Fundamental

Financial Accounting
Concepts
Fourth Edition
by
Edmonds, McNair, Milam, Olds

PowerPoint® presentation by
J. Lawrence Bergin
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Chapter 8

Asset Valuation

Accounting for Inventories

and
Investments (appendix)
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Inventory Cost
Recall that
inventory is
recorded at the
price paid or the
consideration
given up.

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Inventory Cost
◆ The amount recorded for inventory should
include:
• Invoice price, freight charges, inspection costs,
and preparation costs.

◆ Inventory may be tracked with either a

periodic or a perpetual inventory system.

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Cost of Goods Sold

Beginning inventory $
Add: Purchases, net
Goods available for sale $
Less: Ending inventory
Cost of Goods Sold $

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Alternative Inventory Cost Flow Methods

FIFO LIFO

Spe
Weighted Ide c
ntif ific
Average icat
ion

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Inventory Cost Flow Methods

These four inventory costing methods are
used to assign the total dollar amount of
goods available for sale between ending
inventory and cost of goods sold.
Ending
inventory
or
CGS??

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Inventory Account
Inventory
Beginning Balance
100 units @ $3
Units Sold
Purchases during the period
150 units $3.10 200 units sold
100 units $3.05

200 units $3.15

Ending Balance

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Inventory Account
Inventory
Beginning Balance
100 units @ $3
Sold 200 units
Purchases during the period
150 units $3.10

100 units $3.05

What is CGS??

200 units $3.15

Ending Balance
= 350 units
What is EI??

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First-In, First-Out
◆ The cost of the oldest inventory items are
charged to cost of goods sold when goods
are sold.
◆ The cost of the newest inventory items
remain in ending inventory.
◆ The actual physical flow of inventory items
may differ from the FIFO cost flow
assumptions.
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Last-In, First-Out
◆ The cost of the newest inventory items are
charged to cost of goods sold when goods
are sold.
◆ The cost of the oldest inventory items
remain in ending inventory.
◆ The actual physical flow of inventory items
may differ from the LIFO cost flow
assumptions.
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Weighted-Average
◆ Compute cost of goods available for sale:
Cost of Beginning Inventory + Net Cost of Purchases

◆ Compute total units available for sale:

Units in Beginning Inventory + Units Purchased

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Weighted-Average
◆ Compute weighted-average cost per unit:
Cost of Goods Available for Sale
Total Units Available for Sale

◆ Compute ending inventory:

Units in EI × Weighted-Average Cost per Unit
◆ Compute Cost of Goods Sold:
Units Sold × Weighted-Average Cost per Unit

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Specific Identification
◆ Specific cost of each inventory item is
known.
◆ Used with small volume,
high dollar inventory.
Inventory of Yachts
Customer Cost to build
Smith $120,000
Jones 80,000
Baker 150,000
Total inventory $350,000
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Applying these inventory

costing methods:
FIFO, LIFO, and W. Ave. may be applied on
either the PERIODIC or PERPETUAL
basis.

First, let’s apply them using a PERIODIC

approach.

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Example:
Date Event Units Price Total
1/1 Beg. Inv. 10 $ 4 $ 40
3/10 Purchase 12 7 84
6/17 Sale 15 14 210
9/15 Purchase 11 8 88
12/27 Sale 3 20 60

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Inventory Account
Inventory
Beginning Balance
10 units @ $4
Sold 18 units
Purchases during the period
12 units @ $7 What is CGS??
11 units @ $8

Ending Balance
= 15 units

What is EI??

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Goods Available for Sale:

Begin. Inv.
10 @ $ 4 = $40
Purchases: FOR
12 @ $ 7 = $84
11 @ $ 8 = $88 SALE
Total Purchases 172
Goods Available $ 212
Q: How much of the $212 should be in Cost
of Goods Sold expense and how much
should be the Ending Inventory balance?

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Example:
Date Event Units Price Total
1/1 Beg. Inv. 10 $ 4 $ 40
3/10 Purchase 12 7 84
6/17 Sale 15 14 210
9/15 Purchase 11 8 88
12/27 Sale 3 20 60

When applying FIFO, LIFO, W. Ave. on a PERIODIC

inventory basis it does not matter WHEN the SALES were
made. We only care that a TOTAL of 18 units were sold.

