ACC281: Accounting Concepts for Health Care Professionals-Inventory Costs

Chapter 5 Inventory Learning Objectives • Understand the basics of recording inventory purchases and sales. • Understand the typical categories of inventory and their contents. • Understand how an expanded income statement presentation can enhance reporting usefulness. • Explain how inventory costs are allocated to inventory and costs of goods sold and the importance of this allocation to income measurement. • Know how to apply FIFO, LIFO, and moving average inventory-costing assumptions. • Apply specific identification and lower-of-cost-or-market concepts. iStock/Thinkstock eps81189_05_c05.indd 81 12/20/13 9:28 AM Introduction Chapter Outline Introduction 5.1 Categories of Inventory Inventory Costs Freight Consigned Goods Critical Thinking About Inventory Cost 5.2 Cost Assignment 5.3 Perpetual Systems First-In, First-Out Last-In, First-Out The Average Cost Approach 5.4 Comparing Methods Specific Identification Lower-of-Cost-or-Market Adjustments 5.5 The Importance of Accuracy Introduction Y ou may think that since you are working in a healthcare environment and not selling products, you don’t have to worry about inventory costing and managemen\ t. In real- ity, even the smallest medical office has inventory. Physicians give shots and need to hold inventory of the inoculations that will be given to patients. If your of\ fice provides sample medications, you need to track and account for that inventory even if th\ e patients don’t pay for it. Almost everything you do in patient care requires medical supplies that can be directly allocated to each patient. Some things, such as bandages, are not cost effective to bill per patient, but other things, such as medications, will likely be \ billed on a patient-by- patient basis. In some healthcare settings, such as an oncology practice where expensive medical treatments are done in the office using medications that can cost hundreds, if not thousands, of dollars, inventory management becomes critical.

Therefore, in a medical environment, medications and other items used in patient care are goods to be sold, even if they aren’t being sold in the traditional way. Essentially, they become the costs of services sold. A medical office can’t provide an inoculation without first paying costs of buying that inoculation and having it shipped to t\ he practice. eps81189_05_c05.indd 82 12/20/13 9:28 AM CHAPTER 5 Introduction How hard could it be to account for inventory? The basic concept is very simple\ . When you buy inventory, you record the purchase of the asset, like this:

2-10-XXInventory 10,000.00 Accounts payable 10,000.00 Purchased $10,000 of inventory on account Then, when the inventory is resold, two entries are needed—one to record the sales pro- ceeds and another to remove the inventory and charge it to an expense category called Cost of Goods Sold. Cost of Goods Sold is not common in most healthcare environments, but you will see it used in some retail-type environments, such as the sale of medical equipment or pharmaceuticals. In most healthcare environments, the use of inventory is accounted for as a supplies expense. The following example is for an organization that does use Cost of Goods Sold:

3-15-XX Accounts receivable 15,000.00 Sales 15,000.00 Sold merchandise on account 3-15-XX Cost of goods sold 10,000.00 Inventory 10,000.00 To record the cost of merchandise sold This very basic approach would result in the following income statement results:

Sales $15,000 Cost of goods or services sold 10,000 Gross profit $ 5,000 If the organization uses Supplies Expense to offset its use of Inventory, that the entry would look like this: 3-15-XX Supplies expense Inventory To record the use of inventory for patient care In this the account, “Supplies Expense,” would be in the expense section of the income statement. eps81189_05_c05.indd 83 12/20/13 9:28 AM CHAPTER 5 Section 5.1 Categories of Inventory The gross profit is simply the net difference between the cost of inventory that has been sold and the sales proceeds. It is not the net income because it does not reflect all other costs of doing business. Of course, if inventory accounting were only this simple, there would be no need for a separate chapter. So, what issues could possibly arise to compli- cate the accounting for inventory?

For starters, there are issues about what goods are appropriately included in inventory.

What is the appropriate moment to conclude that a transaction has resulted in a sale?

What costs, in addition to the direct purchase price, are to be placed into the inventory accounts? How do we attach costs to specific units sold when numerous identical units have been purchased at different costs on different dates, and we are not sure which phys- ical units have actually been delivered to a customer? Suddenly, accounting for inventory appears to present a number of vexing challenges. This chapter helps sort out these i\ ssues and provides you with a sound understanding of the accounting principles you n\ eed to know to answer these types of questions and more.

5.1 Categories of Inventory T he very simple journal entry that opened this chapter contemplated a retail business model. The company bought goods from a supplier and resold those goods to custom - ers at a higher price point. This is traditional retailing, which is a large segment of the economy but not the only segment. Some aspects of a medical practice may\ work this way.

For example, a practice that sells supplements to its patients would ope\ rate that aspect of the practice as any retail store would.

More likely, the inventory in a medical practice is sold as part of a treatment or procedure.

For example, the medical practice may bill $100 for giving a patient an \ injection. The sup - plies for the injection may have cost $50 to purchase. So in this very simple example, the amount paid to the practice would be the revenue. The amount paid for the inoculation from the supplier would be the cost of goods or services sold.

Some healthcare entities manufacture their goods, such as pharmaceutical firms or medi- cal equipment providers. These types of companies also carry inventory on their books. Inventory Costs As a general rule, inventory should include all costs that are ordinary and necessary to put the goods in place and in condition for their resale. Inventory therefore includes the invoice price, shipping costs incurred when buying the goods, and similar costs. Costs like interest charges on money borrowed to buy inventory, storage costs, and insurance are not included in inventory accounts because they do not meet the genera\ l rule. Those costs are called carrying costs and are to be expensed in the period incurred.

Freight Few people think deeply about how significant freight cost can be to the overall cost of bringing a product to market. It can be expressed in very simple terms. If you drive to the store for a gallon of milk costing $3 and spend $3 on gas to make the trip, how much did eps81189_05_c05.indd 84 12/20/13 9:28 AM CHAPTER 5 Section 5.1 Categories of Inventory the milk actually cost? If you were trying to categorize your milk in the refrigerator as an asset on an accounting balance sheet, would your report its cost at $3 or $6? Because of its significance, accountants have been very careful to describe fully a framework for the handling of freight costs. Developing an understanding of this framework begins with specific knowledge about freight terms.

FOB is a common freight nomenclature. It is an abbreviation for “free on board.” What that really means is the point at which the ownership of goods shifts from the seller to the buyer. Thus, goods may be sold FOB shipping point. Once goods are shipped, they are deemed the property of the buyer. Equally important, the buyer must assume responsi- bility for payment of freight to the destination. Conversely, FOB destination means that the seller owns the goods until they are delivered and must bear the cost of shipping. The implications of freight terms should not be underestimated. There are two highly signifi - cant inventory accounting considerations that are directly affected by the FOB terms.

First, goods sold FOB destination do not belong to the purchaser until they arrive at their final destination. Therefore, goods that have been purchased but not yet received would not be carried in the buyer ’s balance sheet at the end of the accounting period. Similarly, no liability would be reported for the payment obligation. Conversely, goods purchased FOB shipping point that have been shipped by the seller should be reflected on the buy - er ’s balance sheet, even though they may not be in the buyer ’s physical possession. In this case, the buyer needs to show both the inventory and related liability on its books.

Accountants can face interesting challenges to determine the status of goods in transit at the end of each accounting period.

The second major issue pertains to the freight cost. When the buyer assumes the freight cost (as with FOB shipping point), it is deemed to be an ordinary and necessary cost to put the goods in place and in condition for resale. As such, accountants will add freight-in to the cost of the inventory. Thus, the Inventory account will reflect both the invoice cost of the goods, along with any additional amounts for freight. You should be aware that freight-out incurred by a seller of goods faces a different accounting rule. Freight-out is treated like a sales expense and does not increase the cost of goods sold amount; instead, the freight out is subtracted from gross profit in calculating income.

Consigned Goods On occasion, a supplier may approach a healthcare organization about stocking a par - ticular product. The healthcare organization may be reluctant, not wanting to invest in inventory that may not be used for patient services. This negotiation ma\ y result in a con- signment of inventory. A consignment is an agreement whereby the inventory’s owner, the consignor, places it with another party in the hope that the goods will be needed\ for patient care. The party holding physical possession is the consignee but not the le\ gal owner. It must care for the goods and try to sell them to an end customer. The consignor surrenders physical custody but maintains legal ownership. The consignor wou\ ld con - tinue to carry the goods in its inventory records.

Consigned goods pose a record-keeping challenge. Because physical custody does not represent ownership, it becomes difficult for both consignees and consignors to main - tain proper accountability over consigned inventory. When the consignee sells consigned eps81189_05_c05.indd 85 12/20/13 9:28 AM CHAPTER 5 Section 5.1 Categories of Inventory goods to an end user, the consignee becomes obligated to remit a portion of the final sales price to the consignor. Otherwise, it is understood that the consignee reserves the right to return the inventory without obligation to make payment.

Critical Thinking About Inventory Cost Consider that a business is likely to open a new accounting period with \ a carryover balance of inventory from the preceding period. This is probably rather obvious. Just because an accounting period has ended does not mean that unsold goods must be dump\ ed. Instead, the ending balance of one period becomes the beginning inventory balance of the next.

Figure 5.1 shows how a period’s beginning inventory, plus additional purchases, can be combined to represent the total goods available for sale. Some of the goods available fo\ r sale are sold and become cost of goods sold, and the unsold portion represents the ending inventory (which will carry forward into the next accounting period). To simplify word- ing, assume cost of goods or services sold in each instance, but we will simplify the rest of the chapter to just using “cost of goods sold.” In many healthc\ are environments, when inventory is used, it is offset by showing a “Supplies Expense.” Whether the use of inven - tory will be shown as a “Cost of Goods Sold” or a “Supplies Expense,” the basic concepts of managing inventory costs or expenses are similar. Figure 5.1: Goods available for sale Figure 5.1 shows how goods available for sale must be split between ending in\ ventory and cost of goods sold. Though a picture may be worth a thousand words, it is also true that accountants rarely communicate with images. Thus, the drawing is usually converted to a calculation format such as the following (all amounts are assumed for the time being):

Beginning inventory $100,000 Plus: Purchases 450,000 Goods available for sale $550,000 Less: Ending inventory 50,000 Cost of goods sold $500,000 The Cost of Goods Sold may be a Supplies Expense in most healthcare environments. In the drawing, the units appear as physical units, but the natural comming\ ling of homoge - neous inventory sometimes makes it difficult or impossible to truly know which units are Beginning inventory + Net purchases Ending inventory + Cost of goods sold Goods available for sale eps81189_05_c05.indd 86 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems which. Accountants therefore express inventory on the balance sheet in units of money rather than physical quantity descriptions.

A critical factor in determining income is the allocation of the cost of \ goods available for sale between ending inventory and cost of goods sold. Accountants have a significant task to assess what cost attaches to ending inventory and what cost atta\ ches to cost of goods sold, especially in light of the fact that the exact physical flow of goods is probably unknown.

5.2 Cost Assignment I t is unlikely that each unit of inventory will have the exact same cost.\ It can be impractical to trace the exact cost of each unit; even when possible, accountants do\ not require this association. Instead, accountants use inventory cost flow assumptions. These assump- tions do not need to relate to the physical flow of the inventory. Thus, the inventory cost allocation approach is just a systematic approach for dealing with the question of what cost is to be attached to ending inventory and cost of goods sold.

To illustrate this point, consider the case of Jill’s Medical Supplies\ . Jill’s Medical Supplies has a storage bin full of gauze rolls. As customers purchase rolls, Jill’s Medical Supplies randomly selects them from the bin. As Jill’s restocks, they dump newly purchased gauze rolls into the bin. The rolls are constantly being mixed up such that Jill’s has no way of knowing the exact purchase date or price of any particular roll remaining in the bin. Dur - ing a recent period, the bin had an opening supply of 500 rolls and was restocked two different times. At each restocking, 500 rolls were added. The rolls in beginning inventory cost $2 per roll. The first restocking had a unit cost of $2.25. The final restocking was at $2.75. The bin was never allowed to empty completely. At the end of the period, the bin contains 125 rolls, probably including some from beginning inventory and each restock- ing event.

What is the cost of the ending inventory? The answer to this important q\ uestion will directly impact the calculation of not only ending inventory but also cost of goods sold (and therefore income). Jill’s must adopt an inventory-costing method. There are several cost flow assumptions to choose from. One is a first-in, first-out (FIFO) approach. Another is the last-in, first-out (LIFO) approach. The third method reflects a more complex aver- age cost approach. These approaches will be discussed in the next section. The complexity arises because the average cost method is not just the simple average of\ the per-unit price but instead weights the cost by the number of units purchased at each price point. Thus, it is also known as a weighted-average concept. In the average cost exam\ ple that follows, the weighted-average cost is recalculated each time there is a new purchase, resulting in a further refinement of its moniker as the moving-average method.

5.3 Perpetual Systems B efore more closely examining the accounting for Jill’s inventory under the FIF\ O, LIFO, and average cost approaches, it is first necessary to point out that inventory costs can either be accumulated on a real-time perpetual inventory system or occasionally updat - ing via a periodic inventory system. As the name suggests, a perpetual system is one in eps81189_05_c05.indd 87 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems which inventory records are continuously updated for all inventory changes. As inven- tory is purchased, it is added into the Inventory account. As inventory is sold, it is sub - tracted from the Inventory accounts. A periodic system is one in which the Inventory accounts are only updated on designated intervals, such as at the end of each accou\ nting period. At one time, accumulating and assigning costs on a perpetual basis was e\ xceed - ingly difficult because of the extraordinarily tedious record keeping that ensues. Then, companies necessarily resorted to simplifying techniques that only periodically updated inventory records. Modern computers have allowed companies to adopt more sophisti - cated real-time, or perpetual, tracking of inventory. These systems greatly improve asset accountability and business decision making. With a perpetual system, each inventory purchase or sale transaction triggers an update of the inventory records and corporate general ledger. To begin to see how this operates, closely examine the details about Jill\ ’s inventory purchases in Table 5.1.

Table 5.1: Jill’s Medical Supplies inventory purchases Date Quantity Purchased Cost per Unit Total Cost Beginning balance July 1 500$2.00 $1,000 Purchase 2 July 15500$2.25 $1,125 Purchase 3 July 24500$2.75 $1,375 In addition to information about the purchasing activity, we also need detailed informa - tion about Jill’s sales. Table 5.2 provides detailed sales data:

Table 5.2: Jill’s Medical Supplies sales data Date Quantity Sold Sales Price per Unit Total Sales Sale 1 July 9400$4.00 $1,600 Sale 2 July 20550$4.50 $2,475 Sale 3 July 28425$5.00 $2,125 Overall, you will notice that Jill’s had 1,500 units available (500 \ 1 500 1 500) and sold 1,375 units (400 1 550 1 425), leaving the remaining ending inventory on hand at the end of July at 125 units. We mustn’t lose sight of our accounting goals: to determine the total \ sales, total cost of goods sold, gross profit, and ending inventory balances to report in the financial statements. Making this determination will require an inventory cost flow assumption.

Importantly, the cost flow assumption is used to describe the flow of the cost of g\ oods through the accounting system. It is not necessary that a cost flow assumpt\ ion actually correspond to a physical flow, but it useful to visualize a cost flow assumption by thinking about physical flow. In a healthcare setting, you would likely sell medications on a FIFO eps81189_05_c05.indd 88 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems basis. Medications can become outdated, and you want to use them before they expire.

This is logical. On the other hand, if you sold crushed rock that was dumped in large stacks as it was processed and delivered via a loader scooping from the pile as it was sold, you can likely understand the LIFO cost flow concept. We will first perform Jill’s inven- tory calculations using a perpetual FIFO method.

First-In, First-Out Table 5.3 shows the level of detail that is necessary to track the inventory correctly. Study this very carefully. Perhaps you can follow the logic by only tracking amounts in the table; if not, additional explanatory details are provided below the table. Remember, this is a FIFO example. When a sale occurs, the assumption is that the units sold \ were from the first, or earliest, available units: first-in, first-out.

Table 5.3: FIFO inventory tracking Date Purchases SalesCost of Goods Sold Remaining Inventory Balance July 1 500 , $2.00 5 $1,000.00 July 9 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 100 , $2.00 5 $ 200.00 July 15 500 , $2.25 5 $1,125.00 100 , $2.00 5 $200.00 500 , $2.25 5 1,125.00 $1,325.00 July 20 550 , $4.50 5 $2,475.00 100 , $2.00 5 $200.00 450 , $2.25 5 1,012.50 $1,212.50 50 , $2.25 5 $112.50 July 24 500 , $2.75 5 $1,375.00 50 , $2.25 5 $112.50 500 , $2.75 5 1,375.00 $1,487.50 July 28 425 , $5.00 5 $2,125.00 50 , $2.25 5 $112.50 375 , $2.75 5 1,031.25 $1,143.75 125 , $2.75 5 $343.75 eps81189_05_c05.indd 89 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems Notice that a significant amount of detail is in tracking inventory usin\ g a perpetual approach; without computers, this becomes nearly impossible to do correctly when vast inventories and large volumes of transactions are involved. However, given a properly programmed computer, the task is inconsequential. Many businesses have a sufficient level of sophistication that inventory records are being updated as each sale is recorded at a point-of-sale terminal. Jill’s Medical Supplies could have such a t\ erminal.

Be sure to note exactly what is occurring on each date. For example, on July 2\ 0, 50 units remain after selling 550 units. This is determined by first noting that 600 units were on hand prior to the sale transaction (consisting of 100 units that are assumed to cost $2.00 each and 500 units that are assumed to cost $2.25 each). After removing 550 units from stock (assumed to consist of 100 units costing $2.00 and 450 units cost\ ing $2.25), only 50 remain at an assumed unit cost of $2.25. This cost analysis and allocatio\ n process must be repeated with each transaction that results in increasing or decreasing the inventory bal- ance. With FIFO, keep in mind that the layers of inventory assumed to be sold a\ re based on the chronological order in which they were purchased.

The analysis provided within Table 5.3 provides a basis for actually recording the transac- tions into the general journal. Be sure to trace the amounts in the entries back into Table 5.3. Remember, Inventory is debited as purchases occur and credited as sales occur. Fol - lowing are the necessary entries to record July’s activity:

When a sale occurs, the assumption is that the units sold were from the last, or most recent, available units: last-in, first-out.

7-24-XXInventory 1,375.00 Accounts payable 1,375.00 Purchased inventory on account 7-28-XX Accounts receivable 2,125.00 Sales 2,125.00 Sold inventory on account 7-28-XX Cost of goods sold 1,143.75 Inventory 1,143.75 To record the cost of goods sold Using selected T-accounts in Exhibit 5.1, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($\ 3,156.25), and the ending inventory ($343.75). Exhibit 5.1: T-accounts for sales, cost of goods sold, and inventory (FIFO) Sales Cost of Goods Sold Inventory 1,000.00 1,600.00 800.00 800.00 1,212.50 2,475.00 1,212.50 1,212.50 1,375.00 2,125.00 1,143.75 1,143.75 6,200.00 3,156.25 343.75 eps81189_05_c05.indd 91 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems Table 5.4: LIFO inventory tracking DatePurchases SalesCost of Goods Sold Remaining Inventory Balance July 1 500 , $2.00 5 $1,000.00 July 9 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 100 , $2.00 5 $200.00 July 15 500 , $2.25 5 $1,125.00 100 , $2.00 5 $200.00 500 , $2.25 5 1,125.00 $1,325.00 July 20 550 , $4.50 5 $2,475.00 500 , $2.25 5 $1,125.00 50 , $2.00 5 100.00 $1,225.00 50 , $2.00 5 $ 100.00 July 24 500 , $2.75 5 $1,375.00 50 , $2.00 5 $100.00 500 , $2.75 5 1,375.00 $1,475.00 July 28 425 , $5.00 5 $2,125.00 425 , $2.75 5 $1,168.75 50 , $2.00 5 $100.00 75 , $2.75 5 206.25 $306.25 Again, carefully observe the action on each date. For example, the 50 remaining units on July 20 consist of those from the very beginning stock (at $2.00 each) because it is assumed under LIFO that goods from the recent purchases are the ones being sold. With LIFO, the layers of inventory assumed to be sold are based on the reverse order in which they were purchased. Following are the necessary entries to record July’s LIFO-based activity: eps81189_05_c05.indd 92 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems 7-9-XXAccounts receivable 1,600.00 Sales 1,600.00 Sold inventory on account 7-9-XX Cost of goods sold 800.00 Inventory 800.00 To record the cost of goods sold 7-15-XX Inventory 1,125.00 Accounts payable 1,125.00 Purchased inventory on account 7-20-XX Accounts receivable 2,475.00 Sales 2,475.00 Sold inventory on account 7-20-XX Cost of goods sold 1,225.00 Inventory 1,225.00 To record the cost of goods sold 7-24-XX Inventory 1,375.00 Accounts payable 1,375.00 Purchased inventory on account 7-28-XX Accounts receivable 2,125.00 Sales 2,125.00 Sold inventory on account 7-28-XX Cost of goods sold 1,168.75 Inventory 1,168.75 To record the cost of goods sold Using selected T-accounts in Exhibit 5.2, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($\ 3,193.75), and the ending inventory ($306.25). eps81189_05_c05.indd 93 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems (continued) Exhibit 5.2: T-accounts for sales, cost of goods sold, and inventory (LIFO) Sales Cost of Goods Sold Inventory 1,000.00 1,600.00 800.00 800.00 1,225.00 2,475.00 1,225.00 1,212.50 1,375.00 2,125.00 1,168.75 1,168.75 6,200.00 3,193.75 306.25 The Average Cost Approach If Jill’s had instead applied the average cost approach, its cost allocation would appear as shown in Table 5.5. In reviewing this data, be sure to notice how the average cost of the total remaining supply of inventory must be recalculated with each purchase of inventory.

The decimals associated with the pennies can become very important becau\ se the aver - age unit cost is often multiplied times thousands of units (so don’t\ round significantly!).

Another important aspect of these calculations is that you cannot just a\ verage the three unit cost values ($2.00, $2.25, and $2.75) because that would fail to \ weight the cost by the number of units acquired or held at each cost point.

Table 5.5: Cost allocation Date Purchases SalesCost of Goods Sold Remaining Inventory Balance July 1 500 , $2.00 5 $1,000.00 500 , $2.00 5 $1,000.00 July 9 400 , $4.00 5 $1,600.00 400 , $2.00 5 $ 800.00 100 , $2.00 5 $ 200.00 July 15 500 , $2.25 5 $1,125.00 100 , $2.00 5 $ 200.00 500 , $2.25 5 1,125.00 $1,325.00 $1,325.00/600 units 5 $2.2083 average eps81189_05_c05.indd 94 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems Table 5.5: Cost allocation (continued) DatePurchases SalesCost of Goods Sold Remaining Inventory Balance July 20 550 , $4.50 5 $2,475.00 500 , $2.2083 5 $1,214.56 50 , $2.083 5 $110.4217 July 24 500 , $2.75 5 $1,375.00 50 , $2.2083 5 $110.4217 500 , $2.7500 5 1,375.00 $1,485.42 $1,485.42/550 units 5 $2.7008 average July 28 425 , $5.00 5 $2,125.00 425 , $2.7008 5 $1,147.82 125 , $2.7008 5 $337.60 Following are the revised journal entries necessary to reflect the average cost flow assump - tion. The account titles are not changed, only the amounts.

7-9-XX Accounts receivable 1,600.00 Sales 1,600.00 Sold inventory on account 7-9-XX Cost of goods sold 800.00 Inventory 800.00 To record the cost of goods sold 7-15-XX Inventory 1,125.00 Accounts payable 1,125.00 Purchased inventory on account 7-20-XX Accounts receivable 2,475.00 Sales 2,475.00 Sold inventory on account 7-20-XX Cost of goods sold 1,214.58 Inventory 1,214.58 To record the cost of goods sold 7-24-XX Inventory 1,375.00 Accounts payable 1,375.00 Purchased inventory on account eps81189_05_c05.indd 95 12/20/13 9:28 AM CHAPTER 5 Section 5.4 Comparing Methods 7-28-XXAccounts receivable 2,125.00 Sales 2,125.00 Sold inventory on account 7-28-XX Cost of Goods Sold 1,147.82 Inventory 1,147.82 To record the cost of goods sold Using selected T-accounts in Exhibit 5.3, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($\ 3,162.40), and the ending inventory balances ($337.60). Let’s see how these entries impact certain ledg\ er accounts and the resulting financial statements. Exhibit 5.3: T-accounts for sales, cost of goods sold, and inventory (average costing) Sales Cost of Goods Sold Inventory 1,000.00 1,600.00 800.00 800.00 1,125.00 2,475.00 1,214.58 1,214.58 1,375.00 2,125.00 1,147.82 1,147.82 6,200.00 3,162.40 337.60 5.4 Comparing Methods A t this juncture, it is essential to see that alternative accounting methods result in differ - ent reported results for specific periods. With FIFO, Jill’s would report a gross profit of $3,043.75 ($6,200.00 sales 2 $3,156.25). With LIFO, Jill’s would report a gross profit of $3,006.25 ($6,200.00 sales 2 $3,193.75). With average costing, the gross profit amounted to $3,037.60 ($6,200.00 sales 2 $3,162.40). This outcome is consistent with a general rule of thumb that states LIFO will produce the lowest profits during a period of rising prices.

Obviously, income is being charged with higher recent costs. Thus, many companies prefer to use LIFO because it reduces income on which taxes may be assessed. You will probably find it interesting to note that many countries outside of the United States do not p\ ermit the LIFO method. Few healthcare settings use LIFO because older inventory would likely expire, if inventory most recently bought was sold first. eps81189_05_c05.indd 96 12/20/13 9:28 AM CHAPTER 5 Section 5.4 Comparing Methods Some may find fault with allowing accounting choices of this nature. Before reaching a conclusion, consider that these differences in income are usually only temporary. If and when the inventory is completely liquidated, the differences will reverse, and the life- time income of the firm will equal out between the methods. For Jill’\ s, the annual income difference is not very material; in some cases, accounting methods produce significantly different results, and sometimes they do not. The takeaway message is that a financ\ ial statement user should clearly examine financial statements and related disclosures to determine the methods in use. This is particularly important when trying\ to compare the performance of two firms, especially when each uses a different set of accounting meth- ods and assumptions.

Specific Identification In lieu of an inventory cost flow assumption like FIFO or weighted avera\ ge, some busi - nesses may instead elect to use the specific identification method. The business must be able to match each unit of inventory with its actual cost. The item’s\ cost remains in the Inventory account until it is sold, at which point it is assigned to Cos\ t of Goods Sold. You can immediately discern that specific identification requires tedious record keeping and would be useful only for inventories with a fairly high per-unit cost and unique identify - ing characteristics. For example, a medical equipment supplier may use t\ his method if each piece of equipment must be customized to patient needs.

Lower-of-Cost-or-Market Adjustments Notwithstanding the cost flow assumption or other inventory valuation te\ chnique in use, it is imperative that a company not overstate the reported inventory value on the bal- ance sheet. Sometimes a company may find that it is holding inventory th\ at it cannot sell for its reported value. Obsolescence, defects, cost declines, and similar issues can impair the realizable value of selected inventory items. Accountants are required to periodically assess inventory on hand to ensure that it is not reported for more than its market value.

This testing is known as a lower-of-cost-or-market method review. In other words, although accountants normally report assets at cost, they also avoid reporting them at more than their market value. That is, the accounting principle is to report the asset at the lower of its original cost or current market value. If the accountant finds that inventory is being carried in the accounting records at more than market value, a downward reduc - tion in recorded valuations may be in order. These so-called write downs, or impairments, from the recorded cost to the lower market value would be made by crediting the Inven - tory account and debiting a Loss for Reduction in Market Value. This loss reduces income.

A healthcare institution may find this necessary if supplies become outdated.

In the context of inventory testing, market value is generally but not a\ lways considered to be the cost that it would take to replace the goods. This is not the same as expected selling price. Basically, if the inventory on hand can be replaced for a new investment amount that is below reported cost, an impairment reduction is in order. Once a reduction has been recorded, subsequent recoveries in value are not recognized. In essence, the reduced value becomes the new accounting amount to carry in inventory going forw\ ard. eps81189_05_c05.indd 97 12/20/13 9:28 AM CHAPTER 5 Section 5.5 The Importance of Accuracy Case Study: Jack’s Medical Supply Company Jack’s Medical Supply Company began business on January 1 of the current year. Owner, Jack Welsh, is trying to determine which inventory method would be the most appropriate for his business. He asks his accountant, Laurie Gordon, to review the purchases and sales to determine how best to present his inventory value on the Balance Sheet in preparation for his year-end financial reports.

Purchases of walkers were as follows:

1/3: 100 walkers , $125 3/17: 50 walkers , $130 5/9: 246 walkers , $140 7/3: 400 walkers , $150 10/23: 74 walkers , $160 Jack’s Medical Supply sold 710 walkers at an average price of $250 per walker. The company uses a periodic inventory system.

(continued) 5.5 The Importance of Accuracy W hat is the effect of a company’s failure to reduce the carrying value of impaired inventory? Or, what is the effect of failing to adjust inventory records for goods that are shown to exist but cannot be physically located? In general, why does it matter that inventory records accurately reflect the goods on hand, as measured under gener - ally accepted accounting principles? The general rule is that overstatements of ending inventory cause overstatements of income, whereas understatements of ending inventory cause understatements of income. Before giving consideration to offsetting tax effects, this offset is “dollar for dollar.” In other words, if inventory is overstated by $1, so is income for that year. Remember, the total cost of goods available for sale is ultimately allocated either to Cost of Goods Sold or Inventory (i.e., if the cost is not in \ Inventory, then it must be assigned to Cost of Goods Sold, thereby reducing income).

