Horngren's Financial & Managerial Accounting Chapter 6 Merchandise Inventory PDF

Horngren’s Financial & Managerial Accounting Seventh Edition, Global Edition Chapter 6 Merchandise Inventory Copyright © 2022 Pearson Education Ltd. Chapter 6 Learning Objectives (1 of 2) 6....

Horngren’s Financial & Managerial Accounting Seventh Edition, Global Edition Chapter 6 Merchandise Inventory Copyright © 2022 Pearson Education Ltd. Chapter 6 Learning Objectives (1 of 2) 6.1 Identify accounting principles and controls related to merchandise inventory 6.2 Account for merchandise inventory costs under a perpetual inventory system 6.3 Compare the effects on the financial statements when using the different inventory costing methods 6.4 Apply the lower-of-cost-or-market rule to merchandise inventory Copyright © 2022 Pearson Education Ltd. Chapter 6 Learning Objectives (2 of 2) 6.5 Measure the effects of merchandise inventory errors on the financial statements 6.6 Use inventory turnover and days’ sales in inventory to evaluate business performance 6.7 Account for merchandise inventory costs under a periodic inventory system (Appendix 6A) Copyright © 2022 Pearson Education Ltd. Learning Objective 6.1 Identify accounting principles and controls related to merchandise inventory Copyright © 2022 Pearson Education Ltd. What Are the Accounting Principles and Controls That Relate to Merchandise Inventory? Accounting principles help accountants classify and report items on the financial statements. The accounting principles associated with merchandise inventory are: – Consistency – Disclosure – Materiality – Accounting conservatism Copyright © 2022 Pearson Education Ltd. Consistency Principle The consistency principle states that a business should use the same accounting methods and procedures from period to period. Consistency helps investors and creditors compare financial statements from one period to the next. If changes are made in accounting methods, these changes must be reported, generally in the notes to the financial statements. Copyright © 2022 Pearson Education Ltd. Disclosure Principle The disclosure principle states that financial statements should report enough information for outsiders to make knowledgeable decisions about the company. Information should be relevant and have faithful representation. Copyright © 2022 Pearson Education Ltd. Materiality Concept The materiality concept states that a company must perform strictly proper accounting only for items that are significant to the business’s financial situation. Information is significant when it would cause someone to change a decision. For example, $10,000 is material to a small business with sales of $100,000. However, $10,000 isn’t material to a large company with annual sales of $1 billion. Copyright © 2022 Pearson Education Ltd. Conservatism Conservatism means a business should report the least favorable figures in the financial statements when two or more possible options are presented. – Anticipate no gains, but provide for all probable losses. – Record an asset at the lowest reasonable amount and a liability at the highest reasonable amount. – When there’s a question, record an expense rather than an asset. – Choose the option that undervalues, rather than overvalues, your business. Copyright © 2022 Pearson Education Ltd. Control Over Merchandise Inventory Good inventory controls ensure that inventory purchases and sales are properly authorized and accounted for by the accounting system by: – Ensuring inventory is purchased with proper authorization. – Tracking and documenting receipt of inventory. – Recording damaged inventory properly. – Performing physical counts of inventory annually. – Recording and removing inventory from Merchandise Inventory when sold. Copyright © 2022 Pearson Education Ltd. Data Analytics in Accounting Inventory is one of the most important assets for merchandising and manufacturing companies. Businesses can evaluate their inventory by using data analytics tools. Examples: – Airbnb collects has collected over 1.5 petabytes of data on the vacation habits and accommodation preferences of its customers. Analyzing this data helps to identify areas in cities that don’t have enough listings. – Dickey’s Barbecue Pit examines data about its inventory (meat and sides) at each of its 500 locations every 20 minutes using data analysis software. Keeping track of real-time data allows Dickey’s to sell excess inventory and avoid