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1 Challenging Issues Under Accrual Accounting: Merchandise Inventory and Cost of Goods Sold CHAPTER F9 © 2007 Pearson Custom Publishing.

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Presentation on theme: "1 Challenging Issues Under Accrual Accounting: Merchandise Inventory and Cost of Goods Sold CHAPTER F9 © 2007 Pearson Custom Publishing."— Presentation transcript:

1 1 Challenging Issues Under Accrual Accounting: Merchandise Inventory and Cost of Goods Sold CHAPTER F9 © 2007 Pearson Custom Publishing

2 2 Explain goods available for sale (GAFS) and name its components. Learning Objective 1: © 2007 Pearson Custom Publishing

3 3 Tracking Inventory Costs Inventory (or merchandise inventory) consists of the items that a company offers for sale to their customers. Inventory (or merchandise inventory) consists of the items that a company offers for sale to their customers. Inventory is often thought of as the physical goods that are for sale, but in accounting we are usually referring to the cost of the inventory. These inventory costs need to be tracked through the accounting system. Inventory is often thought of as the physical goods that are for sale, but in accounting we are usually referring to the cost of the inventory. These inventory costs need to be tracked through the accounting system. © 2007 Pearson Custom Publishing

4 4 Goods Available for Sale Most companies start an accounting period with some inventory on hand, this is known as beginning inventory. Most companies start an accounting period with some inventory on hand, this is known as beginning inventory. Additional items are usually acquired during the period, known as purchases. Additional items are usually acquired during the period, known as purchases. Add these two amounts together to determine the goods available for sale. Add these two amounts together to determine the goods available for sale. © 2007 Pearson Custom Publishing

5 5 Describe the relationship between ending inventory and cost of goods sold. Learning Objective 2: © 2007 Pearson Custom Publishing

6 6 Cost of Goods Sold The goods available for sale represents the amount that could have been sold. The goods that are NOT sold are called ending inventory. The goods available for sale represents the amount that could have been sold. The goods that are NOT sold are called ending inventory. Subtracting the ending inventory from the goods available for sale determines the amount of cost of goods sold (or cost of sales). Subtracting the ending inventory from the goods available for sale determines the amount of cost of goods sold (or cost of sales). © 2007 Pearson Custom Publishing

7 7 Flow of Inventory Well use a simple example of inventory flow to help visualize the process. Well use a simple example of inventory flow to help visualize the process. Assume that we started the period with only 3 items in inventory. During the period we purchased 8 more items, making a total of 11 items available for sale. Assume that we started the period with only 3 items in inventory. During the period we purchased 8 more items, making a total of 11 items available for sale. At the end of the period, we see that 5 items are still on hand, the other 6 were sold. At the end of the period, we see that 5 items are still on hand, the other 6 were sold. © 2007 Pearson Custom Publishing

8 8 6 units, Cost of Goods Sold Flow of Inventory += 3 units, beginning inventory 8 units purchased 11 units, Goods Available for Sale 5 units, Ending Inv. © 2007 Pearson Custom Publishing

9 9 COGS Schedule All available goods must be accounted for as either ending inventory or COGS. Assume that each unit cost $6

10 10 Manufacturing Companies A manufacturer typically has three different types of inventory: A manufacturer typically has three different types of inventory: ¶ Raw materials inventory: the various items that are used in the production process, · Work-in-process inventory: those items that have been started but not finished, and ¸ Finished goods inventory: those items that are ready to be sold. © 2007 Pearson Custom Publishing

11 11 Explain the differences between periodic and perpetual inventory systems. Learning Objective 4: © 2007 Pearson Custom Publishing

12 12 Inventory Systems Many different ways have been developed for determining how to account for the costs of inventory. Many different ways have been developed for determining how to account for the costs of inventory. A company needs to choose an inventory system, and then apply the concepts of that system to the purchases and sales of the inventory items. A company needs to choose an inventory system, and then apply the concepts of that system to the purchases and sales of the inventory items. © 2007 Pearson Custom Publishing

