Liabilities (2)

Preparing and using an Amortization Table, year-end balances and adjusting journal entries

On April 1, 2005, Mike's Bikes, Inc. signed a 5-year, $50,000 note payable to 6th National Bank in conjunction with the purchase of equipment. The note calls for interest at an annual rate of 8%, with payments of $ 1,013.82 per month starting May 1, 2005. The note is fully amortizing over a period of 60 months. The bank sent Mike an amortization table showing the allocation of monthly payments between interest and principal over the life of the loan. A small part of this amortization table is illustrated below.

In Chapter 7 we prepared a Bank Reconciliation to dertermine the correct Cash account balance. We also entered journal entries to correct any errors and journalize any unrecorded transactions.

In Chapter 10 we are going to verify the correct account balances for Notes Payable and Interest Payable, that is, the balance these accounts should be as of year-end on December 31. This is one of our standard and ordinary year-end procedures.

We determine correct loan and interest payable balances by creating an amortization table. We will write adjusting entries to bring the account balances into agreement with the amortization table.

Let's look at some journal entries over the life of a loan and see how they relate to the amortization table.

Journal entry to record the original note payable of $50,000 on April 1, 2005. We have increased Cash (Debit) and increased Notes Payable (Credit). No interest has accrued yet. Interest is related to time, so at least one day must pass before we can calculate (accrue) interest.

Date	Account	Debit	Credit
Apr-1	Cash	$50,000
	Notes Payable		$50,000
	To record 8% 60-month note with 6th National Bank

Monthly payments and principal balances

Interest calculation
Beginning Balance * Annual Interest Rate * Time Factor
$50,000 * 8% * 1/12 = $333.33

Principal payment = Payment amount - Interest
$1,013.82 - $333.33 = $680.49

Principal balance reduction
Beginning Balance - Principal payment = Ending Balance
$50,000 - $680.49 = $49,319.51

Journal entry to record the first monthly payment on this note, May 1, 2005, payment 1 from the amortization table above.

Date	Account	Debit	Credit
May-1	Notes Payable	$680.49
	Interest Expense	333.33
	Cash		$1013.82
	To record monthly note payment for May.

Balances at December 31, 2006 (year end)

Making Year-End Adjusting Journal Entries
Adjusting journal entries should be made to bring account balances to the correct amount before preparing financial statements. The Books are not always correct or accurate. This situation needs to be corrected at the end of the year, or anytime we need to prepare Financial Statements

At the end of each year we organize our adjusting entries on a Working Trial Balance (WTB) before preparing financial statements. You can see an example of the WTB in Comprehensive Problem 1, in your text. Let's look at an example of year-end adjusting entries.

Example - adjusting Notes Payable at year-end

Assume the following: We look at the WTB and see that the loan balance is recorded as a credit balance of $ 44,329.16. We compare this with our amortization table and see that the correct balance should be a credit balance of $ 44,427.38. We need to make an adjusting entry to bring the books to the correct balance.

In this case we need to credit Notes Payable for $ 98.22 to bring the books into agreement with the amortization table. In some cases we would have to debit Notes Payable. When do you think that would be the case? If an amortization table was used for each monthly loan payment, the books should agree with the amortization table, and no adjusting entry would be needed in that case.

What account should we debit? We must review the related journal entries for the year and see which accounts were debited and credited each month. In most cases we will make the adjustment to the Interest Expense account (look at the monthly entries above). In some cases we may find that a different account was used by mistake. We would correct that error as well, when making the year end adjustments. Let's assume that the only two accounts effected in this example are Notes Payable and Interest Expense. The adjusting journal entry would be.

Date	Account	Debit	Credit
Dec-31	Interest Expense	$ 98.22
	Notes Payable		$ 98.22
	To adjust Notes Payable to agree with amortization table

Proof:

	Debit	Credit
Notes Payable balance		44,329.16
Adjustment		98.22
Corrected NP balance		44,427.38
Balance per amortization table		44,427.38
Difference		0

The same approach can be used to reconcile and adjust Interest Expense. But generally speaking we are more concerned with having the correct Notes Payable balance on the balance sheet.

Large businesses record transactions daily, sometimes in Real Time, as they happen. Smaller businesses may record transactions less frequently, perhaps at the end of the day, week or month. Bookkeepers often have to make estimates, especially when they don't have enough information to write a correct entry. This is common in the business world.

Here's a common example, and one I see on a regular basis as an accountant and tax preparer. A client or their bookkeeper records a loan payment as a debit to "Loan Payment" and a credit to "Cash." You should know by now that accountants don't use an account called "Loan Payment." We record a loan payment with debits to Interest Expense and Notes Payable and a credit to Cash, as shown in the examples above. To correct the bookkeeper's error we would write an adjusting entry to debit the correct accounts and bring the "bogus" account to a zero balance.

