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

Chapter 7 Solved Exercises M 7 -6, M 7 -7, E 7 -2, E 7 -5, E 7 -10, E 7 -17 Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost Given the following information, calculate cost of goods available for sale and ending inventory, then sales, cost of goods sold, and gross profit, under (a) FIFO, (b) LIFO, and (c) weighted average. Assume a periodic inventory system is used. 7 -51

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost a. FIFO Beginning Inventory 50 units x $10 = $ 500 + Purchase 250 units x $13 = $3, 250 Cost of Goods Available for Sale $3, 750 - Ending Inventory (200 x $13) = $2, 600 = Cost of Goods Sold (50 x $10) + (50 x $13) $1, 150 7 -52

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost b. LIFO Beginning Inventory 50 units x $10 = $ 500 + Purchase 250 units x $13 = $3, 250 Cost of Goods Available for Sale $3, 750 - Ending Inventory (150 x $13) + (50 x $10) = $2, 450 = Cost of Goods Sold (100 x $13) $1, 300 7 -53

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost c. Weighted Average Beginning Inventory 50 units x $10 = $ 500 + Purchase 250 units x $13 = $3, 250 Cost of Goods Available for Sale $3, 750 - Ending Inventory (200 x $12. 50) = $2, 500 = Cost of Goods Sold (100 x $12. 50) $1, 250 Weighted Average Cost 7 -54 = $3, 750 300 units = $12. 50 per unit

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost Sales (100 units at $15) Cost of Goods Sold Gross Profit 7 -55 FIFO $1, 500 1, 150 $ 350 LIFO $1, 500 1, 300 $ 200 Weighted Avg $1, 500 1, 250 $ 250

M 7 -7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) Aircard Corporation tracks the number of units purchased and sold throughout each accounting period, but applies its inventory costing method at the end of each period as if it uses a periodic inventory system. Given the following information, calculate the cost of goods available for sale, ending inventory, and cost of goods sold, if Aircard uses (a) FIFO, (b) LIFO, or (c) weighted average cost. 7 -56

M 7 -7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) 7 -57 Goods Available for Sale – same for all methods Unit Cost Total Cost Beginning Inventory + Purchase (July 13) + Purchase (July 25) Goods Available for Sale $ 80, 000 264, 000 400, 000 $744, 000 2, 000 6, 000 8, 000 16, 000 $44 $50

M 7 -7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) a. FIFO Ending Inventory (7, 000 units x $50) = $350, 000 Cost of Goods Sold (2, 000 units x $40) (6, 000 units x $44) (1, 000 units x $50) = $394, 000 b. LIFO Ending Inventory Cost of Goods Sold 7 -58 (2, 000 units x $40) (5, 000 units x $44) = $300, 000 (8, 000 units x $50) (1, 000 units x $44) = $444, 000

M 7 -7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) c. Weighted Average 7 -59 Average Unit Cost $744, 000 / 16, 000 = $46. 50 Ending Inventory (7, 000 units x $46. 50) = $325, 500 Cost of Goods Sold (9, 000 units x $46. 50) = $418, 500

E 7 -2 Inferring Missing Amounts Based on Income Statement Relationships Supply the missing dollar amounts for the income statement of Lewis Retailers for each of the following independent cases. Sales Revenue Beginning Inventory Purchases A $700 $100 $800 ? $300 $? B 900 200 800 ? ? 150 ? C ? 100 ? ? 200 300 400 D 800 ? 650 250 ? E 1, 000 50 900 ? ? ? 500 Case 7 -60 Cost of Goods Available Cost of Goods Sold Cost of Ending Inventory Gross Profit

E 7 -2 Inferring Missing Amounts Based on Income Statement Relationships Supply the missing dollar amounts for the 2010 income statement of Lewis Retailers for each of the following independent cases. Sales Revenue Beginning Inventory Purchases A $700 $100 $800 B 900 200 C 600 ? D E Case 7 -61 Cost of Goods Available Cost of Goods Sold Cost of Ending Inventory Gross Profit 850 ? 600$? 150 400$? 50? 500 ? 200 300 400 900 ? 950 ? 650 250 500 ? 450? 150 ? 500 800 900 ? 1, 000 ? 100 400 ? 800 300 ? 600 1, 000 50 900 $300

