Copyright 2012 Pearson Education Inc Publishing as Prentice

Inventory and Cost of Goods Sold Chapter 6 Copyright © 2012 Pearson Education Inc.

Learning Objective 1 Show to account for inventory Copyright © 2012 Pearson Education Inc.

Merchandise Inventory Balance Sheet (partial) Current assets: Cash $$$$ Accounts receivable $$$$ Inventory (1 chair @ cost of $300) $300 Income Statement (partial) Sales (2 chairs @ $500 selling price) Cost of goods sold (2 chairs @ $300 cost) Gross profit $1, 000 600 $400 Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 4

The cost of inventory on hand = Inventory The cost of inventory that’s been

Sales Price vs. Cost of Inventory • Sales revenue based on sales price of inventory sold • Cost of goods sold based on cost of inventory sold • Inventory based on cost of inventory on hand • Gross profit ▫ Sales revenue minus cost of goods sold Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 6

Number of units • Determined from accounting records • Evidenced by physical count at year end • Consigned goods: ▫ Does not include those held for another company ▫ Does include those out on consignment • In transit goods ▫ Depends on shipping terms Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 7

Shipping terms FOB Shipping Point FOB Destination • Legal title passes to purchaser when items leave seller’s place of business • Purchaser owns good while in transit • Legal title passes to purchaser when items arrive at purchaser’s place of business • Seller owns goods while in transit ▫ Included in purchaser’s inventory count • Purchaser pays transportation costs ▫ Included in seller’s inventory count • Seller pays transportation costs Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 8

Inventory Systems Perpetual Periodic Used for all types of goods Used for inexpensive goods Keeps a running total of all goods bought, sold and on hand Does not keep a running total of all goods bought, sold and on hand Inventory counted at least once a year Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 9

Perpetual Inventory • Bar codes on products provide information to record ▫ Sale of item ▫ Update of inventory record • Two entries needed for each sale ▫ Record revenue and asset received (cash or receivables) ▫ Record cost of sale and reduction of inventory Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 10

Recording Inventory (Amounts Assumed) JOURNAL Date Accounts and explanation Inventory Debit Credit 400, 000 Accounts payable 400, 000 Purchased inventory on account Accounts receivable 750, 000 Sales 750, 000 Sold inventory on account Cost of goods sold 380, 000 Inventory 380, 000 Recorded cost of goods sold Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 11

Recording Inventory (Amounts Assumed) Inventory Beginning balance Purchases Ending balance Cost of goods sold Cost of Goods Sold Cost of goods sold Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 12

Reporting in the Financial Statements Balance Sheet (partial) Current assets: Cash $$$$ Accounts receivable $$$$ Inventory $70, 000 Income Statement (partial) Sales $750, 000 Cost of goods sold Gross profit 380, 000 $370, 000 Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 13

Cost of Net Purchases + = Purchase price Freight-in Purchase returns Purchase allowances Purchase

Net Sales = Sales returns Sales allowances Sales discounts Net sales Copyright © 2012

Learning Objective 2 Apply and compare the various inventory cost methods Copyright © 2012

Inventory Methods Specific unit Average cost First-in, first-out Last-in, first-out Copyright © 2012 Pearson

Specific Unit • Used for businesses with unique inventory items ▫ Automobiles, fine jewelry, real estate • Inventory costed at specific price of the particular unit • Too expensive for inventories with common characteristics Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 18

Average Cost Average cost per unit Cost of goods available * Number of units available* *Goods available = Beginning inventory + Purchases Cost of goods sold Number of units sold Average cost per unit Ending inventory Number of units on hand Average cost per unit Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 19

First-in, First-out (FIFO) • Oldest items assumed to be sold first • Ending inventory

Last-in, First-out (LIFO) • Most recent items purchased are assumed to be sold first

Problem 6 -60 A Date Units Beg. inventory March 3 March 17 March 23 Cost per unit Total cost 75 tents $16 $1, 200 95 tents 165 tents 36 tents $18 $1, 710 $20 $3, 300 $21 $756 Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 22

Problem 6 -60 A Average Cost Average cost per unit Cost of goods available * Number of units available* *Goods available = Beginning inventory + Purchases Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 23

Problem 6 -60 A Average Cost of goods sold Number of units sold Average cost $18. 78 per unit (rounded) Ending inventory Number of units on hand Average cost $18. 78 per unit (rounded) Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 24

