Financial Accounting
A Decision-Making Approach, 2nd Edition
King, Lembke, and Smith
*
Prepared by
Dr. Denise English,
Boise State University
John Wiley & Sons, Inc.
CHAPTER
NINE
PREPAID EXPENSES
AND INVENTORIES
After reading Chapter 9, you should be able to:
1. Describe the role that nonfinancial assets held by businesses
play in operations.
2. Identify the different methods used to value nonfinancial assets,
and describe how the different methods relate to the types of
decisions made.
3. Explain how the matching concept is applied to accounting and
reporting for nonfinancial assets, and why this is important for
decision making.
4. Describe prepaid expenses and how they relate to decision
making.
5. Describe the methods used to value and account for
inventories, and explain how they help decision makers better
assess a company’s activities and financial position.
Nonfinancial Assets




Nonfinancial assets are either held for sale to others
in the normal course of business or used in the
company’s operations.
Nonfinancial assets include all assets except cash,
receivables, and investments .
Most nonfinancial assets are tangible except those
that are purchased rights.
Nonfinancial assets are sold, consumed, or used in
operations and may be either current, or noncurrent,
depending upon length of useful life and management
intent.
Nonfinancial Assets and their Valuation
___
Asset
Prepaid expenses
Inventory
Tangible operating assets:
Land
Buildings
Equipment
Furniture and Fixtures
Intangibles:
Research and development costs
(not treated as an asset)
Other intangibles
Valuation Basis
_
Cost not yet allocated
Cost or market value, whichever is lower
Cost
Cost not yet allocated
Cost not yet allocated
Cost not yet allocated
None (cost is expensed as incurred)
Cost not yet allocated
Reporting Nonfinancial Assets:
The Matching Concept Applied



Costs that are expected to provide future benefits are
reported as assets in the balance sheet.
These costs are then transferred from the balance sheet
to the income statement as expenses in the period in
which associated benefits are received.
Two questions arise:
– What is the proper acquisition cost?
– How does a proper matching of expense with benefit
take place?
How
much?
Determining Cost
Costs incurred in acquiring, locating, and preparing
the asset for its intended use are legitimate to
include, such as:
–
–
–
–
–
–
Invoice price or the amount billed the purchaser;
Discount reductions must be removed from cost;
Freight charges to get the asset in the proper location;
Manufacturing costs if the asset is made or modified;
Preparation costs to ready the asset for use;
Transfer costs to convey legal possession.
Matching Costs and Benefits


Once the purchase of a nonfinancial asset is
recorded, the cost is treated in accordance with
the matching concept.
The original cost is an asset, and as the asset
provides benefits, the cost is recognized as
expired as an expense on the income
statement.
Allocating Costs:
The Matching Process
Transaction
1) Inventory
Purchase inventory
on account
Sell inventory
on account
2) Prepaid Insurance
Purchase insurance
Insurance coverage
for period
3) Equipment
Purchase equipment
Use equipment
during period
Balance Sheet Effect
Increase inventory
Increase accounts payable
Increase accounts receivable
Decrease inventory
EXHIBIT 9-1
Income Statement Effect
Increase sales
Increase cost of goods sold
Increase prepaid insurance
Decrease cash
Decrease prepaid insurance
Increase insurance expense
Increase equipment
Decrease cash
Increase accumulated
depreciation
Increase depreciation expense
Prepaid Expenses and Supplies




Prepaid expenses are future operating costs that have
already been paid, but for which benefits will be received
in future periods.
Common examples are payments made in advance for
rent, insurance, and supplies.
As the benefit is received and the future service potential
of the cost expires, cost is transferred from an asset
(unexpired cost) in the balance sheet, to an expense
(expired cost) in the income statement.
Prepaid expenses are usually current assets related to
relatively short periods of time; deferred charges may
include long-term prepayments of expenses.
Inventories



