How is the balance sheet used?
-Describe the resources a firm has available for generating future cash flows
--> E.g.- Return on asset, inventory turn over ratio
- Evaluate liquidity (current assets vs. current liabilities)
--> Can the company pay its bills?
--> Short-term survival
-Ev
Review of Balance Sheet Components--> Assets
-Probable future economic benefits
- Controlled by an entity
- A result of past transactions or events
Review of Balance Sheet Components--> Liabilities
- Probable future sacrifices of an economic benefits
- Arising from obligations of an entity
--> To transfer assets
--> Or provide services to other entities in the future
Review of Balance Sheet Components--> Sharholders' Equity
- Assets minus liabilites
- If an asset doesn't come from a creditor, the sources must be equity
- Revenues, expenses, gains and losses change owner's equity
Classifications of Balance Sheet--> Assets
- Current Assets
- Long-term investments
- Property, plant, and equipment
- Intangible Assets
- Other Assets
Liabilities and Owners' Equity
- Current liabilities
- Long-term debt
- Owners' equity
--> Capital stock
--> Additional paid-in capital
--> Retained earnings
Current Assets
- Cash and other assets a company expects to convert into cash, or consume either in one year or in the operating cycle, whichever is longer
--> Operating cycle can be longer than one year in some industry
How are current assets presented?
- In order of liquidity
--> Cash and cash equivalents
--> Short-term investments
--> Accounts receivable
--> Inventory
--> Prepaid expense
Cash and Cash Equivalents
- The most liquid Asset: Generally any monies available "on demand"
- Cash equivalents: Short-term highly liquid investments that mature within three months or less
--> Include commercial paper, money market funds and U.S trasury bills
- Restrictions or c
Short-term investments
- Investments in stock and debt securities of OTHER corporations are included as short-term investments if the company has the ability AND intent to sell those securities within the next 12 months or operating cylce, whichever is longer
- Investments are
Receivables
- Accounts receivable: Usually due in 30 to 60 days
- Notes receivable: Related with loans or advances
- Any receivable, regardless of the source, not expected to be collected within on year or the operating cycle, whichever is longer, is classified as a
Inventories
- Include finished goods, work in process and raw materials
- Differ from industry to industry: retailing company vs. manufacturing company
- Inventories are usually sold or used within the operating cycle
- Valuation of inventory
--> Lower-cost-or-market
Prepaid expenses
- Payment of cash, that is recorded as an asset because service or benefit will be received in the future
- Prepayments often occur in regard to:
--> Insurance
--> Supplies
--> Advertising
--> Rent
--> Taxes
Noncurrent Assets
- Assets that are expected to provide economic benefits beyond the next year or operating cycle
- Usually include the following
--> Long-term investments
--> Property, plant, and equipmment (PP&E)
--> Intangible Assets
Investments
- Equity and debt securities in OTHER companies
- Land held for speculation (rather than operation)
- Cash set aside for special purpose
- Special funds (e.g. Pension funds)
PP&E
- Tangible long-lived assets used in regular operation of the business
--> Physical property such as land, buildings, machinery, furniture, tools, and wasting resources (minerals)
--> With the exception of land, a company either depreciates (e.g. building
Intangible Assets
-Lack physical substance and are not financial instruments
--> Limited life intangibles amortized (e.g. patent)
--> Indefinite-life intangible tested for impairment
- Apple 2011 Balance sheet (non-current assets)
--> Long-term marketable securities
--> Pr
Current Liabilities
- Liabilities are classified as current if:
--> They are expected to be liquidated using current assets
--> Or refinanced with other short-term liabilities
- Some examples:
--> Accounts
--> Notes payable
--> Unearned revenues
--> Accrued liabilities (e.g.
