Chapter 10 Cost of Goods Sold and Inventory. 2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson...

Chapter 10Cost of

Goods Soldand

Inventory

2

Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Balance SheetIncome

StatementStatement of Cash Flows

Current AssetsInventory

Current LiabilAccounts Payable

Cost of Goods Sold

OperatingCash paid for

inventory purchases

Financial Statement ItemsCovered in this Chapter

What is Inventory?

4


• Represents goods that are either manufactured or purchased for resale in the normal course of business

• Classified as an asset on the balance sheet

Inventory

5


BUY

raw materials or goods for resale

ADD

value

SELL

finished inventory

COMPUTE

ending

inventorycost of

goods sold

Time Line of Business Issues Involving Inventory

6


Inventory: Manufacturing Firm

• Three types:– Raw materials

•Goods acquired in a raw state that will eventually be finished products

– Work in process•Partially finished products

– Finished goods•Completed products waiting for sale

7


Raw Materials

Work in Process

Finished Goods

Cost of Goods Sold

Balance SheetBalance Sheet Income StatementIncome Statement

Manufacturing Overhead

Labor

Inventory Cost Flow:Manufacturing Company

8


Inventory Ownership

• Legal title rule– Entity holding legal title to the

goods– Report as an asset on the balance

sheet

• Goods in transit– Legal title depends upon the

shipping terms

9


Goods in Transit

• Shipping terms:– FOB (free-on-board) destination

•The seller is paying the shipping cost•The seller owns the inventory until it

is delivered– FOB shipping point

•The buyer is paying the shipping cost•The buyer owns the inventory during

transit

10


Ownership Transferfor Goods in Transit

FOB Shipping Point•Buyer owns goods in transit•Ownership changes at shipping point

Seller

Buyer

FOB Destination•Seller owns goods in transit•Ownership changes at destination

11


Goods on Consignment

• Dealer holds and sells merchandise– Has possession but not asset

• Merchandise owned by supplier– Has asset but not possession

• Dealer does not pay for the inventory unless it is sold

The Cost of Inventory

13



• The cost of inventory includes all costs of acquisition and preparation for sale– Purchase price– Freight– Receiving and storage costs

14


• The cost of work in process and finished goods inventory includes– Raw materials– Production labor– Some allocation of factory overhead

•Activity-based cost (ABC) systems allocate overhead based on some clearly identified cost drivers


Accounting for Inventoryand Cost of Goods Sold

16


Cost of Goods Sold

Beginning Inventory

+ Inventory Purchases

= Goods Available for Sale

– Ending Inventory

= Cost of Goods Sold

17


Overview of Perpetualand Periodic Systems

• Perpetual system– Inventory records are updated

whenever a purchase or a sale is made– Advances in information technology

have made the cost of using this system practical

• Periodic system– Inventory records are not updated

when a sale is made

18


Taking a Physical Countof Inventory

• The actual quantity on hand is determined by taking a physical count

• A cost is attached to the quantity counted

• With a perpetual system, a physical count can reveal inventory shrinkage

19


Ending Inventory Errors

If ending inventory is ...

Cost of Goods Sold is ...

Net Incomeis ...

Overstated Understated Overstated

Understated Overstated Understated

Inventory ValuationMethods

21


Inventory Valuation Methods

• Where specific identification is not possible, an assumption must be made about which cost is associated with the units remaining

• Four assumptions are accepted under U.S. GAAP:– Specific identification– Average cost– FIFO (first-in, first-out)– LIFO (last-in, first-out)

22


Example:Inventory Valuation

MethodsAssume the following data:

Unit TotalUnits Cost Cost

January 1 200 $10 $2,000March 23 300 $12 3,600July 15 500 $11 5,500November 6 100 $13 1,300

1,100 $12,400

Sales: 700 units @ $15Ending Inventory: 400 units

23


Specific Identification

• Requires no assumption about the flow of inventory units

• Inventory items are specifically identified and valued

• The actual cost of goods sold can be computed as inventory is sold

24


Example:Average Cost Method

Ending Inventory 400 Units × $11.27 $4,510

Cost of Goods Sold 700 Units × $11.27 7,890

Cost of Goods Available for Sale $12,400

Cost of Goods Available for Sale = Average Cost Per Unit

Units Available for Sale

$12,400 = $11.27

1,100 units

25


Example:FIFO

Assumption: The units sold are the oldest units on hand.

Purchase

Date

Number of

Units

Unit

Cost

Number of

Units Total Cost

Number of

Units Total Cost

01-Jan 200 10$ 200 2,000$ 0 -$ 23-Mar 300 12 300 3,600 0 - 15-Jul 500 11 200 2,200 300 3,300

06-Nov 100 13 0 - 100 1,300 1,100 700 7,800$ 400 3,300$

FIFO Cost of Goods Ending InventoryPurchases

26


Example:LIFO

Purchase Date

Number of Units

Unit Cost

Number of Units Total Cost

Number of Units Total Cost

06-Nov 100 13$ 100 1,300$ 0 -$ 15-Jul 500 11 500 5,500 0 -

23-Mar 300 12 100 1,200 200 2,400 01-Jan 200 10 0 - 200 2,000

1,100 700 8,000$ 400 2,400$

Purchases LIFO Cost of Goods Ending Inventory

Assumption: The units sold are the newest units on hand.

