Chapter 06 INVENTORIES AND COST OF SALES Power

Chapter 06 INVENTORIES AND COST OF SALES Power. Point Authors: Susan Coomer Galbreath, Ph. D. , CPA Charles W. Caldwell, D. B. A. , CMA Jon A. Booker, Ph. D. , CPA, CIA Cynthia J. Rooney, Ph. D. , CPA Mc. Graw-Hill/Irwin Copyright © 2011 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 -2 C 1 DETERMINING INVENTORY ITEMS Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Items requiring special attention include: Goods in Transit Goods on Consignment Goods Damaged or Obsolete

6 -3 C 1 GOODS IN TRANSIT FOB Shipping Point Public Carrier Seller Buyer Ownership passes to the buyer here. Public Carrier Seller FOB Destination Point Buyer

6 -4 C 1 GOODS ON CONSIGNMENT Merchandise is included in the inventory of the consignor, the owner of the inventory. Consignee Thanks for selling my inventory in your store. Consignor

6 -5 C 1 GOODS DAMAGED OR OBSOLETE Damaged or obsolete goods are not counted in inventory if they cannot be sold. Cost should be reduced to net realizable value if they can be sold.

6 -6 C 2 DETERMINING INVENTORY COSTS Include all expenditures necessary to bring an item to a salable condition and location. Minus Discounts and Allowances Plus Import Duties Invoice Cost Plus Freight Plus Insurance Plus Storage

6 -7 C 2 INTERNAL CONTROLS AND TAKING A PHYSICAL COUNT Ø Most companies take a physical count of inventory at least once each year. Ø When the physical count does not match the Merchandise Inventory account, an adjustment must be made. Good internal controls over count include: 1. Pre-numbered inventory tickets. 2. Counters have no inventory responsibility. 3. Counts confirm existence, amount, and quality of inventory item. 4. Second count is taken. 5. Manager confirms all items counted.

6 -8 C 2 INVENTORY COSTING UNDER A PERPETUAL SYSTEM Inventory affects. . . Balance Sheet Income Statement The matching principle requires matching costs with sales.

6 -9 C 2 INVENTORY COST FLOW ASSUMPTIONS Management decisions in accounting for inventory involve the following: 1. Items included in inventory and their costs. 2. Costing method (specific identification, FIFO, LIFO, or weighted average). 3. Inventory system (perpetual or periodic). 4. Use of market values or other estimates.

6 - 10 P 1 INVENTORY COST FLOW ASSUMPTIONS First-In, First-Out (FIFO) Assumes costs flow in the order incurred. Last-In, First-Out (LIFO) Assumes costs flow in the reverse order incurred. Weighted Average Assumes costs flow at an average of the costs available.

6 - 11 P 1 INVENTORY COSTING ILLUSTRATION Here is information about the mountain bike inventory of Trekking for the month of August.

6 - 12 P 1 SPECIFIC IDENTIFICATION

6 - 13 P 1 SPECIFIC IDENTIFICATION Income Statement Cost of Goods Sold Balance Sheet Inventory

6 - 14 P 1 SPECIFIC IDENTIFICATION Here are the entries to record the purchases and sales. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150

6 - 15 P 1 FIRST-IN, FIRST-OUT (FIFO) Oldest Costs Cost of Goods Sold Recent Costs Ending Inventory

6 - 16 P 1 FIRST-IN, FIRST-OUT (FIFO)

6 - 17 P 1 FIRST-IN, FIRST-OUT (FIFO)

6 - 18 P 1 FIRST-IN, FIRST-OUT (FIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150

6 - 19 P 1 LAST-IN, FIRST-OUT (LIFO) Recent Costs Oldest Costs Cost of Goods Sold

6 - 20 P 1 LAST-IN, FIRST-OUT (LIFO)

6 - 21 P 1 LAST-IN, FIRST-OUT (LIFO)

6 - 22 P 1 LAST-IN, FIRST-OUT (LIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150

6 - 23 P 1 WEIGHTED AVERAGE When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Cost of Goods Available for Sale ÷ Units on hand on the date of sale

6 - 24 P 1 WEIGHTED AVERAGE

6 - 25 P 1 WEIGHTED AVERAGE

6 - 26 P 1 WEIGHTED AVERAGE

6 - 27 P 1 WEIGHTED AVERAGE Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150

6 - 28 A 1 FINANCIAL STATEMENT EFFECTS OF COSTING METHODS Because prices change, inventory methods nearly always assign different cost amounts.

