MANAGEMENT DECISIONS
AND FINANCIAL
ACCOUNTING REPORTS
Baginski & Hassell
Chapter 9
PREPARING FOR SALES
Acquiring Inventory and
Establishing Credit Policies
– Purchasing inventory (merchandising firms)
– Manufacturing inventory (manufacturing firms)
– Accounting for inventory:
• Accounts payable to vendors (financing
inventory).
• Sales of inventory.
• Accounts receivable from customers
(financing sales).
• Costing inventory remainders.
Inventory Concerns
Firms buy/manufacture inventory
as the critical part of strategic plans
to obtain revenues,but ...
• Storage costs are high.
• Sales are lost to competitors due to shortages.
• Management strategy to decide on the best mix of
inventory to maximize sales.
• Important factors: overall sales strategy, target
customers, distribution channels, pricing, credit
policy.
Basic Contrast
• Merchandising firms purchase completed
inventory units for markup and sale.
• Manufacturing firms purchase raw
materials and incur conversion costs
(direct labor and factory overhead).
Inventory Acquisition Cost
In theory, all costs of acquiring inventory
should be reflected in the inventory asset.
• Purchase invoice cost.
• Transportation-in.
• Miscellaneous costs (e.g., insurance and
taxes--according to some theorists).
Merchandising firms
Theoretically, all costs of acquiring inventory
should be capitalized as inventory cost
– Purchase cost
– Transportation cost
– Other costs of acquisition: e.g., insurance,
taxes, etc.
Manufacturing Cost
The Three Elements of
• Direct materials (purchase cost of raw
materials and freight-in, which become
physical components of the product).
• Direct Labor (salaries and wages of those
who physically process the product).
• Factory overhead (FOH): All costs
incurred in factory operations, other
than DL and FOH.
Purchase of Inventory (or Raw
Materials) on Credit
• Financing a purchase with an account
payable is like an interest free loan.
• Purchase returns and allowances reduce
the net cost of acquisition.
Purchase returns indicate items rejected
or unneeded for some reason, whereas
Purchase allowances indicate some
revision in initial cost or billings.
Purchase Discounts
(e.g., 2/10, n/30)
Purchase discounts ...
• Encourage early payment.
• Reduce the net cost of inventory.
• Create significant savings (a missed
purchase discount of just 2% to pay 20
days earlier than a due date equates to
suffering a 36% interest rate)!
Computation of Net Purchases
(in the Income Statement)
• Costs of Goods Sold disclosures:
– Purchases
– Less: Purchase discounts taken
– Less: Purchase returns and allowances
The exact location of subtotals in the
format is a matter of preference.
FAQ?
What happens if a firm presumes that the
purchase discounts will be taken, but
misses the deadline?
The check will be for the gross amount
billed and a Purchases Discounts Lost
account develops, which is an excellent
managerial aid since any balance this
account indicates problems.
Purchases ($750,000 × 97%)
Purchase returns and allowances
($25,000 × 97%)
Net purchases
ALTERNATIVELY:
Purchases
Purchase returns and allowances
Purchase discounts ($725,000 × 3%)
Net purchases
$727,500
(24,250)
$703,250
$750,000
(25,000)
725,000
(21,750)
$703,250
Determining Inventory Cost
• Two systems are used to track inventory
costs: periodic* and perpetual.
• In either system physical counts of
inventory often occur at year-end (or in
cycles) to add confidence in ending
inventory records.
* The
text examples use the periodic system to
simplify the computations.
FAQ?
Two companies are contrasted in the
following display of the Cost of Goods
Sold section of an Income Statement.
Which company is in manufacturing
(and what do the abbreviations
mean)?
Cost of Goods Sold
(Income Statement Displays)
Beginning Mdse.
+ Purchases
xx
xx
Beginning FinGoods xx
+C/G/Mfg’ed
xx
xx
xx
Goods available
for sale
– Ending FinGoods
xx
xx
Cost of goods sold xx
Cost of goods sold
xx
Goods available
for sale
– Ending Mdse.
Costing Inventory Remainders at
Fiscal Period End
Costs to be consistently assigned to ending
inventory is a function of the cost flow
assumptions used for homogeneous items:
• FIFO
• LIFO
• AVERAGES
– average cost figured periodically
– weighted (moving) average (perpetual data)
FAQ?
What about non-homogeneous items?
The presumption is that unique
items would be such that the
specific identification method
would apply (e.g., artworks, cars,
antiques, race horses). Individual
tagging of items, if practical!
Basic Cost Flow Assumptions
• FIFO (first-in, first-out): Units sold are
assumed to be first units purchased (ending
inventory = costs of the last purchases).
• LIFO (last-in, first-out): Units sold are assumed
to be last units purchased (ending inventory =
cost of the first units purchased).
• Average (periodic): Unit cost = [cost of
beginning inventory + cost of purchases]
divided by the total units involved; thus, ending
inventory = unit cost × units on hand!
Inflationary Trends Mean ...
• FIFO: Ending inventory is costed using
nearest-to-year-end replacement costs.