Long-term liabilities
- Obligations that a company does not reasonable expect to satisfy within the normal operating cycle
--> Long-term notes
--> Bonds
--> Pension obligations
--> Lease obligations
Stockholders' Equity
- Contributed Capital
--> Common Stock
----> Par value, stated value or no-par
--> Retained Earnings
----> Accumulated Earnings less accumulated dividends
--> Accumulated Other Comprehensive Income/Loss
Financial Disclosures include
- Notes to financial statements
- Management discussion and analysis
- Management discussion and analysis
- Management's responsibilities
- Auditors' report
- Compensation of Directors and Top Executives
Liquidity Rations (Short-term Survival)
Current Ratio
--> Current asset / current liabilities
Acid Test (Quick) ration excludes inventory and prepayments from current assets
--> Quick assets / current liabilities
Financing ratios (Long-term survival)
- Leverage - the relative mix of debt and equity financing
--> Debt to Equity ratio
----> Total liabilities / Total equity
----> Indicates the extent of reliance on creditors, rather than owners, in providing resources
- Times interest earned ratio
---->
Statement of Cash Flows
- Purpose
--> To provide information about cash receipts and cash disbursements during the period
--> A summary of events that increase/decrease cash
--> Shows cash inflows and outflows during the period
- Complements the Income Statement and the Balance
Components of Statement of Cash Flows
- Operating Activities
- Investing Activities
- Financing Activities
Operating Activities
- Basically, cash basis income
- Inflows
--> Cash receipts from customers
--> Interest and dividends from investments
----> Under IFRS can be operating or investing
- Outflows
--> Cash paid to suppliers for inventory
--> Cash paid for business expenses
--
Direct Method
-Lists all cash inflows and outflows affecting the cash accounts (i.e. just categorize what is in the Cash T-account)
-We organize the list in terms of the three categories noted previously
Indirect Method
-Only affect the way you calculate Operating Cash Flows
-We begin with Net Income and we undo all of the non-cash items influencing Net Income as well as accrual adjustments we made. (We'll see an example shortly)
Difference between two methods
-Both methods arrive at the same answer
--> The overall change in cash
-Only the Operating Cash Flows sections looks different, but that too will result in the same answer
- Indirect Method (by far the most popular) helps the reader understand more aout t
Indirect method format
- Begin with Net Income from I/S and adjust for
--> Non-cash expenses
--> Non-cash changes in working capital - these are the adjustment which "undo" the accruals we made
--> Non-operating items included in net income (e.g gains and losses on sale of asse
Why do we need to do the adjustment from NI to cash flow from operating activities? example
- some transactions only affect one of them
--> Depreciation only affects NI but not CFO.
Indirect Method: Depreciation expense of 1000. The journal entry is:
Debit Deprecation expense: 1000
-->Credit Accumulated Depreciation: 1000
This transaction lowers your NI for 1,000, but has not effect on CFO. So when we use the indirect method, we need to reverse the effect of depreciation by adding 1,000 to NI
Indirect Method: Increase in A/R of 1000
Debit Accounts Receivable 1000
-->Credit Sales revenue 1000
This transaction increases your revenue and therefore NI, but has no effect on CFO. So when you use the indirect method, you should subtract increase in A/R (or add the decrease A/R)
Indirect method: Prepaid expense of 1000
Debit Prepaid expense 1000
--> Credit Cash 1000
For this transaction, the effect on income statement is 0. However, it lowers your cash by 1000. So when you try to derive CFO from NI, you should subtract 1000
Indirect method Unearned revenue of 1000
Debit Cash 1000
--> Credit Unearned revenue 1000
