Chapter 5: Valuation and reporting transactions/Inventory

Cost Principle
Assets should be recorded at their historical cost. The cost of an asset refers to all costs
necessary to acquire the asset and get it ready for its intended use.

Cost of a Plant Asset

Land Buildings

Purchase price; legal fees; costs of grading If bought: purchase price; legal fees;
and clearing; additional permanent repairs and renovations
improvements If self-constructed: architectural fees,
building permits, material, labor, overhead
(e.g. insurance), interest costs

Machinery and equipment Furniture

Purchase price; transportation charges; Purchase price; shipping charges; costs to

insurance while in transit; sales tax (in assemble
U.S.); installation costs; cost of testing
before asset is used

If the expenditure increases the capacity/efficiency or extends the useful life of the
plant asset, it is recorded as a capital expenditure (debit asset account). Otherwise, it is
an expense, and the repairs and maintenance expense will be debited.
Capital expenditure

Recording Acquisition of a Plant Asset expense

A computer is acquired at a price of €900. We have to pay €100 for transportation charges
and €150 for installation costs. The transaction would be recorded in the Journal as:

I sum of all costs

Merchandise Inventory
I

A merchandising company’s most important asset

is the inventory. The entity’s major expense is
the cost of goods sold (or cost of sales).
The main difference between service entities
and merchandisers are illustrated in their income
statements.
Accounting for inventory transactions
Gross profit (gross margin) is sales revenue — cost of goods sold.
The gross profit is so named because operating expenses have not yet been subtracted.
- Sales revenue is based on sale price.
- Cost of goods sold is based on cost.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 (𝐼𝑆) = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑠𝑜𝑙𝑑 × 𝑐𝑜𝑠𝑡/𝑢𝑛𝑖𝑡 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
- Inventory on the balance sheet is based on cost.
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 (𝐵𝑆) = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑜𝑛 ℎ𝑎𝑛𝑑 × 𝑐𝑜𝑠𝑡/𝑢𝑛𝑖𝑡 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
According to the cost principle, the cost of any asset is the sum of all the costs incurred
to bring the asset to its intended use.
The intended use of merchandise inventory is readiness for sale, thus inventory costs
include: the purchase price, the shipping cost (freight-in) and the insurance in transit.

Inventory methods
To compute the cost of goods sold and the cost of inventory on hand, the business’s
actual cost must be assigned to each item sold. The four costing methods GAAP allows are:
- Specific unit cost (specific identification)
The cost of inventories at the specific unit is the cost of each particular unit, and it is
usually used by businesses that deal in high-ticket items (they sell a small number of
expensive items) e.g. automobiles, jewelry, real estate.
- Weighted-average cost
This method is based on the weighted-average cost of inventory during the period.
It is computed by dividing the cost of goods available for sale by the number of units
available for sale.
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡/𝑢𝑛𝑖𝑡 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒
 - First-in, first-out (FIFO) cost
Under this method, the first costs into inventory are the first costs assigned to the cost
of goods sold. Thus, the ending inventory is based on the costs of the latest purchases.

- Last-in, first-out (LIFO) cost

Under this method, the last costs into inventory are the first costs assigned to the cost
of goods sold. Thus, the ending inventory consists of the oldest costs — those belonging to
the beginning inventory and the earliest purchases of the period.

Income E ects of di erent Inventory Costing Methods

When inventory unit costs are increasing
- FIFO ending inventory is the highest: it is priced at the most recent costs (highest)
- LIFO ending inventory is the lowest: it is priced at the oldest costs (lowest)
When inventory unit costs are decreasing
- FIFO ending inventory is the lowest: it is priced at the most recent costs (lowest)
- LIFO ending inventory are the highest: it is priced at the oldest costs (highest)
 lowest of goods (highgousst

The Income Tax Advantage of LIFO

When prices are rising, applying the LIFO method results in the:
- Lowest taxable income
- Lowest income taxes

A Comparison of Inventory Methods

LIFO best matches the current value of cost of goods sold with current revenue by
assigning to this expense the most recent inventory costs.
FIFO reports the most current inventory costs on the balance sheet.
Tax payments
- LIFO results in the lowest tax payments when prices are rising
- FIFO results in the lowest tax payments when inventory prices are decreasing
- The weighted-average method produces amounts between the extremes of LIFO
and FIFO
FIFO produces inventory profits
FIFO overstates income by so-called inventory profit during periods of inflation
- Inventory profit is the difference between gross profit figured on the FIFO basis and
gross profit figured on the LIFO basis 𝐼𝑃 = 𝐺𝑃(𝐹𝐼𝐹𝑂) − 𝐺𝑃(𝐿𝐼𝐹𝑂) 3
The replacement cost of inventory is more closely approximated by the cost of goods sold
under LIFO than by FIFO.
LIFO allows managers to manipulate net income - up or down
When inventory prices are rising rapidly, income and taxes can be lowered by purchasing a
large amount of inventory near the end of the year and increasing the cost of goods sold.
On the contrary, if the business is having a bad year, managers can increase reported
income by delaying a large purchase of high-cost inventory until the next period, delaying
the increased cost of goods sold until the next period.
LIFO liquidation
- Occurs when inventory quantities fall below the level of the previous period
- Increases reported income and income taxes
International perspective
- IFRS does not allow LIFO, but it is allowed under US GAAP
- US companies that use LIFO must use another accounting method for their
inventories in countries where this method is not allowed
- Most countries permit FIFO and weighted-average cost methods
Higher income or lower taxes?
- FIFO — highest income and results in the highest taxes when prices are rising
- LIFO — highest income and results in the highest taxes when prices are falling

Consistency Principle
The consistency principle states that businesses should use the same accounting methods
and procedures from period to period.
This way, it makes it possible to compare a company’s financial statements from one
period to the next. It does not require that a company never change its accounting
methods, just that it discloses the effect of the change on net income.

Ethical Issues in Inventory Accounting

Managers of companies whose profits do not meet stockholder or analyst expectations are
sometimes tempted to “cook the books” to increase reported income by overstating
ending inventory, understating cost of goods sold, and overstating NI and REs.
𝐴𝑠𝑠𝑒𝑡𝑠 (↑) = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 (0) + 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦 (↑)
An inventory error has an offsetting effect in the next period: the next period’s net
income will be lower. Creating fictitious sales such as excluding goods from ending
inventory could imply that the goods had been sold. Sales returns, however, would
eventually have to be reported.

Inventory Accounting Systems

The two main types of inventory accounting systems are periodic and perpetual systems.

Perpetual Inventory System Periodic Inventory System

Keeps a running record of all goods bought Does not keep a running record of all goods
and sold bought and sold
 Inventory counted once a year Inventory counted at least once a year
Used for all types of goods Used for inexpensive goods

Recording transactions in the perpetual system

- Inventory purchases are recorded by debiting the Inventory account and
crediting Cash or Accounts Receivable
- Sales are recorded by debiting Cash/Acc. Receivable and crediting Sales Revenue
- Sales also require a debit to Cost of Goods Sold and a credit to Inventory

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Recording transactions in the periodic system
Throughout the period the inventory account carries the beginning balance left over from
the preceding period. The business records purchases of inventory in the Purchases
account (expenses). Then, at the end of the period, the inventory account must be
updated for the financial statements.
- Inventory purchases are recorded by debiting the purchases account
- Sales are recorded by debiting Cash/Acc. Receivable and crediting Sales Revenue
- No entry for cost of goods sold is needed
Purchase Returns and Allowances
Net Amount of Purchases

The cost of the inventory of $560,000 is the net amount of the purchase.
- A purchase discount is a decrease in the cost of purchases earned by making an
early payment to the vendor.
- A purchase return is a decrease in the cost of purchases because the buyer
returned the goods to the seller I damaged/unsuitable goods)
- A purchase allowance is a decrease in the cost of purchases because the seller
granted the buyer a subtraction (an allowance) from the amount owed

Sales Discounts and Allowances

Net sales are computed exactly as net purchases, but there is no freight-in to account for.
Freight-out is the expense of delivering merchandise to customers and is included in the
Delivery Expense account (which is an operating expense).

Income Statement including the treatment of inventories:

Reporting Purchase of Inventory Transactions (perpetual system)
Purchase of Inventory

Purchase Discounts: a deduction from the invoice price granted to encourage early
payment of the amount due.

Purchase Returns and Allowances

Purchase Return: merchandise returned by the purchaser to the supplier

Purchase Allowance: a reduction in the cost of defective merchandise received by a

purchaser from a supplier (or problems such as shipping the wrong items, the incorrect
quantity, etc.)

Transportation Costs
- Freight in: transportation cost on purchased goods, debit inventory
- Freight-out: transportation cost on goods sold, debit a delivery expense
Reporting Sale of Inventory Transactions (perpetual system)
Sale of Inventory: amount earned from selling inventory, revenue account
Cost of goods sold: cost of inventory that has been sold to customers, expense account

Sales Returns & Allowances: when a customer returns goods or the seller grants a
reduction in price to customer, contra-revenue account (debit balance)
Sales Discounts: if a customer pays within the discount period allowed by the seller,
contra-revenue account (debit balance)

Delivery Expense (Freight Out)

Basic Terminology
- Creditor: the party to whom money is owed
- Debtor: the party who has a debt (owes money)
- Maturity: the date on which a debt becomes payable (matures)

Financing Activities

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝑒𝑞𝑢𝑖𝑡𝑦

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑃𝑎𝑖𝑑 − 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
Internal sources of finance
External sources of finance
- Short-term/current liabilities: obligations due within one year that fall into one of
two categories, liabilities of known amount or whose amount must be estimated.
- Accounts payable are amounts owed for products or services purchased on
account
- Short-term notes are notes payable due within one year

- Long-term/non-current liabilities: the sum of the amounts borrowed from banks

and other financial institutions. The current installment of long-term debt is:
- The amount of the principal that is payable within one year: at the end of the
year, a company reclassifies the amount of its long-term debt that must be paid
during the upcoming year
- Reported as a current liability
Receivables
Receivables are monetary claims against businesses and individuals acquired by selling
goods and services and by lending money.
Accounts receivable (trade receivables) are amounts
owed to the business by customers, classified as current
assets.
They are summarized in the general ledger control
account showing the total amounts receivable from all
customers and detailed in the subsidiary ledger of
accounts receivable with a separate account for each
customer.
Notes Receivable (later)
Other Receivables is a miscellaneous category that includes loans to employees and loans
to subsidiary companies.
Uncollectible accounts: selling on credit creates both a benefit and a cost:
- The benefit — customers who are unwilling or unable to pay cash immediately may
make a purchase on credit, and company revenues and profits rise as sales increase
- The cost — the company may be unable to collect from its credit customers

Notes Receivable
A Note Receivable a formal promise made by a debtor in writing to pay the creditor a
definite sum on a specific future date—the maturity date.
- A current asset if due within one year or less
- A long-term receivable (investment) if due beyond one year
The two parties to a note are:
- The creditor who has a note receivable
- The debtor who has a note payable
A promissory note serves as evidence of the debt.
The principle amount of the note is the amount borrowed by the debtor.
Interest is revenue for the lender and expense for the borrower.
Some companies sell their merchandise on notes receivable (versus selling on accounts
receivable).
This arrangement often occurs when
- The payment term extends beyond the customary accounts receivable period
- A trade customer’s account receivable is past due
Some companies sell their notes receivable to financial institutions, who then collect the
notes and earn the interest.
This practice is called discounting notes receivable because the seller receives a
discounted price for the note. The seller takes less money to receive immediate cash.
Notes are usually sold (discounted) with recourse, which means the company discounting
the note agrees to pay the financial institution if the maker dishonors the note.
A contingent liability is a potential liability that will become an actual liability only if a
occurs

potential event (e.g. potential lawsuits, product warranties). It is created for the seller of
a discounted note receivable, if the note is sold with recourse.
Discounting notes receivable is illustrated with the following entries for discounting a
$100,000 note receivable.
The bank calculates the amount it will get (capital plus interest) and the fee it requires
(including interest for the period it keeps the note) and gives cash to the company.
The company recognizes an interest expense and a commission expense, according to the
bank’s clauses. cumision gestion
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↑
↓
If the customer pays the bank, then the original payee records, and both the discounted
note and the relative debt are now zero.

If a customer fails to pay the bank at maturity then the original payee must pay the bank
the amount due (and the discounted note has to be converted according to the possibility
of receipt):
.
Chapter 6:
Payroll
The payroll (employee compensation) is a major expense of most businesses. It includes:
- Salaries — pay stated at a yearly or monthly rate
- Wages — pay stated at hourly rates
- Commissions — a percentage of the sales the employee has made
- Bonuses — rewards for excellent performance
- Benefits — are extra compensation. Items that are not directly paid to the
employee (benefits to cover health, life and disability insurance)
Salary expense represents employees’ gross pay and includes several payroll liabilities:
- Salary payable to employees — net (take-home) pay
- Employee Income Tax Payable — the employees’ income tax that has been
retense
withheld from their paychecks
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- FICA Tax Payable — the employees’ Social Security tax that has been withheld
(includes a liability for Medicare tax)
- Other withholdings authorized by the employee, e.g., union dues
𝐺𝑟𝑜𝑠𝑠 𝑝𝑎𝑦 − 𝑤𝑖𝑡ℎℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑑𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 = 𝑛𝑒𝑡 𝑝𝑎𝑦
Accounting for Payroll Expenses and Liabilities

*
*

Adjusting the Value of Assets

- Depreciation — applies to Property, Plant and Equipment assets

Depreciation is the process of allocating the cost of a plant asset to expense over its useful
life in a rational and systematic way.
According to the matching principle, depreciation matches the expense against the
revenue to measure net income.
Depreciation — Adjusting Entry
Factors in Computing Depreciation are:
- Cost
- Estimated Residual Value: 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 = 𝐶𝑜𝑠𝑡 − 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
- Estimated Useful Life: physical wear and tear; obsolescence
Depreciation Methods
- Straight-line
- Units-of-production
- Declining balance
Straight-line method

Fried Chicken bought equipment on January 2, 2006 for 15,000$. The equipment was expected to
remain in service for 4 years. At the end of the equipment's useful life, Fried Chicken estimates
that its residual value will be $3,000.

When a plant asset is acquired during the year, compute full year’s depreciation and
multiply that by the fraction of the year the asset is owned.
A fully-depreciated asset is one that has reached the end of its estimated useful life. No
more depreciation is recorded for the asset. If the asset is no longer useful, it is disposed
of. But the asset may still be useful, and the company may continue using it. The asset
account and its accumulated depreciation remain on the books, but no additional
depreciation is recorded.

Now both accounts have a zero balance, as shown in the T-accounts.

Selling an Asset
Suppose you sell furniture on June 30, for $5,000 cash. The furniture cost $10,000 when
purchased back in 2005. It has been depreciated straight-line over 10 years with no
residual value. First, we need to update depreciation for the last 6 monthsJanuary through
June. Your depreciation entry at June 30, 2008 is:

Now both accounts are up-to-date

The book value of the furniture is 6,500. Suppose you sell furniture for 5,000 cash. The
loss of the sale is $1,500.

If the sale price had been 7,500, there would have been a gain of $1,000 (cash 7,00-asset
boodk value 6,500). The entry to record the gain would be:

- Amortization — applies to intangible assets

- Impairments — applies to both
When the carrying amount of a long-lived asset is not recoverable from its expected future
cash flows, it is deemed to be "impaired." That is to say, the owner of the asset no longer
expects to be able to generate returns of cash from the asset sufficient to recapture its
recorded net book value.
When this scenario occurs, a loss must be recognized for the amount needed to reduce the
asset to its fair value (i.e., debit loss and credit the asset).
Impairment Tangible Assets
Assume that a company purchased equipment for $12,000. Suddenly, the market value of
that equipment goes down by half of its value. This loss of value is reversible. In this
situation, the company must record an entry as follows:

Assume that a company purchased equipment for $12,000. Suddenly, the value of that
equipment goes down by half of its value. This loss of value is irreversible. In this
situation, the company must record an entry as follows:

Impairment Inventory
Assume that a company purchased merchandise for $1,000. Suddenly, the value of the
inventory goes down by half of its value. This loss of value is reversible. In this situation,
the company must record an entry as follows:

Assume that a company purchased inventory for $1,000. Suddenly, the value of the
inventory goes down by half of its value. This loss of value is irreversible. In this
situation, the company must record an entry as follows: