Fundamental of accounting II, Chapter 1.pptx

Fundamental of accounting II

1. Chapter One Accounting For Inventories Fundamentals of Accounting II 1 Fundamentals of Acc II: By Alemayo S.

2. One Classification: Merchandise Inventory Three Classifications: Raw Materials Work in Process Finished Goods Merchandising Company Manufacturing Company Helpful Hint: Regardless of the classification, companies report all inventories under Current Assets on the SoFP. Classifying Inventory Classification of Inventories Inventories are asset items held for sale in the ordinary course of business, or goods to be used in the production of goods to be sold.

3. Cont’d… Raw material inventory – are the basic goods that will be used in production but have not yet been placed into production. Example, wood to make a chair or other office furniture’s, the steel to make a car etc. 2. Work in process inventory- is that portion of manufactured inventory that has been placed into the production process but is not yet complete. 3. Finished goods inventory – manufactured items that are completed and ready for sale. 3 Fundamentals of Acc II: By Alemayo S.

4. Why is Inventory Control Important? Inventory is a significant asset and for many companies the largest asset. Inventory is central to the main activity of merchandising and manufacturing companies. Mistakes in determining inventory cost can cause critical errors in financial statements. Inventory must be protected from external risks (such as fire and theft) and internal fraud by employees. 4 Fundamentals of Acc II: By Alemayo S.

5. Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by failure to count or price 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 SoFP. The Effects of Inventories on Financial Statements 5 Fundamentals of Acc II: By Alemayo S.

6. Income Statement Effects 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. Cost of goods sold = Beginning inventory + Net purchase – Ending inventory. If the error understates beginning inventory , cost of goods sold will be understated. If the error understates ending inventory , cost of goods sold will be overstated. 6 Fundamentals of Acc II: By Alemayo S.

7. Income Statement Effects Gross Profit = Net sales – Cost of merchandise sold Operating income = Gross Profit – Expenses 7 Fundamentals of Acc II: By Alemayo S. Illustration; Effects of inventory errors on current year’s income statement

8. Statement of Financial Position Effects The ending inventory of an organization affects the two major components of a balance sheet: A. Current Assets: If ending inventory balance is understated (overstated), the total current assets will be understated (overstated). B. Liabilities: Inventory misstatement has no effect on liabilities. C. Owners’ equity - The net income will be transferred to the owners’ equity at the end of accounting period. If ending inventory is understated (Overstated), the owners’ equity will be understated (Overstated).

9. Effect of inventory errors on the statement of financial position is determined by using the basic accounting equation : Assets = Liabilities + Equity. Errors in the ending inventory have the following effects. Illustration : Effects of ending inventory errors on SoFP Cont’d… 9 Fundamentals of Acc II: By Alemayo S.

10. Cont’d… Illustration: The first set of statements is based on a correct ending inventory of $30,000; the second set, on an incorrect ending inventory of $22,000; and the third set, on an incorrect ending inventory of $37,000. In all three cases, net sales are $200,000, merchandise available for sale is $140,000, and expenses are $55,000.

11. Cont’d…

12. Cost of inventories The cost of inventories shall comprise all costs of: Purchase, Costs of conversion and Other costs incurred in bringing the inventories to their present location and condition. The costs of purchase of inventories comprise: The purchase prices, Import duties and other taxes Transport Handling and other costs directly attributable to the acquisition of finished goods, materials and services.

13. Cont’d… Trade discounts, rebates and other similar items are deducted in determining the costs of purchase. The costs of conversion of inventories include costs directly related to the units of production, such as direct labor.

14. Inventory System 14 Fundamentals of Acc II: By Alemayo S.

15. Cont’d… 15 Fundamentals of Acc II: By Alemayo S.

16. Physical Inventory taken for two reasons: Perpetual System Check accuracy of inventory records. Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. Periodic System Determine the inventory on hand. Determine the cost of goods sold for the period. Determining Inventory Quantities No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period.

17. Involves counting, weighing, or measuring each kind of inventory on hand. Companies often “take inventory” when the business is closed or business is slow. at the end of the accounting period. 1. Taking a Physical Inventory Cont’d Determining inventory quantities involves two steps: taking a physical inventory of goods on hand and determining the ownership of goods.