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FIFO: (Periodic basis)

◆ Cost of Goods Sold: (for the 18 units sold)

From Units Price Cost

◆ Ending Inventory: (for 15 units remaining)

From Units Price Cost

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FIFO: (Periodic basis)

◆ Cost of Goods Sold: (for the 18 units sold)
From Units Price Cost
1/1 10 $ 4 $ 40
3/10 8 7 56
Totals 18 $ 96
◆ Ending Inventory: (for 15 units remaining)
From Units Price Cost
3/10 4 $ 7 $ 28
9/15 11 8 88
Totals 15 $116
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LIFO: (Periodic basis)

◆ Cost of Goods Sold: (for the 18 units sold)

From Units Price Cost

◆ Ending Inventory: (for 15 units remaining)

From Units Price Cost

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Example:
Date Event Units Price Total
1/1 Beg. Inv. 10 $ 4 $ 40
3/10 Purchase 12 7 84
6/17 Sale 15 14 210
9/15 Purchase 11 8 88
12/27 Sale 3 20 60

When applying FIFO, LIFO, W. Ave. on a PERIODIC

inventory basis it does not matter WHEN the SALES were
made. We only care that a TOTAL of 18 units were sold.

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LIFO: (Periodic basis)

◆ Cost of Goods Sold: (for the 18 units sold)
From Units Price Cost
9/15 11 $ 8 $ 88
3/10 7 7 49
Totals 18 $137
◆ Ending Inventory: (for 15 units remaining)
From Units Price Cost
3/10 5 $ 7 $ 35
1/1 10 4 40
Totals 15 $ 75
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Weighted Average: (Periodic basis)

Average cost per unit:

Cost of Goods avail. for sale

# of units avail. for sale

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Weighted Average: (Periodic basis)

Average cost per unit:

Cost of Goods avail. for sale $ 212

# of units avail. for sale

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Weighted Average: (Periodic basis)

Average cost per unit:

Cost of Goods avail. for sale $ 212

# of units avail. for sale 33 units

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Weighted Average: (Periodic basis)

Average cost per unit:

Cost of Goods avail. for sale $ 212 = $6.42

# of units avail. for sale 33 units Per unit

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Weighted Average: (Periodic basis)

Average cost per unit:

Cost of GAFS $ 212 = $6.42/unit

# of units GAFS 33

Cost of Goods Sold:

Ending Inventory:

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Weighted Average: (Periodic basis)

Average cost per unit:

Cost of GAFS $ 212 = $6.42/unit

# of units GAFS 33

Cost of Goods Sold:

18 units sold @ $6.42 cost = $116 (rounded)

Ending Inventory:

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Weighted Average: (Periodic basis)

Average cost per unit:

Cost of GAFS $ 212 = $6.42/unit

# of units GAFS 33

Cost of Goods Sold:

18 units sold @ $6.42 cost = $116 (rounded)

Ending Inventory:
15 units remaining @ $6.42 cost = $ 96 (rounded)

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Income Statements (on Periodic basis)

[Given operating expenses of $50 and a 40% tax rate]
(15@$14 + 3@$20)=
FIFO LIFO Wt. Avg.
Sales $270 $270 $ 270
Cost of G. S. 96 137 116
Gross Margin 174 133 154
Oper. exp. 50 50 50
Pretax Inc. 124 83 104
Taxes (40%) 50 33 42
Net Income $ 74 $ 50 $ 62
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Q1: Does LIFO always result in the lowest Net

Income
Income orStatements (Periodic
is there something basis) about
special
[Given
the operating
economic expenses of $50
situation and a 40% tax rate]
here?

FIFO LIFO Wt. Avg.

