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PRINCIPLES OF ACCOUNTING I-ACCT 201 PREPARED BY: ADEWOLE ADESOKAN INSTRUCTOR  CHAPTER ONE FRAUD, INTERNAL CONTROL, AND CASH Fraud Fraud is dishonest act by an employee that results in personal benefit to the employee at...

PRINCIPLES OF ACCOUNTING I-ACCT 201 PREPARED BY: ADEWOLE ADESOKAN INSTRUCTOR  CHAPTER ONE FRAUD, INTERNAL CONTROL, AND CASH Fraud Fraud is dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. The three main factors that contribute to fraudulent activity are known as the fraud triangle.  Opportunity  Financial Pressure  Rationalization (Justify committing the fraud)  Employees may feel underpaid while their bosses are making a lot of money and use that as a reason to steal money from their employer. Sarbanes-Oxley Act (SOX): Responding to corporate failures and fraud that resulted in substantial financial losses to institutional and individual investors, U.S Congress passed the Sarbanes Oxley Act in 2002. The Act contains provisions affecting corporate governance, risk management, auditing, and financial reporting of public companies, including provisions intended to deter and punish corporate accounting fraud and corruption. The purpose is to maintain public confidence and trust in the financial statements of reporting companies after numerous corporate scandals were uncovered during the early 2000s. The Sarbanes-Oxley: Applies to publicly traded U.S. corporations. Requires  Companies maintain a system of internal control.  Corporate executives and boards of directors to ensure that the controls in place are reliable and effective.  Independent outside auditors to attest to the adequacy of the internal control system. Cash Cash is the most liquid of all assets. A business cannot survive and prosper if it does not have adequate control over its cash. Cash is the asset that has the greatest chance of “going missing” and this is why we must ensure that we have strong internal controls built around the cash process. Since many business transactions involve cash, it is a vital factor in the operation of a business. Of all the company’s assets, cash is the most easily mishandled either through theft or carelessness. To control and manage its cash, a company should:  Account for all cash transactions accurately so that correct information is available regarding cash flows and balances.  Make certain that enough cash is available to pay bills as they come due.  Avoid holding too much idle cash because excess cash could be invested to generate income, such as interest.  Prevent loss of cash due to theft or fraud. The need to control cash is clearly evident and has many aspects. Without the proper timing of cash flows and the protection of idle cash, a business cannot survive. Companies protect their assets by: (1) segregating employee duties, (2) assigning specific duties to each employee, (3) rotating employee job assignments, and (4) using mechanical devices. Internal Control Internal control consists of all of the related methods and measures adopted within a business to: a. Safeguard assets from employee theft, robbery, and unauthorized use; and b. Enhance the accuracy and reliability of its accounting records by reducing the risk of errors (unintentional mistakes) and irregularities (intentional mistakes and misrepresentations) in the accounting process. The PURPOSE of internal control is to 1. Safeguard assets. 2. Enhance accuracy and reliability of accounting records. 3. Increase efficiency of operations. 4. Ensure compliance with laws and regulations. Internal control systems have 5 primary components.  1. Control environment. 2. Risk assessment. 3. Control activities (principles)-company’s efforts to address the risks. 4. Information and communication. 5. Monitoring. INTERNAL CONTROL ACTIVITIES These activities are the backbone of the company’s efforts to address the risks it faces, such as fraud. To safeguard assets and enhance the accuracy and reliability of its accounting records, a company follows internal control activities or principles. Principles of Internal Control The following six internal control principles that apply to most companies: 1. Establishment of Responsibility: An essential characteristic of internal control is the assignment of responsibility to specific individuals. Control is most effective when only one person is responsible for a given task. It requires limiting access only to authorized personnel, and then identifying those personnel. Establishing responsibility includes the authorization and approval of transactions. 2. Segregation of Duties: Segregation of duties is indispensable in a system of internal control. The rationale for segregation of duties is that the work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee. There are two common applications of this principle: 1. The responsibility for related activities should be assigned to different individuals. 