Chapter Six Outline
Chapter Six Outline ACG2021
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This 7 page Class Notes was uploaded by Nicholas D'Ambrosio on Thursday September 29, 2016. The Class Notes belongs to ACG2021 at University of Florida taught by Jill Kristen Goslinga in Fall 2016. Since its upload, it has received 6 views. For similar materials see Introduction to Financial Accounting in Finance at University of Florida.
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Date Created: 09/29/16
Chapter Six: Inventory & Cost of Goods Sold VI. Inventory & Cost of Goods Sold A. Show How to Account for Inventory Merchandisers (companies who sell products) have 2 accounts that service entities don’t need: - Cost of goods sold on the income statement - Inventory on the balance sheet A company like Under Armour has 300 hoodies. They cost $30 each and sell for $50 each. If Under Armour sells 200 of them, the store’s balance sheet reports the 100 hoodies that the company still holds in inventory, and the income statement reports both the revenue from and the cost of the 200 hoodies sold. 1. Sale Price vs. Cost of Inventory - Sales revenue is based on the sale price of the inventory sold ($50) - Cost of goods sold is based on the cost of the inventory sold ($30) - Inventory on the balance sheet is based on the cost of the inventory still on hand ($30) Gross Profit is the excess of sales revenue over cost of goods sold. It is called gross profit because operating expenses have not yet been subtracted. 2. Accounting for Inventory in the Perpetual System 2 systems: Periodic Inventory System: Used for inexpensive goods. Inventory counts are taken periodically throughout the year. Perpetual Inventory System: Used for all types of goods. Uses computer software to keep a running record of inventory on hand. Most businesses use this system. Even in this system, businesses still count inventory annually. When a sale happens in the perpetual system, the transaction is recorded as follows: - The company records the sale- debits cash or accounts receivable and credits sales revenue for the sale price of the goods. - Debit cost of goods sold and credit inventory for the cost of the inventory sold. A purchase return represents a decrease in inventory and a corresponding decrease in accounts payable because the buyer returned the item to the seller. With a purchase allowance, the buyer keeps the inventory but decreases its cost of inventory held because the buyer is granted an allowance from the amount owed. A purchase discount is a decrease in the buyer’s cost of inventory earned by paying quickly. Many companies offer payment terms of 2/10 n/30, which means a 2% discount is offered to the buyer for payment within 10 days, with the final amount due within 30 days. B. Apply and Compare Various Inventory Cost Methods 1. What Goes into Inventory Cost? The cost of inventory includes its basic purchase price, plus freight in, insurance while in transit, and any fees or taxes paid to get the inventory ready to sell, less returns, allowances, and discounts. 2. Apply the Various Inventory Costing Methods To compute cost of goods sold and the cost of ending inventory still on hand, we must assign a unit cost to the items. Accounting uses 4 generally accepted inventory methods: - Specific Unit Cost - Average Cost - First in First out (FIFO) Cost - Last in First out (LIFO) Cost a. Specific Unit Cost Method Some companies sell items that have unique costs. For example a car dealership might sell a model for $19,000 and another fully loaded model for $23,000. If the dealership sells the fully loaded model, the regular model is the only car left in inventory, and under the specific unit cost method, its exact cost ($19,000) is recorded as the ending inventory. b. Average Cost Method Sometimes referred to as the weighted-average method, it is found by the following: Cost of Goods Available $900 Average Cost Per Unit = Number of Units Available = 60 = $15 c. FIFO Cost Method Under the FIFO method, the first costs into inventory are the first costs assigned to cost of goods sold. Under FIFO, the cost of ending inventory is always based on the latest cost incurred, in this example, $18 per unit. d. LIFO Cost Method Under LIFO, the last costs into inventory go immediately to cost of goods sold. Under LIFO, the cost of ending inventory is always based on the oldest costs- from beginning inventory plus the earliest purchases of the period, $10 and $14 per unit. 3. Compare the Effects of FIFO, LIFO, and Average Cost These two diagrams help compare the effects of FIFO, LIFO, and Average Cost: 4. The Tax Advantage of LIFO When costs are rising, LIFO results in the lowest taxable income and thus the lowest income taxes. This is the most attractive feature of LIFO, low income tax payments. Let’s compare the LIFO and FIFO inventory methods from a couple different standpoints: C. Explain and Apply Underlying GAAP for Inventory 1. Disclosure Principle It is understood that companies must report relevant and representationally faithful information. Because of this, companies are required to report which method of inventory they use when reporting financial statements. This allows outsiders to make wise business decisions. Financial statements will typically contain a footnote explaining which inventory methods were used. 2. Lower of Cost or Market Rule The LCM rule requires that inventory be reported in the financial statements at whichever is lower – the inventory’s historical cost or its market value. Applied to inventories, market value generally means current replacement cost (that is, how much the business would have to pay to replace its inventories). The business reports ending inventory at its LCM value on the balance sheet. D. Compute and Evaluate Gross Profit Percentage, Inventory Turnover, and Days Inventory Outstanding (DIO) 1. Gross Profit Percentage Here is the formula to calculate gross profit percentage: 2. Inventory Turnover Here is the formula to calculate inventory turnover: 3. Days Inventory Outstanding This is very easy to calculate. Simply divide the inventory turnover into 365. Therefore, DIO for 2014 was 117 days, meaning on average, items of inventory sat on the shelves for 117 days before being sold. 365 365 DIO = Inventory Turnover = 3.13 = 117 E. Use the COGS Model to Make Management Decisions Below is the Cost of Goods Sold (COGS) Model. This model is used by all companies, regardless of their accounting systems. Study this model carefully. 1. Computing Budgeted Purchases One major issue retailers face is deciding how much inventory to buy. This can be solved by rearranging the COGS model: 2. Estimating Inventory by Using the Gross Profit Method The gross profit method is widely used to estimate ending inventory. We can do this by once again rearranging the COGS model: F. Analyze Effects of Inventory Errors The following two diagrams illustrate the problems created by making inventory errors: