Accounting for Inventories
In the discussion below, we will not consider the specific identification method because it is simple and does not require detailed explanations.
Assume that a company named Brid's Drills has the following beginning balance sheet numbers:
Illustration 7.3: Beginning balances for Brid's Drills
| Assets |
|
Claims |
||||
| Cash |
+ |
Inventory |
= |
Contributed Capital |
+ |
Retained Earnings |
| $4,500 |
+ |
$1,500 |
= |
$4,500 |
+ |
$1,500 |
Consider the following transactions taking place in 20X7:
- Two purchases of drills were made.
- One sale of the drills took place.
The table below shows the quantities and costs of inventory layers:
| Beginning Inventory |
100 units x $15 |
= |
$1,500 |
(at cost) |
| Purchase One |
120 units x $18 |
= |
$2,160 |
(at cost) |
| Purchase Two |
80 units x $20 |
= |
$1,600 |
(at cost) |
|
|
|
|
|
|
| Sale |
270 units x $40 |
= |
$10,800 |
(at selling price) |
| Sale |
270 units x TBD* |
= |
TBD* |
(at cost) |
* TBD - cost to be determined, see below
In addition, at the end of 20X7 the company paid income tax based on 30% of net income.
The two inventory purchases have the same effect on the company's financial records under any cost flow method (FIFO, LIFO or weighted-average). The inventory cost balance increases by $3,760 ($2,160 + $1,600) and quantity on hand increases by 200 units.
The two other transactions (sale and payment of income taxes) differ in amounts under the FIFO, LIFO and weighted-average methods.
7.2.1 Example of FIFO cost flow method
When a sale takes place, two entries are usually made. One is for revenue recognition and the other one is for expense recognition. In out example, the revenue recognition entry has the same sales amount regardless of the cost flow method which is $10,800 for 270 drills. The revenue recognition increases both assets (Cash) and equity (Sales Revenue). This is as asset source transaction.
The cost of goods sold will be different under different cost flow methods. Under FIFO, the cost of goods sold is determined by adding up the costs of 270 drills acquired by Brid's Drills first. The cost of first 270 units available on hand for Brid's Drills is calculated as follows:
Illustration 7.4: Brid's Drills cost of goods sold under FIFO
| Beginning Inventory |
100 units x $15 |
= |
$1,500 |
| Purchase One |
120 units x $18 |
= |
$2,160 |
| Purchase Two |
50 units x $20 |
= |
$1,000 |
| Total |
270 units |
|
$4,660 |
The recognition of cost of goods sold decreases assets (Inventory) and equity (by increasing Cost of Goods Sold). The 30 units from the second purchase remain in the Inventory account.
The gross margin and net income equal $6,140 ($10,800 - $4,660). The gross margin and net income are the same in this simplified case because there are no other expenses besides the cost of goods sold. To determine the income tax expense, we need to multiple the net income by the income tax rate. The rate is 30%, so the income tax is $1,842 ($6,140 x 30%). The effect of the income tax payment is a decrease in Cash and Retained Earnings.
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