2. The responsibility for record keeping for an asset should be separate from the physical custody of an asset.   Related Activities - When one individual is responsible for all of the related activities, the potential for errors and irregularities is increased. Related purchasing activities should be assigned to different individuals. Related purchasing activities include ordering merchandise, receiving goods, and paying (or authorizing payment) for merchandise. Related sales activities also should be assigned to different individuals. Related sales activities include making a sale, shipping (or delivering) the goods to the customer, and billing the customer.  Record Keeping Separate from Physical Custody - The custodian of the asset is not likely to convert the assets to personal use if one employee maintains the record of the asset that should be on hand and a different employee has physical custody of the asset. 3. Documentation Procedures - Documents provide evidence that transactions and events have occurred. Signatures should be required on documents so that the company can identify the individual(s) responsible for the transaction or event. Companies should use pre-numbered documents, and all documents should be accounted for. Examples would be numbers on cheques and invoices (like restaurant receipts). Employees should promptly forward source documents for accounting entries to the accounting department to help ensure timely recording of the transaction and event. 4. Physical, Mechanical, and Electronic Controls – Physical controls relate primarily to the safeguarding of assets. Mechanical and electronic controls safeguard assets and enhance the accuracy and reliability of the accounting records. Use of physical, mechanical, and electronic controls is essential. Examples of these controls include: a. Safes, vaults, and safety deposit boxes for cash and business papers. b. Locked warehouses and storage cabinets for inventory and records. c. Computer facilities with pass key access or fingerprint or eyeball scans. d. Alarms to prevent break-ins. e. Television monitors and garment sensors to deter theft. f. Time clocks for recording time worked. 5. Independent Internal Verification - Independent internal verification involves the review, comparison, and reconciliation of data prepared by employees. a. Verification should be made periodically or on a surprise basis. b. Verification should be done by an employee independent of the personnel responsible for the information. c. Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action. d. In large companies, independent internal verification is often assigned to internal auditors. e. Internal auditors are employees of the company who evaluate, on a continuous basis, the effectiveness of the company’s system of internal control. They periodically review the activities of departments and individuals to determine whether prescribed internal controls are being followed. 6. Human Resource Controls: These controls include: (a) Bond employees who handle cash. Bonding involves obtaining insurance protection against theft by employees. (b) Rotate employees’ duties and require employees to take vacations. (c ) Conduct thorough background checks. Limitations of Internal Control a.) Costs should NOT exceed benefits. A cost-benefit relationship must be observed between controls and security. The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit. b.) The human elements fatigue, carelessness, indifference or collusion can hinder the effectiveness of any internal control. A good system can become ineffective as a result of employee fatigue, carelessness, or indifference. Employees may become tired and not bother to count inventory. Occasionally two or more employees may work together in order to get around prescribed controls. c.) The size of the business may impose limitations on internal control. In a small company, for example, it may be difficult to apply the principles of segregation of duties and independent internal verification. However, an important and inexpensive measure any business can take to reduce employee theft and fraud is to conduct thorough background checks. Two tips include: i. Check to see whether job applicants actually graduated from the schools they list ii. Never use the telephone numbers for previous employers given on the reference sheet; always look them up yourself. Applications of Internal Control to Cash Receipts 1. Cash receipts may result from cash sales; collections on account from customers; the receipt of interest, rents, and dividends; investments by owners; bank loans; and proceeds from the sale of non-current assets. a. The following internal control principles explained earlier apply to cash receipts transactions as shown: i. Establishment of responsibility - Only designated personnel (cashiers) are authorized to handle cash receipts. ii. Segregation of duties - Different individuals receive cash, record cash receipts, and hold the cash. iii. Documentation procedures - Use remittance