Chapter 8 Topic 1. Chapter 8: Topic 1 Valuation of Inventories The Basics. Student Learning Outcomes. Inventories: Financial Analysis

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1 Chapter 8: Topic 1 Valuation of Inventories The Basics Dr. Chula King ACG 3101 Student Learning Outcomes Perpetual versus periodic inventory system Effects of inventory errors Items to include in inventory costs Topic 2 Cost flow assumptions Dollar-value LIFO Advantages and disadvantages of LIFO 2 Inventories: Financial Analysis Liquidity current ratio Asset management Inventory turnover and asset turnover Financial leverage All ratios except debt/equity Profitability All ratios 3 1

2 Inventory Items that a company holds for sale in the ordinary course of business, or goods that it will use or consume in the production of goods to be sold. Merchandising purchases goods in a form ready for sale, e.g., Wal-Mart Manufacturing produces goods to sell to merchandising firms, e.g., Ford 4 The Inventory Equation: Merchandiser Beginning Inventory + Additions (Purchases) Goods Available for Sale - Ending Inventory Cost of Goods Sold 5 Manufacturer: Cost of Goods Sold Beginning finished goods inventory + Cost of goods manufactured = Cost of goods available - Ending finished goods inventory = Cost of goods sold 6 2

3 Another View Goods Available for Sale Goods Sold (Expense) Ending Inventory (Asset) 7 Inventory Systems Perpetual continuously tracks changes in the Inventory account and Cost of Goods Sold (COGS) Purchases recorded as increase in inventory Sales inventory reduced for Cost of Goods Sold Periodic inventory balance determined periodically Purchases recorded in Purchases account (I/S) Sales COGS not recorded at time of sale Closing beginning inventory closed to COGS; purchases closed to COGS; ending inventory established with credit to COGS. 8 Issues in Inventory Valuation What goods should be included in inventory Costs to include in inventory Cost flow assumption (Topic 2) 9 3

4 Goods to Include in Inventory Goods in Transit Company Purchases Goods FOB Shipping Point Include at point of shipment FOB Destination Include when company receives goods Company Sells Goods FOB Shipping Point Exclude at the time of shipment FOB Destination Include until goods reach destination Goods on Consignment Remain property of consignor Include in consignor s inventory Exclude from consignee s inventory 10 Special Sales Agreement Sales with Buyback Agreement Company A transfers inventory to Company B, and simultaneously agrees to repurchase it at a specified price over a specified period of time. Company B uses the inventory as collateral and borrows against it Company B uses the loan proceeds to pay Company A Company A repurchases the inventory in the future Company B uses the proceeds from the repayment to meet its loan obligation. Essence Company A is financing its inventory and retaining risk of ownership 11 Special Sales Agreement Sales with High Rates of Return Returns are predictable Consider the goods sold when company can reasonably estimate the amount of the returns. Returns are unpredictable Do not consider the goods sold. Sales on Installment Recognize revenues because they have been substantially earned and are reasonably estimitable. 12 4

5 Back to Debits and Credits Every account is the result of combinations of debits and credits. Regardless of the type of account, Debits are added to debits. Credits are added to credits. Debits are subtracted from credits. Credits are subtracted from debits. Stated differently, debits move together; credits move together; but debits and credits move in opposite directions. 13 Bring in the Debits and the Credits Sales Less: Cost of Goods Sold Beginning Inventory + Additions (Purchases) Goods Available for Sale - Ending Inventory Costs of Goods Sold CR DR DR DR CR Gross Profit NI CR 14 So What? Beginning Inventory and Cost of Goods Sold both have debit balances; Net Income has a credit balance. Therefore Beginning Inventory (BI) and Cost of Goods Sold (COGS) move in the same direction, but in opposite directions to Net Income (NI) and Retained Earnings (). BI causes COGS causes NI BI causes COGS causes NI 15 5

6 So What? Purchases and Cost of Goods Sold both have debit balances; Net Income has a credit balance. Therefore Purchase (P) and Cost of Goods Sold (COGS) move in the same direction, but in opposite directions to Net Income (NI) and Retained Earnings (). P causes COGS causes NI P causes COGS causes NI 16 So What? Ending Inventory and Net Income both have credit balances; Cost of Goods Sold has a debit balance. Therefore, Ending Inventory (EI), Net Income (NI), and Retained Earnings () move in the same direction, but in opposite directions to Cost of Goods Sold (COGS). EI causes COGS causes NI EI causes COGS causes NI 17 So What? The ending inventory of one period becomes beginning inventory of the next period, causing counterbalancing effects on net income over a two year period. Salad Oil Water 18 6

7 Exercise : Net Income Per Books $50,000 EI overstated NI overstated (3,000) Correct Net Income $47, : Net Income Per Books $52,000 BI overstated NI understated 3,000 EI overstated NI overstated (9,000) Correct Net Income $46, Exercise 8-12 (continued) 2004: Net Income Per Books $54,000 BI overstated NI understated 9,000 EI understated NI understated 11,000 Correct Net Income $74, : Net Income Per Books $56,000 BI understated NI overstated (11,000) EI OK -0- Correct Net Income $45, Exercise 8-12 (continued) 2006: Net Income Per Books $58,000 BI OK -0- EI understated NI understated 2,000 Correct Net Income $60, : Net Income Per Books $60,000 BI understated NI overstated (2,000) EI overstated NI overstated (8,000) Correct Net Income $50,

8 Inventory Costs Costs directly involved in bring the goods to the buyer s place of business and converting the goods to a salable condition, e.g., freight, should be included Costs indirectly related to the acquisition or production are generally treated as period costs and expensed Purchase Discounts Gross Method Net Method 22 Example May 1, Apex, Inc., purchased goods for $10,000, subject to cash discount terms of 2/10, n/60. Apex paid for the goods on May 8, and uses the periodic inventory method. Gross Method May 1 Purchases 10,000 Accounts Payable 10,000 May 8 Accounts Payable 10,000 Purchase Discounts 200 Cash 9, Example (continued) Net Method May 1 Purchases 9,800 Accounts Payable 9,800 May 8 Accounts Payable 9,800 Cash 9,800 What if Apex made payment on May 15, after the discount period? 24 8

9 Example (continued) Gross Method: May 1 Purchases 10,000 Accounts Payable 10,000 May 15 Accounts Payable 10,000 Cash 10,000 Net Method May 1 Purchases 9,800 Accounts Payable 9,800 May 15 Accounts Payable 9,800 Purchase Discounts Lost 200 Cash 10, Topic 2: Financial Reporting Issues Determine the total product cost for a period (Topic 1) Apportion the cost between goods sold during the period and goods in inventory at the period end Value the ending inventory 26 Topic 2: Inventory Valuation Issues What should be included in the acquisition cost of inventory? (Topic 1) How should changes in the market value of inventories subsequent to acquisition be handled? What cost flow assumption should be used? 27 9

10 The Next Step Topic 2 Lecture Exercises related to Topic 1 material: 8-2, 8-5, 8-9, 8-11, 8-12 (worked in this lecture) 28 10