For this transaction, it does not affect NI but increase CFO for 1000. So when you derive to CFO from NI, you should add 1000
Indirect method CFO
+ Depr Expense
+ Loss on disposal of assets
- Increase in Accounts Receivable
- Increase in Inventory
+ Increase in different types of Payables
+ Increase in unearned revenue
= Cash flow from Operating Activities
Net income of Mansfiled Company was $45,000. The accounting record reveal depreciation expense of $80,000 as well as increase in prepaid rent, salaries payable and income taxes payable of $60,000, $15,000, and $12,000 respectively. Prepare the cash flows
Net Income $45,000
+ Depr. expense $80,000
- Increase in prepaid rent ($60,000)
+ Increase in salaries payable $15,000
+ Increase in income taxes payable $12,00
= Net cash inflows from operating activities of $92,000
Investing Activities
-Cash transactions involving long-term assets
--> Investments - debt and equity of other entities
--> Productive assets - Property, plant and equipment
Investing Activities Inflows
--> Sale of property or investments
--> Collection of loans
Investing Activities Outflows
--> Purchasing investment securities
--> Purchasing property, plant or equipment
--> Lending money
Financing Acitivies
- Cash payments and receipts to/from owners and creditors
Financing Activities Inflows
- Proceeds from stock sales
- Issuance of debt
Financing Activities Outflows
- Cash dividend payments
--> IFRS can be operating or financing
- Debt retirement
- Interest expense is not included here under US GAAP
- It's reported in operating cash flows
Noncash Investing Financing
- Noncash Investing/Financing Activities
--> Example: Stock exchanged for property
--> These investing or financing activities are not recorded in statement of cash flows
--> If material, prepare a separate schedule at the bottom of SCF or in notes to SCF
CASH & CASH EQUIVALENTS
...
Cash
Currency, coins, balances in checking accounts, and items acceptable for deposit in these accounts such as checks and money orders received from customers
Cash Equivalents
- Short-term (maturity date usually less than 3 months from the date of purchase), highly liquid investments such as money market fund, treasury bills, and commercial papers.
- How about cash card transactions at Lowe's?
How much cash to hold is a critical question to make for
managers. Too much cash vs. too little cash
- Too much cash: Unused cash does not generating profit
- Too little cash: liquidity concern
Internal control
- Management needs to establish proper controls to prevent any unauthorized transactions by officers or employees
- Auditors need to evaluate the internal control system of
cash management
- Bank reconciliations: a schedule explaining the difference betwe
Restricted Cash and
Compensating Balances
-Companies segregate restricted cash from "regular" cash. For example, cash may be restricted for plant expansion, retirement of long-term debt or compensating balances.
- ->Restricted cash is reported as investments and funds or other assets
-A Bank may
Compensating balance as condition of a loan example: Company A borrows $100,000 from a bank
- Bank requires company A to keep $10,000 in a non-interest-bearing checking account at the bank
- If the restriction is legaly binding, classify it separately as current or non-current investment (depending on the classification of related debt)
- If the
Receivables
-A company's claims to the future collection of cash, other
assets or service
Accounts (trade) receivables:
-From sale of goods or service
Nontrade receivables:
-notes receivables, interest receivable, tax refund
receivables
Valuation of Account Receivable
-Net realizable value: report A/R as the amount due at delivery
(selling price - trade discount) less
-->1. Cash discounts (an estimate)
-->2. Sales returns and allowances (an estimate)
-->3. Uncollectible accounts (an estimate
Cash (sales) discount
-Reduction of payment if
paid within a specified period of time
- Inducements for prompt payment
What does 2/10, n/30 mean?