6 - 29 A 1 FINANCIAL STATEMENT EFFECTS OF COSTING METHODS Advantages of Methods Weighted Average First-In, First -Out Last-In, First. Out Smoothes out price changes. Ending inventory approximates current replacement cost. Better matches current costs in cost of goods sold with revenues.

6 - 30 FINANCIAL STATEMENT AFFECTS When purchase price is the same all inventory methods same results When costs rise: FIFO highest inventory value, lowest COGS highest Gross Margin and Net Income LIFO lowest inventory value, highest COGS and lowest Gross Margin and Net Income Weighted Average In between When costs decline: the opposite

6 - 31 FINANCIAL STATEMENT AFFECTS When purchase price is the same all inventory methods same results When costs decline: FIFO Lowest inventory value, highest COGS lowest Gross Margin and Net Income LIFO Highest inventory value, lowest COGS and highest Gross Margin and Net Income Weighted Average In between When costs rise: the opposite

6 - 32 A 1 TAX EFFECTS OF COSTING METHODS The Internal Revenue Service (IRS) identifies several acceptable inventory costing methods for reporting taxable income. If LIFO is used for tax purposes, the IRS requires it be used in financial statements.

6 - 33 A 1 CONSISTENCY IN USING COSTING METHODS The consistency principle requires a company to use the same accounting methods period after period so that financial statements are comparable across periods. Can only change if it will improve financial reporting Justification and disclosure in notes to financial statements required

6 - 34 P 2 LOWER OF COST OR MARKET Inventory must be reported at market value when market is lower than cost. Can be applied three ways: (1) (2) (3) separately to each individual item. to major categories of assets. to the whole inventory.

6 - 35 P 2 LOWER OF COST OR MARKET A motor sports retailer has the following items in inventory:

6 - 36 P 2 LOWER OF COST OR MARKET Here is how to compute lower of cost or market for individual inventory items.

6 - 37 A 2 FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS Income Statement Effects Inventory errors are self correcting over a two year period Inventory adjustment for Lower of Cost or Market DR COGS CR Merchandise Inventory No adjustment if inventory value increases

6 - 38 A 2 FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS Balance Sheet Effects

6 - 39 A 3 INVENTORY TURNOVER Shows how many times a company turns over its inventory during a period. Indicator of how well management is controlling the amount of inventory available. Inventory Turnover Average Inventory = = Cost of goods sold Avg. inventory (Beg. Inv. + End Inv. ) ÷ 2

6 - 40 A 3 DAYS’ SALES IN INVENTORY Reveals how much inventory is available in terms of the number of days’ sales.

6 - 41 GLOBAL VIEW Items and Costs Making Up Inventory Both U. S. GAAP and IFRS include in inventory all items that a company owns and holds for sale and include in the cost expenditures necessary to bring those items to a salable condition and location. Assigning Costs to Inventory Both U. S. GAAP and IFRS allow companies to use specific identification, FIFO, and Weighted Average. IFRS does not currently allow use of LIFO. Estimating Inventory Costs Both U. S. GAAP and IFRS require companies to write down inventory when its value falls below recorded cost. U. S. GAAP prohibits any later increase in value. IFRS does allow reversals of write downs up to the original acquisition cost. Neither allow inventory to be adjusted upward beyond the original cost.

6 - 42 P 3 APPENDIX 6 A: INVENTORY COSTING UNDER A PERIODIC SYSTEM LIFO computation of COGS and ending inventory under a periodic system.

6 - 43 P 4 APPENDIX 6 B: INVENTORY ESTIMATION METHODS Inventory sometimes requires estimation for interim statements or if some casualty such as fire or flood makes taking a physical count impossible. Retail Inventory Method Gross Profit Method

6 - 44 END OF CHAPTER 06