Accounting Chapter 6 PDF

CHAPTER 6 O kay, we’re ready to start week number three. Stop and consider how much we’ve already learned about accounting! With all the knowledge we’ve gained so far, the coming week promises to be our best ever. Hmmm…maybe next summer, we’ll let someone else run the lemonade stand and we’ll pro...

CHAPTER 6 O kay, we’re ready to start week number three. Stop and consider how much we’ve already learned about accounting! With all the knowledge we’ve gained so far, the coming week promises to be our best ever. Hmmm…maybe next summer, we’ll let someone else run the lemonade stand and we’ll promote ourselves to financial geniuses and become one of those big bucks consultants. Certainly, dreaming of a glorious future is part of being in business. But, it’s Monday morning, and it’s time to return to reality. This summer we’re running a lemonade stand. At breakfast, you glance at the newspaper. The weather forecast promises a hot and sunny week. Great! But you don’t need the newspaper to tell you that there’s a clear, beautiful blue sky outside. Or that, thanks to the warm air, birds are chirping and singly loudly. Finishing your breakfast, you can practically feel the grass, flowers, and leaves growing outside! Boy, it’s great being alive! Yes, you’re definitely hot for another successful week in business! But, before we start, what do we need to do? Roll up the earnings! (Move last week’s earnings into Retained Earnings.) Please do so now. 80 T H E AC C O U N T I N G GA M E BEGINNING BALANCE SHEET–WEEK THREE $34.00 $4.00 $25.00 $6.00 $29.00 $12 $12.00 $5.00 $2.00 $54.00 $54.00 So, it’s a new Monday, and time to replenish your inventory of raw materials. Even though you still have 50 lemons and 5 pounds of sugar left over from last week, you think that more will be needed for this week’s sales. You get your bike out of the garage, jump on, and (checking for cars, of course) cruise down the street. You’re heading toward Pappy Parker’s neighborhood grocery store. You’re feeling like a seasoned and savvy entrepreneur. After all, you’ve worked really hard the past few weeks. As a reward, you promise yourself a bottle of juice, some doughnuts, and a candy bar for later. But, when you reach the store, you’re in a shock. There would be no extra money for treats because the price of lemons has doubled to 40 cents a piece! This is an outrage! Someone should call the President! Or, at least, the governors of Florida and California, where the lemons come from. What’s going on here? Is someone trying to run you out of business? You can’t make lemonade without lemons, though. You want 50 lemons, but you didn’t bring enough money to pay cash. You complain about the price to Pappy. He isn’t happy about the price increase, either. “I’m paying more, too. Apparently, a freak storm destroyed a lot of the lemon crop,” Pappy explains. “No one’s getting rich from the disaster.” 81 C H APTER 6 The explanation calms you some. “We lemon people must stick together—or, maybe, squeeze together in tough times,” you tell good ol’ Pappy. He nods. “Listen, I’ll be happy to sell you these lemons on account. Should I add $20.00 to what you have on credit?” “Please,” you say with a nod. “Mr. Parker, you’re the nicest man in the whole world—except for my dad, of course—and my uncles and grandpas.” Riding home, you feel happy that Pappy is such a nice person. You feel sorry for those lemon farmers who lost their crop. But, mostly, you feel sorry for yourself that the cost of lemons just doubled. When you get home, you do a new Balance Sheet. You ask yourself, what comes in? Inventory. Inventory for how much? $20.00. Did you pay cash for it? No. We charged it. Demonstrate the transaction on the next Balance Sheet. Are we in balance? No. What do we have to do? Increase Accounts Payable. Increase Accounts Payable by how much? $20.00 Now, are we in balance? Yes. $34.00 $25.00 $ 6.00 $5.00 $20.00 $ 2.00 $25 .00 82 T H E AC C O U N T I N G GA M E But, there’s something else. Look at Inventory. We now need a way to separate the 50 lemons @ 20 cents each from the 50 lemons @ 40 cents each. Okay, so let’s take a look at our Inventory. Do we have lemons in Inventory at two different costs? Yes. Right now, we have 100 lemons, and 50 of