Inventory is merchandise or product either
manufactured or purchased for sale to
customers.
Inventory stockout risk must be balanced
against the high costs of carrying inventory.
Just-in-time inventory methods minimize
inventory carrying costs by taking delivery of
inventories almost at the moment they are
needed.
Balancing Inventory Carrying
Costs Against Lost Sales
$
Lost
Sales
$
Carrying
Costs
Exhibit 9-2
Inventory Evaluation Measures
If inventory is not sold efficiently, it will become less
valuable or perhaps obsolete. Inventory turnover
is one indicator of a company’s efficiency with
respect to inventory sales. It is calculated as:
Inventory turnover
Cost of Goods Sold
$3,000,000
= ---------------------------- = ---------------- = 3.0
Inventory Balance
$1,000,000
The higher the turnover ratio, the more efficient is
inventory management.
Inventory Evaluation Measures
A company’s gross profit, or gross margin, is equal to its
sales revenue minus its cost of goods sold. Gross profit
percentage can be compared to previous years’
percentages or for other companies in the same industry.
A low gross profit percentage could suggest that inventory
acquisition or manufacturing costs are too high, or markup
to sales price is too low. It is computed as follows:
Gross Profit
Percentage
=
Gross profit
---------------Net sales
=
$2,000,000
--------------- = 40%
$5,000,000
How
much?
Valuation of Inventories



Inventory is generally valued initially at cost.
Through the matching concept, inventory cost is
matched with the benefits it provides by recognizing
sales revenue and the related cost of goods sold in
the income statement in the same period.
Two questions arise:
–
–
When inventory’s cost varies, what is the proper cost of
goods sold at the time of sale?
As a significant nonfinancial asset, is cost the best
valuation for decision making purposes?
How
much?
Determining Inventory Cost