2% discount if paid within 10 days of invoice date, or pay full price in 30 days
Valuation of cash discounts: Gross method vs. Net Method
-Gross method: expects customers not to take the discount (i.e., paying after the discount period)
- Net method: expects customers to take the discount (i.e., paying within the discount period)
Gross Method Example: On June 3, Lowe's sold to Bolton Company merchandise having a sale
price of $2,000 with terms of 2/10, n/60, f.o.b. shipping point. On June
12, the company received a check for the balance due from Bolton Company. Prepare the journal
June 3
Debit Accounts Receivable 2,000
-->Credit Sales revenue 2000
June 12
Debit cash (2000 x .98) 1,960
Debit Sales discounts (contra revenue) 40
--> Credit Accounts receivable 2,000
June 30
Debit Cash 2,000
--> Credit Accounts Receivable 2,000
Net Method Example: On June 3, Lowe's sold to Bolton Company merchandise having a sale
price of $2,000 with terms of 2/10, n/60, f.o.b. shipping point. On June
12, the company received a check for the balance due from Bolton Company. Prepare the journal e
June 3
Debit A/R 1,960
--> Credit Sales Revenue 1,960
June 12
Debit Cash (2,000 x .98) 1,960
--> Credit A/R 1,960
June 30
Debit Cash 2,000
--> Credit A/R 1,960
--> Credit Interest revenue 40
Sales Returns
- Recall revenue recognition when the right of return exists
--> We can recognize revenue at delivery even though rights of return exists
How to record a sales return
- They should be estimated and recorded in the same period as the related sale
Debit Accounts receivable
--> Credit Sales revenue
Debit Sales returns
--> Credit allowance for sales returns
Sales return example: During 2013, its first year of operations, Hollis Industries recorded sales of $10,600,000 and experienced returns of $720,000. Cost of good sold totaled $6,360,000 (60% of sales). The company estimates that 8% of all sales will be r
To Record sale:
Debit A/R 10,600,000
--> Credit Sales revenue 10,600,000
Debit COGS 432,000
--> Credit Inventory 432,000
To record the returns:
Debit sales returns 720,000
Credit--> A/R 720,000
Debit inventory 432,000
Credit--> COGS 432,000
(60% x 720,000
When Future Returns Happen
Debit Allowance for sales return 128,000
--> Credit A/R 128,000
So the actual returns do not affect the net realizable receivable
Uncollectible Amounts (Bad Debts)
- If you do business on credit, the question of bad debts is
not "whether" but "how much"?
- Some people cannot or will not pay their bills
- You know they are out there.
- You just don't know who they are
The Allowance Method for Bad Debts
- Estimate the uncollected amount and report the net account receivable
--> Companies usually estimate their bad debt expenses at the end of the accounting cycle
- Two approaches to estimate the uncollectible amount:
--> Income Statement approach vs. Bala
Income Statement Approach
- Percentage of sales on credit
- Logic: the more you sell on credit, the more you should expect people do not pay you
-Method:
--> Select a percentage based on past experience or industry averages
--> Multiply the percentage by total credit sales (from t
Income Statement Approach Example:
The following information is from unadjusted trial balance:
- A/R= $650,000
- Allowance for uncollectible accounts = $3,000
- Credit Sales 2011 = $2,500,000
- Percentage of sales estimated uncollectible = 2%
Credit Sales x % estimated uncollectible = Bad Debt Expense
$2,500,000 x 2% = $50,000
Debit Bad Debt Expense 50,000
--> Credit Allowance for Uncollectible Accounts 50,000
*In practice, you may see "allowance for bad debts" or "allowance for doubtful accou
Balance Sheet Approach
- Based on "aging" schedule of individual accounts receivable
--> Logic: The longer receivable is outstanding, the less likely that it will ever be paid
- Percentage of receivables likely to be uncollectible is determined for each receivable age category
Account receivable write-off
- As specific accounts are deemed uncollectible, they are written off against the allowance account
- Debit Allowance for Uncollectible Accounts 500
--> Credit A/R 500
-The write-off does not change net realizable receivable
- There is no income statement
Income Statement Method example: The following information relates to a company's accounts receivable: accounts receivable balance at the beginning of the year, $300,000; allowance for uncollectible accounts at the beginning of the year, $25,000 (credit b
Bad debt expense= 1,500,000 x 2% = $30,000
Allowance for uncollectible accounts:
Beginning balance $25,000
Add: Bad debt expense $30,000
Deduct: Write-offs (16,000)
Ending balance= 39,000
Balance Sheet Method Example: The following information relates to a company's accounts receivable: accounts receivable balance at the beginning of the year, $300,000; allowance for uncollectible accounts at the beginning of the year, $25,000 (credit bala
1) Allowance for uncollectible accounts
Beginning balance: 25,000
Deduct: Write-offs (16,000)
Required allowance (33,400)
=Bad debt expense $24,400
2) Required allowance= $334,000 x 10% = $33,400
Accounts receivable
Beginning balance= $300,000
Add: Credit
Notes receivable
Notes receivable= Formal credit arrangement
--> We focus on short-term notes
--> If note is long-term, then record at the present value of the future cash flows (Discussed in Intermediate Accounting 2)
Bad debts (a big bank issue)
- Estimate bad debt expe
Interest-bearing notes
- For short-term notes (less than one-year in duration), use the simplest interest method:
- Note face amount (Principal) x Annual Rate x Fraction of the year
- Interest rates are always stated as annual rates
- The rate must be adjusted if the borrowing
Notes receivable example:
On December 1, 2013, Davenport Company sold merchandise to a customer for $20,000. In payment for the merchandise, the customer
signed a 6% note requiring payment of interest and principal on March 1, 2014.