Problem 6 -60 A FIFO Date Units Beg. inventory 75 tents $16 $1, 200 March 3 95 tents $18 $1, 710 March 17 165 tents $20 $3, 300 March 23 36 tents $21 $756 Cost of goods sold Cost per unit Total cost Ending inventory Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 25

Problem 6 -60 A LIFO Date Units Beg. inventory 75 tents $16 $1, 200 March 3 95 tents $18 $1, 710 March 17 165 tents $20 $3, 300 March 23 36 tents $21 $756 Cost of goods sold Cost per unit Total cost Ending inventory Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 26

Impact of Inventory Methods on Financial Statements Increasing inventory prices Cost of goods sold Ending inventory FIFO Lowest because based on older costs, which are less expensive Highest because based on more recent and expensive costs LIFO Highest because based on more recent costs, which are more expensive Lowest because based on older costs, which are less expensive Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 27

Impact of Inventory Methods on Financial Statements Decreasing inventory prices Cost of goods sold Ending inventory FIFO Highest because based on older costs, which are more expensive Lowest because based on more recent, less expensive costs LIFO Lowest because based on more recent costs which are less expensive Highest because based on older, more expensive costs Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 28

Tax Advantage of LIFO Results in lowest income In periods of increasing prices Increases

Comparison of Inventory Methods COST OF GOODS SOLD ENDING INVENTORY • LIFO provides a better matching of expense to revenue • FIFO provides a more up-to-date inventory cost ▫ More recent costs included in Cost of Goods Sold ▫ More recent costs on the Balance Sheet Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 30

LIFO Issues • Allows manipulation of net income ▫ Large quantities purchased at end of year to lower taxes • Liquidation can occur ▫ Quantities decrease from last year, companies must “dip into” older inventory layers • Not allowed under International Standards Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 31

Learning Objective 3 Explain and apply underlying GAAP for inventory Copyright © 2012 Pearson

Principles Related to Inventories Consistency Disclosure Conservatism Copyright © 2012 Pearson Education Inc. Publishing

Disclosure • Financial statement should disclose enough information for users to make informed decisions ▫ Information should be relevant and representationally faithful • Examples: ▫ Accounting methods used ▫ Substance of material transactions Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 34

Lower-of-Cost-or-Market (LCM) • Inventory is reported at the lower of: ▫ Cost or ▫ Market Usually replacement cost • If market is lower, inventory is written down JOURNAL Date Accounts and explanation Debit Credit Cost of goods sold Inventory Wrote down inventory to market Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 35

Learning Objective Four Compute and evaluate gross profit (margin) and inventory turnover Copyright ©

Gross Profit Percentage Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 37

Inventory Turnover (Beginning Inventory + Ending Inventory)/2 Copyright © 2012 Pearson Education Inc. Publishing

Learning Objective Five Use the cost of goods sold (COGS) model to make management

Cost of Goods Sold Model Cost of Goods Sold: + = = Copyright ©

Using Cost of Goods Sold Model What merchandise should the company offer its customers? How much inventory should the company buy? Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 41

Rearranging the Cost of Goods Sold Model Cost of goods sold (based on plan for next period) + Ending inventory (based on plan for next period) = Goods available as planned - Beginning inventory (actual amount) = Purchases (amount manager should buy) Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 42

Gross Profit Method Beginning inventory Purchases Goods available for sale Estimated cost of goods sold: Net sales revenue Less estimated gross profit Estimated cost of goods sold Estimated cost of ending inventory Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. $$$$ ($$$) $$$$ 43

Exercise 6 -26 A Beginning inventory $44, 300 Purchases 33, 300 Goods available for sale 77, 600 Estimated cost of goods sold: Net sales revenue $61, 600 Less estimated gross profit 45% x $61, 600 $27, 720 Estimated cost of goods sold Estimated cost of ending inventory Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 33, 880 $43, 720 44

Learning Objective Six Analyze effects of inventory errors Copyright © 2012 Pearson Education Inc.

Effect of Inventory Errors Sales Period 1 Ending inventory overstated Period 2 Beginning inventory overstated No effect Cost of goods sold: Beginning inventory No effect Purchases No effect Goods available No effect Ending inventory No effect Cost of goods sold Gross profit Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall. 46