13 13 Periodic Inventory System When using the periodic inventory system, the accounting records for inventory and cost of goods sold are updated only at the end of the accounting period. When using the periodic inventory system, the accounting records for inventory and cost of goods sold are updated only at the end of the accounting period. Thus, in the middle of the period, there is no record that shows how much inventory is on hand or how much has been sold (COGS). Thus, in the middle of the period, there is no record that shows how much inventory is on hand or how much has been sold (COGS). This is an easy, inexpensive method. This is an easy, inexpensive method. © 2007 Pearson Custom Publishing

14 14 When using a perpetual inventory system, the inventory records are continually updated to provide the company with useful information at any time. When using a perpetual inventory system, the inventory records are continually updated to provide the company with useful information at any time. Each purchase of new inventory is shown as an increase in the inventory account, and each sale is recorded as a reduction to the inventory account. Each purchase of new inventory is shown as an increase in the inventory account, and each sale is recorded as a reduction to the inventory account. Perpetual Inventory System © 2007 Pearson Custom Publishing

15 15 The perpetual inventory system is much more time consuming than the periodic system, if the accounting records are kept manually. The perpetual inventory system is much more time consuming than the periodic system, if the accounting records are kept manually. However, most companies now use a computerized accounting system, and these systems can just as easily (and cheaply) maintain inventory records on the perpetual basis as on the periodic basis. However, most companies now use a computerized accounting system, and these systems can just as easily (and cheaply) maintain inventory records on the perpetual basis as on the periodic basis. Perpetual Inventory System © 2007 Pearson Custom Publishing

16 16 Regardless of the type of accounting system in use, the inventory needs to be physically counted on a regular basis, at least once a year. Regardless of the type of accounting system in use, the inventory needs to be physically counted on a regular basis, at least once a year. This physical count is used to either update the inventory account (periodic system) or verify the amount (perpetual system) of inventory that is shown in the account. This physical count is used to either update the inventory account (periodic system) or verify the amount (perpetual system) of inventory that is shown in the account. Taking a Physical Count © 2007 Pearson Custom Publishing

17 17 Your Company uses the periodic inventory system. At the beginning of the year, the inventory value was $10,000. Your Company uses the periodic inventory system. At the beginning of the year, the inventory value was $10,000. It is now the end of the year. Your inventory account still has a balance of $10,000. You need to take a physical count of the inventory on hand at year end. It is now the end of the year. Your inventory account still has a balance of $10,000. You need to take a physical count of the inventory on hand at year end. If the count equals $15,000, you will adjust your inventory account accordingly. If the count equals $15,000, you will adjust your inventory account accordingly. Physical Count - Periodic © 2007 Pearson Custom Publishing

18 18 Your Company uses the perpetual inventory system. The inventory balance is updated every time you buy or sell some inventory. You accomplish this easily through the use of scanners and bar codes. Your Company uses the perpetual inventory system. The inventory balance is updated every time you buy or sell some inventory. You accomplish this easily through the use of scanners and bar codes. It is now the end of the year. Your inventory account has a balance of $16,000. You take a physical count that equals $15,000. You will adjust your inventory account accordingly. It is now the end of the year. Your inventory account has a balance of $16,000. You take a physical count that equals $15,000. You will adjust your inventory account accordingly. Physical Count - Perpetual © 2007 Pearson Custom Publishing

19 19 Discussion Questions What might have caused the discrepancy between the book inventory of $16,000 and the actual inventory of $15,000? What might have caused the discrepancy between the book inventory of $16,000 and the actual inventory of $15,000? How would you account for that $1,000? How would you account for that $1,000? If you were using the periodic system instead of the perpetual, would you have known about the $1,000 difference? If you were using the periodic system instead of the perpetual, would you have known about the $1,000 difference? © 2007 Pearson Custom Publishing

