© 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8th Edition...

© 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott

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Chapter 6

Inventories andCost of Goods Sold


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Learning ObjectivesAfter studying this chapter, you should be able to: Link inventory valuation to gross profit. Use both perpetual and periodic inventory systems. Calculate the cost of merchandise acquired. Choose one of the four principal inventory valuation

methods. Calculate the impact on net income of LIFO liquidations.


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Learning ObjectivesAfter studying this chapter, you should be able to: Use the lower-of-cost-or-market method to value

inventories. Show the effects of inventory errors on financial

statements. Evaluate the gross profit percentage and inventory

turnover.


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Gross Profit andCost of Goods Sold

An initial step in assessing profitability is gross profit (profit margin or gross margin), which is the difference between sales revenues and the costs of the goods sold.

Products being held for resale are reported as inventory, a current asset.• When the goods are sold, the costs of the inventory

become an expense, Cost of Goods Sold. This expense is deducted from Net Sales to determine Gross Profit.


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Gross Profit andCost of Goods Sold

Sales

Cost ofGoods Sold(an expense)

Selling andAdministrative

Expenses

MerchandiseInventory

Balance Sheet Income Statement

Minus

Equals Gross ProfitMinus

Equals Net Income

MerchandisePurchases

MerchandiseSales


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The Basic Concept ofInventory Accounting

The key to calculating cost of goods sold is accounting for the remaining inventory at the end of the year.

Cost valuation - process of assigning specific historical costs to items counted in the physical inventory• Multiply the number of items in ending inventory

times the cost of each item.


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Perpetual and PeriodicInventory Systems

Two main systems for keeping merchandise inventory records:• Perpetual inventory system - a system that keeps a

running, continuous record that tracks inventories and the cost of goods sold on a day-to-day basis

• Periodic inventory system - a system in which the cost of good sold is computed periodically by relying solely on physical counts without keeping day-to-day records of units sold or on hand


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A perpetual inventory system helps managers control inventory levels and prepare interim financial statements.• The inventory amount can be found at any given point

in time.

Inventory items must be counted at least once a year to ensure correct valuation.• Physical count - the process of counting all the items

in inventory at a moment in time


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In a perpetual system, the journal entries are:

When inventory is purchased:

Merchandise inventory xxx

Accounts payable (or Cash) xxx

When inventory is sold:

Accounts receivable (or Cash) xxx

Sales revenue xxx

Cost of goods sold xxx



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In a periodic system, no day-to-day inventory records are maintained.

The physical count allows management to delete damaged or obsolete items and thus helps to reveal inventory shrinkage - inventory reductions from theft, breakage, or losses of inventory.


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Under the periodic system, calculations for cost of goods sold start with cost of goods available for sale, which is the sum of the beginning inventory plus current year purchases.

Under the perpetual system, cost of goods sold is kept on a day-to-day basis.


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Calculation of Cost of Goods Sold:

Beginning inventory (by physical count) $ 25,000 Add: Purchases 90,000 Cost of goods available for sale $115,000 Less: Ending inventory (by physical count) 33,000 Cost of goods sold $ 82,000

====================


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Both methods produce the same cost of goods sold figure.• The perpetual system is more timely, but it is more

costly to administer.• The perpetual system is less costly to administer

because there is no day-to-day processing regarding inventory costs or cost of goods sold.


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Physical Inventory In both periodic and perpetual

inventory systems, a physical count of each item being held in inventory is required.

The physical count is extremely important in determining net income because inventory is included in the determination of cost of goods sold.


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Cost of Merchandise Acquired Regardless of the inventory system used, the

basis of inventory accounting is the cost of the merchandise a company purchases for resale.

What costs are included in the cost of the merchandise?• The cost of merchandise usually includes the invoice

price plus any directly identifiable transportation charges less any offsetting discounts.


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Transportation Charges The major cost of transporting merchandise is

usually freight charges from the shipping point of the seller to the receiving point of the buyer.• If goods are shipped F.O.B. (free on board)

destination, the seller pays the costs of shipping the goods to the buyer.

• If goods are shipped F.O.B. shipping point, the buyer pays the freight costs of shipping the goods to the buyer.


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Transportation Charges In theory, any costs of transportation

borne by the buyer should be added to the cost of the inventory

acquired.• However, transportation costs are not easy to trace to

specific inventory items, so companies usually use a separate transportation cost account called Freight In, Transportation In, Inbound Transportation, Inward Transportation, etc.


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Transportation Charges Freight in is usually shown in the purchases

section on the income statement as an additional cost of the goods acquired.