Sales $270 $270 $ 270
Cost of G. S. 96 137 116
A1: In a period of RISING prices LIFO charges
Gross Margin 174 133 154
out the latest (highest) prices first, resulting
Oper.
in exp.
the highest C50of G S and50lowest Net50Inc.
Pretax
Q2: Inc. method
Which 124
would YOU 83select? Why?
104
Taxes (40%) 50 33 42
Net Income $ 74 $ 50 $ 62
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Cashflows from Operating Activities

FIFO LIFO Wt. Avg.
Inflows:
Sales collected $ $ $
Outflows:
Purchases paid for
Oper. exp. paid
Taxes (40%) paid
Net cash flow $ $ $

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Cashflows from Operating Activities

FIFO LIFO Wt. Avg.
Inflows:
Sales collected $270 $270 $270
Outflows:
Purchases paid for (172) (172) (172)
Oper. exp. paid (50) (50) (50)
Taxes (40%) paid (50) (33) (42)
Net cash flow $ ( 2) $ 15 $ 6
Why is FIFO cash flow $17 less than LIFO’s?
The ONLY difference in cash flow is the amount of TAXES paid.
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Summary: Effects of Cost Flow Assumptions

◆ Effects on financial statements
❐ Income Statement
❐ cost of goods sold, gross profit & income
before taxes
❐ taxes
❐ net earnings (net income)
❐ Balance Sheet
❐ Inventory
❐ Retained Earnings (because of Net Income effect)
❐ Cashflow Statement
❐ Cashflows are affected only because of taxes.

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Comparison of Methods
◆ Each of the four methods is acceptable, and
an argument can be made for using each.
◆ The choice of an inventory method will
depend on management’s incentives, the tax
laws, and the reporting company’s
particular economic circumstances.

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Consistency Principle
Because the choice of an
inventory method can
significantly affect the
financial statements, a
company might be inclined to
select a new method each year
that would result in the most
favorable financial statements.
However . . .

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Consistency Principle

. . . the consistency principle requires

that companies use the same accounting
methods period after period so the financial
statements of succeeding periods will be
comparable.
comparable

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Alternative Inventory Costing

Methods in Practice
The LIFO conformity rule states that if
LIFO is used for taxes, then LIFO must also
be used for financial reporting.

LIFO for LIFO for

taxes books

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Example: Periodic vs. Perpetual

Using the same data used for

the Periodic method, now
calculate Cost of Goods Sold
and Ending Inventory under
FIFO, LIFO and Average
Cost using the PERPETUAL
method.

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Goods Available for Sale:

Begin. Inv.
10 @ $ 4 = $40
Purchases: FOR
12 @ $ 7 = $84
11 @ $ 8 = $88 SALE
Total Purchases 172
Goods Available $ 212
Q: How much of the $212 should be in Cost of
Goods Sold expense and how much should be
reported on the Bal. Sheet as Ending Inventory?

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Example:
Date Event Units Price Total
1/1 Beg. Inv. 10 $ 4 $ 40
3/10 Purchase 12 7 84
6/17 Sale 15 14 210
9/15 Purchase 11 8 88
12/27 Sale 3 20 60

When applying FIFO, LIFO, W. Ave. on a PERPETUAL

inventory basis it DOES matter WHEN the SALES were
made.

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FIFO--Perpetual
IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGS date units cost $ inv.

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FIFO--Perpetual
IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGS date units cost $ inv.
1/1 10 @ $4
3/10 12 @ $7 1/1 10 @ $4
3/10 12 @ $7
6/17 1/1 10 @ $4 = $ 40
3/10 5 @ $7 = $ 35 3/10 7 @ $7
$ 75
9/15 11 @ $8 3/10 7 @ $7
9/15 11 @ $8
12/27 3/10 3 @ $7 = $ 21 3/10 4 @ $7 = $ 28
9/15 11 @ $8 = 88
Cost of Goods Sold $ 96 End. Inv. $116

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LIFO--Perpetual
IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGS date units cost $ inv.

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Example:
Date Event Units Price Total
1/1 Beg. Inv. 10 $ 4 $ 40
3/10 Purchase 12 7 84
6/17 Sale 15 14 210
9/15 Purchase 11 8 88
12/27 Sale 3 20 60

When applying FIFO, LIFO, W. Ave. on a PERPETUAL

inventory basis it DOES matter WHEN the SALES were
made.

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LIFO--Perpetual
IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGS date units cost $ inv.
1/1 10 @ $4
3/10 12 @ $7 1/1 10 @ $4
3/10 12 @ $7
6/17 3/10 12 @ $7 = $ 84
1/1 3 @ $4 = $ 12 1/1 7 @ $4
$ 96
9/15 11 @ $8 1/1 7 @ $4
9/15 11 @ $8
12/27 9/15 3 @ $8 = $ 24 1/1 7 @ $4 = $ 28
9/15 8 @ $8 = 64
Cost of Goods Sold $120 End. Inv. $ 92

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Weighted Average - Perpetual

When weighted average is applied on a perpetual
basis it is called a “Moving Average”.

