Chapter 8 handout

MGT 220 Chapter 8

Inventory Classification

• Inventory consists of:- finished goods held for sale in the ordinary course of business

- goods held or consumed in the production of finished goods

• A merchandising concern has one inventory account– Merchandise Inventory

• A manufacturing concern will normally have three inventory accounts:– Raw materials– Work in process– Finished goods

Items to Be Included in Inventory

• Legal title to goods determines inclusion• The following goods are included in the seller’s

inventory:1 Goods in transit

(if seller has title during shipment, e.g., f.o.b. destination)

2 Goods on consignment with seller3 Goods, sold under buyback agreements

(Revenue assumption here?)

4 Goods, sold with high rates of return(Revenue assumption here?)

5 Instalment sales (Don’t worry about this)

COSTS TO INCLUDECOSTS TO INCLUDE

Purchase Discounts (2%10, net 30)

Gross MethodDiscount is revenuePurchase is recorded at 100%

Net MethodPurchase price is 98%

Net MethodPurchase inventory for $1000 (2/10 net 30)

Inventory 980

A/P (or Cash) 980

Pay $500 of invoices within discount period

A/P 490

Cash 490

Pay $500 of invoices outside discount period

A/P 490

Purchase discount lost (E) 10

Cash 500

Inventory Control

• Inventory control is important for:- ensuring availability of inventory items- preventing excessive accumulation of inventory

items

• The perpetual system maintains a continuous record of inventory changes

• The periodic system updates inventory records only periodically

Perpetual SystemJournal Entries

Buy: Inventory 100

A/P (or Cash) 100

Sell: A/R 150

Sales Revenue 150

CGS 100

Inventory 100

Perpetual SystemAt year end,

1. Do a physical count of inventory;

2. Compare count to balance in subsidiary inventory ledger; and,

3. Make any adjustments for differences between the two. These differences posted to a separate account – Inventory Over and Short

Periodic SystemJournal Entries

Buy: Purchases 100

A/P (or Cash) 100

Sell: A/R 150

Sales Revenue 150

Periodic SystemAt year end,

1. Do a physical count of inventory;

2. Make the following journal entry:

Inventory (Based on Ending count) xx

CGS (Plug) xx

Purchases (Close out account) xx

Inventory (Close out begin. balance) xx

Cost Flow AssumptionsPossible cost flow assumptions are:

1. Specific identification (of each item sold)

2. Average cost (assigns average value to the item sold)

3. First-in, First-out (FIFO) (first inventory item bought is the first one sold)

4. Last-in, First-out (LIFO)(last inventory item bought is the first one sold)

Cost Flow Assumptions

Simple Example

• There are five items in inventory:

a) $50 b) $60 c) $70 d) $80 e) $90

• They are exactly the same except for the amount paid for each item.

• You sell item d) for $100 cash

Cost Flow Assumptions

Simple Example (Cont.)

Journal Entry:

Cash $100

Sales $100

CGS $XX

Inventory $XX

What is $XX?

Cost Flow Assumptions

Simple Example (Cont.)

4 possibilities

1. Specific Identification - $80 (Actual cost)

2. FIFO - $50

3. LIFO - $90

4. Average - $70 ([50+60+70+80+90]/5)

Cost Flow Assumptions

• It is not easy, or even possible in many cases, to keep track of the actual cost of inventory items.

• As a result, often we must make some sort of “cost flow assumption”

Cost Flow AssumptionsRemember:Beg Inv + Purchases – CGS = End InvBeg Inv + Purchases = CGAS = CGS + End Inv• The accounting problem is how do we

divide the CGAS into CGS and End Inv amounts.

• Putting more into CGS reduces net income, and reduces the inventory asset (End Inv) on the balance sheet

Cost Flow Assumptions• The objective is to most clearly reflect

periodic income • Cost flow assumptions need not be

consistent with physical flow of goods • Objectives of choosing an inventory

valuation method are to: 1. realistically match expenses against revenue 2. report inventory at a realistic amount 3. minimize income taxes

Specific Identification

• Items sold and purchased are individually identified as to cost

• Works best with items that are unique, high cost, with small numbers held as inventory

• Advantage: – Matches revenues and actual costs

• Disadvantages:– May be costly to implement and maintain– May lead to income manipulation

Advantages of LIFO Method

• LIFO matches more recent costs with current revenues

• Under LIFO, the need to write down inventory to market is minimized

Disadvantages of LIFO Method• LIFO yields the lowest net income (when prices are

rising) and therefore reduced earnings • Under LIFO (when prices are rising), the ending

inventory is understated • LIFO does not approximate the physical flow of

goods except in special situations• LIFO liquidation may result in income that is

overstated• LIFO may cause poor buying habits (because of the

LIFO liquidation layer problem)• Not acceptable for tax purposes

Tax advantages

• Given that LIFO is not acceptable for tax purposes, which method should be chosen to minimize tax expense?