Freight out represents the costs borne by the seller and is shown as an expense of selling the merchandise.• It is included with other selling expenses on the

income statement.


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Purchases and Purchase Returns The accounting for purchases, purchase returns,

purchase allowances, and cash discounts on purchases is just the opposite of the accounting for sales.

To record the purchase of merchandise:

Purchases 900,000

Accounts payable 900,000

To record the return of merchandise:

Accounts payable 80,000

Purchase returns and allowances 80,000


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Detailed Gross Profit CalculationGross sales $175,000

Deduct: Sales returns and allowances $ 2,000

Cash discounts on sales 1,500 3,500

Net sales $171,500

Deduct: Cost of goods sold:

Merchandise inventory, 1/1/2002 $ 7,500

Purchases $120,000

Deduct: Purchase returns and allowances $3,000

Cash discounts on purchase 1,000 4,000

Net purchases $116,000

Add: Freight in 10,000

Total cost of merchandise acquired 126,000

Cost of good available for sale $133,500

Deduct: Merchandise inventory, 12/31/2002 9,000

Cost of good sold 124,500

Gross profit $ 47,000 =============


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Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems In the perpetual system, purchases of

merchandise directly increase the Inventory account, and purchase returns and allowances and sales directly decrease the Inventory account.

In the periodic system, purchases of merchandise increase the Purchases account, and purchase returns and allowances are placed in separate accounts that are deducted from Purchases.• Sales of merchandise have no effect on the Purchases

account.


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Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems Under the perpetual system, inventory amounts

are updated each time an inventory transaction is processed.

Under a periodic system, the Inventory account does not change until the end of the accounting period.• At that time, a physical inventory is taken to

determine the amount of inventory on hand, and an entry is made to adjust the Inventory account to that amount.


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Principal InventoryValuation Methods

Four inventory valuation systems have been generally accepted.• Specific identification• First in, first out (FIFO)• Last in, first out (LIFO)• Weighted average


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Principal InventoryValuation Methods

If unit prices and costs did not change, all four inventory valuation methods would show identical results.

Because prices change, cost of goods sold (income measurement) and inventories (asset measurement) are affected.• The choice of the inventory valuation method can

significantly affect the amount reported as net income and ending inventory.


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Specific Identification Specific identification method - concentrates on

the physical tracing of the particular items sold• Used mostly when the physical flow of goods is easy

to track• Works best for relatively

expensive low-volume merchandise, such as automobiles or jewelry


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FIFO FIFO (first in, first out) method - assigns the cost

of the earliest acquired units to cost of goods sold• This might not be the actual physical flow of goods

within the company.• Under FIFO, the oldest units are deemed to be sold,

regardless of which units are actually given to the customer.

• The costs of the newer units in stock are included in ending inventory.


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FIFO FIFO includes the most recent costs in ending

inventory, so the inventory tends to closely approximate that actual market value of the inventory at the balance sheet date.

Also, in periods when prices are rising, FIFO leads to higher net income because the costs of the older, lower costing items are included in cost of goods sold.


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LIFO LIFO (last in, first out) method - assigns the most

recent costs to cost of goods sold• This might not be the actual physical flow of goods

within the company.• Under LIFO, the newest units are deemed to be sold,

regardless of which units are actually given to the customer.

• The costs of the older units in stock are included in ending inventory.


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LIFO LIFO uses the oldest costs to value ending

inventory, so that value may be significantly different from the actual market value of the inventory at the balance sheet date.

In periods when prices are rising, LIFO yields lower net income because the higher costs of more recent purchases are put into cost of goods sold first.


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LIFO Because LIFO results in reduced net income, it

also results in lower income taxes. • The Internal Revenue Code requires that if a company

uses LIFO to compute its taxable income, the company must also use LIFO to compute its financial net income.

• The result is lower income taxes and lower reported earnings figures to investors.


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LIFO If LIFO is such a good deal, why

do some companies still use FIFO?

For several reasons:• The costs of changing methods can be significant.• Management may be reluctant to decrease earnings

and possibly salaries and bonuses.• Management might fear that lower income would hurt

in loan negotiations with banks.• Lower earnings will often lower stock prices.


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Weighted Average Weighted-average method - computes a unit cost

by dividing the total acquisition cost of all items available for sale by the number of units available for sale

salefor available Units

salefor available goods ofCost average Weighted


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Weighted Average The averaging in the weighted average must

consider not only the price paid, but also the number of units purchased at each price.

The weighted-average method produces a gross profit somewhere between gross profit under FIFO and LIFO.


