1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Reporting and Interpreting Cost of Goods Sold and Inventory Chapter 7

2. 7-2 Understanding the Business Provide sufficient quantities of high- quality inventory. Minimize the costs of carrying inventory. Primary Goals of Inventory Management

3. 7-3 Learning Objectives Apply the cost principle to identify the amounts that should be included in inventory and the matching principle to determine cost of goods sold for typical retailers, wholesalers, and manufacturers.

4. 7-4 Items Included in Inventory Inventory TangibleHeld for Sale Used to Produce Goods or Services Merchandise Inventory Raw Materials Inventory Work in Process Inventory Finished Goods Inventory

5. 7-5 Costs Included in Inventory Purchases cost principle The cost principle requires that inventory be recorded at the price paid or the consideration given. Invoice Price Freight Inspection Costs Preparation Costs

6. 7-6 Nature of Cost of Goods Sold Beginning Inventory Purchases for the Period Ending Inventory (Balance Sheet) Goods available for Sale Cost of Goods Sold (Income Statement) Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of goods sold Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of goods sold

7. 7-7 Inventory Costing Methods Specific Identification FIFOFIFO LIFOLIFO Weighted Average

8. 7-8 Specific Identification When units are sold, the specific cost of the unit sold is added to cost of goods sold.

9. 7-9 First-In, First-Out Method Cost of Goods Sold Oldest Costs Ending Inventory Recent Costs

10. 7-10 First-In, First-Out Remember: The costs of most recent purchases are in ending inventory. Start with 11/29 and add units purchased until you reach the number in ending inventory.

11. 7-11 First-In, First-Out

12. 7-12 First-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

13. 7-13 First-In, First-Out Now, we have allocated the cost to all 1,050 units sold.

14. 7-14 First-In, First-Out Here is the cost of ending inventory and cost of goods sold using FIFO.

15. 7-15 Last-In, First-Out Method Ending Inventory Cost of Goods Sold Oldest Costs Recent Costs

16. 7-16 Last-In, First-Out Remember: The costs of the oldest purchases are in ending inventory. Start with beginning inventory and add units purchased until you reach the number in ending inventory.

17. 7-17 Last-In, First-Out

18. 7-18 Last-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

19. 7-19 Last-In, First-Out Now, we have allocated the cost to all 1,050 units sold.

20. 7-20 Last-In, First-Out Here is the cost of ending inventory and cost of goods sold using LIFO.

21. 7-21 Average Cost Method 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 Number of Units Available for Sale ÷

22. 7-22 Average Cost Method

23. 7-23 Average Cost Method

24. 7-24 Comparison of Methods

25. 7-25 Financial Statement Effects of Costing Methods Advantages of Methods Better matches current costs in cost of goods sold with revenues. Ending inventory approximates current replacement cost. First-In, First-Out Last-In, First-Out Smoothes out price changes. Weighted Average

26. 7-26 Learning Objectives Decide when the use of different inventory costing methods is beneficial to a company.

27. 7-27 Managers Choice of Inventory Methods Net Income Effects Managers prefer to report higher earnings for their companies. Income Tax Effects Managers prefer to pay the least amount of taxes allowed by law as late as possible.

28. 7-28 Choosing Inventory Costing Methods LIFO for books LIFO for taxes If...Then... LIFO Conformity Rule

29. 7-29 Learning Objectives Report inventory at the lower of cost or market (LCM).

30. 7-30 Valuation at Lower of Cost or Market Ending inventory is reported at the lower of cost or market (LCM). Replacement Cost The current purchase price for identical goods. The company will recognize a “holding” loss in the current period rather than the period in which the item is sold. This practice is conservative.

31. 7-31 Valuation at Lower of Cost or Market

32. 7-32 Learning Objectives Evaluate inventory management using the inventory turnover ratio and the effects of inventory on cash flows.

33. 7-33 Effect on Cash Flows Inventory Decrease = Increase + to Cash (more sales….) Inventory Increase = Decrease - to Cash (more purchases….) Accounts Payable Increase = + to Cash ( Paying bills later….) Accounts Payable Decrease = - to Cash (Paid more bills……)

34. 7-34 Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly thus reducing storage and obsolescence costs.

35. 7-35 Learning Objectives Compare companies that use different inventory costing methods.

36. 7-36 Inventory Methods and Financial Statement Analysis U.S. public companies using LIFO also report beginning and ending inventory on a FIFO basis if the FIFO values are materially different.

37. 7-37 LIFO and International Comparisons LIFO Permitted? Yes No China Singapore Canada Great Britain Australia

38. 7-38 Learning Objectives Understand methods for controlling and keeping track of inventory and analyze the effects of inventory errors on financial statements.

39. 7-39 Internal Control of Inventory Separation of inventory accounting and physical handling of inventory. Storage in a manner that protects from theft and damage. Limiting access to authorized employees. Maintaining perpetual inventory records. Comparing perpetual records to periodic physical counts.

40. 7-40 Perpetual and Periodic Inventory Systems Provides up-to-date inventory records. Provides up-to-date cost of sales records. PerpetualSystemPerpetualSystem In a periodic inventory system, ending inventory and cost of goods sold are determined at the end of the accounting period based on a physical count.

41. 7-41 Perpetual and Periodic Inventory Systems

42. 7-42 Errors in Measuring Ending Inventory

43. 7-43 LIFO Liquidations Chapter Supplement A

44. 7-44 LIFO Liquidations When a LIFO company sells more inventory than it purchases or manufactures, items from beginning inventory become part of cost of goods sold. This is called a LIFO liquidation. When inventory costs are rising, these lower cost items in beginning inventory produce a higher gross profit, higher taxable income, and higher taxes when they are sold.

45. 7-45 LIFO Liquidations Companies must disclose the effects of LIFO liquidations in the notes when they are material. Many companies avoid LIFO liquidations and the accompanying increase in tax expense by purchasing sufficient quantities of inventory at year-end to ensure that ending inventory quantities are greater than or equal to beginning inventory quantities.

46. 7-46 Additional Issues in Measuring Purchases Chapter Supplement B

47. 7-47 Purchase Returns and Allowances Purchase returns and allowances are a reduction in the cost of purchases associated with unsatisfactory goods. Returned goods require a reduction in the cost of inventory purchases and the recording of a cash refund or a reduction in the liability to the vendor.

48. 7-48 Purchase Discounts Terms Time Due Discount Period Full amount less discount Credit Period Full amount due Purchase or Sale A purchase discount is a cash discount received for prompt payment of an account.

49. 7-49 2/10,n/30 Purchase Discounts Discount Percent Number of Days Discount Is Available Otherwise, Net (or All) Is Due Credit Period

50. 7-50 Purchase Discounts Purchases paid for within the discount period reduce the Inventory account for the amount of the cash discount received.

51. 7-51 Chapter Supplement C Comparison of Perpetual and Periodic Inventory Systems

52. 7-52 Perpetual Inventory System

53. 7-53 Periodic Inventory System

54. 7-54 End of Chapter 7