20 20 Differentiate between the physical flow of merchandise and the cost flow of merchandise. Learning Objective 3: © 2007 Pearson Custom Publishing

21 21 Physical Movement of Goods Assume you own a company called Middleman, Inc. Assume you own a company called Middleman, Inc. You buy a gadget from the Gadget Manufacturing Company for $50. You buy a gadget from the Gadget Manufacturing Company for $50. You put a price of $90 on the gadget and make it available for sale to your customers. You put a price of $90 on the gadget and make it available for sale to your customers. © 2007 Pearson Custom Publishing

22 22 Thus, the product flows from the manufacturer to your company and then to your customer. Thus, the product flows from the manufacturer to your company and then to your customer. This represents the reality of the movement of the inventory. This represents the reality of the movement of the inventory. Physical Movement of Goods © 2007 Pearson Custom Publishing

23 23 When the gadgets and other products flow through your company, you may desire that they do it in a particular order. When the gadgets and other products flow through your company, you may desire that they do it in a particular order. In some cases, the newest goods should be sold first, and in other cases the oldest goods should be sold first, and possibly it doesnt make any difference at all. In some cases, the newest goods should be sold first, and in other cases the oldest goods should be sold first, and possibly it doesnt make any difference at all. Physical Movement of Goods © 2007 Pearson Custom Publishing

24 24 List the different inventory cost flow assumptions and contrast how the use of each affects reported net income on the income statement. Learning Objective 5: © 2007 Pearson Custom Publishing

25 25 FIFO and LIFO If you sell the gadgets in the same order that you purchase them, you have what is known as a first-in, first-out (FIFO) flow of goods. If you sell the gadgets in the same order that you purchase them, you have what is known as a first-in, first-out (FIFO) flow of goods. If you sell the most recent purchases first, then you have a last-in, first-out (LIFO) flow of goods. If you sell the most recent purchases first, then you have a last-in, first-out (LIFO) flow of goods. Possibly, they are sold randomly instead. Possibly, they are sold randomly instead. © 2007 Pearson Custom Publishing

26 26 FIFO Physical Flow Most grocery stores follow the practice of rotating stock. When new boxes of breakfast cereal arrive, they are placed at the back of the shelf, and the older boxes are moved to the front of the shelf. Most grocery stores follow the practice of rotating stock. When new boxes of breakfast cereal arrive, they are placed at the back of the shelf, and the older boxes are moved to the front of the shelf. The grocer is taking these steps so that the inventory items flow through the store on a first-in, first-out basis. The grocer is taking these steps so that the inventory items flow through the store on a first-in, first-out basis. © 2007 Pearson Custom Publishing

27 27 LIFO Physical Flow Old-fashioned hardware stores usually sell nails in big wooden bins. When the supply of nails is getting low, they pour in a new batch. When the customer reaches in for some nails, they are removing the nails that are on the top. Old-fashioned hardware stores usually sell nails in big wooden bins. When the supply of nails is getting low, they pour in a new batch. When the customer reaches in for some nails, they are removing the nails that are on the top. These inventory items flow through the store on a last-in, first-out basis. These inventory items flow through the store on a last-in, first-out basis. © 2007 Pearson Custom Publishing

28 28 Average Physical Flow The local gas station has large underground storage tanks. The last delivery of gas cost them 90 cents per gallon. The tank is still about 1/4 full when the tanker arrives to refill. The new cost of gas is 95 cents per gallon. The local gas station has large underground storage tanks. The last delivery of gas cost them 90 cents per gallon. The tank is still about 1/4 full when the tanker arrives to refill. The new cost of gas is 95 cents per gallon. The dealer now has a mixture of gasoline from different deliveries at different costs. The dealer now has a mixture of gasoline from different deliveries at different costs. Future gallons pumped from the tank would represent the average cost of all the gallons. Future gallons pumped from the tank would represent the average cost of all the gallons.