Present Value
If you owe me $1000 I would like to have it paid as soon as possible. I am losing the use of my money as long as you owe me.

If I fall on hard times I might prefer to get my money paid back sooner, rather than later, because I need the money now. I might be inclined to settle for less than the full amount of the debt, in order to get the cash I need as soon as possible.

Let's say I could earn 10% interest if I had the money you owe me. In one year I would lose:

$1000 x 10% x 1 = $100 interest

if you paid me back now I could accept

$1000 - $100 = $900

Investing that money in an interest bearing account, which compounds daily (typical bank method), the $900 would grow to $1000 in a year. I would be in the same position at the end of a year, either way. But one way I have my money available in case I need it, which may be preferable.

The long and short of this story is simple. Money has a value, over time. It can be calculated fairly easily. If we don't have our money, we lose the use of it. Having money now is better than having it in the future, because I can put it to better use if it is available to me.

The business world accepts these simple facts about money, and business managers assume that interest should be earned or paid whenever appropriate in the situation. Federal tax law mandates that interest be charged where appropriate. Zero interest loans are not recognized for federal tax purposes.

Contingencies
A contingent situation is one that may arise in the future, based on some past event. For instance, if I sell lawnmowers one of them might break in the warranty period, and I will have to replace it. The warranty claim will arise in the future, from a sale made today.

There may be contingent gains or losses. Contingent gains are ignored until they are finalized. Contingent losses are recognized as soon as they can be identified and measured.

GAAP places a couple of requirements on contingent losses. They should be reported in the financial statements if they meet BOTH of two criteria:
1) the loss is probable,
2) the amount can be reasonably estimated.

It must also be a material amount, in order to have a reportable effect on the financial statements. Some are just a normal part of business, called general business risk, and are not reported. For instance, we all know that airplanes can crash. Airlines don't consider this a reportable contingency, because it is impossible to predict the occurrence or amount of loss in advance.

On the other hand, the company may be involved in a lawsuit. Their attorney advises them that they will probably lose, based on other cases and the probable loss will be $100,000. The loss is probable, and the amount can be reasonably estimated. The loss would be entered into the books, with a journal entry, and disclosed in the financial statements.

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Liabilities (1)

Liabilities are essentially debts. They can be:
current (short term): due & payable within 1 year
long-term: due & payable in over 1 year

The most common liabilities are:
Accounts Payable: for routine expenses and inventory purchased on credit

Notes Payable: short- or long-term loans from banks or other lenders

Accrued Expenses: various current expenses, accrued to prepare financial statements; these can include accounts such as interest payable, taxes payable, wages payable, and other similar accruals at the end of the year.

Mortgage Notes: long term borrowing to purchase major assets; the assets purchased are also pledged as collateral

Bonds Payable: corporation general debt; bonds of major corporations can be purchased on a public stock exchange; bonds pay interest on a regular basis, usually twice a year; bonds may have maturity dates from 5 to 30 years, or any other time frame selected by the company and acceptable by lenders.

Liabilities often have to be estimated at balance sheet date, so we can prepare financial statements.

Amortization table
An amortization table is a calculation involving interest and regular payments, or reductions, in an account or debt. Costs can be amortized over several years, using an amortization table. They are usually prepared to show the progress of loan payments, especially in long-term mortgage loans. If you have a home loan, you will probably get an amortization table from your bank, showing how your payments are divided among interest, principle and other fees (escrow).

Amortization tables are relatively easy to prepare. The use of computer spreadsheet programs makes creating these tables a very simple task. One "template" can be created and used over and over for different amounts, interest rates and time frames.

Interest calculation
Interest applies to many liabilities. Notes, bonds and mortgages all involve interest.

Interest is the fee you pay for the use of someone else's money. The calculation is always the same.

Interest = Principle X Annual Interest Rate X Time (portion of a year)

Interest Rates are always expressed in annual terms. For instance, 12% interest means 12% per year, or 1% (1/12) per month.

The Time factor is always in relation to a year, so it maintains the correct relationship with annual interest rates. One month's time factor would be 1/12. Three months' would be 3/12, 7 months would be 7/12, etc.

Sometimes interest agreements are expressed in a number of days. We usually use a 360 day year to make the calculation easier, and more rounded. This goes back to the days before modern calculators and computers, when we used pencil and paper to calculate interest. Example: 30 day note uses 30/360 time factor.

Using Amortization Tables
Amortization is an accounting method used to spread costs or payments over a period of time, based on a few basic concepts: Time, Principal (money or cost), and Interest Rate. Amortizing a loan balance uses all three of these to reduce a loan balance to zero over a number of years. This might apply to a home mortgage or automobile loan. It might also apply to an automobile or equipment lease.

Interest is always expressed as an annual Rate, so your interest calculation must always have a Time factor. For instance, one year's interest on $100 at 12% (annual rate) is

$100 x 12% = $12 annual interest [on your calculator 100 * .12 = 12]

If you make a home or car loan payment every month, you would not want to pay a year's worth of interest on each monthy payment, would you? (this is not a trick question ;-) Of course, you would only want to pay one month's interest each month. So we have to add a Time factor to the annual interest calculation above. In this case there are 12 months in a year, to calculate one month's interest we would use 1/12 as a Time factor.

$100 x 12% x 1/12 = $1 monthly interest [100 * .12 / 12 * 1= 1]

If you wanted to calculate interest for 2 months you would use 2/12:

$100 x 12% x 2/12 = $2 interest [100 * .12 / 12 * 2 = 2]

The monthly payment amount stays the same each month, and is divided between interest expense and principal reduction. As the principal goes down, so does the interest expense. Eventually the principal amount is zero, perhaps over 5 years for a car loan, or 25 years for a home mortgage.

Let's say you buy a new home with a $100,000 mortgage, spread over 25 years, at 8% interest. How much is your payment going to be, and how much interest will you pay over the life of the loan if you make all the payments on time? Here's a good website you can visit to answer this type of question.

http://www.interest.com/calculators

I used their calculator to answer this question, and create an amortization table. It took about 10 seconds. Your monthly payment would be $771.82 and your total interest over the life of the loan (25 years) would be $131,542.40. In total your $100,000 loan would cost you $231, 542.40 -- that's over twice the amount of money you originally borrowed, in fact you would pay back 2.3 times your original loan amount.

Many borrowers reduce their overall interest expense by making extra principal payments on their loans whenever possible. Look at an amortization table you will see that most of the monthly payment goes to Interest and only a small portion goes to Principal Reduction. [If you have not done so yet, use the calculator link, and enter the amounts shown above, then generate an amortization table and look at it.]

At the end of month 1, you would have paid $771.82 ($666.67 interest and $105.15 principal). This reduces your principal balance to $99,894.85. If you were to make all the first 12 payments on time you would have paid $9,261.84 ($7952.69 interest and $1309.15 principal.) At the end of 12 months the loan balance would be $98,690.85. Now, follow closely at this point.

Principal balance after month 1	$99,894.85
Principal balance after month 12	$98,690.85
Difference	$1,204.00
Month 1 payment	$771.82
Total payment	$1975.82

If I pay and extra $1204 principal in month 1, it will reduce my principal balance and move me down the amortization table to where I would be after 12 months. I would avoid paying the amortized interest for months 2 - 12, a savings of $7286.02 over the life of the loan.

In other words, paying an extra $1204 principal saved me $7286 in interest. It would also reduce my total loan payments by 1 year, because I moved down 12 months on the amortization table.

An alternative: Let's say you can't afford to pay that much extra principal each month. If you move down the amortization table one extra month, and pay just that amount of extra principal, you would cut your total interest (about) in half, and cut the loan payoff time in half. In this example you would reduce the loan from 25 years to 12.5 years, and reduce your total interest from $131,542.40 to (about) $65,771.20 - a huge savings!!

CAVEAT: You must still make monthly loan payments, even if you pay off some principal early. So you should incorporate extra principal reduction strategies into your overall cashflow budget. But the earlier you reduce your principal, the better.

Using a spreadsheet, you can quickly create an amortization table for any principal amount, interest rate, payment amount or time factor. With a spreadsheet you can quickly see how different interest rates and payment schedules can effect your personal finances. You can use it for credit cards as well. The same concepts apply.

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Plant Assets and Depreciation (2)

Depreciation Methods
We will study a couple of depreciation methods. There are other methods. If you study international accounting, you will find that other countries deal with these issues in a very different way than we do in the US. But we're #1, so we must be right (hee, hee).

Depreciation Method	my silly comments
Straight-Line Method	causes problems with my spell checker because of the hyphenated word
Declining-Balance Method	oh, no. another hyphenated word. my spell checker is not happy today
MACRS (income tax method)	US congress made up this word. its not in my spell checker dictionary either. whatever they were drinking that night, I want a bottle of it.

OK, let's try this again.

Depreciation Method	my serious comments
Straight-Line Method	an easy method that allocates an equal amount of depreciation to each time period; salvage value is used
Declining-Balance Method (200% & 150% DB)	allocates more depreciation expense to the early years of an asset's life, when it is new; since there should be less down-time and fewer repairs in the early years, the company should get more use out of the asset in the beginning of it's life; no salvage value is used.
MACRS (income tax method)	uses the double-declining balance method, but you only take one-half year's depreciation in the first year, and then you switch to the straight-line method in the middle of the asset's life, so a 5 year asset takes 6 years to depreciate. salvage value? salvage value? we don't need no stinking salvage value!! I still want a bottle of whatever they were drinking when they dreamed this one up.

[It is a little known fact that the US congress is responsible for the rapid growth of the computer industry during the 1980s and 1990s. The MACRS depreciation rules were so complex everyone had to buy computers just to do the calculations each year. Millions of computers were sold, just to calculate MACRS depreciation ........ OK, I'm just kidding. You didn't really think I was serious, did you?. Hey, this is week 8, we're almost done.]

Selling or disposing of Fixed Assets
After selling or disposing of fixed assets, the company no longer has the asset. This requires a journal entry to remove everything in the accounting records relating to the asset.

The depreciable cost and accumulated depreciation relating to the asset must both be removed, or reversed. There might be a gain or loss when disposing of assets. There might also be incidental costs relating to disposing of the asset. All these things should be included in the journal entry recording the disposal.

Let's assume on September 1, the ledger shows these balances for a piece of equipment.

General Ledger
Equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward	$7000		$7000

Accumulated Depreciation - Equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward		$5600	($5600)

Removing these amounts from the books with a journal entry
When assets disposed of there might be a gain, loss or a wash (no gain or loss). In either case all such journal entries will start from the same place, removing the related asset cost and accumulated depreciation. This journal entry does not balance; is the beginnings of a journal entry, and must be completed when all the information is available.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Equipment		$7,000
	To record disposal of equipment

Notice the exact opposite of the account balances is entered for each account. This causes the account balances to go to zero after this journal entry is posted.

General Ledger
Equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward	$7000		$7000
Sep-15	Disposal of asset		$7000	$0

Accumulated Depreciation - Equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward		$5600	($5600)
Sep-15	Disposal of asset	$5600		$0

The asset and related accumulated depreciation have both been removed from the books.

Calculating Book Value
Book Value is the difference between the asset cost and accumulated depreciation:

Equipment cost	$ 7,000
Less: accumulated depreciation	-5,600
Book Value before sale	$ 1,400

Gains and losses are calculated using the Book Value.

Equipment sold for a Gain
If the equipment is sold for more than its book value there will be a gain. Gains are similar to revenues, and will be recorded with a credit entry. Let's say the equipment is sold on September 15 for $2,000. The gain will be:

Selling Price	$ 2,000
Less: Book Value	- 1,400
Gain	$ 600

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$2,000
	Gain on disposal of equipment		$ 600
	Equipment		$7,000
	To record disposal of equipment

The journal entry is now in balance. Did you notice what I did? I started the journal entry with what I already knew - the cost and accumulated depreciation. I left 2 lines blank in the middle of the journal entry, so the sales price and gain or loss could be recorded.

Equipment sold for a Loss
If the equipment is sold for less than its book value there will be a loss. Losses are similar to expenses, and will be recorded with a debit entry. Let's say the equipment is sold on September 15 for $1,000. The loss will be:

Selling Price	$ 1,000
Less: Book Value	- 1,400
Loss	($ 400)

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$1,000
	Loss on disposal of equipment	$ 400
	Equipment		$7,000
	To record disposal of equipment

Equipment sold for a Wash
If the equipment is sold equal to its book value there will be a wash. Let's say the equipment is sold on September 15 for $1,400.

Selling Price	$ 1,400
Less: Book Value	- 1,400
Wash	$ 0

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places. In this case there is a wash, so no gain or loss is recorded. The equipment is simply removed from the books.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$1,400
	Equipment		$7,000
	To record disposal of equipment

Equipment Junked
If the equipment is junked there will be a loss equal to its book value. We call this abandonment. The item is usually just thrown in the trash, or hauled to the dump. Sometimes a company will have to pay to have the item hauled away. Incidental costs are revenue expenditures, and are not included in calculating the capital gain or loss.

Selling Price	$ 0
Less: Book Value	- 1,400
Loss	($ 1,400)

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Loss on abandonment of equipment	$1,400
	Equipment		$7,000
	To record abandonment of equipment

Intangible Assets
Intangibles are assets that have no physical existence. They are legal assets or accounting assets, such as copyrights, patents, trademarks or goodwill. We use a simple form of amortization, usually straight-line, to allocate the cost of these items to expenses.

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Plant Assets and Depreciation (1)

Depreciation expense spreads the cost of major equipment and assets over a period of time that spans a number of years. Amortization is used to allocate the cost of intangible assets, such as patents, copyrights, trademarks, and franchises. Depletion is used to record the cost of natural resources extracted from the earth.

There are three main events in the life of any asset:

1. acquisition
2. useful life
3. disposal or retirement

We will make journal entries for each of these events. Over the useful life we will enter depreciation expense. At the end of the life we will record any gain or loss at the time of disposal or retirement of the asset. Sometimes assets are traded for other assets, and that must be accounted for in the same manner as a disposal or retirement.

Fixed asset acquisition
Fixed asset accounts are debited for the actual cost of fixed assets. The correct account should be debited. Some companies use a Fixed Asset Subsidiary Ledger and show a control account on the Balance Sheet, called Property, Plant and Equipment (PPE) or something similar. In these cases all fixed assets acquisitions debit PPE and the subsidiary ledger carries the details pertaining to the asset.

Depreciable cost
Buildings, equipment, vehicles, computers, furniture and fixtures are all examples of depreciable assets. We will depreciate the depreciable cost of assets. This includes the purchase price paid, sales tax, shipping and installation costs, and possibly incidental costs if they are material. Cost of fixing damage caused during shipping and installation is treated as a Repair Expense.

Some costs are incidental to buying new equipment. A specialist might be hired to install a large printing press, or other specialized, complex piece of manufacturing equipment. This type of cost is included in the depreciable cost of the asset.

Sometimes employees have to be trained. The cost of training may be considered part of the depreciable cost, it the amount is material to the purchase of the asset. A brief training session for one or two machine operators will probably be an immaterial amount.

The cost of training the entire company's personnel when a new computer system is installed would probably be a material amount, especially in a large company. Every employee might require a day's training or more in the new system. The loss of productivity would be a material amount, and should be classified as part of the depreciable cost of the asset.

Recording Asset Acquisitions
If a company buys land, building, equipment etc. all at the same time, the total purchase price has to be divided correctly among the various assets.

Land is a non-depreciable asset. It falls into its own category in the books and on the Balance Sheet. Don't include land costs with other fixed asset costs, such as buildings. They must always be entered separately. Buildings will be depreciated; land will not be depreciated.

General Journal

Date	Account	Debit	Credit
Apr-15	Land	$5,000
	Building	$45,000
	Cash		$10,000
	Mortgage Note Payable		$40,000
	To record purchase of land and building
Apr-30	Manufacturing Equipment	$7,000
	Computers and peripherals	$10,000
	Computer software	$3,000
	Accounts Payable		$20,000
	To record purchase of equipment, computers and software

The Useful Life of an asset, is the period of time the company expects to use the asset in the business. It is also important that the asset be used as it is intended, and for the production of income. For instance, a computer that is being used as a doorstop is not contributing to the production of income, and it is also not being used as it was intended.

[Of course, at this point some very clever student will say something like, "What if the computer is used as part of an art project displayed in the foyer of an office building? It's not being used as intended nor in the production of income." Well, young Einstein, objects d'art are Investments, not depreciable plant assets. Nice try, but no banana for the monkey.]

Why do assets depreciate?
For Federal Income Tax purposes, depreciation is referred to as cost recovery. The government allows you to use the cost of plant assets to offset income. You recover your cost a little bit at a time, over a number of years. Each year you reduce your income tax expense, by an amount relative to the cost recovery amount for that year. It's a slightly strange concept if you're not involved in preparing income taxes. But it does make sense if you think about it a bit.

For financial statement purposes, depreciation reflects a number of different influences that each affect an asset over its useful life.

• recognize physical deterioration
• recognize obsolescence
• recognize a reduction in market value
• recognize benefits derived from using the asset
• apply a logical, systematic cost allocation over a relevant period of time
• apply the matching principle

Each of these is important to a company. When assets are purchased, the cost is reflected in the Balance Sheet. Depreciation expense transfers that cost to the Income Statement in order to reflect the effect of the items listed above, in the financial statements.

Usually, at this point, students are a showing a slight glaze over their eyes. I then reiterate that depreciation expense reduces income, which in turn cuts income taxes. Cutting our taxes, that's something most of us can relate to. So depreciation is a good thing, an important thing, a joyous and wonderful thing.

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Inventories and Cost of Goods Sold (3)

Using the Periodic system
If you use a Periodic inventory system, you value your inventory only once a year - at the end of the year! So the job is fairly easy, and you should have little problem making the calculation. You apply a cost flow assumption once at the end of the year, and it pertains only to the physical merchandise still on hand at the end of the year.

It doesn't matter when sales take place, or when inventory is purchased. We ignore all that when we use the Periodic system. All we have to care about is what inventory is on hand at the end of the year.

Using the Perpetual System
If you use the Perpetual system you have to track each and every purchase and sale of inventory. Time is definitely of the essence. We will use a cost flow and apply it continuously, updating the Sales, Inventory and COGS accounts daily, as merchandise is purchased and sold.

This can be a daunting task, and usually is done by sophisticated and expensive computerized systems. When you go to a grocery or department store, notice that all the products have a bar code, which is scanned by an electronic cash register. All the merchandise is scanned into the the computer inventory records when it arrives at the store, and is scanned out as it is sold. The inventory records are continuously updated, along with the inventory value.

