Acct 230 1st Edition Lecture 20 Outline of Last Lecture I Inventory and Cost of Goods Sold a Recording Inventory Transactions Outline of Current Lecture II Inventory and Cost of Goods Sold a Lower of cost or market method Current Lecture III Lower of Cost or Market Method a Apply the lower of cost or market method for inventories i In other words what is the cost to replace the inventory item in its identical form The cost of inventory is the amount initially recorded in the accounting records based on methods we discussed in the previous section specific identification FIFO LIFO or weightedaverage cost Once it has determined both the cost and market value of inventory the company reports ending inventory in the balance sheet at the lower of the two amounts This is known as the lower ofcost or market LCM method to valuing inventory ii To see how we apply the lower of cost or market method to inventory amounts assume Mario s Game Shop sells FunStation 2 and FunStation 3 iii Calculating the Lower of Cost or Market 1 The write down of inventory has the effect not only of reducing total assets but also of reducing net income and retained earnings 2 FunStation 3 inventory on the other hand remains on the books at its original cost of 8 000 400 x 20 since cost is less than market value Mario s doesn t need to make any adjustment for these inventory items 3 After adjusting inventory to the lower of cost or market the store calculates its ending inventory balance 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 b Analyze management of inventory using the inventory turnover ratio and gross profit ratio i Inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period The more frequently a business is able to sell or turn over its average inventory balance the less the company needs to invest in inventory for a given level of sales Other things equal a higher ratio indicates greater effectiveness of a company in managing its investment in inventory 1 Inventory Turnover Ratio Cost of Goods Sold Average Inventory 2 Average Days in Inventory 365 Inventory Turnover Ratio ii Analyze the inventory of Best Buy and Radio Shack Corporation 1 We can analyze the inventory of Best Buy and Radio Shack Corporation by calculating these ratios for both companies 2 Best Buy sells a large volume of commonly purchased products 3 Radio Shack sells a variety of high end specialty products including electronics toys and other home and personal care products that typically are not carried by most other retailers 4 Below are relevant amounts for each company iii Computation of Gross Profit Ratio 1 The gross profit ratio measures the amount by which the sale price of inventory exceeds its cost per dollar of sales The higher the ratio the higher is the markup a company is able to achieve on its inventories a Gross Profit Ratio Gross Profit Net Sales c Record inventory transactions using a periodic inventory system i Recall that under a perpetual inventory system we maintain a continual or perpetual record of inventory purchased and sold In contrast using a periodic inventory system we do not continually modify inventory amounts Instead we periodically adjust for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand ii Comparing Perpetual and Periodic inventory system Inventory Purchase and Sales 1 Transaction on April 25 involves the purchase of 2 700 of inventory on account Under the periodic system instead of debiting the inventory account we debit a purchases account 2 Remember we re not continually adjusting the inventory account under the periodic method We use the purchases account to temporarily track increases in inventory 3 Transaction on July 17 involves the sale on account of 300 units of inventory for 4 500 4 Notice that under the periodic system we record the revenue earned but we don t record the reduction in inventory or the increase in cost of goods sold at the time of the sale Instead we will record these at the end of the period 5 Final two transactions are 6 The purchase of 600 additional units of inventory for 6 600 on account on October 19 and 7 The sale of 500 units for 7 500 on account on December 15 iii Comparing Perpetual and Periodic inventory system Freight charges Purchase discounts and returns 1 On April 25 Mario pays freight charges of 300 for inventory purchased on April 25 2 On April 30 Mario pays for the units purchased on April 25 less a 2 purchase discount 3 On October 22 Mario returns 50 defective units from the October 19 purchase 4 Freight Charges Under the perpetual system discussed in the chapter we saw that freight charges are included as an additional cost of inventory Here we ll see that under the periodic system we record these charges in a separate account called Freight in 5 Purchase discounts and returns Under the perpetual system purchase discounts and purchase returns are recorded as a reduction in inventory cost Under the periodic system these transactions are recorded in separate accounts Purchase Discounts and Purchase Returns 6 In the perpetual system we credit purchase returns and purchase discounts to Inventory The purchase returns and purchase discounts accounts used in the periodic system are referred to as contra purchases accounts iv Comparing Perpetual and Periodic inventory system Period End Adjustment 1 A period end adjustment is needed only under the periodic system 2 Adjusts the balance of inventory to its proper ending balance 3 Records the cost of goods sold for the period to match inventory costs with the related revenues 4 Closes or zeros out the temporary purchases accounts Purchases Freight in Purchase Discounts and Purchase Returns 5 Notice that 1 the balance of inventory is updated for its ending amount of 1 650 while its beginning balance of 700 is eliminated 2 cost of goods sold is recorded for 8 046 and 3 temporary accounts related to purchases are closed to zero 6 If you look carefully you may notice that the amount of cost of goods sold above calculated under the periodic system is the same as that calculated under the perpetual system 7 The periodic system and perpetual system will always produce the same amounts for cost of goods sold and inventory when the FIFO inventory method is used d Determine the financial