them cost 20 cents each and the other 50 cost 40 cents each. Can that happen in any business with inventory—you buy the same raw material but at different costs? Yes. The price of raw materials can shift without any notice. Which means that you could buy the same material but at any number of different costs. You start to think, Hmmmmm. Soon, I’m going to make another batch of lemonade using 50 lemons. What will be the cost of the lemons? Well, ah, either, you know…some at, like you said, 20 cents and others at, well, 40 cents. Just please don’t ask me which price lemons are going into the next batch! It can get confusing, can’t it? Well, the decision our business makes about how to value its inventory is what we will look at now. Some enterprising entrepreneur once saw this issue and came up with a way for all businesses with inventory to be creative. We’re going to first look at a method of valuing our inventory where the first lemons that come into the stand are the first lemons that go out. First in, first out. FIFO. What does this stand for? Simply stated, it means that the first lemons that came in will be the first lemons that go out, or the first lemons that we sell. Here’s another way to took at FIFO. 83 C H APTER 6 Pretend you are putting the lemons in a pipeline, in the order that you purchased them. So, which lemons are first in the pipeline? The 20 cent ones. And, which are the last in? The 40 cent ones. Good, so make up another batch of lemonade—remember our recipe? Five pounds of sugar + 50 lemons = 60 glasses. (For your information, sugar is 40 cents a pound.) You make this batch yourself, so there’s no labor charge. What is the COST OF PRODUCTION using FIFO: $___________ So, using FIFO, how much do the lemons cost? Ten dollars. You take the cost of the “first-in” lemons, which is 20¢ per lemon—for a total of $10. Then add five pounds of sugar at 40¢/lb., for a total of $2. Get these raw materials (lemons and sugar) and mix them up real good in your pitcher—because it’s time to sell some lemonade! But, first, demonstrate these transactions on a new Balance Sheet. $34.00 $24.00 $25.00 $ 6.00 $49.00 $5.00 $20.00 $ 2.00 $0.00 $25 .00 $74.00 84 T H E AC C O U N T I N G GA M E Maybe you’re feeling a bit challenged by all the important accounting concepts and practices you’re learning. But you’re doing great! Better yet, there are no challenges to selling your lemonade today! It’s hot and people are lined up at your lemonade stand. The word of mouth about your great tasting lemonade has spread—and there are lots of new customers in addition to your regular ones. “Say, kid,” a grownup wearing a suit says, “I’ll give you one hundred dollars for your secret recipe.” “No chance!” you say. “Where would Coca-Cola be if it sold its recipe years ago? Sorry, a hundred dollars is not enough.” Business is great all week long! You sell all the glasses for 50 cents each. Fifty glasses are sold for cash. Ten glasses are sold on account. Total sales = $30.00, $25.00 for Cash and $5.00 in Accounts Receivable. Demonstrate the day’s transaction on the next Balance Sheet. $24.00 $25.00 $49.00 $20 $5.00 $20.00 Let’s review what you just did. First, what goes out of our business? Inventory. How much Inventory $12.00 What comes in? Cash. Okay, so bring in the Cash. How much Cash? $25.00 85 C H APTER 6 And then what else comes in? Accounts Receivable for $5.00 Are we in balance yet? No. The Assets are $92 and the right side equals $74.00 We just made some more Profit, right? What was the sale? $30.00 What did it cost us? $12.00 What are the Earnings Week to Date? $18.00 Add the earnings to the right side, to balance. Let’s go through this again. Now, on FIFO, which cost of lemons did we use. The first ones. What’s our cost of goods? $12—$10 for lemons and $2 for sugar. Which cost of lemons did we leave on the books? The last lemons. Okay, we used 20¢ lemons and left the 40¢ lemons on the books in inventory. Now, we’re at the end of the week. What we want to do is look at different ways of valuing Inventory. Since all we want to do is isolate the inventory, let’s avoid bringing in any expenses this week. Normally, in a business, would we have expenses every week? Yes. Right now, though, we just want to look at different ways