Accounting Chapter 6

Chapter 6             Inventory includes items a company intends for sale to customers in the ordinary course of business. Inventory is a current asset. (balance sheet) Cost of goods sold is an expense. (income statement) Manufacturing companies produce the inventories they sell, rather than buying them in finished form from suppliers. o Manufacturing companies buy the inputs for the products they manufacture. Classify inventory for a manufacturer into three categories: 1. Raw materials inventory includes the cost of components that will become part of the finished product but have not yet been used in production. 2. Work-in-process inventory refers to the products that have been started in the production process but are not yet complete at the end of the period.  The total costs include raw materials, direct labor, and indirect manufacturing costs called overhead. 3. Finished goods inventory consists of items for which the manufacturing process is complete. Intel manufactures the components that are used to build computers. o Intel’s inventory includes the cost of materials that will be used to build computer components (raw materials), partially manufactured components (work-in-process), and fully assembled but unsold components (finished goods).  These separate inventory accounts are added together and reported by Intel as total inventories. Common Terms: Inventory is sometimes referred to as merchandise inventory. Merchandising companies may assemble, sort, repackage, redistribute, store, refrigerate, deliver, or install the inventory, but do not manufacture it. o They serve as intermediaries in the process of moving inventory from the manufacturer to the end user. Wholesalers resell inventory to retail companies or to professional users. Retailers purchase inventory from manufacturers or wholesalers and then sell this inventory to end users. Multiple-step income statement: the income statement reports multiple levels of income (profit). Levels of Profitability o Gross Profit.  Inventory transactions are typically the most important activities of a merchandising company.  The net amount of revenues is commonly referred to as net sales.  Net revenues (or net sales) minus cost of goods sold equals gross profit. o Operating Income  Selling, general, and administrative expenses, are often referred to as operating expenses. Gross profit reduced by these operating expenses is referred to as operating income (or sometimes referred to as income from operations).  It measures profitability from normal operations, a key performance measure for predicting the future profit-generating ability of the company. o Income Before Income Taxes  Other income (expense) items are shown as positive amounts, and other expense items are shown as negative amounts (in parentheses).  Nonoperating revenues and expenses arise from activities that are not part of the company’s primary operations.  Included in the income statement.  Nonoperating expenses most commonly include interest expense.  Combining operating income with nonoperating revenues and expenses yields income before income taxes. o Net Income  A company subtracts income tax expense to find its bottom-line net income.  Income tax is reported separately because it represents a significant expense. Gross profit equals net revenues (or net sales) minus cost of goods sold. Operating income equals gross profit minus operating expenses. Income before income taxes equals operating income plus nonoperating revenues and minus nonoperating expenses. Net income equals all revenues minus all expenses. Four methods of inventory: 1. Specific identification 2. First-in, first-out (FIFO) 3. Last-in, first-out (LIFO) 4. Weighted-average cost The specific identification method matches or identifies each unit of inventory with its actual cost. o The specific identification method records actual units sold. o The Specific identification method is used primarily by companies with unique, expensive products with low sales volume. FIFO, LIFO, and weighted-average assume which units are sold. FIFO, LIFO, and weighted-average cost assume a particular pattern of inventory cost flows. The actual flow of inventory does not need to match the assumed cost flow in order for the company to use a particular method. 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. Using the first-in, first-out (FIFO) method, we assume that the first units purchased (the first in) are the first ones sold (the first out).                           Using the last-in, first-out (LIFO) method, we assume that the last units purchased (the last in) are the first ones sold (the first out). o The very last unit purchased for the year is assumed to be the very first unit sold. Companies that use the LIFO for reporting purposes calculate cost of goods sold and ending inventory only once per period-at the end. Using the 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 Cost of goods available for sale Weighted-average unit cost = -------------------------------------------Number of units available for sale The perpetual inventory system involves recording inventory purchases and sales on a perpetual (continual) basis. A periodic inventory system calculates the balance of inventory once per period, at the end, based on a physical count of inventory on hand. Purchase example: o To record the purchase of inventory we debit inventory (an assets) to show that the company's balance of this asset account has increased. o At the same time, if the purchase was paid in cash, with credit cash. o If the company made a purchase on account we credit accounts payable, increasing total liabilities. Freight Charges o FOB stands for “free on board” 1. FOB shipping point means title passes when the seller ships the inventory. 2. FOB destination means title passes when the inventory reaches the buyer’s destination. Freight charges on incoming shipments from suppliers are commonly referred to as freight-in. o We add the cost of freight-in to the balance of Inventory. o Later, when that inventory is sold, those freight charges become part of the cost of goods sold. The cost of freight on shipments to customers is called freight-out. Purchase discounts allow buyers to trim a portion of the cost of the cost of the purchase in exchange for payment within a certain period of time. Net realizable value is the estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal, and transportation. o It’s the net amount a company expects to realize in cash from the sale of the inventory. Once a company has determined both the cost and the net realizable value of inventory, it reports ending inventory in the balance sheet at the lower of the two amounts. This method of recording inventory is lower of cost and net realizable value The inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period.      Cost of goods sold Inventory turnover ratio = -------------------------------Average Inventory The average days in inventory indicate the approximate number of days the average inventory is held. 365 Average days in Inventory = ----------------------------------Inventory turnover ratio Gross profit ratio A.K.A. gross profit percentage o It measures the amount by which the sale of inventory exceeds its cost per dollar of sales Gross profit Gross profit ratio = ---------------------Net sales o (Net sales equal total sales revenue less sales discounts, returns, and allowances.) Notes:  The difference between LIFO and FIFO disclosed in the notes to the financial statements of a company currently utilizing the LIFO cost flow assumption is sometimes referred to as the LIFO reserve  If a company uses the periodic inventory system, how many entries are made when a sale occurs? (One)  In a perpetual inventory system, when inventory is purchased, the inventory, account is debited, whereas in a periodic system, the purchase, account is debited.  Purchase returns are recorded in a separate contra purchase account in a periodic inventory system. 