The type of system a company uses will depend on how much it can afford to spend. Obviously, not all companies can or need to spend $50,000 to $100,000 for each scanning cash register, plus the cost of the computer and software itself. Installing such a system can easily cost $1 million or more per store. That's a high price tag, so most companies use a Periodic system, and update their inventory only once a year.

Estimating Inventory
Let's say a company uses the Periodic system. In the middle of the year they go to the bank seeking a loan for expansion. The banker asks to see a set of financial statements. Taking a complete physical inventory can be a huge, time-consuming task. The company may simply not have time to drop everything and take a physical inventory at this time. Do they have any options?

In fact, they do. They can estimate the inventory on hand. They can reconstruct the inventory based on their purchase and sales records for the year to date. There are a couple of methods used to do this. They are both similar.

The Gross Profit method is one method. The store needs to know it's gross profit rate or cost ratio (the inverse of gross profit rate). They start with the beginning inventory balance, add purchases, and deduct for sales made using the cost ratio. The result is an estimate of the merchandise on hand.

This method is especially useful when there has been a loss due to theft, fire, flood and so forth. The Gross Profit or Retail methods can be used to substantiate an insurance claim for loss in these situations.

Inventory Turnover
Inventory turnover is not some sort of exotic pastry. It also does not mean we physically pick up our inventory and turn it over or upside down. Having dispensed with those misconceptions, just what is inventory turnover?

Each time you sell your entire inventory, you are said to have "turned" or "turned over" your inventory. We measure this as the number of times per year that this happens. We also measure it in a dollar amount, not by the actual physical objects. A store might have a year-old can of "Uncle Simon's Nasty Stuff That Only Your Aunt Ethel Will Eat". Not selling that can will have not effect on inventory turnover, in the larger sense of the word.

[Managers are definitely interested in micro-inventory management: looking at the sales pattern of individual items. Walmart has been an aggressive pioneer in this area. Right now we are dealing with macro-inventory management: looking at the dollar value of the entire inventory, taken as a whole.]

Earlier I discussed how a grocery store stocks milk. The buy enough for one week. There are 52 weeks in a year, so we would expect their inventory turnover, for milk, to be roughly 52. We usually calculate this using dollars, rather than tracking actual cartons of milk.

Number of Days in Inventory is the concept expressed in number of days. It tells us how many days, on average, inventory stays on a shelf before it is sold. Since there are 365 days in a year, we can divide 365 by the inventory turnover rate and get the number of days in inventory.

365 / 52 = 7 (rounded) or roughly 1 week

There are 52 weeks in the year, and the store wants to stock enough for 1 week at a time. Their weekly milk inventory is sold 52 times a year (turnover), or once every 7 days (days in inventory).

Let's look at a table and see some typical correlation's. Notice the inverse relationship between turnover rate and days in inventory. As one goes up, the other goes down.

Turnover Rate	Days in Inventory	Frequency
52	7	weekly
12	30.4	monthly
6	60.8	2 months
4	91.25	quarter (3 months)
2	182.5	half year
1	365	one year

What I'm hoping you'll get from this is a little common sense. Eggs would not have a turnover rate of 4. Perishable items will have a high turnover rate and low number of days in inventory.

Automobiles, diamond rings, and works of art would probably not have a turnover rate of 52. It can take much longer to sell these expensive items. They will have a low turnover rate, and a high number of days in inventory.

How Turnover relates to Gross Profit
Profits depend on several things. One of the most important is the relationship between turnover and gross profit. Higher turnover brings greater profit. Lets look at a simple example.

A store buys Item X for $20, and sells it for $30. The Gross Profit from each item is $10.

Annual Turnover Rate	Sales	COGS	GP
1	30	20	10
2	60	40	20
4	120	80	40

Guess what, we can just multiply the annual turnover rate and the GP per unit ($10). That would be an easier calculation!

Annual Turnover Rate	$GP x TO Rate	Total $GP
1	$10 x 1	$10
2	$10 x 2	$20
4	$10 x 4	$40
6	$10 x 6	$60
12	$10 x 12	$120
52	$10 x 52	$520

If you sell 1 unit per year, you will only make $10 per year.
If you sell 1 unit per week you make $520 per year.

Which is better?

(I sincerely hope you chose $520 per year. If not, please consult a physician. You may need professional help.)

Turnover is essential to profits. Higher turnover = higher profits.

Let's look at an example
Jim buys pocket knives from the manufacturers and resells them on e-bay. He buys by the case and pays $5 for each knife. At the both the start and end of the year he had 30 knives on hand (to make this example a little easier).

Jim bought and sold 800 knives during the year. He had 32 knives on hand at the start and end of the year, so his average inventory is 32 (32+32/2 = 32).

