College Accounting, by Heintz and Parry

1. College Accounting,by Heintz and Parry Chapter 18: Accounting for Merchandise Inventory

2. In early March, Nick got the opportunity to buy some computerized point-of-sale terminals to replace his old cash registers. Eddie suggested that he jump at the deal. “It will give us the opportunity to use a perpetual inventory system.”“What are you talking about? We are already perpetually buying more inventory.”“Yes, I know, Nick, But with a perpetual inventory system, you keep a perpetual count of how many you have of each inventory item. For example, if I asked you right now how many copies we have of the new Lower Than Dirt CD, the one called ‘We’re Dumber than Dirt, Too,’ how would you find the answer to that question?”“I would go over to the rack and count them.”“Exactly. So how do you know when to order more?”

3. “Every week or so, I find time to look for empty spaces between dividers, or I notice when I’ve had high sales of a certain CD.”“Well, with a perpetual inventory system, we can get computer reports that automatically tell us which compact discs need to be reordered. Besides, this system would give us an accurate number for cost of goods sold each month without guessing, and without taking a physical inventory count.”“I wouldn’t mind skipping those, that’s for sure. What a bore!”“We would still need to do them once or twice a year, mainly to make sure that CDs weren’t being stolen.”“Okay, so tell me what kind of a change it will make to our accounting entries.”“Actually, a lot of our entries would change a little. Let me give you some examples.”

4. “Here’s our normal entry for buying merchandise on account.”Date Description PR Debit Credit2001 Mar. 10 Purchases 1200.00 Accounts Payable-Hospital Records 1200.00“With a perpetual inventory system, the key thing to remember is that whenever our inventory changes, we debit or credit the merchandise inventory account. Thus, the debit part of the entry would change like this.”Date Description PR Debit Credit2001 Mar. 10 Merchandise Inventory 1200.00 Accounts Payable-Hospital Records 1200.00 “Okay, I’ll let you try one.” Question: What accounts would be debited and credited when paying freight charges on inventory purchased?

5. “Here’s our old entry to pay freight charges on merchandise.”Date Description PR Debit Credit2001 Mar. 10 Freight-In 200.00 Cash 200.00“With a perpetual inventory system, we need to debit our merchandise inventory account, since the freight charge is part of the cost of acquiring the merchandise.”Date Description PR Debit Credit2001 Mar. 10 Merchandise Inventory 200.00 Cash 200.00“Okay, let’s try another one.” Question: What accounts would be debited and credited when selling merchandise on account?

6. “Here’s our old entry to sell merchandise on account.”Date Description PR Debit Credit2001 Mar. 10 Accounts Receivable-The Fox Jocks 315.00 Sales 315.00“With a perpetual inventory system, we need a second entry to credit our merchandise inventory account, since we’re giving up merchandise in this transaction. The debit goes to cost of goods sold, which would now be one of our regular accounts.”Date Description PR Debit Credit2001 Mar. 10 Accounts Receivable-The Fox Jocks 315.00 Sales 315.00 Mar. 10 Cost of Goods Sold 220.00 Merchandise Inventory 220.00Question: What accounts would be debited and credited for a purchase returned to a supplier?

7. “Here’s our usual entry for returning merchandise to a vendor.”Date Description PR Debit Credit2001 Mar. 10 Accounts Payable-Hospital Records 70.00 Purchases Returns and Allowances 70.00“Although we should still keep track of how many returns we have, our entry needs to credit merchandise inventory because we sent it back.” Date Description PR Debit Credit2001 Mar. 10 Accounts Payable-Hospital Records 70.00 Merchandise Inventory 70.00“There is just one other transaction that changes.” Question: What accounts would be debited and credited when the customer makes a return of merchandise?

8. “Here’s our old entry to accept merchandise for return.”Date Description PR Debit Credit2001 Mar. 10 Sales Returns and Allowances 13.00 Accounts Receivable-The Fox Jocks 13.00“With a perpetual inventory system, we need a second entry to debit our merchandise inventory account, since merchandise is coming back into the store. The credit goes to cost of goods sold, which reverses the entry made with the original sale.”Date Description PR Debit Credit2001 Mar. 10 Sales Returns and Allowances 13.00 Accounts Receivable-The Fox Jocks 13.00 Mar. 10 Merchandise Inventory 8.00 Cost of Goods Sold 8.00Question: What accounts would be debited and credited when a vendor is paid with a cash discount taken?

