Chapter 7 Inventories and Cost of Goods Sold

Chapter 7 Inventories and Cost of Goods Sold Power. Point Authors: Brandy Mackintosh Lindsay Heiser Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objective 7 -1 Describe the issues in managing different types of inventory. 7 -2

Inventory Management Decisions The primary goals of inventory managers are to: 1. Maintain a sufficient quantity to meet customers’ needs 2. Ensure quality meets customers’ expectations and company standards 3. Minimize the costs of acquiring and carrying the inventory 7 -3

Types of Inventory Merchandisers. . . § Buy finished goods. § Sell finished goods. Merchandise inventory Manufacturers. . . § Buy raw materials. § Produce and sell finished goods. Raw Materials Work in Process Finished goods Completed products awaiting sale Materials waiting to be processed Partially complete products 7 -4

Learning Objective 7 -2 Explain how to report Inventory and Cost of Goods Sold. 7 -5

Balance Sheet and Income Statement Reporting 7 -6

Cost of Goods Sold Equation BI + P – CGS = EI National Outfitters’ beginning inventory was $4, 800. During the period, the company purchased inventory for $10, 200. The cost of goods sold for the period is $9, 000. Compute the ending inventory. Cost of Goods Sold Calculation Beginning Inventory + Purchases = Cost of Goods Available for Sale - Cost of Goods sold = Ending Inventory 7 -7 $ 4, 800 10, 200 15, 000 9, 000 $ 6, 000

Cost of Goods Sold Equation beginning Inventory $4, 800 + purchases $10, 000 goods available for sale $15, 000 ending Inventory $6, 000 (Balance Sheet) 7 -8 Still Here Sold Cost of Goods Sold $9, 000 (Income Statement)

Learning Objective 7 -3 Compute costs using four inventory costing methods. 7 -9

Inventory Costing Methods Specific identification First-in, first-out (FIFO) Last-in, first-out (LIFO) Weighted average 7 -10

Inventory Costing Methods Consider the following information May 3 May 5 May 6 May 8 Purchased 1 unit for $70 Purchased 1 more unit for $75 Purchased 1 more unit for $95 Sold 2 units for $125 each May 6 $95 cost May 5 $75 cost May 3 $70 cost Specific Identification This method individually identifies and records the cost of each item sold as part of cost of goods sold. If the items sold were identified as the ones that cost $70 and $95, the total cost of those items ($70 + 95 = $165) would be reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance sheet at the end of the period. 7 -11

Inventory Costing Methods LIFO May 5 $75 cost May 3 $70 cost Net Sales Cost of Goods Sold Gross Profit $250 145 $105 Balance Sheet Inventory $95 Income Statement Net Sales Cost of Goods Sold Gross Profit $250 170 $ 80 Balance Sheet Inventory $70 Still there May 6 $95 cost Sold May 6 $95 cost Income Statement 7 -12 Weighted average May 6 $95 cost Still there Sold FIFO $80 $240 = per unit 3 Income Statement Net Sales Cost of Goods Sold Gross Profit $250 160 $ 90 Balance Sheet Inventory $80 Sold Still there

Inventory Costing Methods Summary FIFO Cost of Goods sold (Income Statement) Inventory (Balance sheet) LIFO Weighted Average Oldest cost Newest cost Average cost Newest cost Oldest cost Average cost Let’s consider a more complex example. Date Oct 1 Oct 3 Oct 5 Oct 6 7 -13 Description Beginning Inventory Purchase Sales Ending Inventory # of Units 10 30 10 (35) 15 Cost per Unit $ 7 $ 8 $10 To calculate Total Cost $ 70 240 100 To calculate

Inventory Cost Flow Computations FIFO + = beginning Inventory 10 units purchases 30 units 10 units cost of goods available for sale ending Inventory Cost of Goods Sold x x x $ 7 $ 8 $ 10 = $ 70 = 240 = 100 $ 410 140 $ 270 (10 units @ $10) + (5 units @ $8) (10 units @ $7) + (25 units @ $8) 7 -14