Cost Component	Units	$ Cost
COGS @ $5	800	$ 4,000
Avg Inventory @ $5	32	$ 160
Results
Turnover rate	$4000 / $160 =	25
Days in inventory	365 / 25 =	14.6

What this is telling us:
His average inventory was 32 knives last year.
He sells 32 knives every 25 days.
Each batch of 32 knives is in inventory 14.6 days.
If he sells 800 knives every year, that's about 800 / 365 = 2.19 knives per day.
This is consistent with our results. 32 knives / 14.6 days = 2.19 knives per day.
He sells about 2 x 32 = 64 knives each month (avg 66.6 knives per month).

Inventory Management - a delicate balance
By now you should be seeing the correlation between Gross Profit and sales. No matter what your gross profit is, making more sales will always mean making more GP. Since each and every unit of product you sell earns you a GP, you will always do better selling more, rather than less.

Inventory turnover is a measure of ow often your average inventory is sold. Since business managers have access to all the detailed operating information of their company, they can manage inventory on a product by product basis. They can effectively look at the turnover of a single product, and more accurately gauge their real average inventory held for that item.

There is one very important thing that all businesses have to deal with: carrying the right amount of inventory - not too much, not too little.

If you carry too little inventory you will lose sales, and that will reduce your GP.

If you carry too much inventory the surplus will tie up your cash flow. You will have to warehouse, protect and insure the excess inventory. And you run a high risk of spoilage, obsolescence, theft and damage.

A company will maximize its profits by carrying the correct amount of each item in its inventory. This amount is determined by careful analysis and tracking of customer's buying patters. Stores have to pay attention to the seasonal and cyclic buying trends their customers display. Effective inventory management requires both day-to-day attention, and ongoing analysis of customer preferences and buying habits.

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Inventories and Cost of Goods Sold (2)

FIFO
For instance, a grocery store will buy only the amount of milk it can sell in a week. Because milk spoils quickly, the store will buy small amounts each week, and make sure the milk it has for sale is the freshest milk available.

Further, one gallon of milk is basically the same as the next gallon (with only minor differences). We say that milk is a homogeneous product. All the milk can be viewed as a single product group, that follows an almost identical weekly sales and spoilage pattern.

The grocery will use a flow assumption to value its milk inventory at the end of the year. They will use FIFO, assuming that the milk on hand is the last milk that was bought during the year.

The LIFO method would assume that the milk bought in the first week of the year is the same milk on the shelf at the end of the year. Obviously year old milk will probably be coagulated into a solid, stinking block of green muck. So we know that LIFO would be an incorrect flow assumption for milk. So when will the LIFO assumption will be valid?

LIFO
Let's now picture a clothing store. There are basically 4 clothing seasons: Winter, Spring, Summer and Autumn. There is a line of clothing for each season. Further, clothing styles change each year. Except for a few items (socks, handkerchiefs, belts) customers will prefer to buy this year's fashions, rather than last year's fashions. Here's how that works into the LIFO method.

At the end of the year the clothing store looks at its merchandise. If their year ends in December, they have Winter clothes in the show room. But when they look in the storage room, most of the clothes there are from earlier seasons that year. So Last In, First Out means, the most current seasons clothes (Last In) are the ones that people want now (First Out). After all, you wouldn't be buying last summer's clothes in the middle of winter, would you? Most people will wait until the following year and buy clothes in style in the coming summer.

Average Cost
Some merchandise is nearly identical and is carried in large quantities, like lumber, nails, nuts and bolts or gasoline. If you have a tank on gasoline with say 50 gallons in it, and you add 200 more gallons, you can't separate the first 50 gallons out from the rest of it. It all just becomes on take with 250 gallons of gasoline in it. So companies use the average cost method to account for things like this.

If you run a gas station, your costs will change every week. You will always have some left in the tank from the week before, and the delivery truck will dump more gas in your tank at this week's prices. Gas stations use a moving average method - they take the moving average from last week, and calculate a new moving average after adding this weeks batch of gasoline to the tank. So a moving average updates the cost frequently, and applies that particular average cost to that week's gasoline sales. Next week they will calculate a new moving average and apply it to next week's gasoline sales, etc.

At one time my office was next to a company that sold nuts, bolts, screws, nails, washers and other types of small hardware items. They bought directly from the manufacturers, mostly foreign. Their goods came packed in small wooden barrels. Believe me, a small wooden barrel full of nails is heavy!

They repackaged the items into small plastic bags for resale to stores, and ultimately to end consumers. They had a very sophisticated set of scales that would accurately weigh out the pieces into the desired quantity. For instance ,they could weigh out 10 flat washers accurately, and drop them into a small plastic bag. It was much quicker and easier than counting pieces manually.

How do you think they counted and valued their ending inventory? They weighted all the opened containers (no need to weigh a full, unopened one), and used their cost per pound, to calculate the value of their ending inventory. This may seem a bit unconventional, but it is a very good method, and entirely acceptable.