spoiled food. Copyright © 2022 Pearson Education Ltd. Learning Objective 6.2 Account for merchandise inventory costs under a perpetual inventory system Copyright © 2022 Pearson Education Ltd. How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? (1 of 5) Ending Merchandise Inventory = Number of units on hand ´ Unit cost Cost of Goods Sold = Number of units sold ´ Unit cost At the end of the period, count the units in ending inventory and assign dollar amounts to the account. At the end of the period, determine the units sold during the period and assign dollar amounts to Cost of Goods Sold. Copyright © 2022 Pearson Education Ltd. How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? (2 of 5) Exhibit F:6-1 Perpetual Inventory Record Copyright © 2022 Pearson Education Ltd. How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? (3 of 5) Referring to Exhibit F:6-1 on the prior slide, Smart Touch Learning’s cost per unit remained at $350. Ending inventory and cost of goods sold are calculated as: Ending Merchandise Inventory = Number of units on hand ´ Unit cost = 4 units ´ $350 per unit = $1,400 Cost of Goods Sold = Number of units sold ´ Unit cost = 14 units ´ $350 per unit = $4,900 Copyright © 2022 Pearson Education Ltd. How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? (4 of 5) When the costs are different for different groups of inventory, it is more difficult to decide which dollar amounts to assign to the ending inventory. Exhibit F:6-2 Perpetual Inventory Record—Changes in Cost per Unit Copyright © 2022 Pearson Education Ltd. How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? (5 of 5) An inventory costing method approximates the flow of inventory costs in a business that is used to determine the amount of cost of goods sold and ending merchandise inventory. Four basic inventory costing methods are allowable by GAAP: 1. Specific identification 2. First-in, first-out (FIFO) 3. Last-in, first-out (LIFO) 4. Weighted-average Copyright © 2022 Pearson Education Ltd. Specific Identification Method (1 of 2) The specific identification method is an inventory costing method based on the specific cost of particular units of inventory. Used for inventories that include: – Automobiles – Jewels – Real estate Copyright © 2022 Pearson Education Ltd. Specific Identification Method (2 of 2) Exhibit F:6-3 Perpetual Inventory Record: Specific Identification Copyright © 2022 Pearson Education Ltd. First-In, First-Out (FIFO) Method (1 of 3) The first-in, first-out method (FIFO) assumes the first units purchased are the first to be sold. – Cost of Goods Sold is based on the oldest purchases. – Ending Inventory closely reflects current replacement cost. Cost of goods available for sale is the total cost spent on inventory that was available to be sold during a period. Copyright © 2022 Pearson Education Ltd. First-In, First-Out (FIFO) Method (2 of 3) Exhibit F:6-4 Perpetual Inventory Record: First-In, First-Out (FIFO) Copyright © 2022 Pearson Education Ltd. Journal Entries–FIFO Amounts unique to FIFO are shown in blue. Copyright © 2022 Pearson Education Ltd. Last-In, First-Out (LIFO) Method (1 of 3) Last-in, first-out (LIFO) method is the opposite of FIFO. As inventory is sold, the cost of the newest item in inventory is assigned to each unit as Cost of Goods Sold. – Cost of Goods Sold closely reflects current replacement cost. – Ending Inventory contains the oldest costing units. Copyright © 2022 Pearson Education Ltd. Last-In, First-Out (LIFO) Method (2 of 3) Exhibit F:6-5 Perpetual Inventory Record: Last-In, First-Out (LIFO) Copyright © 2022 Pearson Education Ltd. Journal Entries–LIFO Amounts unique to LIFO are shown in blue. Copyright © 2022 Pearson Education Ltd. Weighted-Average Method (1 of 5) The weighted-average method computes a new weighted-average cost per unit after each purchase. Weighted-average cost per unit is determined by dividing the cost of goods available for sale by the number of units available. Weighted-average cost per unit = Cost of goods available for sale / Number of units available Ending Inventory and Cost of Goods Sold are based on the same weighted-average cost per unit. Copyright © 2022 Pearson Education Ltd. Weighted-Average Method (2 of 5) Exhibit F:6-6 Perpetual Inventory Record: Weighted-Average Copyright © 2022 Pearson Education Ltd. Weighted-Average Method (3 of 5) After each purchase, Smart Touch Learning computes a new weighted-average cost per unit. For