Despite a company’s best efforts to maintain an accurate perpetual inventory accounting system, errors and discrepancies will invariably creep into the accounting system. Goods may be lost, damaged, or stolen, or transactions may be recorded incorrectly. Therefore, a company should physically examine its inventory on hand at least once \ each year. This is a highly significant point. Perhaps you have worked for a company and been involved in taking the physical inventory. A physical inventory is the process of actually count - ing and valuing the inventory on hand. Discrepancies should be investigated, and the accounting records should be updated to reflect the balance that is finally determined to be correct—thus the need for accuracy. Employees are often unaware of the connection between a careful count and the final measure of a firm’s income. eps81189_05_c05.indd 98 12/20/13 9:28 AM CHAPTER 5 Key Terms average cost A cost flow assumption. cost flow assumptions Inventory-costing methods such as first-in, first-out; last-in, last-out; or average cost. first-in, first-out (FIFO) An inventory- costing method; the assumption is that the units are sold from the first, or earliest, available units. FOB (free on board) A common freight nomenclature indicating the point at which the ownership of goods shifts from the seller to the buyer. FOB destination A common freight nomenclature indicating that the seller owns goods until they are delivered and must bear the cost of shipping. FOB shipping point A common freight nomenclature indicating that once goods are shipped, they are deemed the buyer ’s property and the buyer must bear the cost of shipping. last-in, first-out (LIFO) When a sales occurs, the assumption is that the units sold were from the last, or most recent, available. lower-of-cost-or-market method A method whereby inventories are accounted for at acquisition cost or market value, whichever is lower. periodic inventory system An updating system in which inventory accounts are only updated on designated intervals, such as at the end of each accounting period. perpetual inventory system An updat- ing system in which inventory records are continuously updated for all inventory changes. physical inventory The process of actu- ally counting and valuing inventory on hand. specific identification The method in which a business must match each unit of inventory with its actual cost. Key Terms Case Study: Jack’s Medical Supply Company (continued) Case Study Exercises 1. Calculate the cost of goods sold, ending inventory, and gross profit under each of the following inventory valuation methods. a. First-in, first-out b. Last-in, first-out c. Weighted average 2. Which of the three methods would be chosen if management’s goal is to a. produce an up-to-date inventory valuation on the balance sheet? b. approximate the physical flow of basic medical supplies? c. report low earnings (for tax purposes) for a separate medical equipment company that has been experiencing declining purchase prices? eps81189_05_c05.indd 99 12/20/13 9:28 AM CHAPTER 5 Review Questions Review Questions The following questions relate to several issues raised in the chapter. Test your knowl- edge of these issues by selecting the best answer. (The odd-numbered answers appear in the answer appendix.) 1. Because of a mathematical error, the 20X8 ending inventory included goods at a $170 figure that had actually cost $710. As a result of this error, a. net income for 20X8 is overstated. b. net income for 20X8 is understated. c. operating expenses for 20X8 are understated. d. total liabilities at the end of 20X8 are overstated. 2. The inventory cost flow assumption in which the oldest costs incurred become part of cost of goods sold when units are sold is a. LIFO. b. FIFO. c. the weighted average. d. retail. 3. The LIFO inventory valuation method a. is acceptable only if a company sells its newest goods first. b. will result in higher income levels than FIFO in periods of rising prices. c. will result in a match of fairly current inventory costs against recent selling prices on the income statement. d. cannot be used with a periodic inventory system. 4. Stanley Medical Supply Company sells two different products. The following information is available at year-end:

Inventory Item UnitsCost per Unit Market Value per Unit A 100 $4 $6 B 200 5 3 Applying the lower-of-cost-or-market rule to each item, what will be Stanley’s ending inventory balance? a. $1,000 b. $1,200 c. $1,400 d. some other amount 5. Which of the following accounting systems maintains a running (continuous) record of merchandising purchases and sales by inventory item? a. perpetual b. gross profit c. periodic d. retail eps81189_05_c05.indd 100 12/20/13 9:28 AM CHAPTER 5 Exercises 6. What items are reported as inventory for (a) merchandising companies and (b) manufacturing companies? 7. The Potter Medical Supply Company purchased the following merchandise on December 28: SupplierTermsAmount Pax Medical Supply Company FOB destination$1,800 James Manufacturing FOB shipping point2,500 Both purchases were shipped December 30, but neither had been received by December 31. Should the purchases be included in Potter ’s December 31 ending inventory? Explain.