29 29 Specific Physical Flow Assume the local sports card collector opens a shop in a strip mall. He buys three Mickey Mantle cards on his first day of business, one from 1952, one from 1954, and one from Assume the local sports card collector opens a shop in a strip mall. He buys three Mickey Mantle cards on his first day of business, one from 1952, one from 1954, and one from He paid different prices for each card due to quality and age. He paid different prices for each card due to quality and age. When he sells one of those cards, he is selling a specific card, not necessarily the last one, the first one, or the average one. When he sells one of those cards, he is selling a specific card, not necessarily the last one, the first one, or the average one. © 2007 Pearson Custom Publishing

30 30 © 2007 Pearson Custom Publishing Flow of Inventory Cost Recall our previous discussions about reality and the measurement of reality. Recall our previous discussions about reality and the measurement of reality. The physical flow of products is the reality of the situation. The physical flow of products is the reality of the situation. The cost flow assumption that we adopt determines our measurement of reality. The cost flow assumption that we adopt determines our measurement of reality.

31 31 We will look at four different cost flow assumptions that are commonly used to account for inventory: We will look at four different cost flow assumptions that are commonly used to account for inventory: 1. FIFO (first-in, first-out) 1. FIFO (first-in, first-out) 2. LIFO (last-in, first-out) 2. LIFO (last-in, first-out) 3. Average cost 3. Average cost 4. Specific identification 4. Specific identification Cost Flow Assumptions © 2007 Pearson Custom Publishing

32 32 As seen before, the measurement of reality need not always match that reality. As seen before, the measurement of reality need not always match that reality. For example, we could choose to use the LIFO method even if our actual flow of goods does not match the LIFO flow. For example, we could choose to use the LIFO method even if our actual flow of goods does not match the LIFO flow. In other words, even if our physical inventory flow reality is FIFO, we could choose to use the LIFO or Average methods as our measurement of that reality. In other words, even if our physical inventory flow reality is FIFO, we could choose to use the LIFO or Average methods as our measurement of that reality. Cost Flow Assumptions © 2007 Pearson Custom Publishing

33 33 Specific Identification Review the example on page F-309 for the Dobbs Motor Company that sells antique automobiles. Review the example on page F-309 for the Dobbs Motor Company that sells antique automobiles. They use the specific identification method to determine the cost of the vehicles that are bought and sold. They use the specific identification method to determine the cost of the vehicles that are bought and sold. The FIFO, LIFO, or Average methods would not be reasonable in this case. The FIFO, LIFO, or Average methods would not be reasonable in this case. © 2007 Pearson Custom Publishing

34 34 For all of the following examples, we will use the following data: For all of the following examples, we will use the following data: 6/1/01 Beg. Inv. = 150 $12 = $1,800 6/1/01 Beg. Inv. = 150 $12 = $1,800 6/8/01 Purchase of 150 $13 = $1,950 6/8/01 Purchase of 150 $13 = $1,950 6/12/01 Sale of 200 units 6/12/01 Sale of 200 units 6/17/01 Purchase of 200 $14 = $2,800 6/17/01 Purchase of 200 $14 = $2,800 6/25/01 Sale of 150 units 6/25/01 Sale of 150 units Total units available = 500, units sold = 350. Total units available = 500, units sold = 350. Sample Inventory Data © 2007 Pearson Custom Publishing

35 35 Cost Flow - Periodic System In the periodic system, we make the calculations of ending inventory and cost of goods sold at the end of the month (or year). In the periodic system, we make the calculations of ending inventory and cost of goods sold at the end of the month (or year). The timing of the individual purchases and sales is irrelevant. The timing of the individual purchases and sales is irrelevant. Using the previous data, the goods available for sale equals $6,550, regardless of which cost flow assumption we make. Using the previous data, the goods available for sale equals $6,550, regardless of which cost flow assumption we make. © 2007 Pearson Custom Publishing