Procedures:
1. A new unit average cost must be calculated after
every purchase.
2. Units SOLD are “costed out” (that is, charged to
Cost of Goods Sold) using the unit average cost of
units in inventory at the time of the sale.

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8- 50

Example:
Date Event Units Price Total
1/1 Beg. Inv. 10 $ 4 $ 40
3/10 Purchase 12 7 84
6/17 Sale 15 14 210
9/15 Purchase 11 8 88
12/27 Sale 3 20 60

When applying FIFO, LIFO, W. Ave. on a PERPETUAL

inventory basis it DOES matter WHEN the SALES were
made.

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Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGSdate units cost $ inv.

Cost of Goods Sold on the annual Income Statement =

Merchandise Inventory on the 12/31 Balance Sheet =

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Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGS dateunits cost $ inv.
1/ 1 10 @ 4.00 40.00
3/10 12 @ $7 1/ 1 10 @ 4.00 40.00
3/10 12 @ 7.00 84.00
ave. 22 @ ?? =124.00

Question: What is the average unit cost as of 3/10?

Total Inv. Cost divided by Total units in inv. = Unit Cost
$124 / 22 = $5.64/unit

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Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGSdate units cost $ inv.
1/ 1 10 @ 4.00 40.00
3/10 12 @ $7 1/ 1 10 @ 4.00 40.00
3/10 12 @ 7.00 84.00
ave. 22 @ 5.64 124.00

Question: What is the average unit cost as of 3/10?

Total Inv. Cost divided by Total units in inv. = Unit Cost
$124 / 22 = $5.64/unit

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Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGSdate units cost $ inv.
1/ 1 10 @ 4.00 40.00
3/10 12 @ $7 1/ 1 10 @ 4.00 40.00
3/10 12 @ 7.00 84.00
ave. 22 @ 5.64 124.00

Now what?!
1. Until another purchase is made, units SOLD are “costed
out” at $5.64 each.
2. A new average cost must be calculated when the next
purchase is made.

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8- 55

Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGSdate units cost $ inv.
1/ 1 10 @ 4.00 40.00
3/10 12 @ $7 1/ 1 10 @ 4.00 40.00
3/10 12 @ 7.00 84.00
ave. 22 @ 5.64 124.00
6/17 15 @ 5.64=84.60 7 @ 5.64 39.48

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Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGSdate units cost $ inv.
1/ 1 10 @ 4.00 40.00
3/10 12 @ $7 1/ 1 10 @ 4.00 40.00
3/10 12 @ 7.00 84.00
ave. 22 @ 5.64 124.00
6/17 15 @ 5.64=84.60 7 @ 5.64 39.48
9/15 11 @ $8 7 @ 5.64 39.48
11 @ 8.00 88.00
18 @ ??? 127.48
Question: What is the new average cost?
$127.48 divided by 18 units = $7.08 per unit (rounded)

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Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGSdate units cost $ inv.
1/ 1 10 @ 4.00 40.00
3/10 12 @ $7 1/ 1 10 @ 4.00 40.00
3/10 12 @ 7.00 84.00
ave. 22 @ 5.64 124.00
6/17 15 @ 5.64=84.60 7 @ 5.64 39.48
9/15 11 @ $8 7 @ 5.64 39.48
11 @ 8.00 88.00
18 @ 7.08 127.48
Question: What is the new average cost?
$127.48 divided by 18 units = $7.08 per unit (rounded)

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Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGSdate units cost $ inv.
1/ 1 10 @ 4.00 40.00
3/10 12 @ $7 1/ 1 10 @ 4.00 40.00
3/10 12 @ 7.00 84.00
ave. 22 @ 5.64 124.00
6/17 15 @ 5.64=84.60 7 @ 5.64 39.48
9/15 11 @ $8 7 @ 5.64 39.48
11 @ 8.00 88.00
18 @ 7.08 127.48
12/27 3 @ 7.08=21.24 15 @ 7.08 106.20

