Classnotes 9 & 10 Flashcards
Production Inventory Process
Purchases -> Raw Materials Inventory -> WIP Inventory -> Finished Goods Inventory -> Cost of Goods Sold
Work in Progress?
The cost of inventory of partially completed goods.
Usually a driver is identified that helps allocate the cost of production labor (# of hours, and how a worker allocates his time)
Raw materials?
The cost of parts and materials purchased from suppliers for use in the production process.
Journal entries to reflect inventory flows Within the Balance Sheet
Dr. Raw materials - Inventory XX
Cr. Accounts payable XX
Dr. Work-in-process - Inventory XX
Cr. Raw materials - Inventory XX
Dr. Finished goods - Inventory XX
Cr. Work-in-process - Inventory XX
Journal entries to reflect inventory flows When inventory is sold – to the income statement
Dr. Cost of goods sold XX
Cr. Finished goods - Inventory XX
(and corresponding sales/accounts receivable entry)
Inventory Lower of Cost or Market
In such a case, the firm must write-down the inventory to its lower, market value
Dr. Loss on inventory write-down (expense) XX
Cr. Inventory (or Inventory Valuation-contra account) XX
Inventory Cost Flow
Beginning inventory + net purchases – cost of goods sold = ending inventory
FIFO
(first in – first out): costs of earliest units acquired are assigned to COGS and costs of most recently acquired units remain in inventory
LIFO
(last in – first out): costs of most recently acquired units are assigned to COGS and costs of earliest unites acquired remain in inventory
Weighted Average:
inventory and COGS based on average costs that existed across time periods in which firm purchased units.
Specific identification:
units and associated costs are specifically identified – e.g., specific cars at a Ford dealer
At the beginning of the current period. Chen carried 1,000 units of its product with a unit cost of $20. A summary of purchases during the current period follows:
Beginning Inventory: Units/Unit Cost/Cost = 1,000/$20/$20,000
Purachses#1: Units/Unit Cost/Cost = 1,800/$22/$39,600
Purachses#2: Units/Unit Cost/Cost = 800/26/20,800
Purchases#3: Units/Unit Cost/Cost = 1,200/29/ 34,800
During the current period, Chen sold 2,800 units.
Assume that Chen uses the FIFO method. Compute its cost of goods sold for the current period and the ending inventory balance.
Beg. Inv. + Purchases – COGS = End. Inv.
rearrange and get…
Ending Inventory = Beg. Inv. + Purchases - COGS
COGS = Beg. Inv. + Purchases – End. Inv.
FIFO
Sold 2,800 units:
COGS = 1000@$20 + 1800@$22 = $59,600
End Inv = 800@$26 + 1200@$29 = $55,600
At the beginning of the current period. Chen carried 1,000 units of its product with a unit cost of $20. A summary of purchases during the current period follows:
Beginning Inventory: Units/Unit Cost/Cost = 1,000/$20/$20,000
Purachses#1: Units/Unit Cost/Cost = 1,800/$22/$39,600
Purachses#2: Units/Unit Cost/Cost = 800/26/20,800
Purchases#3: Units/Unit Cost/Cost = 1,200/29/ 34,800
Assume that Chen uses the LIFO method. Compute its cost of goods sold for the current period and the ending inventory balance.
Beg. Inv. + Purchases – COGS = End. Inv.
rearrange and get…
Ending Inventory = Beg. Inv. + Purchases - COGS
COGS = Beg. Inv. + Purchases – End. Inv.
LIFO
Sold 2,800 units:
COGS = 1200@$29 + 800@$26 + 800@$22 = $73,200
End Inv = 1000@$20 + 1000@$22 = $42,000
Differences between FIFO and LIFO
Both LIFO and FIFO are historical cost methods
Allocate historical costs of inventory differently (all costs are accounted for, but in different ways)
The differences between LIFO and FIFO arise when the costs of inventory change over time.
Inventory Turnover
= Cost of Goods Sold / Average Inventory
LIFO Layers
- Under LIFO, the oldest costs remain in the inventory asset account. These form the ‘bottom layers’. Sales are assumed to be made from the higher layers.
- This may result in part of inventory being costed at very old values. This could cause two problems:
Inventory may be undervalued as compared to current costs.
If inventory quantities ever go to level so low that these old costs are matched against revenues (in COGS), income will show a large increase that has nothing to do with economics.
This is called a LIFO liquidation or dipping into LIFO layers.
