MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING
REPORTS
Baginski Hassell
Electronic presentation adaptation by Dr.
Barbara L. Hassell Dr. Harold O. Wilson
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Chapter 9
PREPARING FOR SALES Acquiring Inventory Credit
Policies
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PREPARING FOR SALESAcquiring Inventory and
Establishing Credit Policies

• Purchasing inventory (merchandising firms)
• Manufacturing inventory (manufacturing firms)
• Accounting for inventory
• Accounts payable to vendors (financing
  inventory).
• Sales of inventory.
• Accounts receivable from customers
  (financing sales).
• Costing inventory remainders.

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Inventory Concerns
Firms buy/manufacture inventory
as the critical part strategic plans
to obtain revenues,but ...

• Storage costs are high.
• Sales are easily lost to competitors by
  shortages.
• Management strategy to decide on the best mix of
  inventory to maximize sales.
• Important factors overall sales strategy,
  target customers, distribution channels, pricing,
  credit policy.

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Basic Contrast

• Merchandising firms purchase completed inventory
  units for markup and sale.
• Manufacturing firms purchase raw materials and
  incur conversion costs (direct labor and factory
  overhead).

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Cost of Inventory

• Theoretically, all costs of acquiring inventory
  should be capitalized as inventory cost
• Merchandising firms
• Purchase Cost
• Transportation Cost
• Other costs of acquisition e.g., insurance,
  taxes

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Acquisition Cost

• In theory, all costs of acquiring inventory
  should be reflected in the inventory asset.
• Purchase invoice cost.
• Transportation-in.
• Miscellaneous costs (e.g., insurance and
  taxes--according to some theorists).

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The Three Elements of Manufacturing Cost

• Direct materials (purchase cost of raw
  materials and freight-in, which become
  physical components of the product).
• Direct Labor (salaries and wages of those who
  physically process the product)
• Factory overhead (FOH) All costs incurred in
  factory operations, other than DL and FOH.

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Cost of Goods Manufactured Schedule (Schema)

• Beginning work-in-process 40,000
• Plus Direct material 30,000
• Direct labor 20,000
• Factory overhead 10,000 60,000
• Less Ending work-in-process lt15,000gt
• Cost of goods manufactured 85,000
  

FYE 12/31/00
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Purchase of Inventory (or Raw Materials) on Credit

• Financing a purchase with an account payable is
  like an interest free loan.
• Purchase returns and allowances reduce the net
  cost of acquisition.

Purchase returns indicate items rejected or
unneeded for some reason, whereas. Purchase
allowances indicate some revision in initial cost
or billings.
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Purchase Discounts(e.g., 2/10, n/30)

• Purchase discounts ...
• Encourage early payment.
• Reduce the net cost of inventory.
• Create significant savings (a missed purchase
  discount of just 2 to pay 20 days earlier than a
  due date, equates to suffering a 36 interest
  rate)!

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Computation of Net Purchases(in the Income
Statement)

• In the Costs of Goods Sold disclosures
• Purchases
• Less Purchase discounts taken
• Less Purchase returns and allowances

The exact location of subtotals in the
format is a matter of preference.
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FAQ?

• What happens if a firm presumes that the purchase
  discounts will be taken, but misses the deadline,
  costing 20 more?

The check will be for the gross amount billed and
a Purchases discounts lost account develops,
which is an excellent managerial aid since any
balance in such an account would indicate
problems.
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Computation of Net Purchases(in the Income
Statement)

• In the Costs of Goods Sold disclosures
• Purchases
• Less Purchase discounts taken
• Less Purchase returns and allowances

The exact location of subtotals in the
format is a matter of preference.
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Determining Inventory Cost

• Two systems are used to track inventory costs
  periodic() and perpetual.
• In either system, a physical counts of
  inventory often occur at year-end (or in
  cycles) to add confidence in ending inventory
  records.

() The text examples use the periodic
system to simplify the computations.
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FAQ?

• Two companies are contrasted in the following
  display of the Cost of goods sold section of an
  Income Statement.
• Which company is in manufacturing (and what do
  the abbreviations mean)?

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Cost of Goods Sold (Income Statement
Displays)

• Beginning Mdse. xx
• Purchases xx
• Goods available
• for sale xx
• Less Ending Mdse. xx
• Cost of goods sold xx

• Beginning F/G xx
• C/G/Mfged xx
• Goods available
• for sale xx
• Less Ending F/G xx
• Cost of goods sold xx

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Costing Inventory Remainders at Fiscal Period End

• Costs to be consistently assigned to ending
  inventory is a function of the cost flow
  assumptions used for homogeneous items
• FIFO
• LIFO
• AVERAGES
• average cost, figured periodically.
• weighted moving averages (perpetual data).