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Weighted (Moving) Ave.--Perpetual

IN OUT BALANCE
# unit # unit # unit
date units cost date units cost CofGSdate units cost $ inv.
1/ 1 10 @ 4.00 40.00
3/10 12 @ $7 1/ 1 10 @ 4.00 40.00
3/10 12 @ 7.00 84.00
ave. 22 @ 5.64 124.00
6/17 15 @ 5.64=84.60 7 @ 5.64 39.48
9/15 11 @ $8 7 @ 5.64 39.48
11 @ 8.00 88.00
18 @ 7.08 127.48
12/27 3 @ 7.08=21.24 15 @ 7.08 106.20
Cost of Goods Sold for annual income statement =
$84.60 + $21.24 = $105.84
Merchandise Inventory on the 12/31 Balance Sheet = $106.20
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Summary of FIFO, LIFO, Ave. Cost

combined with Periodic and Perpetual
Cost of G. S. End. Invent.

FIFO-Periodic $ 96 $116
FIFO-Perpetual $ 96 $116
LIFO-Periodic $137 $ 75
LIFO-Perpetual $120 $ 92
Ave.-Periodic $116 $ 96
Ave.-Perpetual $106 (rounded) $106 (rounded)
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Summary of LIFO-FIFO combined

with Periodic and Perpetual
◆ When using FIFO, the C of GS and End. Inv.
are the same for both perpetual and periodic.
◆ When using LIFO (and W. Ave), the
perpetual and periodic recording methods do
not give the same value for C of GS and E. I.

• In a period of rising prices (inventory costs are

rising) C of G.S. under LIFO PERIODIC will
either be equal to (rarely) or greater than
McGraw-Hill/Irwin(usually) Cost of G.S. using LIFO PERPETUAL.
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Summary of LIFO-FIFO combined

with Periodic and Perpetual
So, if you are using LIFO because of its tax
benefits would you apply it on a PERIODIC
Basis or a PERPETUAL Basis?
Periodic
Why?
Starting with the very first sale, you would
charge Cost of G.S exp. with the cost of the last
purchased goods of the year. The resulting
higher Cost of Goods Sold (assuming rising
prices) means lower profit and, thus, lower taxes.
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Gross Margin Method

of Estimating Inventory
◆ Provides an estimate
◆ Not acceptable for GAAP
◆ When to use
• for interim (any period less than a year)
reporting purposes
• when physical inventory not possible (casualty)
• a check on the accuracy of the physical count
• do we have a problem with theft?

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Example:
Given the following:

Beginning Inventory $ 1,000 (cost)

Purchases 9,000 (cost)
Sales 12,000 (retail)

Assume that gross margin has been 40% of sales.

Estimate the cost of inventory and CGS for the
period.

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If the Gross Margin rate is 40%

what is the Cost of Goods Sold
%?

Net Sales 100% = 60%

Less: Cost of G.S. X%
=Gross Margin 40%
Use these %’s and a partial multi-step
income statement format to find the
“missing” amounts.

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Use given amounts and known %’s

Sales $12,000
Less: Cost of Goods Sold:
Beg. Inv. $1,000
+ Purchases, net 9,000
Goods Avail. 10,000
- End. Inv. (?)
Cost of Goods Sold (60% x Net Sales)

Gross Margin $ (40% x Net Sales)

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Use given amounts and known %’s

Sales $12,000
Less: Cost of Goods Sold:
Beg. Inv. $1,000
+ Purchases, net 9,000
Goods Avail. 10,000
- End. Inv. (?)
Cost of Goods Sold (60% x Net Sales)

Gross Margin $ 4,800 (40% x Net Sales)

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Use given amounts and known %’s

Sales $12,000
Less: Cost of Goods Sold:
Beg. Inv. $1,000
+ Purchases, net 9,000
Goods Avail. 10,000
- End. Inv. (?)
Cost of Goods Sold (60% x Net Sales)

Gross Margin $ 4,800 (40% x Net Sales)

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Use given amounts and known %’s

Sales $12,000
Less: Cost of Goods Sold:
Beg. Inv. $1,000
+ Purchases, net 9,000
Goods Avail. 10,000
- End. Inv. (?)
Cost of Goods Sold (7,200) (60% x Net
Sales)