Inventory Cost Flow Computations LIFO + = beginning Inventory 10 units purchases 30 units 10 units cost of goods available for sale ending Inventory Cost of Goods Sold x x x $ 7 $ 8 $ 10 = $ 70 = 240 = 100 $ 410 110 $ 300 (10 units @ $7) + (5 units @ $8) (10 units @ $10) + (25 units @ $8) 7 -15

Inventory Cost Flow Computations Weighted Average # of Units Description beginning Inventory purchase cost of goods available for sale Weighted = Average Cost 7 -16 Cost per Unit 10 30 10 50 $ 7 $ 8 $10 Total Cost $ 70 240 100 $ 410 Cost of goods Available for Sale Number of Units Available for Sale $410 50 units = $8. 20 per unit

Inventory Cost Flow Computations Weighted Average + = Beginning Inventory 10 units Purchases 30 units 10 units Cost of Goods Available for Sale Ending Inventory Cost of Goods Sold x x x $ 7 $ 8 $ 10 15 units @ $8. 20 35 units @ $8. 20 7 -17 = $ 70 = 240 = 100 $ 410 123 $ 287

Financial Statement Effects on the Income Statement Sales Cost of Goods Sold FIFO $ 525 270 Weighted Average LIFO $ 525 300 $ 525 287 Gross Profit 255 225 238 Operating Expenses Income from Operations Other Revenue (Expenses) 125 130 20 125 100 20 125 113 20 Income before Income Tax Expense (30%) 150 45 120 36 133 40 Net Income $ 105 $ 84 $ 93 $ 140 $ 110 $ 123 Effects on the Balance Sheet Inventory 7 -18

Financial Statement Effects 7 -19

Financial Statement Effects 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. 7 -20

Tax Implications and Cash Flow Effects on the Income Statement Sales Cost of Goods Sold FIFO $ 525 270 Weighted Average LIFO $ 525 300 $ 525 287 Gross Profit 255 225 238 Operating Expenses Income from Operations Other Revenue (Expenses) 125 130 20 125 100 20 125 113 20 Income before Income Tax Expense (30%) 150 45 120 36 133 40 Net Income $ 105 $ 84 $ 93 $ 140 $ 110 $ 123 Effects on the Balance Sheet Inventory 7 -21

Learning Objective 7 -4 Reporting inventory at the lower of cost or market. 7 -22

Lower of Cost or Market The value of inventory can fall below its recorded cost for two reasons: 1. it’s easily replaced by identical goods at a lower cost, or 2. it’s become outdated or damaged. When the value of inventory falls below its recorded cost, the amount recorded for inventory is written down to its lower market value. This is known as the lower of cost or market (LCM) rule. 7 -23

Lower of Cost or Market 1, 000 items @ $165 Item Cost per Item Market Value per Item LCM per Item Leather coats Vintage jeans $165 20 $150 25 $150 20 1 Analyze Assets Inventory 2 1, 000 400 1, 000 items @ $150 Liabilities = -$15, 000 Total cost Writedown $150, 000 $165, 000 8, 000 $15, 000 0 400 items @ $20 Stockholders’ Equity + Cost of Goods Sold (+E) -$15, 000 Record dr 7 -24 Total Lower of cost Quantity or Market Cost of Goods Sold (+E, -SE) cr Inventory (-A) 15, 000

Lower of Cost or Market 7 -25

Learning Objective 7 -5 Analyze and record inventory purchases, transportation, returns and allowances, and discounts. 7 -26

Recording Inventory Transactions We will now look at the accounting for purchases, transportation costs, purchase returns and allowances, and purchase discounts. We will record all inventory-related transactions in the Inventory account. 7 -27