18. 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. 2. Determining Ownership of Goods Cont’d

19. Illustration 6-2 Terms of sale Goods In Transit Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. Ownership of the goods remains with the seller until the goods reach the buyer. Cont’d

20. Cont’d If goods in transit at the statement date are ignored, inventory quantities may be seriously miscounted. For example, assume , that XYZ Company has 20,000 units of inventory on hand on December 31. It also has the following goods in transit: 1. Sales of 1,500 units shipped December 31 FOB destination. 2. Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.

21. Cont’d XYZ has legal title to both the 1,500 units sold and the 2,500 units purchased. If the company ignores the units in transit, it would understate inventory quantities by 4,000 units (1,500 + 2,500).

22. Consigned Goods In some lines of business, it is common 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 are called consigned goods . For example, you might have a used car that you would like to sell. If you take the item to a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is sold.

23. Cont’d… Under this agreement, the dealer would not take ownership of the car, which would still belong to you. Therefore, if an inventory count were taken, the car would not be included in the dealer’s inventory

24. Illustration

25. 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 compute the total cost of the inventory and the cost of goods sold using the following costing methods: Specific identification First-in, first-out (FIFO) Average-cost Cost Flow Assumptions Inventory Costing Methods

26. Specific identification calls for identifying each item sold and each item in inventory. Historically, specific identification was possible only when a company sold a limited variety of high-unit-cost items that could be identified clearly from the time of purchase through the time of sale . It is inappropriate when there are large numbers of items of inventory that are ordinarily interchangeable. Specific Identification

27. Illustration: Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of £700, £750, and £800. During the year Crivitz sold two sets at £1,200 each. These facts are summarized below. Illustration: Data for Inventory Costing Example Cont’d 27 Fundamentals of Acc II: By Alemayo S.

28. If Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is £1,500 (£700 + £800), and its ending inventory is £750. Cont’d… Specific Identification Method 28 Fundamentals of Acc II: By Alemayo S.

29. If Companies can positively identify which particular units it sold and which are still in ending inventory, it can use the specific identification method of inventory costing. Practice is relatively rare. Most companies make assumptions ( cost flow assumptions ) about which units were sold. Cont’d

30. There are two assumed cost flow methods: First-in, first-out (FIFO) 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. Cost Flow Assumptions 30 Fundamentals of Acc II: By Alemayo S.

31. Costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold . Often parallels actual physical flow of merchandise. Companies obtain 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 costed . FIRST-IN, FIRST-OUT (FIFO)

32. Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred. Applies weighted-average unit cost to the units on hand to determine cost of the ending inventory . And also, applies weighted-average unit cost to the units sold to determine cost of good sold . AVERAGE-COST Cont’d

33. A periodic inventory system determines cost of merchandise sold and inventory at the end of the period. To illustrate the inventory cost flow methods, we will use the data for Houston Electronics’ Astro condensers, shown below: Inventory Costing Methods under Periodic Inventory System

34. Required : compute cost of goods sold and ending inventory through periodic inventory system using FIFO WA Cont’d The cost of goods sold formula in a periodic system is: (Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

35. 1) Cost of goods sold and ending inventory using FIFO Cont’d

36. 2) CGS and ending inventory using Average cost Cont’d Here , to determine CGS & EI first weighted average unit cost should be calculated. After weighted average unit cost is computed, we multiply by the units sold to determine CGS and, the units on hand to determine cost of the EI .

37. Cont’d

38. The accounting records of XYZ show the following. Beginning Inventory 4,000 units at £ 3 Purchases 6,000 units at £ 4 Sales 7,000 units at £12 Required: Determine the cost of goods sold during the period under a periodic inventory system using: The FIFO method and (2.5 point) The average-cost method (2.5 point). Quiz (5%)

39. Cont’d Solution:

40. Inventory Cost Flow Methods in Perpetual Inventory Systems In a perpetual inventory system, all merchandise increases and decreases are recorded in a manner similar to the recording of increases and decreases in cash . The merchandise inventory account at the beginning of an accounting period indicated the merchandise in stock on that date . Companies which use perpetual inventory system, may employ FIFO or Average cost to determine CGS & EI .