Gross Margin $ 4,800 (40% x Net Sales)

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Use given amounts and known %’s

Sales $12,000
Less: Cost of Goods Sold:
Beg. Inv. $1,000
+ Purchases, net 9,000
Goods Avail. 10,000
- End. Inv. (2,800)
Cost of Goods Sold (7,200) (60% x Net Sales)
Gross Margin $ 4,800 (40% x Net Sales)

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Use given amounts and known %’s

On the right side is an alternative solution format
where the estimated inventory is the last line.
Sales $12,000 Alternate Solution Format:
- C. of Gds. S. Begin. Inv. $ 1,000
Beg. Inv. $1,000 + Purch., net 9,000
+ Purch. 9,000 Goods Avail. $10,000
Gds Avl. 10,000 Sales $12,000
- End. Inv.(2,800) - 40%Est. G.M. (4,800)
Cost of Gds S. (60%) (7,200) =60%Est. CofGS (7,200)

Gross Margin (40%) $4,800 Est. Ending Inv. $ 2,800

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Lower of Cost or Market

◆ Ending inventory is reported at the lower of
cost or market (LCM) applied in 1 of 3 ways.
• Item-by-item
• Major categories
• Total inventory (not acceptable for tax return)

◆ Market refers to the replacement cost of the

merchandise, which is what you would pay
your supplier if you bought the inventory today.

◆ This practice is in keeping with the generally

accepted accounting principle of conservatism.

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Lower of Cost or Market

Cost $50

Inventory Loss = $10

$40
Market
Market $40 Value
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Lower of Cost or Market

Unit Unit Total Total Item-by-item
Qty. Cost Mkt. Cost Mkt. Lower of
Invent.
SideItem
Mirrors (a)
50 $(b)5 $(c)5 $(a x b) $(a x c) Cost
$ or Mkt $ Loss
Tires 300 $ 42 $
38
Batteries 200 $ 35 $ 30
Car Stereos 100 $115 $138 $ $ $ $
SOLUTION:
End. Inv. Invent. Loss
LCM: item-by-item approach = $ $

Major category (Auto dept.) = $ $

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Lower of Cost or Market

Unit Unit Total Total Item-by-item
Qty. Cost Mkt. Cost Mkt. Lower of
Invent.
SideItem
Mirrors (a)
50 $(b)5 $(c)5 $(a x250
b) $(a x 250
c) Cost
$ or250
Mkt $Loss0
Tires 300 $ 42 $ $12,600 $11,400 $11,400 $1,200
38 $ 7,000 $ 6,000 $ 6,000 $1,000
Batteries 200 $ 35 $ 30 $11,500 $13,800 $11,500 $ 0
Car Stereos 100 $115 $138 $31,350 $31,450 $29,150 $2,200
SOLUTION:
End. Inv. Invent. Loss
LCM: item-by-item approach = $29,150 $2,200

Major category (Auto dept.) = $31,350 $ 0

Because T. Mkt>T.cost

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Errors in Measuring Ending Inventory

◆ Misstatements in inventory may cause errors in the
following areas:
• Income Statement
– Cost of Goods Sold, Gross Profit, Taxes, Net Income
• Balance Sheet
– Inventory, Payables, Retained Earnings
◆ Because the ending inventory of one period
becomes the beginning inventory of the next period,
ending inventory errors affect two accounting
periods.

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Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1.
As Reported As Corrected
Year 1 Year 2 Year 1 Year 2
Sales 10 11
C of GS:
Begin. Inv. 1 2
+Purchases 7 8
Gds. Avail. 8 10
- Ending Inv. 2 4
=C of G. Sold 6 6
Gross Margin 4 5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements?

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Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1.
As Reported As Corrected
Year 1 Year 2 Year 1 Year 2
Sales 10 11
C of GS: 10
Begin. Inv. 1 2
+Purchases 7 8 1
Gds. Avail. 8 10 7
- Ending Inv. 2 48
=C of G. Sold 6 6 3
Gross Margin 4 5 5
5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements?

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Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1.
As Reported As Corrected
Year 1 Year 2 Year 1 Year 2
Sales 10 11 11
C of GS: 10
Begin. Inv. 1 2 3
+Purchases 7 8 1 8
Gds. Avail. 8 10 7 11
- Ending Inv. 2 48 4
=C of G. Sold 6 6 3 7
Gross Margin 4 5 5 4
5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements?

