Gds. Avail. 8 - Ending Inv. =C of G. Sold Gross Margin
2 8 10 2 6 4
As Corrected Year 1 Year 2 10
1 7 48 6 3 5
5 5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 79
Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1. As Reported Year 1 Year 2 10 11
Sales C of GS: Begin. Inv. 1 +Purchases 7 Gds. Avail. 8 - Ending Inv. =C of G. Sold Gross Margin
2 8 10 2 6 4
As Corrected Year 1 Year 2 11 10
1 7 48 6 3 5
3 8 11 4 5 5
7 4
What was the effect of the error on the Yr. 1 and Yr. 2 Statements? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 80
What was the effect of understating the Year 1 ending inventory by $1? (ignore taxes) Year 1
Year 2
Sales Begin. Inventory Purchases Goods Avail. for Sale Ending Inventory Cost of Goods Sold Gross Profit Margin Net Income Ret. Earn, end. Bal. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 81
What was the effect of understating the Year 1 ending inventory by $1? (ignore taxes) Year 1
Year 2
Sales Begin. Inventory Purchases Goods Avail. for Sale Ending Inventory Cost of Goods Sold
Compare the Reported amounts for each year with the Corrected amounts.
Gross Profit Margin Net Income Ret. Earn, end. Bal. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 82
Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1. As Reported Year 1 Year 2 10 11
Sales C of GS: Begin. Inv. 1 +Purchases 7 Gds. Avail. 8 - Ending Inv. =C of G. Sold Gross Margin
2 8 10 2 6 4
As Corrected Year 1 Year 2 11 10 Same = No effect 3 1 8 7 11 4 48 7 6 3 5 4 5 5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 83
What was the effect of understating the Year 1 ending inventory by $1? (ignore taxes) Sales
Year 1 No effect
Begin. Inventory
No effect
Purchases
No effect
Year 2
Goods Avail. for Sale No effect Understated $1 Ending Inventory Cost of Goods Sold
Overstated $1
Gross Profit Margin
Understated $1
Net Income
Understated $1
Ret. Earn, end. Bal.
Understated $1
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 84
What was the effect of understating the Year 1 ending inventory by $1? (ignore taxes) Sales
Year 1 No effect
Year 2 No effect
Begin. Inventory
No effect
Understated $1
Purchases
No effect
No effect
Understated $1 Goods Avail. for Sale No effect Understated $1 No effect Ending Inventory Cost of Goods Sold
Overstated $1
Gross Profit Margin
Understated $1 Overstated $1
Net Income
Understated $1 Overstated $1
Ret. Earn, end. Bal.
Understated $1 No effect (why?)
McGraw-Hill/Irwin
Understated $1
© The McGraw-Hill Companies, Inc., 2003
8- 85
Financial Statement Analysis ◆
Inventory Turnover Inventory = Turnover
Cost of Goods Sold $ Inventory*
Often the AVERAGE inventory is used as the denominator.
Ave. Inv =
Beginning Inventory + Ending Inventory 2
This ratio is often used to measure the liquidity (nearness to cash) of the inventory. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 86
Inventory Ratios Inventory Turnover: (A measure of how fast inventory sells. Higher is better.) Cost of Goods Sold $30,000 = = 6.0 times Inventory $ 5,000 Average Days in Inventory: (How many days go by between the time inventory arrives and it is sold?) 365 365 Inventory Turnover = 6.0 = 60.8 days Generally, lower means better. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 87
Length of Operating Cycle Remember from Chapter 6 that a company’s operating cycle is the time it takes to convert inventory to cash by selling it and collecting the receivable. So, the Operating Cycle is: Ave. days to sell inventory + Ave. days to collect receivables Length of Operating Cycle McGraw-Hill/Irwin
60.8 days 36.5 days 97.3 days
© The McGraw-Hill Companies, Inc., 2003
8- 88
Length of Operating Cycle Ave. days to sell inventory + Ave. days to collect receivables Length of Operating Cycle
60.8 days 36.5 days 97.3 days
The longer the operating cycle the more it costs the company for financing, storage and collection costs. Suppose XYZ Co. has a $10,000,000 inventory and pays 10% annual interest to finance operations. Assume XYZ’s operating cycle is 30 days longer than its main competitor’s. How much does the extra 30 days cost XYZ? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 89
Length of Operating Cycle The longer the operating cycle the more it costs the company for financing, storage and collection costs. Suppose XYZ Co. has a $10,000,000 inventory and pays 10% annual interest to finance operations. Assume XYZ’s operating cycle is 30 days longer than its main competitor’s. How much does the extra 30 days cost XYZ? Inventory x Int. rate x Time = Cost $10,000,000 x
10%
x 30/365 =
$82,192
This extra cost is a competitive disadvantage for XYZ Co. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 90
Chapter 8