9. “Here’s our old entry to pay vendors within a discount period.”Date Description PR Debit Credit2001 Mar. 10 Accounts Payable-Macon Records 460.00 Purchases Discounts 9.20 Cash 450.80 “With a perpetual inventory system, we do not use a Purchases Discounts account, since the discount represents a Iower cost for the merchandise purchased.”Date Description PR Debit Credit2001 Mar. 10 Accounts Payable-Macon Records 460.00 Merchandise Inventory 9.20 Cash 450.80

10. Nick was frowning. “I’m still not sold on buying this expensive equipment. You say that we’ll be able to get an accurate number for cost of goods sold, but we already have been getting a cost of goods sold number every month. How are we getting the number now?”Eddie was puzzled. “I thought we’d discussed the two methods used to estimate cost of goods sold back when we first opened. We use the gross profit method, but other companies use the retail method. Let me explain how the gross profit method works. You need 4 pieces of information. Three of them are:1) Beginning Inventory, 2) Purchases for the period, and3) Sales for the period.Question: Where would the company find these three pieces of information?

11. Answer: “All three pieces of data should be in the general ledger (the balance in the merchandise inventory account should be the beginning inventory).” “The fourth piece of data is our gross profit rate. Normally, this number isn’t known but can be guessed with reasonable accuracy (this is why this is an estimation method). In our case, we use a consistent markup except for our occasional sale items, so our estimate is fairly accurate.The method works like this:STEP 1: Compute the cost of goods available for sale.” Sample NumbersBeginning Inventory$12,000Purchases +44,000Cost of Goods Available for Sale$56,000

12. The Gross Profit Method STEP 2: “Estimate cost of goods sold by deducting a normal gross profit from the net sales.” Sample NumbersNet Sales $80,000X Estimated Gross Profit RateX 40%Estimated Gross Profit$32,000Estimated Cost of Goods Sold: Net Sales $80,000Estimated Gross Profit-32,000Estimated Cost of Goods Sold $48,000“As a shortcut, you can multiply the net sales ($80,000) times the estimated cost of goods sold rate (100% - the gross profit rate of 40% = 60%) and also get $48,000.”

13. The Gross Profit Method STEP 3: “Estimate the ending inventory by deducting estimated cost of goods sold from cost of goods available for sale.” Estimated Ending Inventory:Sample Numbers Cost of Goods Available for Sale $56,000Estimated Cost of Goods Sold-48,000Estimated Ending Inventory $8,000“These are the numbers we’ve been using on our interim financial statements. There is a second method that you can use. The retail method requires five pieces of information and five steps.”

14. The Retail Method: “The five pieces of data required are:1) Beginning inventory at cost2) Beginning inventory at retail (selling) prices3) Purchases at cost4) Purchases at retail (selling) prices 5) Net SalesThis takes an extra effort to accumulate information at retail prices.STEP 1: Compute the cost of goods available for sale at cost and retail.”Sample Numbers Cost RetailBeginning Inventory$11,000 $16,000 Purchases +38,000+54,000Cost of Goods Available for Sale$49,000 $70,000

15. The Retail Method: STEP 2: “Next, compute the ending inventory at retail by subtracting sales at retail from goods available for sale at retail.”Sample Numbers Cost Retail Beginning Inventory $11,000 $16,000 Purchases +38,000+54,000Cost of Goods Available for Sale $49,000 $70,000 Less Net Sales - 52,000 Ending Inventory (at retail) $18,000

16. The Retail Method: STEP 3: “Compute a ratio of cost-to-retail by dividing cost of goods available for sale by retail value of goods available for sale.”Sample Numbers Cost Retail Beginning Inventory $11,000 $16,000 Purchases +38,000+54,000Cost of Goods Available for Sale$49,000 $70,000Less Net Sales - 52,000 Ending Inventory (at retail) $18,000Ratio of cost to retail:cost of goods available for sale$49,000 retail value of goods available for sale = $70,000 = 70%

17. The Retail Method: STEP 4: “Estimate ending inventory at cost by multiplying inventory at retail by the cost-to-retail ratio.”Sample Numbers Cost Retail Beginning Inventory $11,000 $16,000 Purchases +38,000+54,000 Cost of Goods Available for Sale $49,000 $70,000 Less Net Sales - 52,000Ending Inventory (at retail) $18,000 Ratio of cost to retail: cost of goods available for sale$49,000 retail value of goods available for sale = $70,000 = 70%Estimated Ending Inventory at Retail = $18,000 X 70% = $12,600

18. The Retail Method: STEP 5: “Estimate cost of goods sold by subtracting estimated ending inventory from cost of goods available for sale.”Sample Numbers Cost Retail Beginning Inventory $11,000 $16,000 Purchases +38,000+54,000Cost of Goods Available for Sale $49,000 $70,000 Less Net Sales - 52,000 Ending Inventory (at retail) $18,000 Ratio of cost to retail: cost of goods available for sale$49,000 retail value of goods available for sale = $70,000 = 70% Estimated Ending Inventory at Retail = $18,000 X 70% = $12,600Estimated Cost of Goods Sold = $49,000 - 12,600 = $36,400

19. Nick had one other question, and it was a good one. “This decision to switch to a perpetual method: does it have any tax implications?” “It would if we were using LIFO, but it doesn’t for a company like ours that uses FIFO.”“You know, our accountant said the most realistic method was ‘FIFO’ last year, but I didn’t understand what the heck he was talking about. ‘FIFO’ and ‘LIFO’ sound like a couple of new breakfast cereals to me. Can you explain these methods to me so that I actually understand them?”“Sure, Nick. There are actually four basic methods used by different companies.”Question: What are the four methods for computing the value of inventory?

