BA102A

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BA102A

• Inventory!
• Inventory!

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Why is inventory so important?

• It provides the main revenue for merchandising
  and manufacturing firms, and provides the largest
  cost on the Income Statement.
• It is hard to keep safe, and complex to account
  for.
• Errors in accounting for inventory can affect
  most of the financial statements, and will affect
  them for at least two years.

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Perpetual or Periodic Records?

• The Perpetual method keeps track of all changes
  in inventoryboth increases through purchases and
  decreases through salesas they occur.
• The Periodic method keeps track of inventory
  purchases as they occur, but periodically checks
  to see whats left and assumes whatever is not
  there any more has been sold.

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Perpetual Example

• Suppose on Monday you buy 1000 units for 2 each.
  Suppose you sell 200 units on Tuesday, 250 on
  Wednesday, 150 on Thursday, and 100 on Friday,
  all for 5 each. Then you will have this series
  of journal entries

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And your ledger accounts will look so
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But if you use the same example in the periodic
method, your journal entries will look so
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And your ledger accounts will look like this
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Notice

• Inventory does not have the correct ending
  balance
• Cost of Goods Sold is still zero
• There is a strange account called Purchases
  with a value in it.
• So.
• You need an ADJUSTING ENTRY to correct these
  accounts.

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In this case

• You will count the number of units left in
  inventory on Friday.
• Assuming we count 300 units of inventory on
  Friday, they would be valued at 2 x 300 600.
• So we need to record 600 in Inventory.
• If we had no units at the beginning of the
  period, bought 1000 units, and have 300 left, we
  must have sold 700 units, so Cost of Goods Sold
  would be 700 x 2 1400. We need to record
  this also.

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Here is the adjusting entry to record the correct
Inventory and Cost of Goods Sold

• Notice that you close the Purchases account. It
  is a temporary account, called a clearing
  account.
• You put the new value of Inventory into that
  account as a debit. If Inventory had a
  beginning balance for the period (rather than
  zero as in this example) you would credit
  Inventory for the beginning balance to remove it.
• You can write the COGS calculation as
• Beginning Inventory Purchases Ending
  Inventory COGS

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After the adjusting entry, your ledger accounts
look so
This ends up the same as the ledger accounts for
the Perpetual method.
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Inventory Valuation Methods

• This was a simple example.
• What would happen if, as often occurs in real
  life, you paid DIFFERENT amounts for your
  inventory?
• Then you would have to pick an inventory
  valuation method to decide which inventory items
  you sell in which order

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Suppose your example were more like this

• Suppose on Monday you buy 500 units for 2 each.
  Suppose you sell 200 units on Tuesday and 250 on
  Wednesday. Then you buy another 500 units on
  Thursday, but for 2.50 each, and you sell 150 on
  Thursday, and 100 on Friday. All sales are for
  5 each.
• Now the it is clear that the units you sold on
  Tuesday and Wednesday had to come from the Monday
  (2) purchases, but on Thursday you have 50 units
  left.
• So when you sell the 150 units on Thursday, are
  they all from Thursday (2.50) purchases, or do
  you use 50 units from Mondays purchase and 100
  units from Thursdays purchase, or some other
  combination?

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This is where you have to decide on an Inventory
Flow Assumption

• There are four inventory flow assumptions, or as
  we call them in accounting, inventory methods.
• First in, first out (FIFO)
• Last in, first out (LIFO)
• Average
• Specific identification
• The inventory method you use does NOT have to
  match the physical flow of inventory! This
  allows you to make assumptions about your
  inventory without having to keep track of
  individual items.

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Lets go back and look at the example again

• Suppose on Monday you buy 500 units for 2 each.
  Suppose you sell 200 units on Tuesday and 250 on
  Wednesday. Then you buy another 500 units on
  Thursday, but for 2.50 each, and you sell 150 on
  Thursday, and 100 on Friday. All sales are for
  5 each.
• Under FIFO you would assume this inventory cost
  flow
• Tuesday you sell 200 units that cost 2
• Wednesday you sell 250 units that cost 2
• Thursday you sell 50 units that cost 2 (to use
  up the first units in) and then you sell 100
  units that cost 2.50
• Friday you sell 100 units that cost 2.50
• That makes your Cost of Goods Sold for the week
  1,500, and your gross profit will be 3500-1500
  2000.
• Note that this will be the same whether you use
  Perpetual or Periodic inventory.

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And then using another method

• Suppose on Monday you buy 500 units for 2 each.
  Suppose you sell 200 units on Tuesday and 250 on
  Wednesday. Then you buy another 500 units on
  Thursday, but for 2.50 each, and you sell 150 on
  Thursday, and 100 on Friday. All sales are for
  5 each.
• Under Perpetual LIFO you would assume this
  inventory cost flow
• Tuesday you sell 200 units that cost 2
• Wednesday you sell 250 units that cost 2
• Thursday you sell 150 units that cost 2.50
  (because now the last things into your warehouse
  are the new costlier units)
• Friday you sell 100 units that cost 2.50
• That makes your Cost of Goods Sold for the week
  1,525, and your gross profit will be 3500-1525
  1975.
• Note that this will be DIFFERENT under Periodic
  inventory.

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For Periodic LIFO

• Because you are not keeping track of inventory
  changes at the time of each sale, the dates of
  the sales are irrelevant.
• All you are concerned with is that you bought
  1000 units (500 at 2 and 500 at 2.50) and that
  you have 300 left, so you must have sold 700.
• If you sold 700 and you assume LIFO, then you
  assume you sold the 500 that cost 2.50 each
  FIRST, then you sold another 200 that cost 2.
• So, your COGS for the period is 1250 400
  1650, and your gross profit is 3500 - 1650
  1850.
• Notice that each method gives a different COGS
  and Gross Profit! Because of this and of the
  CONSISTENCY principle, you pick ONE method and
  use it every year.

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The AVERAGE methods

• Now you assume that some average mix of units
  from all purchases is sold randomly.
• In the Periodic method, you take an average cost
  of all purchases for the period
• 500 x 2 500 x 2.50
• 500 500
• 2.25 per unit average cost
• Then you expense this average for the number of
  units sold for the period.
• 2.25 per unit x 700 units sold 1575
• So Gross Profit is 3500 - 1575 1,925

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Perpetual Average is more complicated, because
now the timing of the sale matters, and you take
an average after every new purchase

• On Monday the average cost of one unit is 2.
• On Tuesday and Wednesday, cost of sales are based
  on 2 per unit, so COGS so far will be
• 200 x 2 250 x 2 900
• On Thursday you have 50 units left at 2 each,
  and buy 500 more at 2.50, so the average cost of
  one unit NOW is
• 50 x 2 500 x 2.50
• 50 500
• 2.45 per unit average cost
• Then COGS for Thursday and Friday will be
• 150 x 2.45 100 x 2.45 612.50
• And Gross Profit for the period will be
• 3500 - 1512.50 1987.50

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There are a couple more things to learn in this
chapter, but

• This has been a complicated lecture
• You need time to digest it
• The other topics are not that pressing
• We will deal with them next week

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The End