36 36 Calculate cost of goods sold and ending inventory using FIFO,LIFO, and average cost inventory cost flow assumptions. Learning Objective 6: © 2007 Pearson Custom Publishing

37 37 Periodic - FIFO Method Using the FIFO method, the 350 units sold were the first 350 units, and the 150 units remaining were the last units purchased. Using the FIFO method, the 350 units sold were the first 350 units, and the 150 units remaining were the last units purchased. COGS = $12) + $13) + $14) = $4,450 COGS = $12) + $13) + $14) = $4,450 End. Inventory = $14 = $2,100 End. Inventory = $14 = $2,100 © 2007 Pearson Custom Publishing

38 38 Periodic - LIFO Method Using the LIFO method, the 350 units sold were the last 350 units, and the 150 units remaining are the first units (beginning inv). Using the LIFO method, the 350 units sold were the last 350 units, and the 150 units remaining are the first units (beginning inv). COGS = $14) + $13) = $4,750 COGS = $14) + $13) = $4,750 End. Inventory = $12 = $1,800 End. Inventory = $12 = $1,800 © 2007 Pearson Custom Publishing

39 39 Periodic - Average Method Using the Average method, we need to calculate the average cost of all 500 units: Total Cost =$6,550 = $13.10 Using the Average method, we need to calculate the average cost of all 500 units: Total Cost =$6,550 = $13.10 Total Units 500 Total Units 500 COGS = $13.10 = $4,585 COGS = $13.10 = $4,585 End. Inv. = $13.10 = $1,965 End. Inv. = $13.10 = $1,965 © 2007 Pearson Custom Publishing

40 40 Below is a summary of the results from the periodic system, all three methods. Below is a summary of the results from the periodic system, all three methods. Summary of Results © 2007 Pearson Custom Publishing

41 41 Discussion Questions In the previous example, which system would result in the highest reported net income for the period? In the previous example, which system would result in the highest reported net income for the period? If your only concern was to reduce your income taxes, which system would you prefer to use in the previous example? Would that always be the case? If your only concern was to reduce your income taxes, which system would you prefer to use in the previous example? Would that always be the case? © 2007 Pearson Custom Publishing

42 42 Cost Flow-Perpetual System Under the perpetual system, the cost of goods sold is calculated every time we make a sale, rather than waiting until the end of the accounting period. Under the perpetual system, the cost of goods sold is calculated every time we make a sale, rather than waiting until the end of the accounting period. We now need to pay attention to the date of each transaction, and apply the concept of the cost flow assumption (FIFO, LIFO, etc.) to each individual sale. We now need to pay attention to the date of each transaction, and apply the concept of the cost flow assumption (FIFO, LIFO, etc.) to each individual sale. © 2007 Pearson Custom Publishing

43 43 Perpetual - FIFO Method Using the perpetual FIFO method, we get exactly the same answers as the periodic FIFO method. The 350 units sold were the first 350 units, and the 150 units remaining were the last units purchased. Using the perpetual FIFO method, we get exactly the same answers as the periodic FIFO method. The 350 units sold were the first 350 units, and the 150 units remaining were the last units purchased. COGS = $4,450 COGS = $4,450 End. Inventory = $2,100 End. Inventory = $2,100 © 2007 Pearson Custom Publishing

44 44 Perpetual - LIFO Method We need to separately calculate the COGS for each sale made to customers: We need to separately calculate the COGS for each sale made to customers: COGS on 6/12 = $13) + $12) = $2,550 COGS on 6/12 = $13) + $12) = $2,550 COGS on 6/25 = $14) = $2,100 COGS on 6/25 = $14) = $2,100 Total COGS = $4,650 Total COGS = $4,650 End. Inv. = $12) + $14) = $1,900 End. Inv. = $12) + $14) = $1,900 © 2007 Pearson Custom Publishing

