ACCTG 211 1st Edition Lecture 9 Outline of Last Lecture II. Financial Statement “Flow” on InventoryIII. The Inventory Roll forwardIV. Inventory Cash Flow AssumptionsV. Financial Statement Flow on Inventory VI. Two key questionsVII. FIFO, LIFO, Average Cost Flow ExampleOutline of Current Lecture I. Cost Flow Accounting MethodsII. Transportation CostsIII. Purchase DiscountsIV. Effects of Inventory ErrorsV. Valuation CostsVI. Gross Profit Method Current LectureI. Important Items from Unit 4a. Financial Statement “Flow” of Inventoryi. Appears first on the Balance Sheet, then transferred to Income Statementas Inventory is soldb. Inventory Cost Flow Assumptionsi. Specific ID, FIFO, LIFO, Weighted-Average Costii. Remember: companies may use any cost flow assumption, regardless of what they use for the “physical flow” of inventory in the businessc. Ending Inventory and COGS: Periodic vs. Perpetual Methodsi. Be ready for FIFO, LIFO, Weighted-Average Cost via Periodic Methodii. Only LIFO and FIFO for Perpetual Methodd. Lower of Cost or Marketi. Conservatism – compare, then take the lower value to the Balance Sheetii. Replacement Cost is often used as “market” value for comparisonThese 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.e. Gross Profit Method of Estimating Ending Inventoryi. Often used in interim reporting periods or for insurance purposesii. Makes use of “gross profit percentage” to estimate COGS, which is then used to estimate Ending Inventoryf. FOB-Related Chargesi. Determine who owns the inventory when it is “in transit”ii. Freight-In: account used by buyer to capitalize FOB-related chargesiii. Freight-Out: account used by seller to expense FOB-related chargesg. Discountsi. Offered to increase speed with which cash is collectedh. Effect of Inventory Errorsi. Inventory errors affect two financial statements (B/S and I/S) in two different accounting periodsii. Overstated / Understated COGS and Overstated / Understated InventoryII. Reasons for using different styles of Cost Flow Accounting methodsa. 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 inventoryi. 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 statementIII. Transportation Costsa. 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?1. For FOB shipping point shipments:a. Buyer owns inventory while in transitb. Buyer pays for the shipping costsc. Buyer capitalizes the shipping costs in an account called “freight-in,” which is a sub-account of inventory2. For FOB destination point shipments:a. Seller owns inventory while in transitb. Seller pays for the shipping costsc. 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?)IV. Purchase Discountsa. Purchase Discounts: Discount Percent/Discount Period, i. Otherwise Net (All, in this case) is due at the end of the Credit Period/credit periodb.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. V. Effect of Inventory Errorsa. Examples of Inventory Errorsi. Physical count errorsii. Accounting errorsb. 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 Earningsc. EXAMPLE: Inventory Overstatedi. 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 Understatedi. 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.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.VI. Valuation: Lower of Cost or Marketa. Lower of Cost or Market:i. Comparison performed for each inventory itemii. “Cost” is FIFO / LIFO / Ave Cost ending inventory value from the inventorycost flow calculationsiii. “Market” is the item’s current market valueiv. For spoiled or obsolete inventory: market = $0b. EXAMPLEi. At the end of 2008, Yard Town had 200 hoses in inventory with a recordedcost of $6.00 each. The cost to replace each hose just dropped to $5.00 each.1. Cost is $1,2002. Market is $1,0003. The write down is $200 and you should put in your accounting