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FAQ?

• What about non-homogeneous items?

The presumption is that unique items would be
such that the specific identification method
would apply (e.g., artworks, cars, antiques, race
horses). Individual tagging of items, if
practical!
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Basic Cost Flow Assumptions

• FIFO (first-in, first-out) Units sold are
  assumed to be first units purchased (ending
  inventory costs of the last purchases).
• LIFO (last-in, first-out) Units sold are
  assumed to be last units purchased (ending
  inventory cost of the first units purchased).
• Average (periodic) Unit cost cost of
  beginning inventory cost of purchases divided
  by the total units involved thus, ending
  inventory unit cost x units on hand!

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Inflationary Trends Mean ...

• FIFO Ending inventory is costed using
  nearest-to-year-end replacement costs.
• Old lower costs were matched to sales, which
  produces a higher reported gross profit.
• LIFO Ending inventory is costed using
  nearest-to-year-start (oldest) costs.
• New higher costs were matched to sales, which
  produces a low reported gross profit.
• The opposite types of results are reported
  during deflationary times.

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FAQs?

• Is LIFO common in international business? Is
  LIFO, which is acceptable per GAAP, also OK for
  income tax purposes?

No. The U.S. is the only major country to allow
LIFO. As to taxes, if LIFO is used for financial
reporting purposes, the IRS requires that it be
used for tax purposes!
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Example Compute the Cost of Ending Inventory
(Remainders)

• Facts Cannan Co. had beginning inventory of
  14,000 units purchased at 6 per unit, for a
  total opening cost of 84,000.
• Annual inventory activity follows

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Transactions ...
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Cost of Good Available for Sale?

• Solution
• 47,000 units were available during the period
  (14,000 beginning inventory 33,000
  purchased, per books)
• 38,000 units were sold, per books
• 9,000 units were in ending inventory (counted)
• Cost of goods available for sale 84,000 of
  beginning inventory purchases of
  258,000 342,000.

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LIFO Assumption

• Ending Inventory 54,000
• The cost of the first 9,000 units purchased
  9,000 beginning inventory x 6
• Therefore, Cost of Goods Sold 288,000
• Details (8,000 x 8.50) (15,000 x 8)
  (10,000 x 7) (5,000 x 6)
• Check 54,000 288,000 342,000, the cost
  of goods available for sale

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FIFO Assumption

• Ending Inventory 76,000
• The cost of the first 9,000 units purchased
  (8,000 x 8.50) (1,000 x 8)
• Therefore, Cost of Goods Sold 266,000
• Details (14,000 x 6) (10,000 x 7)
  (14,000 x 8)
• Check 76,000 266,000 342,000, the cost
  of goods available for sale

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Periodic Averaging

• Average Cost 7.2766
• Math 342,000 cost of goods available for sale
  ? 47,000 units available for sale
• Ending Inventory 65,489
• Math 9,000 units x 7.2766
• Therefore, Cost of Goods Sold 276,511
• Math 38,000 units x 7.2766
• Check 65,489 276,511 342,000, the cost
  of goods available for sale

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Weighted Moving Average Cost
An excellent alternative provides a perpetual
reading on the cost of inventory on hand. After
every purchase, a new average is calculated
(based on the prior balance plus the purchased
items). Any items sold are issued at the
then-current average cost.
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Comparative Results During Inflation
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Comparative Results During Inflation

• (1)In a period of rising prices, LIFO has the
  smallest ending inventory and FIFO the largest.
• (2)In a period of rising prices, LIFO has the
  largest cost of goods sold and FIFO the smallest.
• (3)In a period of rising prices, FIFO has the
  largest gross profit and LIFO has the smallest.

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Balance Sheet Presentation Using an LCM
Adjustment!

• Inventory is often reported at the lower of cost
  or market (LCM) to be conservative
• Cost is initially determined by an inventory
  cost method (specific identification, LIFO,
  FIFO, Average)
• Market Current replacement cost, subject to
  the following constraints

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• Market cannot be more than a ceiling amount, net
  realizable value (NRV).
• NRV Sales price minus cost to complete and
  dispose of the item.
• Market cannot be lower than a floor amount NRV
  minus a NPM.

Using NPM, a normal profit margin, is
theoretically sound it means that no profit is
recognized until a sale is made!
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Example Balance Sheet Presentation of Inventory

• Determine market value to be used in lower of
  cost or market computation based on the following
  assumed data.