of valuing our inventory. Okay? To do this, let’s examine the week-end Balance Sheet and Income Statement. Here’s your latest Balance Sheet, filled out for your convenience. ACCRUAL FIFO BALANCE SHEET $59.00 $24.00 $25.00 $ 1 1 .00 $49.00 $20 $20.00 $0 $5.00 $20.00 $ 2.00 $ 1 8 .00 $43 .00 $92.00 $92.00 86 T H E AC C O U N T I N G GA M E Does the left side equal the right side? It sure does. Since this is the end of the week, this Balance Sheet is an Ending Balance Sheet. Now, fill out the Income Statement below. FIFO INCOME STATEMENT INC OME STATEMENT SALES Beginning Inventory + Purchases + Labor Total Available for Sale - Ending Inventory = C OST OF GO ODS SOLD Begin: Monday A.M. End: Sunday P.M. $ $ $ GROSS PROFIT = TOTAL EXPENSES NET PROFIT $ Sales were what? $30.00 Beginning Inventory? $12.00 Purchases? $20.00 Ending Inventory? $20.00 Total available for sale? $32.00 So, our Cost of Goods Sold was what? $12.00 Which makes our Gross Profit what? $18.00 And, remember, we’re not going to show any Expenses—so that’s zero. Which means that our Net Profit is how much? $18.00 Does your Net Profit on the Income Statement match your Earnings Week to Date on the Balance Sheet? It should. If you got $18.00 on both, give yourself a pat on the back! So, this week on FIFO, which cost of lemons did we use? Twenty cent lemons. Which is the cost of the lemons left on the Balance Sheet? Forty cent ones. We said earlier that there were different systems to value our inventory. We just used FIFO to develop the week’s financial records. But, now, let’s go through the transactions a second time, using the other system to value our Inventory. 87 C H APTER 6 Let’s redo the week. Instead of First In, First Out (FIFO), we will use the opposite method of valuing inventory, which is Last In, First Out (LIFO). Remember, we purchased 50 lemons on account. The price had just increased to forty cents a lemon. Let’s start from this transaction. What comes in? Inventory. For how much? $20.00. Do you pay cash? No. So, to make the balance sheet balance, you need to increase what? Accounts Payable. By how much? $20.00. Remember, this time we will have the same Balance Sheet as on page 83, but we’re using the LIFO system of valuing our Inventory. $34.00 $24.00 $25.00 $6.00 $49.00 $32 $32.00 $0 $5.00 $20.00 $2.00 $0.00 $25.00 $74.00 $74.00 We’re using the system where the last-in lemons will be the first lemons that go out—that we sell. The last lemons that come in will be the first lemons out. What is this method called? LIFO. Which means what? Last in, first out. The pipeline metaphor won’t work this time. Instead, let’s pretend we’re putting the lemons in a barrel. 88 T H E AC C O U N T I N G GA M E Which lemons are on the bottom? The 20 cent lemons. And which are on the top? The 40 cent lemons. Yes, and the last ones in are the first ones out. Good. Now, make up another batch of lemonade: 5 pounds of sugar plus 50 lemons (and 2 gallons of water) make 60 glasses of lemonade. If we make up this batch of lemonade using the LIFO system, what is the cost of the lemons? $20.00. So, the lemons cost what? $20.00. Plus the sugar, which is how much? $2.00. So, what is the cost of production using LIFO? The Cost of Production using LIFO is $_______ We’ll need this in a moment, so let’s repeat it. What’s the cost of production using LIFO? $22.00 Demonstrate this on the next scorecard. 89 C H APTER 6 $34.00 $24.00 $25.00 $ 6.00 $49.00 $5.00 $20.00 $ 2.00 $25 .00 $74.00 Moving on, you have a great week and sell the entire batch of 60 glasses. Again, 50 glasses for cash and 10 on account. What goes out of the business? Inventory. How much inventory (using LIFO)? $22.00. Remember, on LIFO, the last lemons— or the expensive, higher priced lemons—are the ones that go out. The cheaper, lower priced lemons are left where? In Ending Inventory. How much Cash comes in? $25.00. How much comes in as Accounts Receivable? $5.00 Let’s do a new Balance Sheet. 