example, on August 5: The cost of goods sold on August 15 is calculated using the weighted-average cost of $356.67 per unit. Copyright © 2022 Pearson Education Ltd. Weighted-Average Method (4 of 5) On August 26 when the next purchase is made, the new weighted-average unit cost is as follows: Cost of goods available for sale / Number of units available = ($713 + $4,560) / (2 units + 12 units) = $5,273 / 14 units = $376.64 The weighted-average cost summary at August 31 is as follows: Cost of goods sold: 14 units that cost a total of $5,193. Ending inventory: 4 units that cost a total of $1,507. Copyright © 2022 Pearson Education Ltd. Journal Entries–Weighted-Average Amounts unique to the weighted-average method are shown in blue. Copyright © 2022 Pearson Education Ltd. Learning Objective 6.3 Compare the effects on the financial statements when using the different inventory costing methods Copyright © 2022 Pearson Education Ltd. How Are Financial Statements Affected by Using Different Inventory Costing Methods? Income Statement – Cost of Goods Sold is higher under LIFO than under FIFO when costs are rising. – Net income is lower under LIFO than under FIFO when costs are rising. Balance Sheet – When costs are increasing, FIFO inventory will be the highest, and LIFO inventory will be the lowest. Copyright © 2022 Pearson Education Ltd. Income Statement Exhibit F:6-7 Comparative Results for Specific Identification, FIFO, LIFO, and Weighted-Average—Income Statement Note that FIFO results in the highest gross profit, while LIFO shows the highest cost of goods sold. Copyright © 2022 Pearson Education Ltd. Balance Sheet Exhibit F:6-8 Comparative Results for Specific Identification, FIFO, LIFO, and Weighted-Average—Balance Sheet Copyright © 2022 Pearson Education Ltd. Exhibit F:6-9 Effects on the Financial Statements During Periods of Rising and Declining Inventory Costs Period of Rising Inventory Costs: Blank Specific Weighted- FIFO LIFO Identification Average Income Statement: Varies Lowest Highest Middle Cost of Goods Sold Net Income Varies Highest Lowest Middle Balance Sheet: Varies Highest Lowest Middle Ending Merchandise Inventory Period of Declining Inventory Costs: Blank Specific Weighted- FIFO LIFO Identification Average Income Statement: Varies Highest Lowest Middle Cost of Goods Sold Net Income Varies Lowest Highest Middle Balance Sheet: Varies Lowest Highest Middle Ending Merchandise Inventory Copyright © 2022 Pearson Education Ltd. Learning Objective 6.4 Apply the lower-of-cost- or-market rule to merchandise inventory Copyright © 2022 Pearson Education Ltd. How Is Merchandise Inventory Valued When Using the Lower-Of-Cost-Or-Market Rule? The lower-of-cost-or- market (LCM) rule requires that inventory be reported in the financial statements at the lower of the inventory’s historical cost or its market value. Market value generally means the current replacement cost. Copyright © 2022 Pearson Education Ltd. Recording the Adjusting Journal Entry to Adjust Merchandise Inventory (1 of 2) Smart Touch Learning paid $3,000 for its TAB0503 inventory. By December 31, it can be replaced for only $2,200, and the decline in value appears permanent. Copyright © 2022 Pearson Education Ltd. Recording the Adjusting Journal Entry to Adjust Merchandise Inventory (2 of 2) Smart Touch Learning’s balance sheet would report this inventory as follows: Note 1: Statement of Significant Accounting Policies Merchandise Inventories. Merchandise inventories are valued at the lower-of-cost-or-market. Cost is determined using the first-in, first-out (FIFO) method. Copyright © 2022 Pearson Education Ltd. Learning Objective 6.5 Measure the effects of merchandise inventory errors on the financial statements Copyright © 2022 Pearson Education Ltd. What Are the Effects of Merchandise Inventory Errors on the Financial Statements? (1 of 5) An error in inventory can lead to errors in other related accounts. Because the ending inventory number is used in other computations, when ending inventory is incorrect, other numbers will also be incorrect, such as: – Cost of goods sold – Gross profit – Net income Copyright © 2022 Pearson Education Ltd. What Are the Effects of Merchandise Inventory Errors on the Financial Statements? (2 of 5) The following shows how an overstatement of ending inventory affects cost of goods sold, gross profit, and net income: Copyright © 2022 Pearson Education Ltd. What Are the Effects of Merchandise Inventory Errors