PRINCIPLES OF FINANCIAL ACCOUNTING

1. PRINCIPLES OF FINANCIAL ACCOUNTING CHAPTER 6

2. INVENTORY SYSTEMS • Periodic Inventory System • No attempt is made to account for the cost of the merchandise at the time of sale. • Cost of goods sold is computed only at period end. • Perpetual Inventory System • Cost of goods sold is accounted for every time a sale is recorded.

3. Periodic Inventory • Entry to record the purchase of an item that cost $500 on account • + Purchases (dr) 500 • + Accounts Payable (cr) 500 • Entry to record the sale of that item for $800. • +Accounts Receivable (dr) 800 • +Sales (cr) 800 • Note – no entry is made for the cost of goods sold at this time.

4. Periodic Inventory (cont) • To calculate the cost of goods sold for the period a physical inventory must be taken. • Calculation: • Beginning Merchandise Inventory • Plus Net Purchases • Plus Freight In • Minus Ending Merchandise Inventory • Refer to example on page 253

5. Perpetual Inventory • Entry to record the purchase of a item for $500 on account: • Merchandise Inventory (dr) 500 • Accounts Payable (cr) 500 • Entries to record the sale of the item for $800 • Accounts Receivable (dr) 800 • Sales (cr) 800 • Cost of goods sold (dr) 500 • Merchandise Inventory (cr) 500

6. Cost Flow Assumptions(Periodic) • FIFO (refer to example on page 256) • In times of steady price increases: • Net income will be higher than the other methods • Asset valuation on the balance sheet will be higher • LIFO (refer to example on page 257) • In times of steady price increases: • Net income will be lower than the other methods • Asset valuation on the balance sheet will be lower.

7. Cost Flow Assumptions (Cont)(Periodic) • Average cost (also called weighted average) • Refer to example on page 259 • In times of steady rising or falling prices • Net income will fall between LIFO and FIFO • Asset valuation on the balance sheet will fall between LIFO and FIFO

8. Advantage of LIFO • Lower reported earnings means lower taxable income reported, hence lower taxes (temporarily). • Closer matching of current cost with current revenues.

9. Disadvantages of LIFO • Lower reported earnings – shareholder’s may be dissatisfied with management. • Lower asset valuation causes a lower current ratio and working capital. • LIFO layer erosion could cause earnings catch up at a bad time or can permit manipulation of income.

10. LOWER OF COST OR MARKET • Departs from the Cost Principle. • The conservatism concept dictates that “when in doubt, avoid overstating assets and income.” • Therefore, if inventory has lost value below cost, then you must write down the inventory to the price you believe you can sell the item.

11. Inventory Ratios • Inventory Turnover Ratio: • Cost of Goods sold/Average inventory • Days in inventory • 365/Inventory turnover ratio

12. Appendix 6A • Perpetual cost flow • FIFO the same whether using perpetual or periodic • LIFO • Must analyze the date of each sale and purchase • Refer example on page 273 • Average cost (also called moving average) • Must recompute the average cost per item every time you have a purchase. • Refer to example on page 273