90 T H E AC C O U N T I N G GA M E Once again, there are no Expenses for the week. Now, show these transaction on the LIFO Income Statement. LIFO INCOME STATEMENT INC OME STATEMENT SALES Beginning Inventory + Purchases + Labor Total Available for Sale - Ending Inventory = C OST OF GO ODS SOLD Begin: Monday A.M. End: Sunday P.M. $ $ $ GROSS PROFIT = TOTAL EXPENSES NET PROFIT Sales were what? $30.00. Beginning Inventory? $12.00. Purchases? $20.00. $ 91 C H APTER 6 Total available for sale? $32.00. Ending Inventory of what? $10.00 Cost of Goods Sold is what? $22.00. Wait a second! Twenty-two dollars in cost of goods sold? That’s expensive? Why was the COGS higher? Because the last ones in were the more expensive ones. Gross Profit is what? $8.00. No Expenses this week, so that’s zero. Thus, our Net Profit is what? $8.00. Wow! That’s low, compared to FIFO. On the LIFO method, what are the total Assets? $82.00. On the LIFO method, what are the total Liabilities and Owner’s Equity? $82.00. Does the left side equal the right side? Yes. Okay! We used two different Inventory valuation methods. Did we get different bottom lines? Yes. What was our Net Profit with FIFO? $18.00. And what was our net profit with LIFO? $8.00. FIFO gives us a Net Profit that is what? Higher. Why was it higher with FIFO? Because with FIFO, our Cost of Goods Sold was lower and Ending Inventory was higher. Fill out the following table, to make comparisons between FIFO and LIFO. FIFO vs. LIFO–THE NUMBERS DO NOT LIE! FIFO LIFO SALES $______________ $______________ COGS (Cost of Goods Sold) $______________ $______________ PROFIT $______________ $______________ ENDING INVENTORY $______________ $______________ 92 T H E AC C O U N T I N G GA M E What conclusions can we reach? FIFO IS LOW COG, HIGH ENDING INVENTORY HIGH NET PROFIT. LIFO IS HIGH COG, LOW ENDING INVENTORY LOW NET PROFIT. Remember, we said that accounting could be creative. Here is another way that businesses can be creative by how they account for what happens to their inventory. Which method would you prefer?Well…it depends. Yes, it depends. What’s a good reason for using FIFO? For one, it looks better on paper. FIFO gives me a better bottom line! Good thinking! But if you make more earnings, what will the government want from you? More taxes. So, why use LIFO? Taxes. With lower earnings, our taxes will be lower, too. Which method do you think is simpler to keep track of? FIFO. True, FIFO is easier. So, remember this, the only reason a business would choose LIFO is to SAVE TAXES! What was that? I can’t hear you! The only reason a business would choose LIFO is to SAVE TAXES! But, you may ask, is this always true? That’s a good question to look at. What is happening to prices in this example that makes LIFO show lower profit and taxes? Prices are rising. True, companies and businesses with rising costs who want to pay less taxes would chose which method? LIFO. Suppose, though, prices are falling and you still want to save taxes. Which method should you pick? FIFO. C H APTER 6 What major industry has had falling prices over the past few years? Electronics. So, companies in those industries that want to save taxes would use what inventory valuation method? FIFO. The choice of FIFO or LIFO is an important one, which involves two criteria. What is your tax strategy? What direction are prices going in your industry? (Also, you wouldn’t look at pricing in the next couple years. You’d look at the trend over a twentyfive period and try to predict the future.) Let’s look at the week’s numbers, to review the two different systems. What are total Assets on FIFO? $92.00. And on LIFO? $82.00. What’s the difference between the two Balance Sheets? $10.00. Where on the left side of the two Balance Sheets does the difference show up— besides the total assets? Inventory. And where on the right side of the two balance sheets does the difference show up—besides the total Liabilities and Owner’s Equity? Earnings. How many lemons do you have left in ending Inventory using FIFO? Fifty. And how many lemons are left in ending Inventory using LIFO? Fifty. We’ve got 50 lemons either way! With both FIFO and LIFO, you have exactly the same thing out on your lemonade stand. If you compare the FIFO and LIFO Balance Sheets, you have the same cash ($59), receivables ($11), 50 lemons, and a $2 insurance policy. So, by looking at our lemonade stand, could you tell what method of valuing Inventory we’re using? No. No, it’s just on paper. LIFO and FIFO are ways of valuing inventory where? Just on paper. Now, maybe you’re thinking that LIFO would be a problem with a perishable product, like lemons. In other words, if you don’t use the old lemons, what happens to them? They spoil. Let’s look at this situation. Here are two bowls of lemons. 