BUS103: Introduction to Financial Accounting

• Net income for an accounting period depends directly on the valuation of ending inventory.
• If ending inventory is overstated, cost of goods sold is understated, resulting in an overstatement of gross margin, net income, and retained earnings.
• When ending inventory is misstated in the current year, companies carry that misstatement forward into the next year.
• An error in the net income of one year caused by misstated ending inventory automatically causes an error in net income in the opposite direction in the next period because of the misstated beginning inventory.
• Inventory cost includes all necessary outlays to obtain the goods, get the goods ready to sell, and have the goods in the desired location for sale to customers.
• Inventory cost includes:
  1. Seller's gross selling price less purchase discount.
  2. Cost of insurance on the goods while in transit.
  3. Transportation charges when borne by the buyer.
  4. Handling costs, such as the cost of pressing clothes wrinkled during shipment.
• Specific identification: Attaches actual cost of each unit of product to units in ending inventory and cost of goods sold. Specific identification creates precise matching in determining net income.
• FIFO (first-in, first-out): Ending inventory consists of the most recent purchases. FIFO assumes that the costs of the first goods purchased are those charged to cost of goods sold when goods are sold. During periods of rising prices, FIFO creates higher net income since the costs charged to cost of goods sold are lower.
• LIFO (last-in, first-out): Ending inventory consists of the oldest costs. LIFO assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold. Net income is usually lower under LIFO since the costs charged to cost of goods sold are higher due to inflation.

The ending inventory may differ between perpetual and periodic inventory procedures.

• Weighted-average: Ending inventory is priced using a weighted-average unit cost. Under perpetual inventory procedure, a new weighted-average is determined after each purchase. Under periodic procedure, the average is determined at the end of the accounting period by dividing the total number of units purchased plus those in beginning inventory into total cost of goods available for sale. In determining cost of goods sold, this average unit cost is applied to each item. Under the weighted-average method, in a period of rising prices net income is usually higher than income under LIFO and lower than income under FIFO.
• Specific identification: Advantages: (1) States cost of goods sold and ending inventory at the actual cost of specific units sold and on hand, and (2) provides the most precise matching of costs and revenues. Disadvantage: Income manipulation is possible.
• FIFO: Advantages: (1) FIFO is easy to apply, (2) the assumed flow of costs often corresponds with the normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for inventory is likely to approximate the current market value. Disadvantages: (1) Recognizes paper profits, and (2) tax burden is heavier if used for tax purposes when prices are rising.
• LIFO: Advantages: (1) LIFO reports both sales revenue and cost of goods sold in current dollars, and (2) lower income taxes result if used for tax purposes when prices are rising. Disadvantages: (1) Often matches the cost of goods not sold against revenues, (2) grossly understates inventory, and (3) permits income manipulation.
• Weighted-average: Advantages: Due to the averaging process, the effects of year-end buying or not buying are lessened. Disadvantage: Manipulation of income is possible.
• Perpetual inventory procedure requires an entry to Merchandise Inventory whenever goods are purchased, returned, sold, or otherwise adjusted, so that inventory records reflect actual units on hand at all times. Thus, an entry is required to record cost of goods sold for each sale.
• Companies should not carry goods in inventory at more than their net realizable value. Net realizable value is the estimated selling price of an item less the estimated costs incurred in preparing the item for sale and selling it. Inventory items are written down to market value when the market value is less than the cost of the items. If market value is greater than cost, the increase in value is not recognized. LCM may be applied to each inventory item, each inventory class, or total inventory.
• The steps in calculating ending inventory under the gross margin method are:
  1. Estimate gross margin (based on net sales) using the same gross margin rate experienced in prior accounting periods.
  2. Determine estimated cost of goods sold by deducting estimated gross margin from netsales.
  3. Determine estimated ending inventory by deducting estimated cost of goods sold from cost of goods available for sale.

• The retail inventory method estimates the cost of the ending inventory by applying a cost/retail price ratio to ending inventory stated at retail prices. To find the cost/retail price ratio, divide the cost of goods available for sale by the retail price of the goods available for sale.

$\text { Inventory turnover ration }=\frac{(\text { Cost of goods sold })}{(\text { Average inventory })}$

• Inventory turnover measures the efficiency of the firm in managing and selling inventory. It gauges the liquidity of the firm's inventory.