41. 1. FIFO Under perpetual FIFO , the company charges to cost of goods sold the cost of the earliest goods on hand prior to each sale. Or Costs are included in the merchandise sold in the order in which they were incurred. Cont’d

42. Cont’d… 2. Average-Cost The average-cost method in a perpetual inventory system is called the moving-average method . Under this method, the company computes a new average after each purchase by dividing the cost of goods available for sale by the units on hand . The average cost is then applied to (1) the units sold, to determine the cost of goods sold, and (2) the remaining units on hand, to determine the ending inventory amount.

43. To illustrate the application of the assumed cost flow methods (FIFO and average-cost), let us use the following data;

44. Cost of goods sold Ending inventory You can see that the results under FIFO in a perpetual system are the same as in a periodic system . In both cases, the ending inventory is $5,800 and cost of goods sold is $6,200.

45. Cost of goods sold Ending inventory

46. FS and Tax Effects of Cost Flow Methods The reasons companies adopt different inventory cost flow methods are varied, but they usually involve one of three factors: Income statement effects Statement of financial position effects, or Tax effects.

47. INCOME STATEMENT EFFECTS In periods of changing prices, the cost flow assumption can have a significant impact on net income. In a period of inflation , FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues. Therefore; in a period of rising prices , FIFO reports a higher net income than average-cost. If prices are falling , the results from the use of FIFO and average-cost are reversed. FIFO will report the lower net income and average-cost the higher.

48. Cont’d… To management, higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher . Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO because it results in higher net income .

49. A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost . A major shortcoming of the average-cost method is that in a period of inflation, the costs allocated to ending inventory may be understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior accounting periods. Statement of Financial Position Effect

50. Both inventory on the statement of financial position and net income on the income statement are higher when companies use FIFO in a period of inflation. Some companies use average-cost instead of FIFO. The reason is that average-cost results in lower income taxes (because of lower net income) during times of rising prices. TAX EFFECTS

51. Whatever cost flow method a company chooses, it should use that method consistently from one accounting period to another. This approach is often referred to as the consistency concept , which means that a company uses the same accounting principles and methods from year to year . Consistent application enhances the comparability of financial statements over successive time periods. Using Cost Flow Methods Consistently

52. In contrast , using the FIFO method one year and the average-cost method the next year would make it difficult to compare the net incomes of the two years . Although consistent application is preferred, it does not mean that a company may never change its inventory costing method. When a company adopts a different method, it should disclose in the financial statements the change and its effects on net income. Cont’d…

53. When the value of inventory is lower than its cost companies must “write down” the inventory to its net realizable value . Net realizable value : Amount that a company expects to realize (receive from the sale of inventory). Lower-of-Cost-or-Net Realizable Value

54. Illustration: Assume that Gao TV has the following lines of merchandise with costs and market values as indicated. Computation of lower-of-cost-or-net realizable value Cont’d

55. Estimates the cost of ending inventory by applying a gross profit rate to net sales. Gross Profit Method Illustration: Gross profit Method Formulas Estimating Inventories 55 Fundamentals of Acc II: By Alemayo S.

56. Illustration: Kishwaukee Company’s records for January show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. The company expects to earn a 30% gross profit rate. Compute the estimated cost of the ending inventory at January 31 under the gross profit method. Illustration: Example of Gross Profit Method Cont’d 56 Fundamentals of Acc II: By Alemayo S.

57. Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost. Retail Inventory Method Illustration 6B-3: Retail Inventory Method Formulas 57 Fundamentals of Acc II: By Alemayo S.

58. Note that it is not necessary to take a physical inventory to estimate the cost of goods on hand at any given time. Cont’d Illustration; A pplication of Retail Inventory Method 58 Fundamentals of Acc II: By Alemayo S.

59. The End of Chapter 1 Thank You!!! 59 Fundamentals of Acc II: By Alemayo S.