20. Answer:”The four methods are:1) FIFO2) LIFO3) Weighted-Average, and4) Specific Identification. Specific identification involves coming up with some type of tagging or marking system so you can tell exactly when any item was purchased (or at what price). This method is generally only used with merchandise that is very expensive and/or unique, like cars, jewelry, or artwork.As an example for the other three methods, we can look at last year’s beginning inventory and purchases for the previous year’s biggest CD, ‘My Mom Hates Me’ by The Whiners:”Beginning Inventory: 4 @ $8.50 = $34.00April purchase: 5 @ 8.95 = 44.75October purchase: 3 @ 9.15 = 27.45Cost of Goods Available for Sale $106.20 At the end of the year, we counted 5 CDs.

21. The FIFO (First-In, First-Out) Method “Under FIFO, we assume that new purchases are stocked on the shelves behind the old merchandise, so that the old merchandise is picked up by customers and sold first. Therefore, the items in our ending inventory would be the ones most recently purchased.”Ending InventoryBeg. Inventory: 4 @ $8.50 = $34.00April purchase: 5 @ 8.95 = 44.75 2 @ $8.95 = $17.90October purchase: 3 @ 9.15 = 27.453 @ 9.15 = 27.45Cost of Goods Available for Sale $106.20 5 $45.35The five most recently purchased items cost $45.35. As always, cost of goods sold can be calculated by the formula:cost of goods avail. for sale - ending inv. = cost of goods soldor $106.20 - $45.35 = $60.85

22. The LIFO (Last-In, First-Out) Method “Under LIFO, we assume that new purchases are stocked on the shelves in front of the old merchandise, so that the new merchandise is picked up by customers and sold first. Therefore, the items in our ending inventory would be the oldest ones, which continue to rest on the back of the shelves.”Ending InventoryBeg. Inventory: 4 @ $8.50 = $34.00 4 @ $8.50 = $34.00April purchase: 5 @ 8.95 = 44.75 1 @ $8.95 = 8.95October purchase: 3 @ 9.15 = 27.455 $42.95Cost of Goods Available for Sale $106.20The five oldest items cost $42.95. Cost of goods sold is:cost of goods avail. for sale - ending inv. = cost of goods soldor $106.20 - $42.95 = $63.25

23. The Weighted-Average Method “Under the weighted-average method, we assume that inventory is intermingled on the shelves and that the fairest way to value the ending inventory is to use an average price paid for that item for the year. It is called a ‘weighted’ average because the quantity purchased at each price is built into the calculation.”Beg. Inventory: 4 @ $8.50 = $34.00 April purchase: 5 @ 8.95 = 44.75 October purchase: 3 @ 9.15 = 27.45Cost of Goods Available for Sale 12$106.20 The average price is $106.20 / 12 = $8.85. The ending inventory of 5 items is valued at 5 X $8.85 = $44.25.Cost of goods sold is:cost of goods avail. for sale - ending inv. = cost of goods soldor $106.20 - $44.25 = $61.95

24. Comparison of Methods: The ending inventory and cost of goods sold under the different methods are as follows:Method Ending Inventory Cost of Goods SoldFIFO $45.35 $60.85Wtd. Avg. 44.25 61.95LIFO 42.95 63.25Therefore, in aninflationarysituation like this one (a period of rising prices), FIFO will produce the lowest expenses (because cost of goods sold is an expense) and thus the highest net income. This means that FIFO would also lead to the highest income tax expense, since income tax is typically calculated as a percentage of net income. LIFO gives the opposite results: the highest expenses, the lowest net income, and the lowest income taxes. (The IRS does not allow a company to use FIFO on the books and LIFO for taxes.)

25. Comparison of Methods (Continued): The advantages of FIFO and LIFO include the following:Advantages of FIFO1) generally reflects the reality of inventory flows most accurately2) puts a realistic inventory value onto the balance sheet3) results in the highest net income during inflationary timesAdvantages of LIFO1) results in cost of goods sold amounts that most closely reflect replacement costs of inventory2) results in the lowest income taxes during inflationary timesThe weighted-average method tends to fall between LIFO and FIFO on all measures discussed.

26. “Overall, Nick, this computer and these point-of-sale terminals can save us bookkeeping time and help us minimize inventory. We’ll know exactly what’s selling, so we can stock just what we need.”“It’s certainly a good price we’re being offered. I guess I can afford to move into the high-tech 21st century, especially if I don’t give you that raise I was considering. Now what’s the difference between LIFO and FIFO one more time?”“Let me explain it this way: If inventory purchases are listed in chronological order, you find LIFO inventory by starting at the top and working down until you’ve accounted for the quantity counted. With the FIFO method you start at the bottom and work your way up.”