ACCTG 211 1st Edition Lecture 9 Outline of Last Lecture II Financial Statement Flow on Inventory III The Inventory Roll forward IV Inventory Cash Flow Assumptions V Financial Statement Flow on Inventory VI Two key questions VII FIFO LIFO Average Cost Flow Example Outline of Current Lecture I Cost Flow Accounting Methods II Transportation Costs III Purchase Discounts IV Effects of Inventory Errors V Valuation Costs VI Gross Profit Method Current Lecture I Important Items from Unit 4 a Financial Statement Flow of Inventory i Appears first on the Balance Sheet then transferred to Income Statement as Inventory is sold b Inventory Cost Flow Assumptions i Specific ID FIFO LIFO Weighted Average Cost ii Remember companies may use any cost flow assumption regardless of what they use for the physical flow of inventory in the business c Ending Inventory and COGS Periodic vs Perpetual Methods i Be ready for FIFO LIFO Weighted Average Cost via Periodic Method ii Only LIFO and FIFO for Perpetual Method d Lower of Cost or Market i Conservatism compare then take the lower value to the Balance Sheet ii Replacement Cost is often used as market value for comparison These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute II III e Gross Profit Method of Estimating Ending Inventory i Often used in interim reporting periods or for insurance purposes ii Makes use of gross profit percentage to estimate COGS which is then used to estimate Ending Inventory f FOB Related Charges i Determine who owns the inventory when it is in transit ii Freight In account used by buyer to capitalize FOB related charges iii Freight Out account used by seller to expense FOB related charges g Discounts i Offered to increase speed with which cash is collected h Effect of Inventory Errors i Inventory errors affect two financial statements B S and I S in two different accounting periods ii Overstated Understated COGS and Overstated Understated Inventory Reasons for using different styles of Cost Flow Accounting methods a FIFO Ending Inventory more closely approximates the replacement cost of the inventory i Thus the most recent costs are included in the ending inventory balance a more realistic balance sheet b LIFO COGS more closely approximates the replacement cost of the inventory i Thus the most recent costs are included in the COGS and Gross Profit a more realistic income statement c Ave Cost Smooth out price fluctuations presenting a balance between favoring either the balance sheet or income statement Transportation Costs a Question Does GAAP allow companies to capitalize the costs of shipping Inventory i FOB free on board is a shipping term that indicates the point in the shipping process where legal title of merchandise passes from the seller to the buyer b Example We own an import business and we purchase goods from China to be sold in the United States The goods will be shipped from Hong Kong to New York i If ownership of the merchandise passes to the buyer at the point of origin i e Hong Kong the shipping terms are said to be FOB free on board shipping point ii If ownership of the merchandise passes to the buyer at the point of delivery i e New York the shipping terms are said to be FOB free on board destination point iii Who buyer or seller owns the inventory while it is in transit under each case IV V 1 For FOB shipping point shipments a Buyer owns inventory while in transit b Buyer pays for the shipping costs c Buyer capitalizes the shipping costs in an account called freight in which is a sub account of inventory 2 For FOB destination point shipments a Seller owns inventory while in transit b Seller pays for the shipping costs c Seller expenses the shipping costs in an account called freight out which is an operating expense but who do you think really pays for the shipping costs Purchase Discounts a Purchase Discounts Discount Percent Discount Period i Otherwise Net All in this case is due at the end of the Credit Period credit period b c Purchase discount is an offer from the supplier to the purchaser For example a purchaser bought a 100 item with a purchase discount term 3 10 net 30 If he pays within 10 days he will only need to pay 97 Effect of Inventory Errors a Examples of Inventory Errors i Physical count errors ii Accounting errors b Inventory Errors Affect Balance Sheet and Income Statement in Two Different Accounting Periods i Trace through effects from Inventory to COGS to Net Income to Retained Earnings c EXAMPLE Inventory Overstated i Often the result of double counting inventory but may be due to another factor such as forgetting to decrease inventory when a sale is made May also be due to an erroneous capitalization of FOB related charges ii The inventory is higher than it should be so we assume that we sold fewer units Therefore Expenses are understated COGS is understated iii Net Income is then overstated iv Retained Earnings is then overstated v Owner s equity is then overstated vi Assets are also overstated Inventory which balances out the A L E equation d EXAMPLE Inventory Understated i Often the result of under counting inventory but may be due to another factor such as recording the same sale of inventory twice May also be due to forgetting to capitalize FOB related charges VI VII ii The inventory is lower than it should be so we assume that we sold more units Therefore Expenses are overstated COGS is overstated iii Net Income is then understated iv Retained Earnings is then understated v Owner s equity is then understated vi Assets are also understated Inventory which balances out the A L E equation Valuation Lower of Cost or Market a Lower of Cost or Market i Comparison performed for each inventory item ii Cost is FIFO LIFO Ave Cost ending inventory value from the inventory cost flow calculations iii Market is the item s current market value iv For spoiled or obsolete inventory market 0 b EXAMPLE i At the end of 2008 Yard Town had 200 hoses in inventory with a recorded cost of 6 00 each The cost to replace each hose just dropped to 5 00 each 1 Cost is 1 200 2 Market is 1 000 3 The write down is 200 and you should put in your accounting records that you have 1 000 in inventory 4 Write down is an asset a 200 5 Retained Earnings is part of Shareholder s Equity a 200 Gross Profit Method of estimating Ending Inventory a Gross Profit Sales COGS Sales b Why would we estimate ending inventory i