The Appendix follows. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 91
Chapter 8
APPENDIX Accounting For Investments and Reporting Comprehensive Income
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 92
Investments in Marketable Securities ◆
A company may use some of its extra cash to invest in the debt or equity securities of another company
◆
These investments must be classified as one of three types: • Securities held to maturity • Trading Securities • Securities available for sale
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 93
Securities held to maturity ◆ ◆
◆
◆
Debt securities Intent and ability to hold to maturity Must not be sold in response to changes in interest rates, funding sources, etc.. Measured at cost on the balance sheet
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 94
Trading securities ◆ ◆ ◆ ◆ ◆ ◆
Debt and equity securities Readily determinable fair values Bought and held to sell in the near term Actively and frequently traded (goal: profit!) Measured at fair value and classified as a current asset Unrealized gains and losses, included in determination of net income
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 95
Securities available for sale ◆ ◆ ◆ ◆ ◆ ◆
Debt and equity securities Readily determinable fair values Not classified as either securities held to maturity or trading securities Measured at fair value on balance sheet May be either current or noncurrent May have holding gains or losses, to be reported net, NOT as part of Net Income, but as a component of “other comprehensive income”.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 96
Summary of Reporting Requirements Investm’t. Type of Category Security
Type of Value on Unreal. G/L Cashflow Revenue Bal. Sheet part of NI? Purch/Sale
Held to Maturity
Interest
Amortized Cost
No
Investing Activities
Trading Debt & Securities Equity
Interest & Divid.
Market Value
Yes
Operating Activities
Available Debt & Equity for sale Securities
Interest & Divid.
Market Value
No (in “Other Comprehensive Income”)
Investing Activities
McGraw-Hill/Irwin
Debt
© The McGraw-Hill Companies, Inc., 2003
8- 97
What is Comprehensive Income? All changes in Owners’ Equity except owners’ capital investments and distributions to owners. Includes Net Income and “Other Comprehensive Income.” Other Comprehensive Income includes: -Unrealized gains/losses on Available for Sale Securities. and the following 3 items discussed in higher level courses:
-A type of pension plan accounting adjustment. -Certain gains/losses on “derivative” securities. -Translation adjustments from converting the financial statements of its foreign operations into U.S. dollars.
How is Comprehensive Inc. reported?? McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 98
Comprehensive Income Reporting Options Bottom of Income Statement: Income Statement Revenue $100 - Expenses 40 Net Income 60 Other Comp. Inc.(Loss) $(10) Comprehensive Income $ 50 The third option (used by most companies) is to report the current period’s Other Comprehensive Income as a separate section on the Statement of Changes in Stk. Equity. McGraw-Hill/Irwin
Separate Statements Income Statement Revenue $100 - Expenses 40 Net Income $ 60
Statem’t of Comprehensive Inc. Net Income $ 60 Other Comp. Inc. (Loss) (10) Comprehensive Income $ 50 © The McGraw-Hill Companies, Inc., 2003
8- 99
Reporting Comprehensive Income Statement of Changes in Stk. Equity Option Bal., 1/1/X1 Comp. Inc.
Comp. Common Ret. Accumulated Inc. Stock Earn. Other Comp. Inc. Total $100 $205 $30 $335 $60
Net Inc.
60
60 Other Comp. Inc. Unreal. Loss Compreh. Inc.
Own. Invest. Distribution Bal. 12/31/X1
(10) $50
(10)
(10)
$20
20 (5) $400
20 $120
(5) $260
Accumulated Other Comprehensive Income balance is always reported in the Stockholders’ Equity section of the Balance Sheet. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 100
Additional Types of Equity Investments
“Significant Influence” investments
A company (investor) owning 20-50% of another company’s stock is presumed to have significant influence over it (the “investee”). These investments are valued using the equity method which is based on the book value of the investee, rather than cost or market value of the investment.
“Controlling Interest” investments A company owning more than 50% of another company’s stock has the controlling interest. The company owning the controlling interest is the PARENT, the other company is the SUBSIDIARY. CONSOLIDATED financial statements must be issued combining the results of the Parent and all its subsidiaries. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
8- 101
Chapter 8
The End McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
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