7/e

PowerPoint Author: Catherine Lumbattis

5

COPYRIGHT © 2011 South-Western/Cengage Learning

Inventories and Cost of Goods

Sold

Inventory of Wholesalers and Retailers

Purchased in finished formResold without transformationClassified as “Merchandise Inventory” on

balance sheet

LO1

CURRENT ASSETS:Cash and cash equivalents $ 1,715 $ 1,724Short term investments ---- 177

Restricted cash 41 38Merchandise inventory 1,506 1,575Other 743 572TOTAL CURRENT ASSETS 4,005 4,086

Gap, Inc.Consolidated Balance Sheets

[Partial] January 31, February 2, 2009 2008ASSETS (in millions)

More than

1/3 of currentassets

Inventory of Manufacturers

Manufacturingoverhead

Direct materials

Direct labor

Costs Included in Inventory

Inventory of Manufacturers

Manufacturingoverhead

Direct materials

Direct labor

Manufactureproducts Work in

process

Finishedgoods

Raw materials

Costs Includedin Inventory

Balance SheetClassifications

Current assets: Inventories: Raw materials $ 3,356

Work in progress 1,107Finished goods 4,022

Supplies 296 Total inventories $ 8,781

IBMConsolidated Balance Sheets

[Partial]

2008ASSETS (in millions)

Condensed Income Statement for a Merchandiser

Net sales $100,000Cost of goods sold 60,000Gross profit $ 40,000Selling and administrative expenses 29,300Net income before tax $ 10,700Income tax expense 4,280

Net income $ 6,420

LO2

Contra-Sales AccountsSales

normalcredit

balance

Sales Discounts

Sales AllowancesSales Returns

normaldebit

balance

normaldebit

balance

normaldebit

balance

Credit Terms and Sales Discounts

n/30 Payment due 30 days from invoice

1/10, n/30 Deduct 1% of invoice amount if paid within 10 days; otherwise full

invoice amount is due in 30 days

2/10, n/30 Deduct 2% of invoice amount if paid within 10 days; otherwise full

invoice amount is due in 30 days

Purchases of merchandise

Beginninginventory

The Cost of Goods Sold Model

Cost of goods

sold

=Goods Available

for Sale

Less: Ending inventory

LO3

+

=

An increase in ending inventory means more was bought than sold

The Cost of Goods Sold ModelBeginning inventory $ 15,000

+ Cost of goods purchased 63,000= Cost of goods available for sale 78,000– Ending inventory (18,000)= Cost of goods sold $ 60,000

“Pool” of goodsavailable to sell

during the period

Perpetual Inventory Systems

Point-of-sale terminals have improved the ability of mass merchandisers to maintain perpetual systems

Inventory records are updated after each purchase or sale

Periodic Inventory Systems

Reduces record keeping but also decreases the ability to track theft, breakage, etc., and prepare interim financial statements

Inventory records are updated periodically based on physical

inventory counts

Cost of Goods Purchased Cost of inventory purchased (invoice price):

Less:Purchase returns and allowancesPurchase discounts

Plus:Transportation-in

Recording Purchases

Purchases 4,000 Accounts Payable 4,000

To record purchase of inventory on account

Recording Purchase Returns

Accounts Payable 850Purchase Returns and Allowances 850

To record inventory returned to supplier

Recording Purchase DiscountsAccounts Payable 500

Cash 495Purchase Discounts 5

To record payment within discount period to

supplier who offers 1% purchase discount.

($ 500 × 1% = $5 discount)

FOB Destination Point

No sale or purchase until inventory reaches its destination

Seller responsible for inventory while in transit

Title passes at destination

FOB Shipping Point

Both sale and purchase recorded upon shipment Buyer responsible for inventory while in transit

Title passes when shipped

Recording Shipping Costs

Transportation-In 300 Cash 300

To record shipping costs on inventory purchased

Analysis of Profitability

Gross Profit %

Of particular interest

to current and potentialinvestors

LO4

Gross Profit Ratio = Gross Profit Net Sales

(How many cents on every $ of sales are left over after covering the cost of the product)

Daisy’s Profitability Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000

Gross profit ratio = 40%

Inventory Valuation and Income Measurement

Value assigned toinventory on balance

sheet

Valueexpensedas cost of goods soldon incomestatement

When Sold =

LO5

Inventory Costs IncludedAny freight costs incurred by buyerCost of insurance for inventory in transitCost of storing inventory before sellingExcise and sales taxes

Inventory Costing Methods Four costing methods available:

SpecificIdentification

WeightedAverage

First-in, First-out(FIFO)

Last-in, First-out(LIFO)

LO6

Beginning inventory, Jan. 1: 500 units (unit cost $10)

Inventory purchases:Date Units Unit Cost1/20 300 $ 114/8 400 129/5 200 1312/12 100 14Total purchases 1,000 units

Ending inventory, Dec. 31: 600 units

Detailed Costing Method Example

Calculate the Cost of Goods Sold and Ending Inventory under each cost

flow method

Specific Identification Method

Step 1: Identify the specific units in inventory at the end of the year and their costs.

