Accounting for Bad Debts & Cost of Sales ROSS SCHOOL OF BUSINESS UNIVERSITY OF MICHIGAN Winter 2006 Accounting 501 Jefferson P. Williams University of Michigan Profitablity Ratios Revenue - Cost of Goods Sold Gross Margin/Gross Profit - Operating Expenses Operating Income, EBIT - Interest Expense ± Nonrecurring Gains Pretax Income - Income Taxes Net Income Gross Margin % Return on Sales ROE Receivables Accounting Why? Income Statement: Matching Balance Sheet Valuation: Net Realizable Value Example: Sales: Year 1 -- $ 1,000,000 Year 2 -- 1,500,000 Collections: Year 1 -- $ 800,000 Year 2 -- 1,392,000 ( 192,000 from year 1) Bad Debts: Approach 1 -- 1% of sales Approach 2 -- 5% of receivables Approach 3 -- Aging of receivables Recording Estimate of Bad Debt Expense Journal Entry: Bad Debts Expense xxx Allow. For Uncollectible Accts. xxx Effect: 1. Decrease Net Income 2. Decrease Net A/R 3. Decrease Total Assets Writing-Off Bad Debts Journal Entry: Allowance for Uncollectible Accts. xxx Accounts Receivable xxx Effect: 1. Net Income --- NO EFFECT 2. Net A/R --- NO EFFECT 3. Total Assets --- NO EFFECT Receivables Analysis Turnover: Net Credit Sales ÷ Avg. A/R Collection Period: Avg. A/R ÷ (Sales /365) Percentage Uncollectible: Allowance ÷ A/R Expense ÷ Sales Inventory Four Main Inventory Steps: Select a system for recording inventory transactions Identify components of inventory cost and measure inventory quantities Choose an inventory cost flow method Compare cost of inventory to market value at end of period (Lower-of-Cost-or-Market Rule) Inventory Systems Periodic Inventory System Take periodic physical inventory count to get ending inventory Use Purchases, Beginning Inventory, and Ending Inventory to calculate Cost of Goods Sold We will use this method in class Perpetual Inventory System Continually update balances of Inventory and Cost of Goods Sold for purchases and sales The two systems do not usually produce the same Inventory and Cost of Goods Sold balances. Measurement of Inventory Cost Inventory Cost Should include all costs necessary to place the inventory into its intended useful state Product Costs Costs included in Inventory, including all material, direct labor, freight-in, and other production costs Period Costs Costs not included in inventory, including packaging, minor assembly, etc. These costs are expensed in the period incurred. Inventory Cost Flow Methods Specific Identification (SI) Actual cost of each specifically identified unit is charged to Cost of Goods Sold. First-in, First-out (FIFO) Costs of "first goods in" are charged to Cost of Goods Sold. Last-in, First-out (LIFO) Costs of “last goods in" are charged to Cost of Goods Sold. Weighted-Average (WA) Weighted-average cost of all prior purchases used to assign costs. Weighted-average cost per unit = Cost of Goods Available for Sale / Number of units available for sale Lower-of-Cost-or-Market Rule I Conservatism principle All possible losses and costs should be recognized as soon as apparent, but gains should only be recognized when clearly realizable. Lower-of-Cost-or-Market (LCM) When the market value of inventory is below cost, it should be written down to market value. However, inventory should never be written up to market value if it exceeds cost. Current Replacement Cost The cost to replace inventory at end of period This cost is used to approximate market value. Lower-of-Cost-or-Market Rule II Application of LCM LCM should be applied at the end of each accounting period. LCM can be applied to: Each type of inventory separately, Each category or inventory, or Inventory in total. LCM Adjusting Entry: Debit Cost of Goods Sold, Credit Inventory General Concepts of Cost Flow Methods I * For all methods, Cost of Goods Available for Sale = Ending Inventory + Cost of Goods Sold. * Assignment of costs to goods need not mirror actual flow of goods. * If costs of merchandise do not change over time, all four methods result in same Ending Inventory and Cost of Goods Sold. * When inventory costs are rising, LIFO produces the lowest Ending Inventory, the highest Cost of Goods Sold, and the lowest Net Income among the methods. * However, different methods only affect when costs are recognized (timing), not whether they are recognized. General Concepts of Cost Flow Methods II Choice of method: If a firm uses LIFO for tax purposes, it must use LIFO for its books. With rising costs, LIFO is better because it results in lower taxes. Consistency principle Accounting methods should be consistently applied from year to year whenever possible. LIFO liquidations Occur when an older (cheaper) layer of inventory is released into Cost of Goods Sold. Result in an artificial boost in net income. Financial Statement Analysis Regarding Inventory Changes From information in the balance sheet and income statements, we can answer the following questions concerning amounts not directly reported: * How much inventory was purchased during the period? Purchases = Ending Inventory - Beginning Inventory + Cost of Goods Sold * How much were payments to suppliers? Payments to suppliers = Beginning Accounts Payable + Purchases - Ending Accounts Payable Adjusting from LIFO to FIFO Income Statement: LIFO COGS – Inc. in LIFO Reserve = FIFO COGS Balance Sheet: Inv. @ LIFO + Bal. in LIFO Reserve = Inv. @ FIFO Inventory Errors For errors within period, make correcting entry. * For errors across periods, errors are generally self-correcting, reversing in the later period.