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 Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.