on the Financial Statements? (3 of 5) If Smart Touch Learning understated the inventory by $1,200, the effect would be as shown here: Copyright © 2022 Pearson Education Ltd. What Are the Effects of Merchandise Inventory Errors on the Financial Statements? (4 of 5) Exhibit F:6-10 Inventory Errors Copyright © 2022 Pearson Education Ltd. What Are the Effects of Merchandise Inventory Errors on the Financial Statements? (5 of 5) Exhibit F:6-11 Effects of Inventory Errors An inventory error cancels out after two periods. The overstatement of cost of goods sold in Period 2 counterbalances the understatement for Period 1. Copyright © 2022 Pearson Education Ltd. Learning Objective 6.6 Use inventory turnover and days’ sales in inventory to evaluate business performance Copyright © 2022 Pearson Education Ltd. Inventory Turnover Inventory turnover = Cost of goods sold / Average merchandise inventory Average merchandise inventory = (Beginning merchandise inventory + Ending merchandise inventory)/2 The inventory turnover ratio measures how rapidly inventory is sold. The ratio should be evaluated against industry averages. – A high turnover rate indicates ease of selling. – A low turnover rate indicates difficulty of selling. Copyright © 2022 Pearson Education Ltd. Days’ Sales in Inventory Days' sales in inventory = 365 days/Inventory turnover The days’ sales in inventory ratio measures the average number of days inventory is held by the company. Some types of inventory will move faster than others. For inventory with an expiration date, this measure is very important. Copyright © 2022 Pearson Education Ltd. Evaluating Kohl’s Corporation (1 of 2) From Kohl’s Corporation’s financial statements for the year ended February 2, 2019 (in millions): Kohl’s inventory turnover is 3.48 times per year and is calculated as: Inventory turnover = Cost of goods sold/Average merchandise inventory = $12,199 / [($3,542 + $3,475) / 2] = 3.48 times per year Copyright © 2022 Pearson Education Ltd. Evaluating Kohl’s Corporation (2 of 2) From Kohl’s Corporation’s financial statements for the year ended February 2, 2019 (in millions): Kohl’s days’ sales in inventory is 105 days and is calculated as: Days sales in inventory = 365 days/ Inventory turnover = 365days / 3.48 = 105 days Copyright © 2022 Pearson Education Ltd. Learning Objective 6.7 Account for merchandise inventory costs under a periodic inventory system (Appendix 6A) Copyright © 2022 Pearson Education Ltd. How Are Merchandise Inventory Costs Determined Under a Periodic Inventory System? (1 of 3) Under a periodic inventory system: Inventory is not tracked in the accounting system continuously. The beginning inventory balance is carried until the end of the period. Purchases are accumulated during the period. The ending inventory balance replaces the beginning inventory balance. Copyright © 2022 Pearson Education Ltd. How Are Merchandise Inventory Costs Determined Under a Periodic Inventory System? (2 of 3) Exhibit F:6A-1 Perpetual Inventory Record—Changes in Cost per Unit Copyright © 2022 Pearson Education Ltd. How Are Merchandise Inventory Costs Determined Under a Periodic Inventory System? (3 of 3) Under a periodic inventory system the company will calculate ending merchandise inventory and cost of goods sold at the end of each time period using the cost of goods sold formula: Copyright © 2022 Pearson Education Ltd. First-In, First-Out (FIFO) Method (3 of 3) Ending Inventory will be calculated using the newest items in inventory. Cost of Goods Sold will include the oldest unit costs. Note: Amounts for Cost of Goods Sold and Ending Inventory are always the same for FIFO perpetual and FIFO periodic. Copyright © 2022 Pearson Education Ltd. Last-In, First-Out (LIFO) Method (3 of 3) Ending Inventory will be calculated using the oldest items in inventory. Cost of Goods Sold will include the newest unit costs. Note: Amounts for Cost of Goods Sold and Ending Inventory are usually different for LIFO perpetual and LIFO periodic. Copyright © 2022 Pearson Education Ltd. Weighted-Average Method The the average cost per unit is calculated as follows: Cost of goods available for sale (entire period)/Number of units available = $6,700/18 units* = $372.22 per unit *2 units from beginning inventory + 16 units purchased during August The single weighted-average cost per unit will be applied to compute ending merchandise inventory and cost of goods sold: Copyright © 2022 Pearson Education Ltd.