93 94 T H E AC C O U N T I N G GA M E The left bowl holds the lemons from our imaginary pipeline. In other words, the First-In lemons. The right bowl holds the lemons from our imaginary barrel. In other words, the Last-In lemons. On FIFO, which lemons will we use? The first-in lemons. At what cost? Twenty cents each. On LIFO, which lemons will we use? The last-in lemons. And what cost? Forty cents each. But now, think about this for a moment. If we actually use the last ones in, what will happen to the first (or old) lemons? They’ll spoil. Then rot. Then attract all sorts of disgusting mold and vermin. Then the health department will show up…you get the idea! Which lemons should we use on LIFO? The first ones. At what cost (be careful here!)? Forty cents–remember the valuation is just on paper. The point is, LIFO and FIFO are methods of valuing inventory. Are they methods of using inventory? No. Which lemons will we always use? The first ones. Otherwise, they will spoil and rot. LIFO is just creative accounting. You would always USE the older lemons first, but with LIFO you just PRETEND that you would use the new ones. Really, you are using the old lemons and the new price. As we learned earlier, this is just a creative way to save taxes. You might be wondering if you can switch methods. The answer is yes and no. Let me explain, starting with switching from FIFO to LIFO. Most companies start on the simpler method, FIFO. You can switch from FIFO to LIFO, the first time on your own. And why would you want to do that? In an inflationary economy, in which costs are going up, you would save on taxes. Once you have made that first switch, though, you cannot make a second switch without permission from the IRS. (The IRS?! And your were worried about the health inspector?) It’s rare that the IRS will grant permission for a business to make the second switch from LIFO back to FIFO. You must file for permission with the IRS Commissioner and that permission must be granted before you switch a second time. If you switch from LIFO to FIFO, would you have to pay back the taxes that had been saved? Yes, I’m afraid so. In reality, would the taxes ever catch up with you? To answer, let’s look at when they could catch up with us. C H APTER 6 On LIFO, what is the book value of our 50 lemons? $10.00. But what would it cost us to buy 50 lemons now? $20.00. So, suppose you sold the business. What would you sell the 50 lemons for? $20. Ah, so you would have $10 in earnings and owe what? Taxes! Suppose we sold the last 50 lemons, then our ending inventory is what? Zero. The taxes would catch up then. So, we can save the taxes due on the $10 difference as long as we always keep at least how many lemons? Fifty. One last thing regarding FIFO versus LIFO. How would you know what method a company is using? Well, there is a special section of a company’s financials that’s called footnotes. In the footnotes, a company is required to reveal the method it uses to value its inventory. In the footnotes, a company can also disclose the difference between the FIFO and LIFO amounts, so that investors will know that assets are “understated” on LIFO. However, the government does not allow companies to show FIFO on financial statements and LIFO on tax reports. Unless a company wants to have some serious explaining to do, all external reporting has to be consistent. Okay, but can you average the cost of inventory? Yes. Many companies do use the average cost method. If your inventory can be specifically identified, like items with serial numbers, you can always value inventory by specific identification. Before getting back to our lemonade business, let’s summarize the FIFO versus LIFO methods. FIFO and LIFO are ways to value inventory on what? Paper. The only reason anyone would use LIFO is to save what? Taxes. Phew! That’s the end of another week. Time to give yourself a break before moving on. Put on some music and dance around. Go outside for some fresh air. Do some stretches. Or, I know, pour yourself a refreshing glass of ice-cold lemonade! 95