– Old [lower] costs were matched to sales, which
produces a “higher” reported gross profit.
• LIFO: Ending inventory is costed using
nearest-to-year-start (oldest) costs.
– New [higher] costs were matched to sales, which
produces a “lower” reported gross profit.
[Opposite results are reported during deflationary
times.]
FAQs?
Is LIFO common in international
business? Is LIFO, which is acceptable
per GAAP, also OK for income tax
purposes?
No. The U.S. is the only major country to
allow LIFO. As to taxes, if LIFO is used for
financial reporting purposes, the IRS
requires that it be used for tax purposes!
Example: Compute the Cost of
Ending Inventory (Remainders)
• Facts: Cannan Co. had beginning
inventory of 14,000 units purchased at $6
per unit, for a total opening cost of $84,000.
Annual inventory activity follows:
Transactions ...
Purchases
January 10
# Units
10,000
Unit
Cost
$7.00
June 15
15,000
8.00
120,000
8,000
8.50
68,000
December 1
Total
33,000
Total
Cost
$ 70,000
$258,000
Sales
February 15
May 1
October 1
December 15
Total
# Units
7,000
5,000
11,000
15,000
38,000
Sales
Price
$15
16
17
18
Total
Sales
$105,000
80,000
187,000
270,000
$642,000
Calculate ending inventory, cost of goods sold
and gross profit under three [periodic] methods:
LIFO, FIFO, Average.
Cost of Good Available for Sale?
• Solution:
– 47,000 units were available during the period
(14,000 beginning inventory + 33,000
purchased)
– 38,000 units were sold
– 9,000 units were in ending inventory
• Cost of goods available for sale = $84,000
of beginning inventory + purchases of
$ 258,000 = $ 342,000.
LIFO Assumption
• Ending Inventory = $54,000
The cost of the first 9,000 units purchased: 9,000
beginning inventory × $6
• Cost of Goods Sold = $288,000
Details: (8,000 × $8.50) + ($15,000 × $8) +
(10,000 × $7) + (5,000 × $6)
• Check: $54,000 + $288,000 = $342,000, the
cost of goods available for sale
FIFO Assumption
• Ending Inventory = $76,000
The cost of the last 9,000 units purchased:
(8,000 × $8.50) + (1,000 × $8)
• Cost of Goods Sold = $266,000
Details: (14,000 × $6) + (10,000 × $7) +
(14,000 × $8)
• Check: $76,000 + $266,000 = $342,000, the
cost of goods available for sale
Periodic Averaging
• Average Cost = $7.2766
$342,000 cost of goods available for sale
47,000 units available for sale
• Ending Inventory = $65,489
9,000 units × $7.2766
• Cost of Goods Sold = $276,511
38,000 units × $7.2766
• Check: $65,489 + $276,511 = $342,000, the
cost of goods available for sale
Weighted Moving Average Cost
An excellent alternative provides a
perpetual reading of the cost of
inventory on hand. After every
purchase, a new average is calculated
(based on the prior balance plus the
purchased items). Any items sold are
issued at the then-current average cost.
Comparative Results During Inflation
Balance Sheet
Ending Inventory (1)
Income Statement
Sales
CGS (2)
Gross Profit (3)
LIFO
FIFO
Average
54,000
76,000
65,489
642,000 642,000 642,000
288,000 266,000 276,511
$354,000 $376,000 $365,489
Comparative Results During Inflation
(1) In
a period of rising prices, LIFO has the smallest
ending inventory and FIFO the largest.
(2) In
a period of rising prices, LIFO has the largest
cost of goods sold and FIFO the smallest.
(3) In
a period of rising prices, FIFO has the largest
gross profit and LIFO has the smallest.
Dollar Value LIFO
EI @ current cost
Price Index
EI @ base year cost
Prior year EI @ base
2004
300,000
÷ 1.00
300,000
2005
451,000
÷ 1.10
410,000
2006
500,000
÷ 1.25
400,000
n/a
300,000
410,000
110,000
(10,000)
Current increase (decrease)
in base year costs
2004: 300,000 × 1.00 = 300,000
2005: 300,000 + (110,000 × 1.10) = 421,000
2006: 300,000 + (100,000 × 1.10) = 410,000
Balance Sheet Presentation Using an
LCM Adjustment!
• Inventory is often reported at the lower of
cost or market (LCM) to be conservative:
– Cost is initially determined by an
inventory cost method (specific
identification, LIFO, FIFO, Average)
– Market: Current replacement cost,
subject to the following constraints:
• Market cannot be more than a ceiling
amount, net realizable value (NRV).
NRV: Sales price minus cost to
complete and dispose of the item.
• Market cannot be lower than a floor
amount: NRV minus a NPM.
Using NPM, a normal profit margin, is
theoretically sound; it means that no profit is
recognized until a sale is made!
Example: Balance Sheet
Presentation of Inventory
Determine market value to be used in lower of
cost or market computation based on the
following assumed data.