advice (mail receipts), cash register tapes, and deposit slips. iv. Physical, mechanical, and electronic controls - Store cash in safes and bank vaults; limit access to storage areas; use cash registers. v. Independent internal verification - Supervisors count cash receipts daily; treasurer compares total receipts to bank deposits daily. vi. Other controls - Bond personnel who handle cash; require vacations; deposit all cash in bank daily. Applications of Internal Control to Cash Disbursement 1. Cash is disbursed to pay expenses and liabilities or to purchase assets. a. Internal control over cash disbursements is more effective when payments are made by cheque, rather than by cash, except for incidental amounts that are paid out of petty cash. b. Cash payments are generally made only after specific control procedures have been followed. c. The paid cheque provides proof of payment. d. The principles of internal control apply to cash disbursements as follows: i. Establishment of responsibility - Only designated personnel (treasurer) are authorized to sign cheques. ii. Segregation of duties - Different individuals approve and make payments; cheques signers do not record disbursements. iii. Documentation procedures - Use pre-numbered cheques and account for them in sequence; each cheque must have approved invoice. iv. Physical, mechanical, and electronic controls - Store blank checks in safes with limited access; print check amounts by machine with indelible ink. v. Independent internal verification - Compare cheques to invoices; reconcile bank statement monthly. vi. Other controls - Stamp invoices PAID. 2. Methods of Disbursing and/or safeguarding Cash: a. Electronic Funds Transfer (EFT) System: A new approach developed to transfer funds among parties without the use of paper (deposit tickets, cheques, etc.). The approach, called electronic funds transfers (EFT), uses wire, telephone, telegraph, or computer to transfer cash from one location to another. b. Petty Cash Fund - A cash fund used to pay relatively small amounts. The petty cash fund is an exception to the “all expenditures by cheque” rule, for minor amounts. This involves the following steps:  Cheque written and cashed to establish fund  Minor disbursements are reimbursed from it when receipts are presented  Replenish periodically by totaling receipts and writing a cheque to bring the cash in the fund up to its original amount  Record expenses in accounting records per receipts c. Use of a Bank i. Contributes significantly to good internal control over cash by creating a separate set of records (bank and books). ii. The asset account Cash maintained by the company is the “flip-side” of the bank’s liability account for that company. It should be possible to reconcile these accounts—make them agree—at any time. 1. Bank statements - Each month the company receives a bank statement showing its bank transactions and balances. For example, some transactions and balances shown include: 2. Cheques paid and other debits that reduce the balance in the depositor's account. 3. Deposits and other credits that increase the balance in the depositor's account. 4. The account balance after each day's transactions. d. Minimizes the amount of cash that must be kept on hand In order to safeguard cash while disbursing, the amount of cash that must be kept on hand must be minimized. Prepare a Bank Reconciliation 1. The bank and the company maintain independent records of the checking account. The two balances are seldom the same because of: a. Time lags that prevent one of the parties from recording the transaction in the same period. i. Days elapse between the time a cheque is written and dated and the date it is paid by the bank. ii. A day may pass between the time receipts are recorded by the company and the time they are recorded by the bank. iii. A time lag may occur when the bank mails a debit or credit memo to the company. b. Errors by either party in recording transactions. The incidence of errors depends on the effectiveness of internal controls maintained by the company and the bank. 2. Reconciliation procedure - In reconciling the bank account, it is customary to reconcile the balance per books and balance per bank to their adjusted (correct or true) cash balances. a. To obtain maximum benefit from a bank reconciliation, the reconciliation should be prepared by an employee who has no other responsibilities related to cash. b. The reconciliation schedule is divided into two sections: i. balance per bank and ii. balance per books. c. Adjustments are made to correct what was not recorded on either set of books. i. Remember: only correct bank or books for the items that were unknown on that particular record on the date of the reconciliation. d. The following steps should reveal all the reconciling items causing the difference between the two balances: i. Compare the individual deposits on the bank statement with the deposits in transit from the preceding bank reconciliation and with the deposits per company records or copies of duplicate deposit slips. 