-How much interest rev
- $100 (20,000 x 6% x 1/12) for 2013 and $200 for 2014.
12/1/13
Debit Notes Receivable $20,000
Credit Sales Revenue $20,000
12/31/13
Debit interest receivable $100
Credit interest revenue $100
3/1/14
Debit Cash $20,300
Credit Note receivable $20,000
Credi
Non-interest bearing Notes
- Term refers to notes in which the interest is deducted "Up front" from the cash proceeds of the note
--> Money is NEVER FREE
--> Need to calculate effective interest rates and then interest revenue
Example: Non-interest bearing notes: On Dec. 1 2012, ABC Auto Dealer sells a luxury car to a customer for a one-year, $50,000 non-interest bearing
note. The discount rate is 10%. Write down the journal
entry that ABC Auto Dealer records on 12/1/12, 12/31/
12/1/12
Debit Note receivable $50,000
Credit Discount on N/R $5,000
Credit Sales Revenue $45,000
($50,000 x 10% x 12/12)
So it is similar to selling a car at $45,000 and the $5,000 are interest revenue, which will be earned gradually over the 1 year perio
Receivables can be used as an immediate source of cash, which...
shortens a company's operating cycles by providing cash
immediately rather than having to wait until credit customers pay the amounts due. Many companies avoid the difficulties of servicing (billing and
collecting) receivables by having financial institut
Two methods of financing with receivables
Secured borrowing
� Pledging or assigning accounts receivable means using them as collateral for a loan
� A/R remains on the borrower's balance sheet
- Sale of receivables: A/R moves from the borrower's balance sheet to the lender's
- Which method does Lo
INVENTORY: MEASUREMENT
...
Inventory refers to the
assets a company (1) intends to sell in the normal course of business, (2) has in production for future sale, or (3) uses currently in the production of goods to be sold.
Merchandise inventory vs. manufacturing inventory
- In this class we focus on merchandise inventory
� For example: a retail or wholesale company
- Manufacturing inventory: raw materials, work-in-progress, finishing
goods
� Will be discussed in cost (managerial) accounting
GAAP for Inventory: Valuing inventory on the balance sheet
- Inventory is (generally) a current asset, recorded at its
acquisition or production cost on the Balance Sheet.
Connecting inventory to the income statement
- Recall from our discussion of revenue recognition, that it is the sale of the product or service that triggers the release of the
associated costs, from inventory to the income statement (as
COGS).
