Inventory

Accounting 200 4/13/2020 Understand that inventory flows from manufacturing companies to merchandising companies and is reported as an asset in the balance sheet (6-1) - Inventory - includes items a company intends for sale to customers in the ordinary course of business. Also includes items that are not yet finished - Inventory is a current asset - Cost of goods sold is an expense - Cost of goods sold. - the cost of the inventory a company sold; recorded as an expense in the income statement - Cost of goods sold = Beginning inventory + net purchases - ending inventory - Manufacturing companies produce the inventories they sell, rather than buying them in finished form from suppliers - Manufacturer inventory in three categories: - 1) Raw materials: Includes the cost of components that will become part of the finished product but have not yet been used in production - 2) Work-in-progress: refers to the products that have been started in the production process but are not yet complete at the end of the period. Overhead is the indirect manufacturing costs. Included in total costs with raw materials and direct labor. - 3) Finished goods: consists of items for which the manufacturing process is complete - *Inventory is sometimes referred to as merchandise inventory - Merchandising companies purchase finished goods from manufacturers and sell them to customers. Can be classified into wholesalers or retailers - Wholesalers resell inventory to retail companies or to professional users, but not to the general public. Retailers purchase inventory from manufacturers or wholesalers and then sell this inventory to end users or customers Understand how cost of goods sold is reported in a multiple-step income statement (6-2) - Total inventory is recorded as an asset in the balance sheet, adding purchased inventory throughout the year. - The beginning inventory less the end year inventory gives you the total inventory sold that year. This total would be the cost of goods sold expense - Multiple-step income statement - the income statement reports multiple levels of income (or profit). Used by companies to show the revenues and expenses that arise from different types of activities - Reporting on Multiple-step income statement - 1) Sales of inventory commonly reported as sales revenue, while services provided are reported as service revenue. Can be reported together as just revenue. - Net sales is the net amount of revenues or total revenue less sales discounts, returns, and allowances - 2) Cost of inventory sold is reported as an expense called cost of goods sold - - - 3) Gross profit - net revenue minus cost of goods sold makes gross profit. Reported as first level of profit shown in multiple-step income statement 4) Selling, general, and administrative expenses are reported next, often refers to as operating expenses 5) Operating income - gross profit reduced by these operating expenses. Measures profitability from normal operations, a key performance measure for predicting the future profit-generating ability of a company 6) Nonoperating revenues and expenses reported next. Can be referred to as other income *Gains on the sale of investments occur when investments are sold for more than their recorded amounts. Investment income includes earnings from dividends and interest. These are two types of nonoperating revenue examples Nonoperating expenses most commonly include interest expense, but could also include losses on the sale of investments Income before income taxes - combining operating income with nonoperating revenues and expenses 7) Net income - subtract income tax expense from income before income taxes to get net income. Income tax expense reported separately because it represents a significant expense Determine the cost of goods sold and ending inventory using different inventory cost methods (6-3) - Four methods for inventory costing; specific identification, first-in first-out (FIFO), last-in first out (LIFO), and weighted-average cost - Specific identification method - matches—or identifies—each unit of inventory with its actual cost. This method records actual units sold - Involves keeping track of the cost of each unit of inventory, which is typically not practicable for most companies - Specific identification method used primarily by companies with unique, expensive products with low sales volume - Other methods assume which units are sold. Companies are allowed to report inventory costs by assuming which units of inventory are sold and not sold, even if this does not match the actual flow - First-in first-out (FIFO) method - we assume that the first units purchased (first in) are the first ones sold (first-out). Assume that beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase and so on. Ending inventory would be whatever remains after this process - Last-in first-out (LIFO) method - we assume that the last units purchased (last in) are the first ones sold (first out). The very last unit purchased for the year is assumed to be the very first unit sold. Companies that use LIFO for reporting purposes calculate cost of goods sold and ending inventory only once per period—at the end. - Weighted-average cost method - we assume that both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale. Assume each - unit of inventory has a cost equal to the weighted-average unit cost of all inventory items Weighted-average unit cost = Total cost of goods available for sale / Number of units available for sale Explain the financial statement effects and tax effects of inventory cost methods (6-4) - Note that the reported amounts for ending inventory and cost of goods sold will not be the same across all inventory reporting methods - When inventory costs are rising, FIFO results in 1) Higher reported amount for inventory in the balance sheet and 2) Higher reported gross profit in the income statement - If inventory costs are falling, LIFO would produce higher reported inventory and gross profit - *FIFO has a