Inventory Purchases American Eagle Outfitters purchases $10, 500 of vintage jeans on credit. 1 Analyze Assets Inventory (+A) 2 Liabilities + Stockholders’ Equity Accounts Payable (+L) $10, 500 Record dr 7 -28 +$10, 500 = Inventory (+A) cr Accounts Payable (+L) 10, 500

Transportation Cost American Eagle pays $400 cash to a trucker who delivers the $10, 500 of vintage jeans to one of its stores. 1 Analyze Assets Cash (-A) Inventory (+A) 2 Liabilities + Stockholders’ Equity -$400 +$400 Record dr 7 -29 = Inventory (+A) cr Cash (-A) 400

Purchase Returns and Allowances American Eagle returned some of the vintage jeans to the supplier and received a $500 reduction in the balance owed. 1 Analyze Assets Inventory (-A) 2 -$500 Accounts Payable (-L) + Stockholders’ Equity -$500 Record dr 7 -30 Liabilities = Accounts Payable (-L) cr Inventory (-A) 500

Purchase Discounts American Eagle’s vintage jeans purchase for $10, 500 had terms of 2/10, n/30. Recall that American Eagle returned inventory costing $500 and received a $500 reduction in its Accounts Payable. American Eagle paid within the discount period. 1 Analyze Assets Cash (-A) Inventory (-A) 2 -$9, 800 -$200 + Stockholders’ Equity Accounts Payable (-L) -10, 000 Record dr 7 -31 Liabilities = Accounts Payable (-L) cr Cash (-A) cr Inventory (-A) 10, 000 9, 800 200

Summary of Inventory Transactions 7 -32

Learning Objective 7 -6 Evaluate inventory management by computing and interpreting the inventory turnover ratio. 7 -33

Inventory Turnover Analysis 7 -34

Comparison to Benchmarks 7 -35

Supplement 7 A FIFO, LIFO, and Weighted Average in a Perpetual Inventory System Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Perpetual Inventory System This is the same information that we used earlier in the chapter to illustrate a periodic inventory system. The only difference is that we have assumed the sales occurred on October 4, prior to the final inventory purchase. 7 -37

FIFO (First-in, First-Out) 7 -38

LIFO (Last-in, First-Out) 7 -39

Weighted Average Cost $310 ÷ 40 units = $7. 75 per unit 7 -40

Financial Statement Effects Summary of Perpetual Inventory System Cost Flow Assumptions on Financial Statements 7 -41

Supplement 7 B The Effects of Errors in Ending Inventory Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Effects of Errors in Ending Inventory Cost of Goods Sold Equation BI + P – CGS = EI Errors in Ending Inventory will affect the Balance Sheet and the Income Statement. Assume that Ending Inventory was overstated in 2012 by $10, 000 due to an error that was not discovered until 2013. 2012 7 -43 + - Beginning Inventory Purchases Ending Inventory Accurate Overstated $10, 000 = Cost of Goods Sold Understated $10, 000

The Effects of Errors in Ending Inventory Now let’s examine the effects of the 2012 Ending Inventory Error on 2013. Assume that Ending Inventory was overstated in 2012 by $10, 000 due to an error that was not discovered until 2013 7 -44 + - Beginning Inventory Purchases Ending Inventory Overstated $10, 000 Accurate = Cost of Goods Sold Overstated $10, 000

Supplement 7 C Recording Inventory Transactions in a Periodic System Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Recording Inventory Transactions in a Periodic System A local cell phone dealer stocks and sells one item. The following events occurred in the past year: We will record these events assuming the company uses a periodic inventory system and then compare the periodic inventory system to a perpetual inventory system. 7 -46

Recording Inventory Transactions in a Periodic System Periodic Inventory System 7 -47 Perpetual Inventory System

Recording Inventory Transactions in a Periodic System Periodic Inventory System BI + P – CGS = EI End-of-year adjustment entries are not required using a perpetual inventory system. 7 -48

Recording Inventory Transactions in a Periodic System Summary of the Effects on the Accounting Equation Periodic Inventory System 7 -49 Perpetual Inventory System