1. Deposits recorded by the depositor that have not been recorded by the bank represent deposits in transit and are added to the balance per bank. 2. Compare the paid cheques shown on the bank statement or the paid cheques returned with the bank statement with (a) cheques outstanding from the preceding bank reconciliation and (b) cheques issued by the company as recorded in the cash payments journal. Issued cheques recorded by the company that have not been paid by the bank represent outstanding cheques that are deducted from the balance per bank. 3. Note any errors discovered in the foregoing steps and list them in the appropriate section of the reconciliation schedule. All errors made by the depositor are reconciling items in determining the adjusted cash balance per books. In contrast, all errors made by the bank are reconciling items in determining the adjusted cash balance per bank. 4. Trace bank memoranda to the depositor's records. Any unrecorded memoranda should be listed in the appropriate section of the reconciliation schedule.  CHAPTER TWO ACCOUNTS RECEIVABLES AND TEMPORARY INVESTMENT Accounts Receivables Accounts Receivable (AR) is the balance of money due to a firm for goods or serves delivered or used but not yet paid for by customers. In other words, Accounts Receivable (AR) is any amount of money owed by customers for purchases made on credit. Accounts Receivables are created when a company allows a buyer to purchase their goods or services on credit. Accounts receivable or receivables represent a line of credit extended by a company and normally have terms that require payments due within a relatively short time period. It typically ranges from a few days to a fiscal or calendar year. Accounts Receivables are listed on the balance sheet as a current asset. Benefits of Accounts Receivable Accounts receivable is an important aspect of a business’s fundamental analysis. Accounts receivable, being an asset, is used to measure a company’s liquidity or ability to cover short-term obligations without additional cash flows. Fundamental analysts often evaluate accounts receivable in the context of turnover, also known as accounts receivable turnover ratio, which measures the number of times a company has collected its account receivable balance during an accounting period. Further analysis would include days sales outstanding analysis, which measures the average collection period for a firm’s receivables balance over a specified period. Valuation of Accounts Receivable Allowance for doubtful accounts, a valuation account, is also called allowance for bad debts, or allowance for uncollectible accounts. This is gross accounts receivable less allowance for doubtful accounts equals net recoverable amount of accounts receivable. This is also called net realizable value, or accounts receivable, net. Two methods of accounting for bad debts Direct write-off method creates a timing problem because it does not match expense (bad debts) associated with sales with period in which sales were made. This violates the matching principle. Allowance method estimates bad debts before they occur. This reports bad debt expense on the income statement, and increase allowance for doubtful accounts. Allowance is a contra asset, that is, it reduces the asset to its net realizable value. To write off a specific customer's account, reduce both the allowance for doubtful accounts and the accounts receivable account. After the write off, there is no change in net realizable value. Two approaches to estimate bad debts, using the allowance method Income statement method matches bad debts with revenues. It bases estimate on credit sales of the period. It uses historical average percent of credit sales that resulted in bad debts, applied to current period’s credit sales. Its debit bad debt expense, credit allowance for this number. Balance sheet method matches bad debts with net balance of accounts receivable at the end of the period. It bases estimate on historical percentage of ending accounts receivable that resulted in bad debts. It apply to current period’s ending accounts receivable. IMPORTANT: this method does not yield the amount to debit to bad debt expense and credit to the allowance. The amount calculated is the ending balance of the allowance account. It is necessary to subtract any existing balance to arrive at the debit to bad debt expense. Aging of accounts receivable Aging of accounts receivable is variation of the percent of accounts receivable method  Refines the calculation, considering the length of time receivables have been outstanding  Groups receivables by age (time outstanding)  Estimated uncollectibility increases as receivables get older Accounts receivable turnover is the rate of collection of accounts receivable. Accounts Receivable Turnover = net credit sales divided by average accounts receivable Sales XXX Less: Sales returns and allowances (XX) Sales discounts (XX ) Net Sales XXX Accounts receivable turnover is an efficiency ratio or activity ratio that measures how many times a business can turn its accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year. Example A company has a beginning accounts receivable of $125,000 and an ending accounts receivable of $235,000 and a net credit sales of $2.8 Million. Calculate the accounts receivable turnover. Accounts Receivable Turnover = net credit sales / average accounts receivable Average account receivable= ($125,000 + $235,000) / 2 = $180,000 Accounts Receivable Turnover =$2,800,000 / $180,000 =15.56 times Days in Accounts Receivable / Accounts Receivable Days Days in accounts receivable is the days an item spends, on average, in accounts receivable. In other words, it is the number of days that an invoice will remain outstanding before it is collected. Accounts receivable Days = Accounts receivable / Turnover x 365 days Example Imagine company A has a total of $120,000 in their accounts receivable along with an annual revenue of $800,000. Calculate the Accounts receivable Days. Accounts receivable Days = $120,000 / $800,000 x 365 days =54.75 days The result above shows that Company A takes just under 55 days to collect a typical Invoice. Accelerating the Inflow of Cash from Sales Recording sales of merchandise is made using cash or credit (on account). Service revenue, like Sales revenue, is recorded when the performance obligation is satisfied-when the goods are transferred from the seller to the buyer. Sales invoice should support each credit sale. When companies sell merchandise inventory, the transaction requires two journal entries:  the first entry records the revenue from the sale at the selling price and  the second entry decreases the inventory account and records the expense of the sale at cost. Journal Entries to Record a Sales Cash or Accounts receivable XXX Sales XXX Entries passed using selling price Revenue (sales) is recorded at the time the transaction occurs, regardless of whether payment is received from the buyer. Revenue is always greater than the cost of the goods sold. Inventory is decreased for the cost of the Inventory sold, which includes the price paid for the goods plus all necessary costs of getting the Inventory to the company’s place of business and ready to sell. The rules of FOB determine whether freight costs are recorded as transportation out (a selling expense) or as part of the cost of Inventory. Cash discounts are used to motivate customers to pay earlier. Sales (cash) discount is offered to customers to promote prompt payment of the balance due. NB: Trade discounts are deducted as part of the initial sale transaction; they are not a sales discount not a contra-revenue. Trade discount is granted with the aim of increasing the sales in bulk quantity whereas cash discount is granted to facilitate a quick payment. Cash discount is always calculated on sales minus sales returns and allowances. Credit terms may permit buyer to claim a cash discount for prompt payment. Advantages  Purchaser saves money  Seller shortens the operating cycle by converting the accounts receivables into cash earlier Example: Credit terms may read 2/10, n/30 When a company sells goods to a customer, the discounts-Credit Terms to stimulate early (cash) payment of receivables (credit sales) can, generally, take the form of 2/10, n/30 where:  2 is the discount %  10 is the discount period in days  n is the net (total) amount to pay  30 is the number of days after the invoice date that the net amount is due 2/10, n/30 means 2% discount if paid within 10 days, otherwise net amount due within 30 days. 1/10 EOM means 1% discount if paid within first 10 days of next month n/10 EOM means Net amount due within the first 10 days of the next month Note the following:  Only the purchases are subject to discount, transportation/ freight costs paid by the seller on behalf of the buyer are not subject to a cash discount.  Cash discounts reduce the cost of inventory for the buyer (credit merchandise inventory)  Cash discounts reduces revenue for the seller (debit sales discounts, a contra-revenue account) Temporary Investment Temporary Investments are securities that can be sold in the near future, and for which there is expectation of doing so. These are commonly made when a business has a short-term excess funds (idle cash) of which it wants to earn interest which will be needed to fund operations in the nearest future. Determining Idle Cash How does a company determine that it has an “idle” cash and need to put it to work ? The company considers such needs as payroll and accounts payable due within the current week. They also look at deadlines beyond the immediate ones to take advantage of cash discounts. Within a month, there are again payables, and recurrent items such as rent and utilities. Lease and mortgage payments are both short- and long-term obligations. The company may have committed to large