Specific Identification Method Units in ending inventory:

Date purchased Units Cost Total Cost

1/20 100 $11 $ 1,100

4/8 300 12 3,600

9/5 200 13 2,600

Ending inventory 600 $ 7,300

Units × Cost = Total cost

Specific Identification Method

Step 2: Identify the units sold and calculate the cost of goods

sold.

Specific Identification Method Date purchased Units Cost Total Cost

Beg. inventory 500 $10 $5,000

1/20 200 11 2,200

4/8 100 12 1,200

12/12 100 14 1,400

Cost of goods sold 900 $9,800

Units × Cost = Total cost

Weighted Average Method

Step 1: Calculate the cost of goods available for sale.

Weighted Average Method Date purchased Units Cost Total cost

Beg. inventory 500 $10 $ 5,000

1/20 300 11 3,300

4/8 400 12 4,800

9/5 200 13 2,600

12/12 100 14 1,400 Cost of goods available for sale 1,500 $17,100

Weighted Average Method

Step 2: Divide the cost of goods availablefor sale by the total units todetermine the weighted averagecost per unit.

Weighted Average MethodCost of Goods Available for Sale

Units Available for Sale

$17,100 1,500 = $11.40/unit

Weighted Average Method Step 3: Calculate ending inventory and

cost of goods sold by multiplying the weighted average cost per unit by the number of units in ending inventory and the number of units sold.

×Avg.Cost

# ofUnits

Weighted Average Method ALLOCATE TO Ending Cost of Inventory Goods

SoldUnits on hand 600 Units sold 900Weighted average cost $11.40 $ 11.40

× Total cost of goods available of $17,100 allocated: $6,840 $10,260

First-in, First-out (FIFO) Method

Step 1: Assign the cost of the beginning inventory to cost of goods sold.

First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of

Units Cost Inventory Goods Sold

1/1 500 $10 $5,000

1/20 300 $11

4/8 400 $12

9/5 200 $13

12/12 100 $14

First-in, First-out (FIFO) Method

Step 2: Continue to work forward until you assign the total number of units sold during the period to cost of goods sold. Allocate the remaining costs to ending inventory.

First-in, First-out (FIFO) Method

ALLOCATE TO Ending Cost of

Units Cost Inventory Goods Sold

1/1 500 $10 $5,000

1/20 300 $11 3,300

4/8 300 / 100 $12 $3,600 1,200

9/5 200 $13 2,600

12/12 100 $14 1,400

TOTALS $7,600 $9,500

Last-in, First-out (LIFO) Method

Step 1: Assign the cost of the last units purchased to cost of goods sold.

Last-in, First-out (LIFO) Method ALLOCATE TO

Ending Cost ofUnits Cost Inventory Goods Sold

1/1 500 $10

1/20 300 $11

4/8 400 $12

9/5 200 $13

12/12 100 $14 $1,400

Step 2: Work backwards until you assign the total number of units sold during the period to cost of goods sold (allocate the remaining costs to ending inventory).

Last-in, First-out (LIFO) Method

Last-in, First-out (LIFO) Method

ALLOCATE TO Ending Cost of

Units Cost Inventory Goods Sold

1/1 500 $10 $5,000

1/20 100 /200 $11 1,100 $ 2,200

4/8 400 $12 4,800

9/5 200 $13 2,600

12/12 100 $14 1,400

TOTALS $6,100 $11,000

Comparison of Costing Methods

Cost of GoodsSold

Ending Inventory

11,000

6,840

7,600

10,260

9,500

17,100

17,100

17,100

WeightedAverageFIFO

LIFO

Goods Available for Sale

6,100

Specific Identification $7,300 $ 9,800 $17,100

LO7

Comparison of Costing Methods

X X X

X X

Weighted Average FIFO LIFO

In periods of rising prices: Highest cost of goods sold? Lowest cost of goods sold?Highest gross profit?Lowest net income?Lowest income taxes?

