# For Next Next Class

340aclass22

April 10, 2002

for next class:

Come prepared to take exam 2 again. I will give you your test, with which multiple choice questions you missed, and a new scantron, and a new copy of the problems. You will give me back everything and I will grade: the new scantron + new problems or old problems (you can't add to old problems on the original test paper - if you want more points on a particular problem, you must re-do the whole problem on a new copy). I will give you the average between the original and the do-over.

for next next class:

HW: E9-1,9, P9-10

In class 23 (Allicorp) bring this next Wednesday

today:

M&M's

3 things required to show inventory on the balance sheet at its proper value:

1)journal entries (Ch. 9)

2)determine cost of the inventory (Ch. 9 and 10)

3)determine the market value of the inventory (Ch. 10)

Review of basic inventory cost methods:

Inventory exercise

I assign costs as:

7 costs:cost 1 -4.00/bag 6 * 4 = 24

cost 2 -5.00/bag6 * 5 = 30

cost 3 -6.00/bag6 * 6 = 36

cost 4 - 10.00/bag6 * 10 =60

cost 57.00/bag6 * 7 = 42

cost 6 - 6.00/bag6 * 6 = 36

cost 7 - 5.00/bag6 * 5 = 30

Scenario 1:

Sell 15 bags of candy for \$10 per bag

Question:

What is cost of goods sold?

What is ending inventory?

Concepts:

Assumptions used in financial accounting to estimate cost flows

Our earlier problems (part 2) always had constant costs – in reality costs change

Accountants make cost flow assumptions  physical flows

Possibilities for cost flows above:

Assume the first costs in were first out (FIFO)

Assume the last costs in were first out (LIFO)

Assume an average cost

Specific I.D. of costs – IF WE USED THE BAR CODE TO TRACK EACH PIECE OF INVENTORY, WE WOULDN’T NEED TO MAKE ASSUMPTIONS (some industries that use specific i.d. – JEWELRY STORE (each piece of inventory is unique)

Set-up for FIFO:

Summarize costs:

6 * 4 = 24

6 * 5 = 30

6 * 6 = 36

Total90 = Goods available for sale

First – in First – out implies that the 15 units sold came from the \$4 costs first then the \$5 costs and finally the \$6 costs:

COGS = (6*\$4) + (6*\$5) + (3*\$6) = 72

Ending inventory = (3*6) = 18

Let class do LIFO

COGS = (6*6) + (6*5) +(3*4) = 78

Ending inventory = (3*4) =12

Let class do Average Cost

COGS = 15*5 = 75

Ending inventory = 15

Summarize balance sheet and income statement impacts:

FIFOLIFOAvg. Cost

Balance sheet HI LO middle

Net income HI LO middle

COGS LO HI middle

How did prices behave in this scenario? Rising prices

Which is preferred by manager who gets a bonus based upon n.i.? FIFO

Which is preferred by owner who wants high cash flows? LIFO (lower taxes)

EMPHASIZE AGAIN: COMPANIES CAN CHOOSE WHICH METHOD THEY USE

COST FLOW DOESN’T HAVE TO MATCH PHYSICAL FLOW

If prices were falling, how would the calculations change?

Cost 4: 6 * 10 = 60

Cost 56 * 7 = 42

Cost 66 * 6 = 36

Cost 76 * 5 = 30

total: 24 bags, \$ 168 Purchases

Assume that we sold 23 bags at \$10 each

Let class do FIFO, LIFO, and Avg. Cost

FIFO

GAFS = \$18+\$168 = \$186

COGS = (3*6) + (6*10) + (6*7) + (6*6) +(2*5)= \$166

Ending inventory = \$20

LIFO

GAFS = \$12+\$168 = \$180

COGS = (6*5) + (6*6) + (6*7) +(5*10)= \$158

Ending inventory = \$22

Avg. Cost

GAFS = \$15+\$168 = \$183 (\$183/27 bags = \$6.77 per bag)

COGS = 23 * \$6.77 = \$156

Ending inventory = \$27

Summarize impact when prices are falling:

FIFOLIFOAvg. Cost

Balance sheet LO HI depends

Net income LO HIdepends

COGS HI LOdepends

Note: Thanks 9:30 for coming up with the right reason why the Average was NOT in the middle in our example today. (It is because of the different beginning inventory levels in year 2)

EMPHASIZE AGAIN: COMPANIES CAN CHOOSE WHICH METHOD THEY USE

CAN THEY SWITCH EVERY YEAR?

** CONSISTENCY SAYS NO,NO,NO

This will be covered on Tuesday.

Accounting for inventory: 2 approaches - Perpetual and Periodic

Periodic: This is what was assumed in our in-class M&M exercise. Under this method, you only do entries to Cost of goods sold and Inventory at the end of the year! During the year, each time a sale is made, only the sale side of the entry is recorded (remember chapter 7 and 8!). Also, during the year, any purchases of inventory are recorded in a Purchases account (this is a weird, quasi-permanent account -- you would never see it on the balance sheet because it is closed at year end - but it is used to record the acquisition of assets, so it is not an expense account - very weird). Look at this example:

Purchase 6 bags of M&M's at \$5 per bag:

Purchases\$30

Cash\$30

To record the purchase of inventory.

(In addition, we would have an inventory control account if we had more than one kind of inventory, where we would keep track of each product separately)

At year end (using the FIFO assumption):

Step 1: Close Purchases and Beginning Inventory to COGS

Cost of goods sold\$90

Purchases\$90

(To close purchases to COGS -note: now our COGS account = Goods available for sale. Also note that we had no beginning inventory)

Step 2: Count inventory and record the ending inventory

Ending Inventory\$18

Cost of goods sold\$18

To record ending inventory - FIFO.

Step 3: What is the balance in Cost of goods sold? Look at the T-account

Perpetual: Under this method, you make entries to COGS and Inventory each time that a sale is made. (You don't use a Purchases account here - everything goes straight to the inventory account. How would you handle multiple products?) This is more bookkeeping during the year, but at year end, you should have the correct amount in COGS and Inventory without the adjustments you have to make with the periodic method.

Look at these questions before Tuesday.

Can you use FIFO, LIFO and AVG Cost methods if you use a perpetual inventory system?

Will the balance in ending inventory be different if, for instance, you use LIFO periodic vs. LIFO perpetual?

What about FIFO periodic vs. FIFO perpetual?

How messy is AVG Cost on a perpetual basis? Very MESSY! (But you need to know how to do it!)

Try to work through the in-class exercise for Class 23 (LIFO perpetual versus LIFO periodic).