payments for assets or other purchases that will require large amounts of cash in the future, or anticipate retirement of long-term debt. All these can be scheduled fairly accurately. The needs are matched to current cash and investment balance, with maturities noted, and receivables and other expected cash inflows. The difference will be the cash surplus or shortfall in each time period. Any surplus is invested in instruments that mature in time for the company’s need for the cash. The company balances the optimal returns desired against the ability to access the cash as necessary Investing the Idle Cash in instruments / Securities Trading securities are current assets the investor’s intent is to hold them for a short time for a profit. The investor sells the securities for a profit that it expects to generate from increases in the market price of the securities. Temporary Investment is recorded at cost, which includes broker fees and commissions. Dividends earned are recorded as dividend income. When securities are sold, gain or loss is recorded as “other income and expenses”. At the end of the accounting period, securities still held are marked to market, that is, individually adjusted to reflect their current market value on the balance sheet. The sum of the increases and decreases results in an unrealized gain or loss on trading securities is termed, “other income and expense item”. The investment accounts are adjusted to reflect the market value. When a security that has been adjusted to market value is sold, the gain or loss on the sale is the difference between cash proceeds and the adjusted fair value at the most recent reporting date, not the cost.  CHAPTER THREE INVENTORIES Inventories include assets held for sale in the ordinary course of business (finished goods), assets in the production process for sale in the ordinary course of business (work in progress) and materials and supplies that are consumed in production (raw materials). Classifying Inventories How company classifies its inventory will depend on whether the company is a merchandising or manufacturing company. Inventory can be classified thus: Merchandising Company  Inventory Manufacturing Company Manufacturers usually classify their inventory into three categories:  Raw Materials  Work In Progress  Finished Goods By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management’s production plans. Determining Inventory Quantities All companies must determine the inventory quantities at the end of accounting period whether they are using Perpetual Inventory System or Periodic Inventory System. Determining inventory quantities involves two steps: 1. Taking a physical inventory of goods on hand 2. Determining the ownership of the goods/inventories Physical Inventory are taken for two reasons: Perpetual System 1. Check accuracy of inventory records. 2. Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. Periodic System 1. Determine the inventory on hand at balance sheet date. 2. Determine the cost of goods sold for the period. Taking a Physical Inventory Involves counting, weighing, or measuring each kind of inventory on hand. Physical inventory is taken:  when the business is closed or business is slow.   at the end of the accounting period Determining Ownership of Goods Goods in Transit:  Purchased goods not yet received.  Sold goods not yet delivered. Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of sale. Free On Board (FOB) Shipping Point Goods in Transit Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. The buyer pays the freight costs. Free On Board (FOB) Destination Point Ownership of the goods remains with the seller until the goods reach the buyer. The seller pays the freight costs. Consigned Goods: This to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These goods are called Consigned Goods. Many car, boat, and antique dealers sell goods on consignment in order to:  keep their inventory costs down (low) and  to avoid the risk of purchasing an item that they may not be able to sell. Today, even some manufacturers are making consignment agreements with their suppliers in order to keep their inventory levels low. Under this consignment agreement, the dealer (consignee) would not take ownership for the consigned goods because the seller/importer (consignor) is still the owner of the goods. Therefore, when the inventory is taken, the consigned goods will not be included in the inventory of the dealer. Inventory Costing Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. Unit costs are applied to quantities to determine the total cost of the inventory and the cost of goods sold using the following costing methods: ► Specific identification Cost Flow Assumptions: ► First-in, first-out (FIFO) ► Last-in, first-out (LIFO) ► Average-cost Specific identification This is an actual physical flow costing method in which items still in inventory are specifically cost to arrive at the total cost of the ending inventory. This practice is