- So, think of the inventory account as the storage pla
Two accounting systems are used to record transactions involving inventory
-Perpetual and Period Inventory systems
Perpetual Inventory
The inventory account is continuously update as purchases and sales are made
Periodic Inventory System
The inventory account is adjusted at the end of a a reporting period
Inventory account reflects beginning inventory
balance only
� Record all acquisition of goods during period in a
purchases account
� Sales of goods not reflected in the Inventory
account
Advantage and Disadvantage of Periodic Inventory
- Advantage= The cost of maintaining it is less than perpetual
- Disadvantage= have to depend on physical count at the end of accounting cycle to determine ending inventory
For Perpetual inventory example: Litton Industries uses a perpetual inventory system. The company
began its fiscal year with inventory of $267,000. Purchases of merchandise on account during the year totaled $845,000. Merchandise costing $902,000 was sold
1) Record the purchase
Debit Inventory 845,000
-->Credit Accounts payable 845,000
2) Record the sale
Debit Accounts Receivable 1,420,000
-->Credit Sales Revenue 1,420,000
Debit cost of goods sold 902,000
-->Credit inventory 902,000
Issue 1.
Determine the Balance of Inventory
For periodic inventory recording
1) Record the purchase
Debit purchases 845,000
-->Credit Accounts payable 845,000
2) Record the sale
Debit Account receivable $1,420,000
--> Credit Sales revenue $1,420,000
3) At the end of the accounting cycle record COGS
COGS $902,000
Inventory (ending)
What to include in inventory
Inventory includes all goods owned (goods for which the
company holds legal title)
� Location doesn't matter
� At the end of accounting cycle, ask:
- Are all goods held in the company warehouse owned by the company?
- Are there goods in shipment (coming i
Example: What should be included?
The Phoenix Corporation's fiscal year ends on December 31. Phoenix determines inventory quantity by a physical count of inventory on hand at the close of business on December 31. The company's controller has asked for you
1. Merchandise held on consignment for Trout Creek Clothing.
2. Goods shipped f.o.b. destination on December 28 that arrived at the customer's
location on January 4.
3. Goods purchased from a vendor shipped f.o.b. shipping point on December 26 that
arrive
Issue 2. Determine the Amount of Purchases
...
The cost of inventory purchases include
The cost of inventory purchases (acquisition cost) include:
- Purchase price of the goods
- Shipping costs related to the purchase
� Perpetual: added to inventory account
� Periodic: recorded in a separate account, DR "Freight-in" or
"Transportation-in"
�
the cost of purchase is reduced by:
Purchase returns
- Purchase discounts
� If the buyer records purchase at gross method, credit "Purchase
Discounts"
� The buyer can also record the purchase at net method
Purchase Discount Gross Method Example: On July 15, 2013, the Nixon Car Company purchased 1,000 tires from the
Harwell Company for $50 each. The terms of the sale were 2/10, n/30.
Nixon uses a periodic inventory system and the gross method of
accounting f
7/15/13
Debit Purchases $50,000
Credit Accounts payable $50,000
7/23/13
Debit A/C payable 50,000
Credit Cash $49,000
Credit Purchase discounts $1,000
If paid on 8/15
Debit A/C payable $50,000
Credit Cash $50,000
Purchase Discount Net Method Example:
On July 15, 2013, the Nixon Car Company purchased 1,000 tires from the Harwell Company for $50 each. The terms of the sale were 2/10, n/30. Nixon uses a periodic inventory system and the net method of accounting for p
7/15/13
Debit Purchases $49,000
Accounts payable $49,000
7/23/13
Debit Accounts payable $49,000
Credit Cash $49,000
If paid on 8/15
Debit Accounts payable $49,000
Debit Interest expenses $1,000
Credit Cash $50,000
Issue 3. Determine the COGS
...
Inventory Cost Flow Assumptions
Because firms often hold more units than they sell in some
period, inventory layers get created.
� Each layer of cost could, in theory (and in practice, usually
does), have a different unit cost.
- Prices of inventory items usually change during the year.
Inventory Cost Flow Assumptions Example: 3 cars with 3 different costs ($25,000, $27,000, $29,000) are sold at the same price of $30. If all three cars are sold then there's a $9,000 proft. What would happen if only one car was sold?