27


Comparison of Methods

Goods Available for Sale

=Ending

Inventory+

Goods Sold

1,100 units

= 400 units + 700 units

FIFO $12,400 = $4,600 + $7,800

LIFO $12,400 = $4,400 + $8,000

Average Cost

$12,400 = $4,510 + $7,890

28


Comparison of Methods

• In period of rising prices, highest Net Income with FIFO

• LIFO favored for tax purposes– Must also use for financial reporting

• Choice:– High profits and high taxes with FIFO– Low profits and low taxes with LIFO

More About LIFO

30


LIFO Layers

• Any year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending inventory

• The creation of LIFO layers results in ending inventory at very old prices

31


LIFO Layers Example

Year of Purchase

Number of Units

Unit Cost

Number of Units

Number of Units Unit Cost Total Cost

2004 120 $5 100 20 $5 $100

2005 150 $10 120 20 $530 $10 $400

2006 160 $15 120 20 $530 $1040 $15 $1,000

Purchases Sales Ending Inventory

20 units from 2004 + 30 units from 2005

20 units from 2004 + 30 units from 2005 + 40 units from 2006

32


LIFO Reserve

• The difference between the LIFO ending inventory amount and the amount obtained using another method (e.g., FIFO or average cost)

• Disclosed to aid in comparing companies that use different inventory cost flow assumptions

33


LIFO Liquidation

• Occurs when the number of units purchased does not exceed the number of units sold

• The old LIFO layer costs to flow through cost of goods sold, reducing cost of goods sold and increasing net income

HW #E10-15

Inventory Estimationand Valuation

35


Gross Profit Method

• Used to estimate inventory without actually taking a physical count

• The gross profit percentage is applied to estimate cost of goods sold, and ultimately gross profit Sales - CGS

= Gross Profit %Sales

36


Example:Gross Profit Method

Assume the following data:

Beginning inventory, January 1 $25,000

Purchases, January 1 through January 31 40,000

Sales, January 1 through January 31 50,000

Historical gross profit percentage 40%HW # E10-17

37


Gross Profit Method

Sales (actual) $50,000 100%

Gross profit (estimate) 20,000 40%

Cost of goods sold (estimate) $30,000 60%

Beginning inventory (actual) $25,000

+ Purchases (actual) 40,000

= Cost of goods avail for sale (actual) 65,000

= Ending inventory (estimate) 35,000

- Cost of goods sold (estimate) 30,000

38


Lower of Cost or Market

• Recognizes inventory price declines, but not price increases until the inventory is sold

• Market value is defined as– Replacement cost or – Net realizable valueHW # E10-18

39



• Replacement cost is the cost to buy equivalent new inventory items

• Net realizable value is the amount expected to be received when the inventory is sold

• Rule of thumb: Inventory is valued on the balance sheet at the lowest of

1. historical cost,2. replacement cost, or3. net realizable value

40



• An inventory write-down when market value is lower than cost recognizes the economic loss when it happens rather than when the inventory is sold

• This is another example of the principle of conservatism

Evaluating Inventory Levels and Budgeting Cash

Disbursements

42


Evaluating the Level of Inventory

• Inventory turnover– Measures how many times a

company turns over its inventory during the year

• Number of days’ sales in inventory– Measures the number of days’ sales

represented in the inventory value

43


Evaluating the Level of Inventory

These ratios are compared with those of other firms in the same industry and with comparable ratios for the same firm in previous years.

Cost of Goods SoldInventory turnover =

Average Inventory

365Number of Days' Sales in Inventory =

Inventory Turnover

44


Number of Days’ Purchases in Accounts Payable

Indicates how long it takes for a company to pay its suppliers

365Number of Days' Purchases = in Accounts Payable Inventory Turnover

45


Managing Cash Flow

Number of Days’ Sales in Inventory

Average Collection Period

Detailed cash payment forecasting is used to plan the specific timing of loan receipts and

repayments

Operating Cycle

Number of Days’

Purchases in Accounts

Payable

External financing needed

46


Budgeting Cash Outflows

• A cash budget is an important tool in helping management plan its cash needs

• Estimating cash and credit sales, as well as estimating the pattern of collection of accounts receivable, are key to the cash receipts budgeting process

47


Cash Budgeting Example

November $100,000December 200,000 January 100,000 February 50,000 March 150,000

Sales

Month after purchase 50%Second month following 50%

Merchandise Payment Pattern

Cost of Goods Sold = 80% of sales

48


January Sales 100,000Cost of Goods Sold Percentage 80%Inventory required

for estimated sales 80,000Adjustment for desired

inventory levels 0Required Purchases 80,000

Pay in February$40,000

Pay in March$40,000

49


Third QuarterCash Disbursements for

InventoryNovember December January February March

Total Sales 100,000$ 200,000$ 100,000$ 50,000$ 150,000$

Cost of Goods Sold (80%) 80,000$ 160,000$ 80,000$ 40,000$ 120,000$

Inventory Purchases 80,000$ 160,000$ 80,000$ 40,000$ 120,000$

Cash Disburse for Inven:November Purchases 40,000 40,000 December Purchases 80,000 80,000 January Purchases 40,000 40,000 February Purchases 20,000 March Purchases -

-$ 40,000$ 120,000$ 120,000$ 60,000$

50


In Summary ...

• Retailer inventory: purchased for resale• Manufacturer inventory: raw materials purchased for

further processing; work in process, and finished goods held for resale

• Inventory cost: all costs necessary to bring to a point of readiness

• Cost flow assumptions: LIFO, FIFO, and average cost• LIFO creates layers; inventory is carried at oldest

(lowest) costs which results in higher cost of sales, lower profit, and lower taxes

• Gross profit method is an estimation tool for inventory value

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Chapter 10 Cost of Goods Sold and Inventory. 2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson...

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