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Oahu Kiki tracks the number of units purchased and sold throughout each accounting period but applies its inventory costing method at the end of each month, as if it uses a periodic inventory system. Assume Oahu Kiki’s records show the following for the month of January. Sales totaled 240 units. Required: 1. Calculate the number and cost of goods available for sale. 7 -62 Goods Available for Sale – same for all methods Unit Cost Total Cost Beginning Inventory + Purchase (Jan 15) + Purchase (Jan 24) Goods Available for Sale $ 9, 600 34, 200 22, 000 $65, 800 120 380 200 700 $80 $90 $110

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 2. Calculate the number of units in ending inventory. Units in Ending Inventory = Units Available – Units Sold Units in Ending Inventory = 700 – 240 = 460 units 7 -63

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending Inventory and Cost of Goods Sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. a. FIFO ending Inventory Cost of Goods Sold 7 -64 (200 units x $110) (260 units x $ 90) = $45, 400 (120 units x $80) (120 units x $90) = $20, 400

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. b. LIFO Ending Inventory Cost of Goods Sold 7 -65 (120 units x $80) (340 units x $90) = $40, 200 (200 units x $110) ( 40 units x $ 90) = $25, 600

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. c. Weighted Average 7 -66 Average Unit Cost $65, 800 / 700 units = $94 Ending Inventory (460 units x $94) = $43, 240 Cost of Goods Sold (240 units x $94) = $22, 560

E 7 -10 Reporting Inventory at Lower of Cost or Market Peterson Furniture Designs is preparing the annual financial statements dated December 31, 2012. Ending inventory information about the five major items stocked for regular sale follows: Required: 1. Complete the final two columns of the table and then compute the amount that should be reported for the 2012 ending inventory using the LCM rule applied to each item. Item Qty Total Cost Total Market LCM Per Item LCM Valuation Alligator Armoires 50 x $30 = $1, 500 x $24 = $1, 200 $24 $1, 200 Bear Bureaus 75 x $40 = $3, 000 40 3, 000 Cougar Beds 10 x $50 = $ 500 x $52 = $ 520 50 500 Dingo Cribs 30 x $30 = $ 900 30 900 Elephant Dressers 400 x $15 = $6, 000 x $12 = $4, 800 12 4, 800 Total $11, 900 7 -67 $1, 500 $10, 400

E 7 -10 Reporting Inventory at Lower of Cost or Market Peterson Furniture Designs is preparing the annual financial statements dated December 31, 2012. Ending inventory information about the five major items stocked for regular sale follows: Required: 2. Prepare the journal entry that Peterson Furniture Designs would record on December 31, 2012. dr Cost of Goods Sold (E+, -SE) 1, 500 cr Inventory (-A) 1, 500 7 -68

E 7 -17 Analyzing and Interpreting the Inventory Turnover Ratio Polaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the following amounts in its financial statements (in millions): Required: 1. Calculate to one decimal place the inventory turnover ratio and average days to sell inventory for 2010, 2009, and 2008. 2010 Inventory Turnover Ratio = Days to Sell = Cost of Goods Sold Average Inventory 365 Days Inventory Turnover *7. 0 = $1, 461 ÷ $208 7 -69 = 7. 0* 2009 5. 8** 2008 6. 8*** Times per year = **5. 8 = $1, 173 ÷ $201 51. 9 62. 5 days 53. 4 ***6. 8 = $1, 502 ÷ $220

E 7 -17 Analyzing and Interpreting the Inventory Turnover Ratio Polaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the following amounts in its financial statements (in millions): Required: 2. Comment on any trends, and compare the effectiveness of inventory managers at Polaris to inventory managers at its main competitor, Arctic Cat, where inventory turns over 3. 6 times per year (101. 4 days to sell). Both companies use the same inventory costing method (FIFO). The inventory turnover ratio reflects how many times average inventory was made and sold during the year. The inventory turnover ratio for Polaris Industries has increased in 2010 over 2009, leading to a decrease in the average days to sell. This trend suggests that Polaris is selling its inventory more quickly. This is generally considered to be a positive performance. Polaris is performing better than Arctic Cat, where the inventory turnover is 3. 6 times per year or every 101. 4 days. 7 -70

End of Chapter 7 7 -71