-Specific identification (track each inventory item)
- May difficult and expensive
- This method is used frequently by companies selling unique, expensive products (for example, Tiffany & Co)
-Most retailers will not identify each inventory item but rely
Average Cost
-Price inventory items based on an average price paid for all
items, weighted by the quantity purchased at each price.
-Average cost = Cost of Goods available for sale /Quantify
available for sale
-Multiply number of units in ending inventory by average
u
First-in, First-out (FIFO)
FIFO assumes that the oldest inventory items
(first-in) are the first sold
- Generally, this conforms to the physical flow of goods
� FIFO gives a fairly accurate statement of the value
of current assets since inventory reflects most
recent purchase price
Last-in, First-out (LIFO)
� Cost flow assumes that the newest inventory
items (last-in) are the first sold
� LIFO gives the most current inventory costs.
- If inventory costs are rising, Net Income under LIFO
may be a better representation of economic events
- But Inventory on the
Is each method allowed under GAAP?
-Yes, but IFRS prohibits LIFO
Many multinational firms in the US use ____ for domestic inventories and ____ or ______ for foreign subsidiaries
LIFO, FIFO, average cost
During a period of rising inventory costs, _____ leads to higher COGS and lower net income
- LIFO
-Avg. cost in the middle
Are companies allowed to use multiple methods for different types of inventories?
Yes, Tiffany Co. uses average cost, except for certain diamond and gemstone jewelry which uses specific identification
LIFO issues
Many firms use LIFO to lower their tax liabilities in
periods when prices are rising
- LIFO Conformity Rule: IRS requires that firms that use LIFO for
tax purposes must also use LIFO for book purposes.
� Many companies use LIFO for external reporting
and
LIFO Liquidation
-When old layers of inventories are sold.
-May lead to one-time boost of earnings.
-If material, need to disclose in footnotes
Downside of LIFO
-Record keeping is complex
� Requires careful monitoring of inventory levels
- If inventory levels drop, the cost of older inventory layers will have
to be transferred to CGS
- An inventory liquidation increases current income and income
taxes.
ADDITIONAL INVENTORY ISSUES
...
Lower cost or market
-Inventory is stated at the lower of cost or market using the
first-in, first-out method of inventory accounting.
-LCM is a departure from historical cost. The method
causes losses to be recognized in the period the value of
inventory declines below its c
Steps of LCM
� Step 1: Determine Designated Market Value
- Compute:
� Net Realizable Value (NRV) -- Ceiling
- Selling Price - Incremental Selling Costs
� Replacement Cost (RC)
� Net Realizable value - normal profit (NRV-NP) -- Floor
- Choose the middle value as the de
If the inventory value recovers back in the future period...
don't add the value back
- IFRS allows value recovery
LCM can be applied three ways
To each inventory item separately
� The most conservative method since gains and losses on individual
items are not offset.
� Most common practice
- To each category of items in the inventory
- To the inventory as a whole
Example: LCM
The Strand Company sells four products that can be grouped into two
major categories. Information necessary to apply the LCM rule at the end
of 2013 for each of the four products is presented below. The normal
profit margin for each of the pr
...
LCM example step one
-Determine the designated market value for each of the four products
LCM example step two
-Determine the amount of the loss from write-down of
inventory that would be required.
How to report LCM loss
-Debit: loss on write-down of inventory
-Credit: Inventory
Some companies report it as part of COGS if write-downs are common place (for example, retailers)
-Debit: COGS
-Credit: Inventory
Example: Microsoft adjusted its inventory value
($900 million) of Surface tablets in 2013 by applying LCM
method.