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Weighted AverageSmith Corporation purchased 5 units of Product X for $4.00 on Monday and 7 units of Product X for $4.25 on Friday. What is the weighted-average cost per unit?

12

$4.25) x (7 $4.00) x (5 average Weighted

12

75.49$

= $4.15


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Cost Flow Assumptions The accounting profession has determined that

companies may choose any of the four methods for valuing inventory.

The units are all the same, but their costs are different, so tracing the flow or assignment of those costs is more important than tracing where each specific unit actually goes.


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Cost Flow Assumptions Because three out of the four methods are not

linked to the physical flow of the goods, inventory valuation methods are often called cost flow assumptions.• No matter which cost flow assumption is picked, the

cumulative gross profit over the life of a company remains the same.

• The need to match particular costs to particular revenues makes the choice of cost flow assumptions important.


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Inventory Cost Relationships The four cost flow assumptions affect inventory

only; they do not affect purchases and liabilities for those purchases.

Note that in the detailed computation of gross profit, ending inventory affects cost of goods sold.• The lower the ending inventory, the higher the cost of

goods sold.• The higher the ending inventory, the lower the cost of

goods sold.


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The Consistency Convention Although companies can choose any cost flow

assumption, they have to be consistent over time.

Consistency - conformity from period to period with unchanging policies and procedures• Consistency makes year-to-year comparisons of

financial information useful.• Companies may change inventory methods for

justifiable reasons, such as changes in market conditions.


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Characteristics and Consequences of LIFO

LIFO is widely used in the U.S. for reasons stated earlier; however, LIFO is a fairly uncommon inventory method.• Many countries do not allow its use.

The most popular method worldwide is weighted average, followed by FIFO.


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Holding Gains andInventory Profits

LIFO approximates a replacement cost view of transactions, and measures profit relative to newer costs. • Replacement cost - the cost at which an inventory

item could be acquired today

In contrast, FIFO measures profit relative to older costs.


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Holding Gains andInventory Profits

The difference between profit measured under FIFO and LIFO is called a holding gain or an inventory profit.• The holding gain is also the difference between the

historical cost under FIFO (older costs) and the historical cost under LIFO (newer costs).

• LIFO ending inventory rarely has holding gains.• FIFO ending inventory often has holding gains.


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LIFO Layers LIFO layer - a separately identifiable additional

segment of LIFO inventory• Ending inventory under LIFO will have one total

value, but it may contain prices from many different points in time.

• As a company continues in business, the LIFO layers tend to pile on top of one another over the years.


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LIFO Layers Many companies show inventories that have

LIFO layers dating as far back as 1940, when LIFO was first used.• These inventories are probably far below the true

market value or replacement cost of the inventory.

LIFO presents an economic reality on the income statement, but FIFO presents a more up-to-date valuation on the balance sheet.


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LIFO Inventory Liquidations As stated before, in periods of rising prices, LIFO

will produce a higher cost of goods sold and lower gross profit than FIFO.

Sometimes companies must “liquidate” some of their LIFO layers, that is, units in the older LIFO layers are sold.• In such a case, cost of goods sold decreases because

very old costs are now included in cost of goods sold. When cost of goods sold decreases, gross profit increases.


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LIFO Inventory Liquidations Security analysts often like to keep track of the

effect of choosing LIFO over FIFO because the effect on net income can be significant.

LIFO reserve - the difference between a company’s inventory valued at LIFO and what it would be under FIFO• The balance in the LIFO reserve indicates the

cumulative effect on gross profit over all prior years due to LIFO.


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Adjusting from LIFO to FIFO When lower costs are used to calculate cost of

goods sold under LIFO, cost of goods sold will be lower and net income will be higher.

The change in the LIFO reserve from one year to another answers the question “How much did this year’s LIFO cost of goods sold differ from the FIFO cost of goods sold?”


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Lower-of-Cost-or-Market Method (LCM)

Lower-of-cost-or-market (LCM) method - the superimposition of a market-price test on an inventory cost method• The current market price is compared with historical

cost of inventory under one of the valuation methods.• The lower of the two values is selected as the basis for

the valuation of goods at a specific inventory date.– When the market value is lower and is used for valuing

ending inventory, cost of goods sold is effectively increased.


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Lower-of-Cost-or-Market Method (LCM)

LCM is an example of conservatism, which means selecting the methods of measurement that yield lower net income, lower assets, and lower stockholders’ equity.

• Erring in the direction of conservatism is better than erring in the direction of overstating assets and net income.


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Role of Replacement Cost The concept of replacement cost assumes that as

replacement costs decline, selling prices also decline.• If this is the case, the inventory must be written down

to the replacement cost (market value), and the replacement cost is regarded as the “new historical cost.”