Firms must also disclose the income effects of any liquidation of LIFO layers
Summary
Inventory & COGS are related in the same way that A/R & Revenue are related.
Basic inventory equations:
Beg. Inventory + Purchases = Goods Avail. for Sale
Goods Avail. for Sale = COGS + Ending Inventory
Allocation between expense (COGS) and asset (Inventory) depends on the cost flow assumption.
Different assumptions (especially LIFO) can have dramatic effects on the financial statements
Inventory may be revalued down, sometimes substantially (but never up)
Question 1: Assume Spencer Ltd. reports the following initial balance and subsequent purchase of inventory: Beginning Inventory, 2017 1,000 units @ $100 each $100,000
Inventory purchased in 2017
2,000 units @ $150 each
$300,000
Cost of goods available for sale in 2017
3,000 units
$400,000
Assume that 1,700 units are sold during 2017. Compute the cost of goods sold for 2017 using a FIFO inventory costing method.
Step 1: Look at the OLDEST inventory first.
Spencer Ltd. had 1,000 units @ $100 each at the beginning of the period. This is the oldest inventory. We will first deplete that.
Step 2: Look at the NEXT OLDEST inventory
Spencer Ltd. purchased an additional 2,000 units at $150 during the period. We are going to expense 700 units @ $150 each to COGS.
Step 1: 1,000 @ 100 each = $100,000 added to COGS
Step 2: 700 @ $150 each = $105,000 added to COGS
1,000 @ 100 each = $100,000 added to COGS
+ 700 @ $150 each = $105,000 added to COGS
= 1,700 units for total COGS of $205,000
Capitalize vs. Expense
Asset = resource that is expected to provide a company with a future economic benefit.
It must be owned or controlled by the company
It must possess expected future benefits that can be measured in monetary units.
When a company incurs a cost to acquire future benefits = capitalized asset
Whether an asset is capitalized as a current or long term asset is a matter of financial statement presentation, but is not related to the capitalization rule itself.
Capitalization: When cost incurred: P,P&E (+A) XX Payable (+L) XX Future entries: Depr. Expense (+E,-SE) XX Accum. Depr (+XA, -A) XX
Expense: When cost incurred: Expense (+E,-SE) XX Payable (+L) XX Future entries: No Entry
Long lived assets, Intangible?
Examples: patents, goodwill, brand name
General rule: only capitalized if acquired externally
Exception to general rule: software development costs
Only exception to the immediate expensing of internally developed intangibles
Costs incurred after “technological feasibility” has been reached may be capitalized and subsequently amortized over the expected sales life of the product (we will go through an example)
Long lived assets Tangible
Examples: land, buildings, machinery, vehicles, equipment
Generally capitalized
Acquisition cost
Acquisition cost of an asset should include all costs necessary to get the asset ready to use, including:
Purchase price (less discounts)
Transportation and freight costs
Installation, customization and inspection costs
Labor, materials, overhead and borrowing costs (“capitalized interest”) for self-constructed assets
Depreciation/amortization
– the process of systematically allocating the cost of asset to the periods which benefit from its use
Determining the Amount of Depreciation - 3 key issues:
Measuring the depreciable basis
Acquisition cost less estimated salvage value
Estimating the useful life
Depreciate over the expected life of service
Choosing the pattern or method of depreciation
Accelerated, straight-line or decelerated?
Many acceptable methods under GAAP:
Straight-line = (Cost-Salvage value)/Useful life
Accelerated methods – declining-balance, sum-of-the years digits
Production/use method
Lambert Company acquired machinery costing $130,000 on January 2, 2016 (assume that is the first day of the reporting period). At that time, Lambert estimated that the useful life of the equipment was 6 years and that the residual value would be $10,000 at the end of its useful life. Complete the depreciation schedule (for all 6 years) using the straight-line method.
Annual depreciation expense =
Annual depreciation expense = ($130,000 - $10,000)/6 = $20,000
Assume that on January 2, 2018 (assume that is the first day of the reporting period), Lambert revised its estimate of the useful life to 7 years and changed its estimate of the residual value to $5,000. Complete the depreciation schedule (for all 7 years) using the straight-line method, including this new information.
Annual Depreciation Expense 2016 – 2017:
Annual Depreciation Expense 2018 – 2022:
Annual Depreciation Expense 2016 – 2017: ($130,000 - $10,000)/6 = $20,000
Annual Depreciation Expense 2018 – 2022: ($90,000 - $5,000)/5 = $17,000