Some bulk products and how they might be measured for average costing:

product	measurement
gasoline, oil, milk, orange juice	gallon, liter
crude oil	barrel
natural gas	cubic yard, cubic meter
nails, nuts and bolts	pound, kilo
wheat, oats, corn, other grains	bushel
electric, telephone or TV cable	foot, meter

The importance of time when working with inventory methods
When it comes to inventory values, time is of the essence. That's a legal term, and means that time is more than just important, it is essential. You can't sell something you don't have, right? You can sell only what you have on hand in your inventory. Once an item is sold we have to determine how much cost to transfer from the Inventory account to the COGS account.

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Inventories and Cost of Goods Sold (1)

Manufacturing companies have three types of inventory: materials, work in process and finished goods. Retailers have one inventory: merchandise. In all cases, inventory is something the company will re-sell to someone else. Inventory cost is an asset until it is sold; after merchandise is sold, the cost becomes an expense, called Cost of Goods Sold (COGS). A journal entry transfers costs from the Balance Sheet to the Income Statement.

There are several important points, or events, in the life on an inventory item. The company must first order and buy the item. It then holds the item on a shelf or warehouse, until a customer wants to but the item. Once the item is sold, the cost is transferred to COGS. So the three important times in an item's life are buying, holding and selling.

Let's think for a moment about a hypothetical inventory item, we'll call it Item X. If you buy, hold and sell Item X all in the same year, say 2002, the entire transaction relating to Item X will be a completed and realized transaction. If the customer has paid for Item X there will be absolutely no accounting left to do, except show the sale and related COGS on the 2002 Income Statement. Nothing about Item X will affect the company in the future. Everything about Item X relates only to the past.

If Item X costs you $40, and you sell it for $65, you made a Gross Profit on the item of $25.

Income Statement 2002

Selling Price of Item X	$ 65.00
Less: Cost of Item X	40.00
Gross Profit from selling Item X	$25.00

This is the information that will be included in the 2002 Income Statement. Nothing will be left on the Balance Sheet.

Now let's think for a moment about Item Z. Assume you buy Item Z for late in 2002, and you are still holding it. There will be no sale to report, so the cost will remain on the Balance Sheet. If Item Z cost $50 that is the amount that will be shown on the Balance Sheet.

Balance Sheet Dec. 31, 2002

Inventory at December 31, 2002
Cost of Item Z	$50.00

If Item Z is sold in 2003, the cost will flow to the Income Statement for 2003, and the gross profit will be reported on that income statement.

Inventory Valuation
In the example above, you determined a value for Item Z at the end of the year. It is important for companies to count the physical inventory at the end of the year (Chapter 6). They must also place a dollar value on that inventory. The inventory value will be reported on the Balance Sheet at the end of the year.

It is also important to know the correct value of merchandise sold. That is the cost used to determine Gross Profit. Without enough Gross Profit a company can't pay it's operating expenses, such as salaries and wages, rent and utilities, etc. We will discuss Gross Profit a little more later in this section.

There are four methods commonly used to calculate a value for ending inventory. A company should select and use the method that best matches their merchandise and how it is sold.

4 methods of inventory valuation

Inventory method	How it works	When used
Specific Identification	the cost of each individual inventory item is tracked separately; the exact cost of each item is used in the value of ending inventory	auto sales, gems and jewelry, works of art, unique, one of a kind items
First In, First Out (FIFO)	cost of earliest purchases flow to COGS; we assume that the items remaining at the end are the last ones bought in the year	eggs, milk, meat, produce; this is the default flow assumption, unless a different method is specified
Last In, First Out (LIFO)	cost of last purchases flow to COGS; we assume that the items remaining at the end are the earliest ones bought in the year	clothing, seasonal items; a highly specialized method of retail inventory
Average Cost	cost of items bought are averaged across the year; the average cost is used at the end of the year; a moving weighted average is sometimes used	lumber, nails, nuts and bolts (simple average); gasoline (moving average)

Using a Cost Flow Assumption

• must meet cost-benefit rule
• accounts for quantities of homogeneous products
• matches the physical flow of goods
• can be used with either Periodic or Perpetual costing system

Specific Identification
The Specific Identification method assumes that each inventory item is special enough, unique enough, and costly enough to merit tracking one at a time. But does that apply to each and every item? What about a ream (500 sheets) of typing paper. Is it necessary to place a value on each and every sheet of paper?

Most business would answer "No" to that question. The cost of keeping that much detailed information would exceed the usefulness, or benefit, of the information. We call that the cost-benefit rule. The cost of an accounting system (or any other venture) should be outweighed by the benefits, or it is not cost-effective to follow that course of action.

For most companies, the Specific Identification method is far too costly and the additional information that could be gained is of little value. Most companies use a cost flow assumption. This simply means that the flow of inventory follows a certain pattern. Companies will buy merchandise in a manner consistent with the merchandise itself.

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