Inventory’s cost should include all amounts spent by
the company to acquire that inventory, including:
– Shipping charges borne by the purchasing
company;
– Costs of preparing the inventory for sale, such as
packaging;
– Interest charges incurred when constructing
inventory over a long period of time; interest costs
when inventory is acquired on credit should be
expensed.
How
much?
Valuing Inventory
on the Balance Sheet
Because inventory is held for sale, market value is
relevant to decision makers and is provided on the
balance sheet using the lower-of-cost- or-market rule,
as follows:
- market value is the replacement cost of the inventory;
- inventory cannot be valued higher than realizable value,
or anticipated selling price;
- original cost is compared to these other two values, and
- inventory is valued at the lowest of these three
amounts, either on a unit, inventory category, or whole
inventory basis.
Assigning Costs to Inventory
As groups of inventory are acquired and sold, two
primary approaches are used to assign costs to
inventory:
1) Specific identification: costs of inventory units
(typically of small number and high value) are tracked
by the accounting system. The use of automation like
scanners and bar coding assist in tracking units of
inventory.
2) Cost flow assumptions: costs of inventory units
(typically of high number and low value) are assumed
based upon GAAP (generally accepted accounting
principles).
Cost Flow Assumptions
Inventory consisting of a large number of similar, relatively smallvalue items requires that a cost flow assumption be used to
assign costs to ending inventory and to cost of goods sold. The
assumption does not necessarily follow the physical flow of
inventory. The most common cost flow assumptions are:
1) Average cost--costs of different purchases are averaged,
weighted by the quantity purchased at various prices, to
determine a weighted average cost per unit.
2) First-in, first-out (FIFO)--costs of the first units purchased are
assigned to the first units sold.
3) Last-in, first-out (LIFO)--costs of the most recently purchased
units are assigned to the first units sold.
Effects of Cost
Flow Assumptions
Assuming that prices rise over time, the effects of
different cost flow assumptions are as follows:
Cost of
Net
Ending
Assumption Goods Sold
Income
Inventory
FIFO
lowest
highest
highest
LIFO
highest
lowest
lowest
Average cost
middle
middle
middle
___________________________________________
Inventory Cost Flow Example
Cost-Flo Co. makes the following purchases of
inventory during the year:
First purchase
Second purchase
Third purchase
Total
1,000 units @ $ 3.20 = $ 3,200
2,000 units @ $ 3.50 =$ 7,000
3,000 units @ $ 3.80 =$ 11,400
6,000 units
$ 21,600
=======
If 4,000 units are sold during the year, 2,000 units are still in
inventory at year end.
Inventory Cost Flow Example
The Average Cost Assumption would calculate
the average cost per unit of inventory as:
$21,600 / 6,000 units = $ 3.60 per unit
Cost of Goods Sold:
Ending Inventory:
4,000 units @ $3.60 = $14,400
2,000 units @ $3.60 = $ 7,200
6,000 units
$21,600
====
======
Inventory Cost Flow Example
The First-in, First-out (FIFO) Assumption would
calculate the costs of inventory sold and on hand
as:
Cost of Goods Sold
Ending Inventory
1,000 units @ $3.20 = $ 3,200
2,000 units @ $3.50 = $ 7,000
1,000 units @ $3.80 = $ 3,800
4,000 units
$14,000
2,000 units @ $3.80 = $ 7,600
6,000 units
$21,600
====
======
Inventory Cost Flow Example
The Last-in, First-out (LIFO) Assumption would
calculate the cost of inventory sold and on hand as:
Cost of Goods Sold
Ending Inventory
3,000 units @ $3.80 = $11,400
1,000 units @ $3.50 = $ 3,500
4,000 units
$14,900
1,000 units @ $3.50 = $ 3,500
1,000 units @ $3.20 = $ 3,200
2,000 units
$ 6,700
6,000 units
$21,600
====
======
Inventory Cost Flow Example
To summarize, the following comparison highlights the
quality of earnings differences that result simply because of
the choice of inventory cost flow assumption. LIFO leads to
lower income due to higher Cost of Goods Sold, and lower
ending inventory valuation.
Cost of
Ending
Assumption
Goods Sold
Inventory
FIFO
$14,000
$7,600
LIFO
$14,900
$6,700
Average cost
$14,400
$7,200
________________________________________
Accounting for Inventory Transactions
The way in which the cost of inventory moves through the
accounting system reflects the way it moves through a
business enterprise.
STORE
Beginning Inventory
Purchases
Total goods
available for
sale
Cost of Goods Sold
Ending Inventory
Two Types of Inventory Systems
1) With a Perpetual Inventory System, the company keeps
track of the cost of all purchases and sales of inventory as
they occur. These systems have become more affordable
with the aid of electronic tracking systems, such as bar-code
scanners.
To record the purchase at cost: To record the sale of inventory costing
$40,000 for $65,000:
Inventory(+)
100,000
Accounts Payable(+) 100,000 Accounts Receivable(+) 65,000
Sales Revenue(+)
65,000
Cost of Goods Sold(+) 40,000
Inventory(-)
40,000
Two Types of Inventory Systems
2) A Periodic Inventory System tracks inventory
purchases but not the cost of inventory sold. At periodend, inventory is determined through a physical count,
cost flow is assumed and applied, and adjusting entries
made to record the cost of inventory sold and to update
the inventory account balance. Cost of goods sold must
be computed as follows:
+
=
=
Beginning Inventory
Purchases of Inventory (tracked)
Total Goods Available for Sale
Ending Inventory (per physical count)
Cost of Goods Sold
Inventory Errors


Inventory errors can affect both the Income Statement and
the Balance Sheet and can extend over more than one
year.
A number of common errors can occur:
–
–
–
–
–
–
miscounting the inventory (perhaps due to poor controls)
failing to record a purchase in the proper year
overlooking or improperly counting inventory that is (is not)
company property
assigning the wrong costs to inventory
including damaged or obsolete inventory as if it were first-rate
including nonexistent inventory due to poor inventory management
Manufacturing Inventories
Manufacturing firms take raw materials, or
components, and make them into products that are
sold to customers. Therefore, several types of
inventory are held:
–
–
–
Raw Materials: the basic inputs to the manufacturing
process from which products are made
Work-in-Process: units of product that are partially
complete at financial statement date;
Finished Goods: units of completed product awaiting
sale to customers.
Accumulating Costs in a
Manufacturing Operation
Exhibit 9-3
Manufacturing labor
Cost
of
Goods
Sold
Purchases
Raw materials inventory
Other manufacturing costs
Work-inprocess
inventory
Finished Goods
Inventory
All costs directly or indirectly related to
production are considered part of the
cost of the inventory manufactured.
Copyright
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