FA

Inventory Valuation Methods

• Types of Methods:

  • FIFO (First In First Out):

  • Results in the lowest cost of goods sold (COGS), leading to the highest net income.

  • Preferred for showing strong financial performance to attract investors.

  • LIFO (Last In First Out):

  • Results in the highest COGS and hence the lowest net income.

  • Typically chosen by businesses looking to reduce tax liabilities.

  • Weighted Average Cost:

  • Less commonly used than FIFO and LIFO.

  • Specific Identification:

  • Used for specific inventory items, not frequently used by large scale operations.

• Market Trend Consideration:

  • In scenarios of rising costs (inflation):

  • FIFO maintains higher ending inventory and profitability.

  • LIFO results in lower net income.

  • In scenarios of falling costs:

  • The roles of FIFO and LIFO reverse.

  • LIFO would show lower COGS and higher inventory valuations when the most recently purchased items are the cheapest.

Inverse Relationship Between COGS and Ending Inventory

• Definition: COGS and ending inventory carry an inverse relationship.

  • Higher COGS results in lower ending inventory and vice versa.

  • This relationship is based on available for sale inventory principles.

Calculation and Recording of Inventory Costs

• Inventory Calculations:

  • Inventory is debited when purchased (increases assets).

  • COGS is recorded as inventory is sold (moving out of inventory).

• Methods of Calculation:

  • Periodic Method: Used for FIFO, LIFO, and Weighted Average Cost.

  • Involves calculating inventory costs at the end of the accounting period.

  • Perpetual Method: Used for journal entries involving updates on inventory with every sale or purchase.

  • More complex and not covered in introductory accounting courses.

Freight and Shipping Terminology

• FOB (Freight On Board): Determines ownership transfer.

  • Shipping Point: Buyer owns the goods in transit; risks of loss are on the buyer.

  • Destination: Seller maintains ownership until goods reach the destination; risks of loss are on the seller.

• Freight Costs:

  • Freight In: The shipping cost to bring inventory to the seller, part of inventory cost (debited to inventory).

  • Freight Out: Shipping cost to deliver goods to customers, recorded as an expense.

Purchase Discounts, Returns, and Allowances

• Recording Discounts and Returns:

  • Buyers utilize discounts, returns, and allowances directly impacting the inventory cost.

  • There is no separate account for purchases; adjustments are made directly to the inventory account.

  • Example: Credit inventory for purchase discounts or returns.

• Net Purchase Price Calculation:

  • Includes:

  • Sticker price

  • Sales tax

  • Freight in

  • Minus any discounts, returns, or allowances.

Journal Entry Example: Littleton Books

• Transaction Recording Example:

  • Date: May 2 - Purchased books worth $3,300 on account

  • Debit: Inventory $3,300

  • Credit: Accounts Payable $3,300

  • Date: May 3 - Paid cash for $200 freight costs

  • Debit: Inventory $200

  • Credit: Cash $200

  • Date: May 5 - Returned $400 worth of incorrect order

  • Debit: Accounts Payable $400

  • Credit: Inventory $400

  • Date: May 10 - Paid remaining amount (400) after discounts

  • Calculate if within discount terms: Eligible for 1% discount.

  • Debit: Accounts Payable $2,900, Credit Cash $2,871, Credit Inventory $29.

  • Date: May 30 - Sold books for $4,000 on account

  • Two Journal Entries Required:

    • Revenue Entry:

    • Debit: Accounts Receivable $4,000

    • Credit: Sales Revenue $4,000

    • Inventory Transfer:

    • Calculate COGS based on method used (FIFO, LIFO, etc.), credit inventory and debit COGS accordingly.

Inventory Impairment and Adjustment

• Recording Inventory Reductions:

  • Must evaluate inventory annually for market value declines.

  • Adjust inventory downward to reflect net realizable value (NRV) if lower than cost.

Inventory Errors

• Two Main Types of Inventory Errors:

  • Moving too much cost to COGS affects inventory and net income until corrected in future periods.

  • Adjustment must be made without altering future inventory values.

Multistep Income Statement Structure

• Purpose: Provides detailed presentation of income generated, allowing stakeholders to evaluate operational effectiveness.

• Format:

  • Header: Company Name, Report Title (Multistep Income Statement), and Date.

  • Sections:

  • Net Revenue – COGS = Gross Profit.

  • Gross Profit – Operating Expenses = Operating Income.

  • Operating Income – Other Expenses = Income Before Tax.

  • Income Before Tax – Income Tax = Net Income.

• Importance of Subtotals: Allows management to assess control over operational revenue versus fixed costs and taxes.