balance-sheet focus and is often called the balance-sheet approach. The amount it reports for ending inventory (which shows on balance sheet) better approximates the current cost of inventory - *LIFO has an income-statement focus and is often called the income-statement approach. The amount it reports for cost of goods sold (which shows on income statement) better matches the current costs of inventory needed to produce current revenues - FIFO better suited for higher assets and higher net income when inventory costs are rising - LIFO generally results in greater tax savings and will report higher gross profit than FIFO when inventory costs are falling - LIFO conformity rule - a company that uses LIFO for tax reporting must also use LIFO for financial reporting - Companies that report using LIFO must report difference between LIFO amount and what that amount would have been if they had used FIFO, referred to as the LIFO reserve - Companies can choose whatever method they prefer, however, they can’t frequently change to another one Record inventory transactions using a perpetual inventory system (6-5) - Perpetual inventory system - involves recording inventory purchases and sales on a perpetual (continual) basis. Most commonly used by nearly all companies. - Periodic inventory system - calculates the balance of inventory once per period, at the end, based on a physical count of inventory on hand. Doesn’t record continuously, so less favored by companies - To record a purchase of inventory, we debit Inventory (an asset) and credit cash (if purchase was paid in cash) or accounts payable (if purchase was made on account) - To record a sale of inventory we 1) record an increase to an asset account and an increase to sales revenue (amount to record is price charged to the customer) and 2) record an increase to cost of goods sold and a decrease to Inventory (amount to record is the assumed cost of the units sold) - Record all purchases and sales this way and examine these postings to determine the ending balance of Inventory - - - - In practice, most companies maintain their own inventory records throughout the year using the FIFO assumption, because that’s how they typically sell their actual inventory LIFO adjustment - used to adjust a company’s FIFO inventory records to a LIFO basis for preparing financial statements. If FIFO has larger Inventory balance than LIFO, simply reduce the Inventory balance to the LIFO balance. The difference is recorded as a decrease to inventory and an increase to cost of goods sold Three other Inventory Transactions 1) Freight (shipping and delivery) charges: Cost of shipments of inventory from suppliers, as well as the cost of shipments to customers FOB shipping point means title passes when the seller ships the inventory FOB destination means title passes when the inventory reaches the buyer’s destination. The time title passes is when transaction is recorded, based on these two FOB terms of purchase Freight-in - freight charges on incoming shipments from suppliers. We add, or debit, the cost of freight-in to the balance of Inventory Later, when the inventory is sold, those freight charges become part of the cost of goods sold Freight-out - the cost of freight on shipments to customers Shipping charges for outgoing inventory is reported in the income statement either as part of cost of goods sold or as an operating expense, usually among selling expenses 2) Purchase Discounts: allows buyers to trim a portion of the cost of the purchase in exchange for payment within a certain period of time To record purchase discount, debit accounts payable the original price and credit the discount from the balance in the inventory account and the new discounted price from your method of purchase (cash for example) 3) Purchase Returns: unacceptable inventory items—whether damaged, are different from what they ordered, or some other reason—can be returned. This would be recorded as a reduction in both inventory and accounts payable. Apply the lower of cost and net realizable value rule for inventories (6-6) - When the value of inventory falls below its original cost, companies must report inventory at the lower net realizable value - Net realizable value - the estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal, and transportation, or the net amount a company expects to realize in cash from the sale of the inventory - Once cost and net realizable value is determined, report ending inventory in the balance sheet as the lower of the two amounts. Method is known as the lower of cost and net realizable value - If recorded cost is higher or net realizable value is higher, debit cost of goods sold and credit inventory the difference between the two values Analyze management of inventory using the inventory turnover ratio and gross profit ratio (6-7) - Inventory turnover ratio - shows the number of times the firm sells its average - - inventory balance during a reporting period. Calculated as: Inventory turnover ratio = cost of goods / average inventory *Average inventory is the average of inventory reported in this period’s and last period’s balance sheet The more frequently a business can sell or “turnover” its average inventory balance, the less the company needs to invest in inventory for a given number of sales. Higher ratio indicates greater effectiveness of a company managing investment in inventory Average days in inventory - indicates the approximate number of days the average inventory is held. Average days in inventory = 365 (days) / Inventory turnover ratio The lower the ratio, the more efficient inventory investment is Gross profit ratio - measures the amount by which the sale of inventory exceeds its cost per dollar of sales Gross profit ratio = Gross profit / Net sales (*Net sales is total sales revenue less sales discounts, returns, and allowances) (Gross profit is net revenue minus cost of goods sold) The higher the ration, the higher the “markup” a company is able to achieve on its inventories