INTERMEDIATE ACCOUNTING 1 FAR CHAPTER 10 KEY TERMS INVENTORY COST FLOW NOTES / DRAWINGS Inventories - Assets for sale in the ordinary course of business Goods purchased and held for resale Finished goods Goods in process Materials and supplies for production Goods includible in the inventory - All goods which the entity has title shall be included in the inventory regardless of location a. Goods owned and on hand b. Goods in transit (sold FOB destination and purchased FOB Shipping Point) c. Goods out on consignment d. Goods in the hands of salesmen or agents e. Goods held by customers on approval or on trial *Actually, goods under installment are still the property of the seller and therefore normally includible in his inventory because the title only passes to the buyer upon payment of the full price (if following the legal test) HOWEVER, Installment sale shall be treated as a “regular purchase” on part of the buyer and the BUYER SHALL ACCOUNT FOR THE INVENTORY PURCHASED UNDER INSTALLMENT SALE (following the economic substance over form - an exception to Legal Test) Who is the Owner of Goods in Transit? FOB Destination = Seller FOB Shipping Point = Buyer Freight Terms Freight Collect = actually paid by the buyer upon receipt Freight Prepaid = actually paid by the seller upon shipment Consigned Goods - Shall be includible in the consignor’s inventory Freight and other handling charges on goods out on consignment are part of the COG Consigned Methods of Recording Purchases Inventories are generally classified as CURRENT ASSETS presented as one line item in the statement of financial position but the details of the inventories shall be disclosed in the notes to financial statements When PERPETUAL SYSTEM is used, a physical count of the units on hand should at least be made once a year INVETORY SHORTAGE is usually closed to COGS because this is often the result of normal shrinkage and breakage ABNORMAL and MATERIAL SHORTAGE shall be separately classified and presented as “OTHER EXPENSE” TRADE DISCOUNT are deductions from the list or catalog price to arrive at the invoice price. This is NOT RECORDED CASH DISCOUNTS are deductions from invoice price when payment is made within the discount period. There are RECORDED as “Purchase Discount” – buyer and “Sales Discount”- Seller PURCHASE DISCOUNT is deducted from purchases to arrive at net purchases SALES DISCOUNT is deducted from sales to arrive at net sales 1. Gross Method – violates matching principle but is more convenient 2. Net Method – represent theoretically correct historical cost INTERMEDIATE ACCOUNTING 1 FAR CHAPTER 10 INVENTORIES Cost of Inventories Costs EXCLUDED from cost of Inventories cont. Cost of Purchase o Purchase price o Import duties o Irrecoverable taxes o Freight o Handling and other cost directly attributable to acquisition o Trade discounts, rebates and other similar items are deducted in determining the cost of purchase o The cost of purchase shall not include foreign exchange differences o When inventories are purchased with deferred settlement terms, the difference between the purchase price for normal credit terms and the amount paid is recognized as INTEREST EXPENSE over the period of financing Cost of Conversion o Direct Labor o Direct Materials o Manufacturing Overhead Other cost incurred in bringing the inventories to their present location and condition o Cost of designing product for specific customers ABNORMAL amounts of wasted manufacturing costs (expensed) Storage costs, unless these are necessary in production process o Goods in process = capitalized o Finished goods = expensed Administrative overheads that do not contribute to bringing the inventories to their present location and condition Distribution or selling costs INTERMEDIATE ACCOUNTING 1 FAR CHAPTER 11 KEY TERMS COST OF INVENTORIES: *FIFO *Weighted Average INVENTORY COST FLOW NOTES / DRAWINGS - favors financial position because inventory is stated at current replacement cost improper matching of cost against revenue resulting in understatement of CoS results to HIGHEST INCOME during period of INFLATION, and vice versa results to the same amount In both Periodic and Perpetual inventory system * Periodic Average Unit Cost = Total Cost of TGAS/Total Units of TGAS * Perpetual (Moving Average Method) Average Unit Cost = computer after every purchase and purchase return - produces inventory valuation that approximates current value if there is a rapid turnover of inventory - there may be a considerable lag between the current cost and inventory valuation since the average unit cost involved early purchases *LIFO - favors income statement because there is matching of current cost against current revenue - Not permitted by the standard because it permits income manipulation - differs in amount when using either Periodic or Perpetual inventory system - results to HIGHEST INCOME during period of declining prices, and vice versa *Specific Identification - specific costs are attributed to identified items of inventory - flow of inventory cost corresponds with the actual physical flow of goods, however it is very costly to implement even with high-speed computers Standard Costs - predetermined product costs and it is applied to all inventory movements such as inventories,TGAS, purchases, and WIP Relative Sales Price Method - when different commodities are purchases at a LUMP SUM, the single cost is allocated in PROPORITIONATE to SELLING PRICE INTERMEDIATE ACCOUNTING 1 FAR CHAPTER 12 LOWER OF COST AND NET REALIZABLE VALUE (LCNRV) KEY TERMS NOTES / DRAWINGS MEASURE OF INVENTORIES: - Inventories must be measured at LCNRV Net Realizable Value (NRV) = Est. Selling price – Est. cost of completion and disposal Circumstances wherein cost of inventories may not be recoverable a. damaged b. wholly or partially obsolete c. selling prices have declined d. est. cost of completion or est. cost of disposal has increased Therefore, the practice of writing inventories down below cost to NRV is consistent with the view that “assets shall not be carried in excess of amounts expected to be realized from their sale or use.” Determination of NRV Accounting for Inventory writedown Methods of accounting for inventory writedown - Inventories are written down to NRV on item by item or individual basis - It is not appropriate to write down inventories based on a classification of inventory, but it may be appropriate to group similar or related items Inventory writedown = Cost - LCNRV *If cost is lower - no accounting problem because inventory is measured at cost and the increase in value is not recognized *If NRV is lower - inventory is measured at NRV and decrease in value is recognized a. Direct Method (COGS method) - inventory is recorded at LCNRV - loss on inventory writedown is not accounted for separately but is charged in COGS b. Allowance method (Loss method) - inventory recorded at cost and any loss on inventory writedown is accounted for separately Loss on inventory writedown Allowance for inventory writedown xxx xxx - the allowance account is adjusted upward or downward depending on the difference between the cost and NRV at year-end * allowance increases = additional loss * allowance decreases = gain on reversal of inventory writedown is recorded (a reduction from COGS) - Gain is limited only to the extent of the allowance balance - Whether direct method or allowance method, the COGS must be the same INTERMEDIATE ACCOUNTING 1 FAR Chapter 12 LCNRV cont. Purchase Commitments - obligations to acquire certain goods in the future at fixed price and quantity - if there is a decline in purchase price after a purchase commitment has been made, a loss is recorded in the period of the price decline - purchase commitment must be noncancelable for a loss to be recognized Loss on purchase commitments(other expense) xxx Estimated liability for purchase commitment (liability) xxx Entry on the actual purchase: Purchases (contract or actual price whichever is lower) Loss on purchase commitment (credit if gain MP>CP) Est. Liability for purchase commitment Accounts payable (contract price) xxx xxx (other income) xxx xxx Agricultural, forest and mineral products Commodities of broker-traders - measured at NRV at certain stages of production: a. when sale is assured under a forward contract or government guarantee b. when a homogeneous market exists and there is a negligible risk of failure to sell - measured at fair value (FV) of an asset as the price that would be received to sell the asset in an orderly transaction between market participants INTERMEDIATE ACCOUNTING 1 FAR CHAPTER 13 KEY TERMS GROSS PROFIT METHOD NOTES / DRAWINGS 2 widely accepted procedures for approximating the value of inventory: 1) Gross profit method 2) Retail inventory method Common Reasons for making an estimate of the Cost of Goods on Hand a. inventory is destroyed by fire and other catastrophe, or theft b. physical count of the goods on hand is made and it is necessary to prove correctness (gross profit test) c. Interim financial statements are prepared and physical count is not necessary Gross profit method - based on the assumption that the rate of gross profit remains approximately the same from period to period and ratio of COGS to net sales is relatively constant from period to period Beginning Inventory Purchases Freight In Purchase Ret. & Allow. Purchase Discount TGAS COGS Ending Inventory xxx xxx xxx (xxx) (xxx) xxx xxx (xxx) xxx COGS Formula: *Based on Sales = Net sales x Cost Ratio *Based on COGS = Net sales/Sales Ratio Gross profit rate *Based on Sales = Gross profit/Sales *Based on COGS = Gross profit/COGS Cost to Sales % = GP %/ Sales % Sales to Cost % = GP %/ COGS % * gross profit rate ON SALES is the common way of quoting gross margin because goods are stated on a sale price basis, rather than on cost basis * it is naturally lower than that based on cost and this lower rate creates a favorable impression on the part of the customers *In computing “net sales”, only sales return is deducted from the gross sales *Sales allowance and Sales discount are ignored because even though they decrease the amount of sales, they do not affect the physical volume of goods sold so deducting these items would result to overstatement of inventory and gross income, and understatement of COGS INTERMEDIATE ACCOUNTING 1 FAR CHAPTER 14 KEY TERMS RETAIL INVENTORY METHOD NOTES / DRAWINGS - retail inventory method is often used in the retail industry for measuring inventory of large number of rapidly changing items with similar margin Information required in using retail inventory method a. Beginning inventory (at cost and retail) b. Purchases (at cost and retail) c. Adjustments to the original retail price (additional mark-up and cancelation, markdown and cancelation) d. Other adjustments (departmental transfer in and out, breakage, shrinkage, theft, damaged goods, employee discount) Cost ratio = TGAS at cost/ TGAS at SP TGAS at SP Net Sales (only deduct sales return) Ending Inventory at SP Multiply by cost ratio Ending Inventory at cost xxx xxx xxx % xxx TREATMENT OF ITEMS: a. Purchases: * * * * * discount return allowance Freight in Dept. Trans. In/Out - Deducted at cost Deducted at cost and retail Deducted at cost Added at cost Added/Deducted at cost and retail - Ignored Deducted from sales Added to sales - Deducted from TGAS at retail; added in sales Deducted from TGAS at cost and retail (recorded separately as loss); ignored - Records only up to mark-up and mark-up cancelation in computing for TGAS used in computing for Cost ratio (%); lower than average cost - Record up to mark-up and mark-down and its cancelation in computing for TGAS used in computing for Cost ratio (%) - Does not include beginning inventory in computing for TGAS used in computing for Cost ratio (%) b. Sales: * discount; allowance * return * employee discount c. Other adjustments - shortage, shrinkage, spoilage, breakage *Normal *Abnormal Approaches used in retail method: a. Conservative/ conventional/ LCNRV b. Average cost c. FIFO