8. Why is it necessary to take a physical count of inventory at the end of \ each accounting period? 9. Why is the specific identification method of inventory valuation used in\ frequently? 10. In a period of rising prices, which inventory valuation method (LIFO or FIFO) tends to result in the following? a. highest cost of goods sold b. lowest inventory valuation c. highest income taxes 11. Discuss the advantages of a perpetual inventory system when compared with a periodic system. Exercises 1. Inventory errors and income measurement. The income statements of Keagle Medical Equipment Company for 20X3 and 20X4 follow. 20X3 20X4 Sales $100,000$109,000 Cost of goods sold 62,000 74,000 Gross profit $ 38,000$ 35,000 Expenses 26,000 22,000 Net income $ 12,000 $ 13,000 A recent review of the accounting records discovered that the 20X3 ending inven- tory had been understated by $4,000. a. Prepare corrected 20X3 and 20X4 income statements. b. What is the effect of the error on ending owner ’s equity for 20X3 and 20X4? eps81189_05_c05.indd 101 12/20/13 9:28 AM CHAPTER 5 Problems 2. Inventory valuation methods: basic computations. The January beginning inven- tory of the White Medical Supply consisted of 300 units costing $40 each\ . During the first quarter, the company purchased two batches of goods: 700 units at $44 on February 21 and 800 units at $50 on March 28. Sales during the first quarter were 1,400 units at $75 per unit. White Medical Supply uses a periodic invent\ ory system.

Using the White Medical Supply data, fill in the following chart to comp\ are the results obtained under the FIFO, LIFO, and weighted-average inventory met\ hods. FIFOLIFOWeighted Average Goods available for sale $$$ Ending inventory, March 31 Cost of goods sold 3. Analysis of LIFO versus FIFO. Indicate whether LIFO or FIFO best describes each of the following: a. gives highest profits when prices fall. b. yields lowest income taxes when prices rise. c. generates an ending inventory valuation that somewhat approximates replacement cost. d. matches recent costs against current selling prices on the income statement. e. comes closest to approximating the physical flow of goods of a fruit and vegetable dealer. f. results in lowest cost of goods sold in inflationary periods. Problems 1. Inventory errors. The income statements of Duty Medical Supply Company for the years ended December 31, 20X1 and 20X2, follow. 20X1 20X2 Net sales $ 440,000 $483,000 Cost of goods sold Beginning inventory $ 95,000 $109,000 Add: Net purchases 380,000 404,000 Goods available for sale $ 475,000 $513,000 Less: Ending inventory 109,000 127,000 Cost of goods sold 366,000 386,000 Gross profit $ 74,000 $ 97,000 Operating expenses 58,000 67,000 Net income $ 16,000 $ 30,000 eps81189_05_c05.indd 102 12/20/13 9:28 AM CHAPTER 5 Problems Duty uses a periodic inventory system. A detailed review of the accounting records disclosed the following:

• A review of 20X1 purchase invoices revealed that a clerk had incorrectly re- corded a $12,600 purchase as $1,260. • A $4,800 purchase was made on December 30, 20X2, terms FOB shipping point. The invoice was not recorded in 20X2, nor were the goods included in the 20X2 ending physical inventory count. Both the goods and invoice wer\ e received in early 20X3, with the invoice being recorded at that time. • Goods costing $3,000 were accidentally excluded from the 20X1 ending physi- cal inventory count. These goods were sold during 20X2, and all aspects of the sale were properly recorded.

Instructions a. Prepare corrected income statements for 20X1 and 20X2. b. Determine the impact of the preceding errors on the December 31, 20X2, owner ’s equity balance. 2. Inventory valuation methods: computations and concepts. Jack’s Medical Supply Company began business on January 1 of the current year. Purchases of walkers were as follows: 1/3: 100 walkers , $125 3/17: 50 walkers , $130 5/9: 246 walkers , $140 7/3: 400 walkers , $150 10/23: 74 walkers , $160 Jack’s Medical Supply sold 710 walkers at an average price of $250 pe\ r walker.

The company uses a periodic inventory system.

Instructions a. Calculate cost of goods sold, ending inventory, and gross profit under each of the following inventory valuation methods:

• First-in, first-out • Last-in, first-out • Weighted average b. Which of the three methods would be chosen if management’s goal is to (1) produce an up-to-date inventory valuation on the balance sheet? (2) approximate the physical flow of basic medical supplies? (3) report low earnings (for tax purposes) for a separate medical equipment\ company that has been experiencing declining purchase prices? eps81189_05_c05.indd 103 12/20/13 9:28 AM CHAPTER 5 Problems 3. Lower-of-cost-or-market method. Davenport Opticians began business on Sep- tember 1 of the current year. The following purchases were made during the first few months of operation: Reading GlassesSunglassesContact Lenses 9/2 1,000 , $20 450 , $102,500 , $5 10/15 750 , $22 200 , $152,000 , $6 12/6 300 , $25 1,500 , $7 The December 31 physical inventory count revealed the following items on hand:

650 reading glasses, 400 sunglasses, and 1,000 contact lenses. Total sales through year-end were $85,000, and operating expenses (excluding cost of goods sold) totaled $17,800. Davenport uses the FIFO inventory valuation method coup\ led with a periodic inventory system.

Instructions a. Compute the company’s inventory as of December 31. In addition, calcu\ late cost of goods sold and net income through the end of the year. b. Assume that the manufacturer of contact lenses announced a price decrease to $6.50. Determine the impact of the announcement on the firm’s ending \ inven - tory valuation. c. Prepare the journal entry necessary to value the inventory at the lower-of-cost- or-market value. eps81189_05_c05.indd 104 12/20/13 9:28 AM CHAPTER 5