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• (1) Ceiling NRV
• (2) R.C. Current replacement cost
• (3) Floor NRV NPM
• (4) Designated market, used for computing LCM by
  comparing market to cost.

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Determining Lower of Cost or Market
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Decision to Extend Credit

• Companies decide to extend credit because
  management believes it may increase
  sales/profits, but ...
• Extending credit exposes a company to bad debts.
• GAAP requires that potential bad debts be
  estimated and reported (accrued)
• Two basic alternative methods
• percent of sales (income statement oriented)
• aging or similar technique (balance sheet
  oriented)

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Observation!

• The direct write-off method No bad debt
  is recognized until a specific customers account
  is identified for a write-off.

Unacceptable under GAAP!
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Sales Discounts(e.g., 2/10, n/30)

• Cash (sales) discounts are used to encourage
  customers to pay in a prompt and
  timely fashion!
• The net method records sales and accounts
  receivable net of any proffered cash discounts
• This is the theoretically preferred method.
• The net method is conservative, but is
  uncommon in practice.

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Example Sales on Account

• A company sells inventory with a cost of 150,000
  for 240,000, with terms 2/10, net 30
• Customer is offered a 2 cash discount if paid
  within 10 days.
• Sales and account receivable recorded at
  235,200 240,000 x 98 235,200
• If sales discount is not taken, the 4,800 would
  be considered as interest income.

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Examples Bad Debts Expense

• Percent of credit sales method
• The Spivey Co. believes that 4 of credit sales
  will never be collected Spivey recorded
  20,000,000 in credit sales during the year.
• Spivey records 800,000 in bad debts expense!
• The Bad debts expense f(credit sales)

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• Aging (or similar) method
• The Landers Co. uses the aging method. At year
  end, an aged analysis indicates that 150,000
  is a likely amount of receivables to remain
  uncollected.
• The current balance in the allowance for
  uncollectible accounts is 25,000 (credit).
• Landers increases the allowance by 125,000, from
  25,000 to 150,000.
• The Allowance account f(A/R balance)

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Sales Returns

• Any sales returns by customers reduces accounts
  receivable and is a part of the calculation of
  net sales.
• An Allowance for estimated sales returns should
  appear on the Balance Sheet as a contra asset.
  (Rare in practice!)

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Using Accounts Receivableto Increase
Liquidity(Borrowing Against Receivables or
Selling Receivables)

• Borrowing using accounts receivable as
  collateral
• Specific assignment (specific receivables are
  designated as collateral)
• General assignment (all receivables are
  designated as collateral)

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Selling accounts receivable to a Factor
(Factoring)

• With recourse If the receivables are not
  collected, the factor can look to the seller
  company for payment.
• Without recourse If the receivables are not
  collected, the factor cannot look to the
  seller company for payment.

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Short-Term Trade Notes Receivable

• If accepted in return for sale of inventory, the
  notes receivable are designated as Notes
  Receivable - Trade in the Balance Sheet.
• Record at face value.
• Accrue interest revenue separately.
• The SCF reflects cash flows from trade notes
  receivable under Operating Activities.

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Statement of Cash Flows Indirect Method

• The cash flows from selling inventory to
  customers are Operating Activities, but
• The SCF using an indirect method is used by many
  publicly traded companies.
• The indirect method starts with net income then
  adjusts for certain items to reconcile to cash
  flow from operating activities

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Categories of reconciling items in indirect
method for SCF

• Noncash expenses and revenues.
• Non-operation gain and losses.
• Operational balance sheet accounts for which
  cash basis accounting and accrual basis
  accounting give differing results.

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Indirect Method Adjustments

• Cash flow from operating activities
• Net Income
• Add (Deduct)
• Non-cash expenses (e.g., depreciation, depletion,
  amortization) (1)
• (Non-cash revenues) (e.g., investment income for
  securities accounted for under the equity method)
  (1)
• Losses (gains) on sales(2)

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• Decreases (increases) in operational current
  assets and deferred income tax assets (3)
• Increases (decreases) in operational current
  liabilities and deferred income tax liabilities
  (3)
• Net cash flows from operating activities

The indirect approach to a SCF is thought by many
to be somewhat difficult to interpret.
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Documentation

• (1) Non-cash expenses and revenues affect net
  income, but not cash.
• (2) Gains and losses are non-operational in
  nature for most companies.
• (3) Reconciling items adjust from the accrual
  basis effects, reflected in net income, to
  the cash basis effects. (Deferred income tax
  assets and liabilities are discussed in Chapter
  11.)

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End of Chapter 9