45 45 Perpetual - Average Method For this method, we need to calculate the moving average cost of the units on hand. When we sell a unit, the cost of goods sold is recorded at this average cost. For this method, we need to calculate the moving average cost of the units on hand. When we sell a unit, the cost of goods sold is recorded at this average cost. Calculate the average cost as of the 6/12 sale: Calculate the average cost as of the 6/12 sale: 6/1 Beg. Inv. = 150 $12 = $1,800 6/1 Beg. Inv. = 150 $12 = $1,800 6/8 Purchase of 150 $13 = $1, $3,750 Average = $3,750 / 300 = $12.50 each 6/8 Purchase of 150 $13 = $1, $3,750 Average = $3,750 / 300 = $12.50 each © 2007 Pearson Custom Publishing

46 46 Perpetual - Average Method Of the 300 units on hand, 200 units were sold at an average cost of $12.50 each. COGS for 6/12 = $12.50 = $2,500 Of the 300 units on hand, 200 units were sold at an average cost of $12.50 each. COGS for 6/12 = $12.50 = $2,500 The remaining 100 units are carried forward at the average cost of $12.50 until the next purchase of 200 units $14 each) on 6/17. Then a new average must be calculated. The remaining 100 units are carried forward at the average cost of $12.50 until the next purchase of 200 units $14 each) on 6/17. Then a new average must be calculated. © 2007 Pearson Custom Publishing

47 47 Perpetual - Average Method Calculate the average cost as of the 6/25 sale: Calculate the average cost as of the 6/25 sale: Remaining units = 100 $12.50 =$1,250 Remaining units = 100 $12.50 =$1,250 6/17 Purchase of 200 $14.00 =$2, $4,050 Average = $4,050 / 300 = $13.50 each 6/17 Purchase of 200 $14.00 =$2, $4,050 Average = $4,050 / 300 = $13.50 each COGS for 6/25 = $13.50 = $2,025 COGS for 6/25 = $13.50 = $2,025 © 2007 Pearson Custom Publishing

48 48 Perpetual - Average Method To summarize the previous data: To summarize the previous data: COGS 6/12 = $12.50 = $2,500 COGS 6/12 = $12.50 = $2,500 COGS 6/25 = $13.50 = $2,025 Total = $4,525 COGS 6/25 = $13.50 = $2,025 Total = $4,525 End. Inv. = 150 $13.50 = $2,025 End. Inv. = 150 $13.50 = $2,025 © 2007 Pearson Custom Publishing

49 49 Below is a summary of the results from the perpetual system, all three methods. Below is a summary of the results from the perpetual system, all three methods. Summary of Results © 2007 Pearson Custom Publishing

50 50 The choice of inventory methods has a clear impact on two of the major financial reports: the income statement and the balance sheet. The choice of inventory methods has a clear impact on two of the major financial reports: the income statement and the balance sheet. The total cost of goods available for sale must be accounted for. This amount is split into two amounts, the ending inventory (balance sheet) and the cost of goods sold (income statement). The total cost of goods available for sale must be accounted for. This amount is split into two amounts, the ending inventory (balance sheet) and the cost of goods sold (income statement). Effects of Inventory Cost Flow Method Choice © 2007 Pearson Custom Publishing

51 51 Discussion Questions In the example just completed, the cost of the inventory item was increasing. What impact would it have on the results if the cost of the item was decreasing? In the example just completed, the cost of the inventory item was increasing. What impact would it have on the results if the cost of the item was decreasing? What impact would it have if the cost was stable, not increasing or decreasing? What impact would it have if the cost was stable, not increasing or decreasing? © 2007 Pearson Custom Publishing

52 52 Discussion Questions Over the long run (several years), do you think the reported results will be much different between the periodic system and the perpetual system? Over the long run (several years), do you think the reported results will be much different between the periodic system and the perpetual system? Over the long run, do you think the reported results will be much different among the FIFO, LIFO, and Average methods? Over the long run, do you think the reported results will be much different among the FIFO, LIFO, and Average methods? © 2007 Pearson Custom Publishing

53 53 End of Chapter 9


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