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What was the effect of understating the

Year 1 ending inventory by $1? (ignore taxes)
Year 1 Year 2
Sales
Begin. Inventory
Purchases
Goods Avail. for Sale
Ending Inventory
Cost of Goods Sold
Gross Profit Margin
Net Income
Ret. Earn, end. Bal.
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What was the effect of understating the

Year 1 ending inventory by $1? (ignore taxes)
Year 1 Year 2
Sales
Begin. Inventory
Purchases
Goods Avail. for Sale Compare the Reported
Ending Inventory
amounts for each year with
the Corrected amounts.
Cost of Goods Sold
Gross Profit Margin
Net Income
Ret. Earn, end. Bal.
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Ex: In Yr. 3 we find that Yr. 1 ending inv. was understated by $1.
As Reported As Corrected
Year 1 Year 2 Year 1 Year 2
Sales 10 11 11
C of GS: 10
Same = No effect
Begin. Inv. 1 2 3
+Purchases 7 8 1 8
Gds. Avail. 8 10 7 11
- Ending Inv. 2 48 4
=C of G. Sold 6 6 3 7
Gross Margin 4 5 5 4
5
What was the effect of the error on the Yr. 1 and Yr. 2 Statements?

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What was the effect of understating the

Year 1 ending inventory by $1? (ignore taxes)
Year 1 Year 2
Sales No effect
Begin. Inventory No effect
Purchases No effect
Goods Avail. for Sale No effect
Ending Inventory Understated $1
Cost of Goods Sold Overstated $1
Gross Profit Margin Understated $1
Net Income Understated $1
Ret. Earn, end. Bal. Understated $1
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What was the effect of understating the

Year 1 ending inventory by $1? (ignore taxes)
Year 1 Year 2
Sales No effect No effect
Begin. Inventory No effect Understated $1
Purchases No effect No effect
Goods Avail. for Sale No effect Understated $1
Ending Inventory Understated $1 No effect
Cost of Goods Sold Overstated $1 Understated $1
Gross Profit Margin Understated $1 Overstated $1
Net Income Understated $1 Overstated $1
Ret. Earn, end. Bal. Understated $1 No effect (why?)
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Financial Statement Analysis

◆ Inventory Turnover
Cost of Goods Sold
Inventory
=
Turnover
$ Inventory*
Often the AVERAGE inventory is used as the denominator.
Beginning Inventory + Ending Inventory
Ave. Inv =
2
This ratio is often used to
measure the liquidity (nearness
to cash) of the inventory.

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Inventory Ratios
Inventory Turnover: (A measure of how fast
inventory sells. Higher is better.)
Cost of Goods Sold $30,000
Inventory
=
$ 5,000
= 6.0 times

Average Days in Inventory: (How many days go

by between the time inventory arrives and it is sold?)
365 365
Inventory Turnover = 6.0 = 60.8 days
Generally, lower means better.
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Length of Operating Cycle

Remember from Chapter 6 that a
company’s operating cycle is the time it
takes to convert inventory to cash by
selling it and collecting the receivable.
So, the Operating Cycle is:

Ave. days to sell inventory 60.8 days

+ Ave. days to collect receivables 36.5 days
Length of Operating Cycle 97.3 days

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Length of Operating Cycle

Ave. days to sell inventory 60.8 days
+ Ave. days to collect receivables 36.5 days
Length of Operating Cycle 97.3 days
The longer the operating cycle the more it costs
the company for financing, storage and collection
costs. Suppose XYZ Co. has a $10,000,000
inventory and pays 10% annual interest to finance
operations. Assume XYZ’s operating cycle is 30
days longer than its main competitor’s.
How much does the extra 30 days cost XYZ?
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Length of Operating Cycle

The longer the operating cycle the more it costs
the company for financing, storage and collection
costs. Suppose XYZ Co. has a $10,000,000
inventory and pays 10% annual interest to finance
operations. Assume XYZ’s operating cycle is 30
days longer than its main competitor’s.
How much does the extra 30 days cost XYZ?
Inventory x Int. rate x Time = Cost
$10,000,000 x 10% x 30/365 = $82,192
This extra cost is a competitive disadvantage for XYZ Co.