LIFO Issues LIFO liquidation

• Liquidation can result in high gross profit (and large tax bill)

LIFO conformity rule• If used for tax, LIFO must also be used for books

LIFO reserve• Difference between inventory value stated at FIFO

and value stated at LIFO

International Inventory Valuation Methods

Acceptable methods of costing inventory in the United States may not be acceptable in other countries

• LIFO is generally accepted in the United States• IASB (international standards) prohibit the use of LIFO

by companies that follow international standards It is uncertain whether LIFO will survive as an acceptable

inventory valuation method

Reasons for Inventory Errors

Mathematical mistakesPhysical inventory counting errorsCutoff problems – in-transitGoods on consignment

LO8

Effect of Inventory Errors on the Income Statement, 2010

Reported Corrected EffectSales $1,000 $1,000Beginning inventory $ 200 $ 200 Add: Purchases 700 700 Goods available for sale $ 900 $ 900 Less: Ending inventory 300 250 $50 OS Cost of goods sold $ 600 $ 650 50 US Gross margin $ 400 $ 350 50 OS Operating expenses 100 100 Net income $ 300 $ 250 50 OS

OS = overstatement

US = understatement

Effect of Inventory Errors on the Income Statement, 2011

Reported Corrected EffectSales $1,500 $1,500Beginning inventory $ 300 $ 250 $50 OS Add: Purchases 1,100 1,100 Goods available for sale $1,400 $1,350 50 OS Less: Ending inventory 350 350Cost of goods sold $1,050 $1,000 50 OSGross margin $ 450 $ 500 50 USOperating expenses 120 120Net income $ 330 $ 380 50 US

OS = overstatement

US = understatement

Counterbalancing ErrorsAssume ending inventory is overstated (+) by$50 in 2010:

2010 Beginning inventory xxxAdd: Purchases xxx = Goods available for sale xxx Less: Ending inventory +50 = Cost of goods sold –50

Counterbalancing Errors2010 ending inventory becomes 2011 beginninginventory:

2010 2011Beginning inventory $xxx +50Add: Purchases xxx= Goods available for sale xxx Less: Ending inventory +50= Cost of goods sold –50

Counterbalancing Errors

–50 +50

The 2010 error reverses in 2011 (but 2010 inventory both 2010 and 2011 profits are misstated by 50):

2010 2011Beginning inventory $xxx $+50Add: Purchases xxx xxx= Goods available for sale xxx +50Less: Ending inventory +50 xxx= Cost of goods sold

Lower of Cost or Market Before After Price Price

Change Change

Cost $100 $ 85

Report loss in year

market falls below cost…

LO9

Before After Price Price

Change ChangeSelling price $100 $ 80Cost 75 60Gross profit $ 25 $ 20

Lower of Cost or Market

Gross profit % 25% 25%

…to maintain

normal gross

profit % when

sold

Market = replacement cost (not retail value) Cost determined under one of the costing methods Justified on basis of conservatism Can be applied to:

• Entire inventory• Individual items• Groups of items

Lower of Cost or Market

Both U.S. GAAP and international financial reporting standards (IFRS) require lower-of-cost-or-market

Differences between U.S. GAAP and IFRS• How market value is defined • Recording changes in market value in

future periods

Lower of Cost or Marketunder International Standards

Cost of Goods SoldAverage Inventory

Inventory Turnover Ratio

LO10

The number of times per period inventory is turned over (ie. sold)

Number of Days’ Sales in Inventory

The average number of days inventory is on hand before its sold

Number of Days in the PeriodInventory Turnover Ratio

Statement of Cash FlowsCash Flows from Operating Activities: Net income xxx Increase in inventory – Decrease in inventory + Increase in accounts payable + Decrease in accounts payable –

IndirectMethod

LO11

AppendixAccounting Tools:

Inventory Costing Methods with the Use of a Perpetual Inventory System

FIFO Costing with a Perpetual System

FIFO applied at

time of sale

Same FIFO inventory total under periodic and perpetual systems

LIFO Costing with a Perpetual System

LIFO applied at

time of sale

Different LIFO inventory total under periodic and perpetual systems because of pricing gap

Moving Average with a Perpetual System

Different inventory total under weighted average (periodic) and moving average (perpetual)

New weighted average

cost is computed for each

purchase

End of Chapter 5