-Debit: Loss on write down of inventory 900 M
-Credit: Inventory 900M
Direct method vs. allowance method
� The method in the last slide is the direct method
� A lot of companies also use the allowance method
Debit: Loss on write-down of inventory 67,000
Credit: Allowance to reduce inventory to market 67,000
� Lowe's 2013 Annual Report
"The Company records an
Estimating instead of counting physical inventory benefits and deficits
Less time-consuming
- Less costly
- Downside: may not be that accurate. So at the end of day, it's a
cost and benefit tradeoff
Two popular methods of estimating ending inventory are
-Gross profit method
- Retail inventory method
Gross profit method is used...
- To estimate ending inventory for interim financial
statements
-->Not allowed in preparation of annual financial statements.
- To test the reasonableness of an inventory valuation
- To estimate the cost of inventory destroyed in a
disaster.
� Basic logic and assumptions of Gross profit method
-Beginning inventory plus purchases equal total goods to be
accounted for.
- Goods not sold must be on hand.
- The sales, reduced to cost, deducted from the sum of the opening
inventory plus purchases, equal ending inventory.
Periodic Inventory System equation
Beg. Inventory
+ net purchases
Goods available for sale
- Ending inventory (from
physical count)
=Cost of goods sold
Gross Profit Method equation
Beg. Inventory
+ net purchases
Goods available for sale
- Cost of good sold (from
estimate)
=Ending inventory
Information needed for gross profit method
-Beginning inventory
- Current period purchases
- Current period sales
- Historical gross profit percentage
-->Gross Profit/Sales
-Gross Profit Method Example
-Beginning Inventory $100,000
Net purchases 300,000
Goods Available for Sale 400,000
Net Sales (280,000)
Ending Inventory ?
Step 1: Estimated Cost of Goods Sold = Sales x [1-20%]
= 280,000 x 0.8 = 224,000
Step 2: Estimated Ending Inventory = CGAS - COGS
= 400,000 - 224,000 =176,000
Benefits and deficits of Gross Profit Method
Benefits:
- Simple
- Quick
- Cheap
Deficits:
-Depends on old data relationships
- May not be any good in a changing situation
Retail Inventory Method
-Retail inventory method provides a more accurate
estimate than gross profit method because it's
based on the current cost-to-retail percentage
rather than a historical profit ratio
-This method is used
-->To provide an estimate of ending inventory for in
-Retail Inventory Method
-Beginning Inventory $100,000 / 125,000
Net purchases 300,000 / 360,000
Goods Available for Sale 400,000 / 485,000
Deduct: Net Sales N/A /(280,000)
Ending Inventory ? / 205,000
-Goal: What is the cost of ending inventory?
1. Calculate Cost-to-retail percentage 400,000/485,000 = 82.5%
2. Estimated ending inventory at cost 205,000 x 82.5%= 169,072 (or 169,125)
Retail terminology:
1) Initial markup
2) Additional markup
3) Markup cancellation
4) Markdown
5) Markdown Cancellation
1) Original amount of markup from cost to selling price.
2) Increase in selling price subsequent to initial markup.
3) Elimination of an additional markup.
4) Reduction in selling price below the original selling price.
5) Elimination of a markdown.
session 7 cont...
...
simplifying lifo
-have looked at "unit lifo"
--> lifo cost determined for each individual item
- An alternative is to group similar items into categories or pools
---> lifo inventory pools or dollar value lifo
---> less expensive to maintain
--> lower chance of lifo liqui
dollar value lifo
-Rather than define changes in pools in terms of physical quantities, companies typically look at increases and decreases in inventory in terms of an inventory pool
--> large variety of goods may be pooled together
advantages of dollar value lifo
-Increases and decreases in a pool are measured in terms of total dollar value
-The IRS allows a wider range of goods to be included in the pool
-in practice, dollar value lifo is easier to apply than unit lifo
session 8 continued
..
cost-to-retail ratio (lcm)
-Compute cost-to-retail percentage
---> after retail prices have been adjusted for ner markups, but before retail prices have been adjusted for net markdowns
-Excluding net markdowns from retail prices
---> decreases the cost-to-retail ratio
---> decrease