Loss on write-down (or Cost of goods sold) xxx



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Conservatism in Action The LCM method reports less net income in the

period of decline in market value and more net income in the period of sale.• The LCM method affects

how much income is reported in each year, but not the total income over the company’s life.


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Effects of Inventory Errors An undiscovered inventory error usually affects

two accounting periods.• Amounts are affected in the period

in which the error occurred, but the effects will be counterbalanced by identical offsetting amounts in the following period.

• The net effect on retained income across the two periods is zero.


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Effects of Inventory Errors A handy rule of thumb:

• If ending inventory is understated, retained income is understated because cost of good sold is overstated.

• If ending inventory is overstated, retained income is overstated because cost of goods sold is understated.


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Cutoff Errors andInventory Valuation

Cutoff errors - failure to record transactions in the correct time period

The general approach to recording purchases and sales is keyed to the legal transfer of ownership.• Inventory is counted only if it is owned by the

company.


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The Importance of Gross Profit Management and investors are interested in gross

profit and how it changes over time.

The inventory method chosen might have a significant affect on a company’s gross profit, so gross profit is often expressed as a percentage of sales.

Sales

profit Gross %Profit Gross


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Gross Profit Percentage Often the nature of the business of a company

affects the gross profit as compared to other types of companies.• Wholesaler - an intermediary that sells inventory

items to retailers and incurs few selling costs - often have low gross profit percentages

• Retailer - a company that sells items to the final users, individuals


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Estimating IntraperiodGross Profit and Inventory

The gross profit percentage is very useful in estimating inventory amounts when related information is unavailable.• Companies that prepare interim financial statements

cannot take physical inventories each period; therefore, they must rely on gross profit percentage or ratios to estimate inventory amounts.

• For example, if a company knows its normal gross profit percentage, it can estimate its cost of goods sold based on its amount of sales.


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Gross Profit Percentageand Turnover

Retailers often lower their gross profit margins and selling prices and hope that the lower selling prices will increase sales volume enough to compensate for the lower gross profit.

One measure of sales level is inventory turnover, which tells how fast inventory is sold.

period theduring heldinventory Average

sold goods ofCost Inventory

Turnover


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Gross Profit Percentageand Turnover

Industries with higher gross profit percentages tend to have the lowest inventory turnover.• Inventory turnover is especially effective for

assessing companies in the same industry.• A higher inventory turnover indicates an ability to use

smaller inventory levels to attain a high sales level.


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Gross Profit Percentages and Accuracy of Records

Auditors use the gross profit percentage to help satisfy themselves about the accuracy of records.• IRS auditors watch gross profit percentages of

companies and compare them to those of other companies in the same industry as a clue that all sales might not have been reported.

• Managers watch gross profit percentages to judge operational profitability.


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Internal Control of Inventories Inventories are more easily accessible than cash

in many instances, so internal controls must be in place to protect inventory.

Retail merchants must contend with inventory shrinkage, a polite term for shoplifting by customers and theft by employees.


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Internal Control of Inventories Internal controls over inventory:

• Alert employees at the point of sale• Sensitized tags on merchandise that set off an alarm

as the item leaves the store• Surveillance cameras

Retailers must also watch their own employees.• Employees account for 30% to 40% of inventory

shortages.


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Shrinkage in Perpetual and Periodic Inventory Systems

In perpetual systems, shrinkage is simply the difference between the cost of inventory identified by a physical count and the clerical inventory balance.

The entries to record the shrinkage:Inventory shrinkage xxx

Inventory xxx

Cost of goods sold xxx

Inventory shrinkage xxx


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Shrinkage in Perpetual and Periodic Inventory Systems

In periodic systems, no clerical balance of inventory exists.

Inventory shrinkage is automatically included in cost of goods sold.• Beginning inventory plus purchases less ending

inventory measures all inventory that has flowed out, whether it was sold, stolen, or damaged.


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Inventory in a Manufacturing Environment

When a company manufactures products, the cost of inventory is a combination of the cost of raw materials, the wages paid to workers who make the product, and an allocation of costs of space, energy, and equipment used by the workers to make the product.


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Inventory in a Manufacturing Environment

Manufacturing firms have three types of inventory, each of which is in a different stage of completion.• Raw materials inventory - includes the cost of materials

held for use in the manufacturing of a product• Work in process inventory - includes the cost incurred

for partially completed items, including costs of raw materials, labor, and other costs

• Finished goods inventory - the accumulated costs of manufacturing for goods that are complete and ready for sale


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