Illustration: Deriving “Market” for LCM
Case
Ceiling(1)
R.C.(2)
Floor(3) Market(4)
A
$80
$60
$30
$60
B
80
45
30
45
C
80
90
30
80
D
80
90
30
80
E
80
25
30
30
Note: Designated market is the middle of the three
market values in all cases; it neither exceeds the
ceiling nor is lower than the floor
(1) Ceiling
(2) R.C.
= NRV
= Current replacement cost
(3) Floor
= NRV – NPM
(4) Designated
market used for computing
LCM by comparing market to cost.
Determining Lower of Cost or Market
Case
A
B
C
D
E
Designated
Market
$60
45
80
80
30
Cost (1)
$ 50
50
50
100
100
Balance Sheet
Valuation
$50
45
50
80
30
Determined by “regular” inventory costing
method (e.g., LIFO).
(1)
Decision to Extend Credit
• Companies decide to extend credit because
management believes it may increase
sales/profits, but ...
• Extending credit exposes a company to bad
debts.
• GAAP requires that potential bad debts be
estimated and reported (accrued):
– Two basic alternative methods:
• percent of sales (income statement
oriented)
• aging or similar technique (balance
sheet oriented)
Sales Discounts
(e.g., 2/10, n/30)
• Cash (sales) discounts are used to
encourage customers to pay in a
prompt and timely fashion!
– The net method records sales and accounts
receivable net of any proffered cash discounts
• This is the theoretically preferred method.
• The net method is conservative, but is
uncommon in practice.
Example: Sales on Account
• A company sells inventory with a cost of
$150,000 for $240,000, with terms 2/10, net
30:
– Customer is offered a 2% cash discount if paid
within 10 days.
– Sales and account receivable recorded at
$235,200 ($240,000 × 98%)
– If sales discount is not taken, the $4,800 would
be considered interest income.
Sales Returns
• Any Sales Returns by customers reduce
accounts receivable and are a part of the
calculation of net sales.
• An Allowance for Estimated Sales Returns
should appear on the Balance Sheet as a
contra asset. (Rare in practice!)
Bad Debts
The “direct write-off” method: No bad
debt is recognized until a specific
customer’s account is identified for a
write-off.
Unacceptable under GAAP!
Examples: Bad Debts Expense
• “Percent of credit sales” method
– The Spivey Co. believes that 4% of credit sales
will never be collected; Spivey
recorded $20,000,000 in credit sales
during the year.
• Spivey records $800,000 in bad debts
expense!
• Annual bad debts expense is the expectation
of uncollectible credit sales
• “Aging” (or similar) method
– The Landers Co. uses the aging method.
At year end, an aged analysis indicates
that $150,000 is a likely amount of
uncollectible receivables.
– The current balance in the allowance for
uncollectible accounts is $25,000 (credit).
• Landers increases the allowance by
$125,000, from $25,000 to $150,000.
– Focus is on the valuation of the asset
Using Accounts Receivable
to Increase Liquidity
(Borrowing Against Receivables or
Selling Receivables)
Borrowing using accounts receivable as
collateral
• Specific assignment (specific receivables are
designated as collateral)
• General assignment (all receivables are
designated as collateral)
Selling accounts receivable to a Factor
(Factoring):
• With recourse: If the receivables are not
collected, the factor can look to the
seller company for payment.
• Without recourse: If the receivables are not
collected, the factor cannot look to the
seller company for payment.
Short-Term Trade Notes Receivable
If accepted in return for sale of inventory, the
notes receivable are designated as Notes
Receivable - Trade in the Balance Sheet.
• Record at face value.
• Accrue interest revenue separately.
• The SCF reflects cash flows from trade
notes receivable under Operating
Activities.
Statement of Cash Flows:
Indirect Method
• The cash flows from selling inventory to
customers are Operating Activities, but
• The SCF using an indirect method is used
by many publicly traded companies.
• The indirect method starts with net income
then adjusts for certain items to
reconcile to cash flow from operating
activities
Categories of reconciling items in
indirect method for SCF:
• Noncash expenses and revenues.
• Non-operational gain and losses.
• Operational balance sheet accounts for
which cash basis accounting and accrual
basis accounting give differing results.
Indirect Method Adjustments
• Cash flow from operating activities
– Net Income
– Add (Deduct)
• Non-cash expenses (e.g., depreciation,
depletion, amortization) (1)
• (Non-cash revenues) (e.g., investment
income for securities accounted for under
the equity method) (1)
• Losses (gains) on sales(2)
• Decreases (increases) in operational
current assets and deferred income tax
assets (3)
• Increases (decreases) in operational
current liabilities and deferred income tax
liabilities (3)
• Net cash flows from operating activities
The indirect approach to the SCF is thought by
many to be somewhat difficult to interpret.
Documentation
(1)
Non-cash expenses and revenues affect net
income, but not cash.
(2) Gains and losses are non-operational in
nature for most companies.
(3) Reconciling items adjust from the accrual
basis effects, reflected in net income, to
the cash basis effects. (Deferred income
tax assets and liabilities are discussed in
Chapter 11.)
End of Chapter 9