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Chapter 8

The Appendix follows.

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Chapter 8

APPENDIX
Accounting For Investments
and
Reporting Comprehensive
Income

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Investments in Marketable Securities

◆ A company may use some of its extra

cash to invest in the debt or equity
securities of another company

◆ These investments must be classified as

one of three types:
• Securities held to maturity
• Trading Securities
• Securities available for sale

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Securities held to maturity

◆ Debt securities
◆ Intent and ability to
hold to maturity
◆ Must not be sold in
response to changes
in interest rates,
funding sources, etc..
◆ Measured at cost on
the balance sheet

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Trading securities
◆ Debt and equity securities
◆ Readily determinable fair
values
◆ Bought and held to sell in the
near term
◆ Actively and frequently
traded (goal: profit!)
◆ Measured at fair value and
classified as a current asset
◆ Unrealized gains and losses,
included in determination of
net income

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Securities available for sale

◆ Debt and equity securities
◆ Readily determinable fair values
◆ Not classified as either securities
held to maturity or trading securities
◆ Measured at fair value on balance sheet
◆ May be either current or noncurrent
◆ May have holding gains or losses, to be
reported net, NOT as part of Net Income,
but as a component of
“other comprehensive income”.

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Summary of Reporting Requirements

Investm’t. Type of Type of Value on Unreal. G/L Cashflow
Category Security Revenue Bal. Sheet part of NI? Purch/Sale

Held to Debt Interest Amortized No Investing

Maturity Cost Activities

Trading Debt & Interest Market Yes Operating

Securities Equity & Divid. Value Activities

Available Debt & Interest Market No Investing

for sale Equity & Divid. Value (in “Other Activities
Securities Compre-
hensive
Income”)

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What is Comprehensive Income?

All changes in Owners’ Equity except owners’
capital investments and distributions to owners.
Includes Net Income and “Other Comprehensive
Income.”
Other Comprehensive Income includes:
-Unrealized gains/losses on Available for Sale Securities.
and the following 3 items discussed in higher level courses:
-A type of pension plan accounting adjustment.
-Certain gains/losses on “derivative” securities.
-Translation adjustments from converting the
financial statements of its foreign
operations into U.S. dollars.
How is Comprehensive Inc. reported??
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Comprehensive Income
Reporting Options
Bottom of Income Statement: Separate Statements
Income Statement Income Statement
Revenue $100 Revenue $100
- Expenses 40 - Expenses 40
Net Income 60
Net Income $ 60
Other Comp. Inc.(Loss) $(10)
Comprehensive Income $ 50

The third option (used by most Statem’t of Comprehensive Inc.

companies) is to report the
current period’s Other
Comprehensive Income as a
separate section on the State-
ment of Changes in Stk. Equity.
McGraw-Hill/Irwin
Net Income $ 60
Other Comp. Inc. (Loss) (10)
Comprehensive Income $ 50
© The McGraw-Hill Companies, Inc., 2003
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Reporting Comprehensive Income

Statement of Changes in Stk. Equity Option
Comp. Common Ret. Accumulated
Inc. Stock Earn. Other Comp. Inc. Total
Bal., 1/1/X1 $100 $205 $30 $335
Comp. Inc.
Net Inc. $60 60
60
Other Comp. Inc.
Unreal. Loss (10) (10) (10)
Compreh. Inc. $50
Own. Invest. 20 20
Distribution (5) (5)
Bal. 12/31/X1 $120 $260 $20 $400
Accumulated Other Comprehensive Income balance is always
reported in the Stockholders’ Equity section of the Balance Sheet.
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Additional Types of Equity Investments

“Significant Influence” investments
A company (investor) owning 20-50% of another
company’s stock is presumed to have significant
influence over it (the “investee”). These investments
are valued using the equity method which is based on
the book value of the investee, rather than cost or
market value of the investment.
“Controlling Interest” investments
A company owning more than 50% of another
company’s stock has the controlling interest. The
company owning the controlling interest is the PARENT,
the other company is the SUBSIDIARY. CONSOLIDATED
financial statements must be issued combining the
results of the Parent and all its subsidiaries.
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Chapter 8

The End

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