relatively rare. Most companies make assumptions (cost flow assumptions) about which units were sold. Cost Flow Assumptions Specific identification inventory costing method is often impractical, therefore other cost flow methods are permitted. These costing methods are difference from specific identification in that they assume flows of costs that many be unrelated to the physical flow of goods. There are three assumed cost flow assumptions: ► First-in, first-out (FIFO) ► Last-in, first-out (LIFO) ► Average-cost There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost flow method. First-in, First-out (FIFO) The First-in, first-out (FIFO) method assumes costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold. FIFI often parallels actual physical flow of merchandise. It is generally a good business practice to sell the oldest units first. Under the FIFO method, therefore, the costs of the earliest goods purchased are the first to be recognized (issued) in determining cost of goods sold. Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been cost. Last-in, First-out (LIFO) The Last-in, first-out (LIFO) method assumes that the latest goods purchased are the first to be sold. In The Last-in, first-out (LIFO), the costs of the latest goods purchased are the first to be recognized (issued) in determining cost of goods sold. The LIFO method seldom or rarely coincides with actual physical flow of merchandise. The exceptions include goods stored in piles, such as coal or hay where goods are removed from the top of the pile as they are sold. Average-Cost Method This method allocates cost of goods available for sale or cost of goods sold or cost of materials input into production on the basis of weighted-average unit cost incurred. The average cost method assumes that goods are similar in nature. The method applies weighted-average unit cost to the units on hand to determine cost of the ending inventory. Estimating inventories Companies sometimes estimate inventories. Firstly, a casualty or loss such as fire, flood, or earthquake may make it impossible for a company to take a physical inventory. Secondly, the managers may want monthly or quarterly financial statements, but a physical inventory is taken only annually. The need to estimate inventories occurs primarily with a periodic inventory system because of the absence of perpetual inventory records. There are two widely used methods of estimating inventories: 1. The gross profit method 2. The retail inventory method Gross Profit Method Gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales. This method is relatively simple but effective. Accountants, Auditors and Managers frequently use this method to test the reasonableness of the ending inventory amount. The method detects large errors. To use this method, a company needs to know its net sales, cost of goods available for sale and gross profit rate. The company then can estimate its gross profit for the period. STEP 1 Net sales –Estimated Gross Profit= Estimated cost of goods sold STEP 2 Cost of goods available for sale-Estimated cost of goods sold= Estimated cost of ending inventory Retail Inventory Method A retail store like Wal-Mart, Home Depot or Ace Hardware has thousands of different types of merchandise at low unit costs. In such cases it is difficult and time-consuming to apply unit costs to inventory quantities. An alternative is to use the retail inventory method to estimate the cost of inventory. Most retail companies can establish a relationship between cost and sales prices. The company then applies the cost- to- retail percentage to the ending inventory at retail prices to determine inventory at cost. Under the retail inventory method, a company’s records must show both the cost and retail value of the goods available for sale. Below are the formulas for using the retail inventory method. STEP 1 Goods available for sale at retail –Net sales= Ending inventory at retail STEP 2 Goods available for sale at cost/Goods available for sale at retail = Cost of retail ratio STEP 3 Ending inventory at retail X Cost of retail ratio = Estimated cost of Ending inventory Inventory Errors Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by failure to count or price the inventory correctly. In other cases, errors occur because companies do not properly recognize the transfer of legal title to goods that are in transit. When errors occur, they affect both the income statement and balance sheet. Income Statement Effects Under a periodic inventory system, both the beginning and ending inventories appear in the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold and net income in two periods. Beginning Inventory+ Cost of goods purchased – Ending Inventory= Cost of goods sold Balance Sheet Effects Companies can determine the effects of ending inventory errors on the balance sheet by using the basic accounting equation: Assets= Liabilities+Owner’s Equity. Since the ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of ending inventory of one period and the beginning inventory of the next period. Illustration A company overstated its 2020 ending inventory by $12,000. Determine the impact of this error on opening inventory, ending inventory, cost of goods sold and owner’s equity. Solution 2020 2021 Opening Inventory No effect $12,000 over-stated Ending Inventory $12,000 over-stated No effect Cost of goods sold $12,000 under-stated $12,000 over-stated Owner’s Equity $12,000 over-stated No effect Statement Presentation and Analysis Presentation Balance Sheet - Inventory classified as current asset. Income Statement - Cost of goods sold subtracted from sales. There also should be disclosure of: 1) major inventory classifications, 2) basis of accounting (lower of cost or net realizable value). NB- Lower of cost or market (LCM) is the same as lower of cost or net realizable value. 3) costing method (FIFO, LIFO, or average) Analysis The amount of inventory carried by a company has significant economic consequences. And Inventory management is a double-edged sword that requires constant attention. On the one hand, management wants to have a great variety and quantity on hand so that customers have a wide selection and items are always in stock. But such a policy may incur high carrying cost (e.g investment, storage, insurance, obsolescence, and damage). On the other hand, low inventory levels lead to stock-outs and lost sales. In summary, inventory management is a double-edged sword that requires constant attention in order to avoid:  1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). 2. Low Inventory Levels – may lead to stock-outs and lost sales. Common ratios used to manage and evaluate inventory levels are inventory turnover and days in inventory (inventory days). Inventory turnover measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure of the inventory. Inventory Turnover = Cost of Goods Sold Average Inventory Average inventory = Beginning inventory + Ending inventory 2 Days in inventory measures the average number of days inventory is held. Days in Inventory = Days in Year (365) Inventory Turnover Ratio Main Inventory Costing methods Costing Explanation When To Use Effects on Financial Method The Method Statement Last-in, first-out Companies assign When prices are During the period of (LIFO) the most recent rising (inflation), increasing costs: cost to inventory the COGS is the Balance sheet-lower for COGS highest with the inventory costs, lower taxable income shareholders’ equity. lowest Income Statement- lower income and higher COGS. First-in, first-out Companies match When prices are During the period of (FIFO) the oldest cost rising (inflation), increasing costs: against the the lowest COGS Balance sheet-more revenue and and the highest accurate value assign it to COGS taxable income (higher) for ending inventory. Income Statement- increased net income. Weighted The average unit Used by higher With rising prices, Average Cost cost over the volume and average costs are (WAC) period, calculated inventory higher and net income by dividing the turnover is lower. Results will total cost of the companies be between those goods available yielded by FIFO OR for sale by total LIFO units available for sale Specific Track the Used for one-of- The effect on net Identification individual a-kind, high income depends on (SI) inventory items value, low- items sold and their volume items acquisition costs. such as art or jewelry CLASS EXERCISE Below accounting records relate to SUCCESS Electronics. 1st January Beginning inventory 3,000 units at $3 15 January Purchases th 8,000 units at $7 19th January Sales 9,200 units at $10 Required: Determine the cost of goods sold and the cost of ending inventory during the period under a periodic inventory system using: a) the FIFO method b) the LIFO method c) the Average cost method SOLUTION FIFO METHOD DATE PURCHASES ISSUED/ GOODS SOLD ENDING NVENTORY UNIT UNIT UNIT Particular UNIT COST AMOUNT UNITS COST AMOUNT UNITS COST AMOUNT 1st Opening Jan Bal. 3,000 3 9,000.00 0 0 - 3000 3 9,000.00 15th Jan Purchases 8,000 7 56,000.00 0 0 - 8,000 7 56,000.00 3,000 X 19th 3 6,200 Jan Sales 0 0 - 9,200 X7 52,400.00 1,800 7 12,600.00 LIFO METHOD DATE PURCHASES ISSUED/ GOODS SOLD ENDING NVENTORY UNIT UNIT UNIT Particular UNIT COST AMOUNT UNITS COST AMOUNT UNITS COST AMOUNT 1st Opening Jan Bal. 3,000 3 9,000.00 0 0 - 3000 3 9,000.00 15th Jan Purchases 8,000 7 56,000.00 0 0 - 8,000 7 56,000.00 8,000 X 19th 7 1,200 Jan Sales 0 0 - 9,200 X3 59,600.00 1,800 3 5,400.00 AVERAGE COST METHOD DATE PURCHASES ISSUED/ GOODS SOLD ENDING NVENTORY UNIT UNIT UNIT Particular UNIT COST AMOUNT UNITS COST AMOUNT UNITS COST AMOUNT 1st Opening Jan Bal. 3,000 3 9,000.00 0 0 - 3000 3 9,000.00 15th Jan Purchases 8,000 7 56,000.00 0 0 - 8,000 7 56,000.00 19th Jan Sales 0 0 - 9,200 5.91 54,364.00 1,800 5.91 10,636.00 METHOD COST OF GOODS ENDING INVENTORY SOLD FIFO $52,400 $12,600 LIFO $59,600 $5,400 AVERAGE COST METHOD $54,364 $10,636