1. Merchandise Inventory and Cost of Sales C H A P T E R 7 © 2007 McGraw-Hill Ryerson Ltd. Electronic Presentations in Microsoft® PowerPoint®

2. 1. Identify the components and costs included in merchandise inventory. 2. Calculate the cost of goods sold and merchandise inventory using specific identification, moving weighted average, FIFO, and LIFO-perpetual. 3. Analyze the effects of the costing methods on financial reporting. Learning Objectives © 2007 McGraw-Hill Ryerson Ltd.

3. 4. Calculate the lower of cost or market value of inventory. 5. Analyze the effects of inventory errors on current and future financial statements- perpetual. 6. Apply both the gross profit and retail methods to estimate inventory. Learning Objectives © 2007 McGraw-Hill Ryerson Ltd.

4. 7. Calculate cost of goods sold and merchandise inventory using specific identification, weighted average, FIFO, and LIFO-periodic. (Appendix 7A). 8. Analyze the effects of inventory errors on current and future financial statements- periodic. (Appendix 7A). 9. Assess inventory management using both merchandise turnover and days’ sales in inventory. (Appendix 7B) Learning Objectives © 2007 McGraw-Hill Ryerson Ltd.

5. Accounting for inventory requires several decisions which include:  Items to include in cost.  Inventory System.  Perpetual or Periodic  Costing Method.  FIFO, LIFO, Moving Weighted Average, Specific ID  Use of estimates.  Gross profit method, Retail inventory method Assigning Costs to Inventory © 2007 McGraw-Hill Ryerson Ltd.

6. Inventory includes all goods owned by a company and held for sale. Items requiring special attention:  Goods in Transit  Goods on consignment  Obsolete or damaged goods Items in Merchandise Inventory © 2007 McGraw-Hill Ryerson Ltd.

7. All expenditures necessary to bring an item to a saleable condition and location.  This includes:  Invoice price less discounts  Import duties  Transportation-in  Storage  Insurance Costs of Merchandise Inventory © 2007 McGraw-Hill Ryerson Ltd.

8.  Management must decide on method of determining unit cost.  This will affect both the income statement and the balance sheet. Methods: 1. Specific Identification 2. FIFO 3. LIFO 4. Average Cost Assigning Costs to Inventory © 2007 McGraw-Hill Ryerson Ltd.

9. Merchandise Available for Sale Net Cost of Purchases Cost of Goods Sold Beginning Inventory Ending Inventory Balance Sheet Income Statement Merchandising Cost Flows © 2007 McGraw-Hill Ryerson Ltd.

10. Use of Inventory Methods in Practice © 2007 McGraw-Hill Ryerson Ltd.

11. This method is used when items:  Are unique.  Can be directly identified with a specific purchase and its invoice. Examples: Automobiles, art custom furniture. Specific Identification © 2007 McGraw-Hill Ryerson Ltd.

12. Specific Identification — Example The opening inventory consists of 10 units @ $91/unit. © 2007 McGraw-Hill Ryerson Ltd.

13. Specific Identification — Example This results in two layers of inventory. Additional units are purchased @ $106/unit. © 2007 McGraw-Hill Ryerson Ltd.

14. Specific Identification — Example On August 14, 20 units are sold. Eight of these units came from the opening inventory and the remaining 12 units came from the August 3 purchase. © 2007 McGraw-Hill Ryerson Ltd.

15. Specific Identification — Example This leaves 2 units remaining from the original inventory and 3 units remaining from the August 3 purchase. © 2007 McGraw-Hill Ryerson Ltd.

16. Under this method, the cost of all units are averaged together. Cost of goods available for sale Number of units available for sale Average cost per unit = Moving Weighted Average Method © 2007 McGraw-Hill Ryerson Ltd.

17. Moving Weighted Average - Example The opening inventory consists of 10 units @ $91/unit. © 2007 McGraw-Hill Ryerson Ltd.

18. Moving Weighted Average- Example Additional units are purchased @ $106/unit. This results in an average cost of $100/unit. (10 x $91) + (15 x $106) 25 units © 2007 McGraw-Hill Ryerson Ltd.

19. Moving Weighted Average- Example These 20 units are sold at the average cost of $100/unit. © 2007 McGraw-Hill Ryerson Ltd.

20. Moving Weighted Average- Example This leaves 5 units remaining at an average cost of $100/unit. © 2007 McGraw-Hill Ryerson Ltd.

21. Mini-Quiz A company that uses a perpetual inventory system made the following cash purchases and sales: Jan. 1-Purchased 100 units at $10 per unit. Feb. 5-Purchased 60 units at $12 per unit. Mar.16-Sold for cash 40 units for $16 per unit. Prepare journal entries to record the sale assuming a Moving Weighted Average system is used. Cash 640 Sales (40x16) 640 Cost of goods sold430 Inventory 430 (100x10 + 60x12)/160 x 40 © 2007 McGraw-Hill Ryerson Ltd.

22. Based on the assumption that the items are sold in the order acquired. When a sale occurs:   The earliest units purchased are charged to Cost of Goods Sold.   The cost of the most recent purchases remain in inventory. First-In, First-Out (FIFO) © 2007 McGraw-Hill Ryerson Ltd.

23. FIFO — Example The opening inventory consists of 10 units @ $91/unit. © 2007 McGraw-Hill Ryerson Ltd.

24. FIFO — Example Additional units re purchased @ $106/unit. This results in two layers of inventory. Additional units are purchased @ $106/unit. © 2007 McGraw-Hill Ryerson Ltd.

25. FIFO — Example Under FIFO, units are assumed to be sold in the order acquired. Therefore, of the 20 units sold on August 14, the first 10 units come from beginning inventory. Therefore, those 10 units are removed from the inventory record based on the cost of those units of $91. © 2007 McGraw-Hill Ryerson Ltd.

26. FIFO — Example The remaining 10 units sold on August 14 th come from the next purchase, made on August 3 rd. Therefore, these units are removed from the inventory record based on their cost of $106. © 2007 McGraw-Hill Ryerson Ltd.

27. FIFO — Example The ending inventory consists of the 5 remaining units from the August 3 purchase. © 2007 McGraw-Hill Ryerson Ltd.

28. Mini-Quiz A company that uses a perpetual inventory system made the following cash purchases and sales: Jan. 1-Purchased 100 units at $10 per unit. Feb. 5-Purchased 60 units at $12 per unit. Mar.16-Sold for cash 40 units for $16 per unit. Prepare journal entries to record the sale assuming a FIFO system is used. Cash 640 Sales (40x16) 640 Cost of goods sold400 Inventory (40x10) 400 © 2007 McGraw-Hill Ryerson Ltd.

29. Based on the assumption that the most recently purchased items are sold first. When a sale occurs:   The latest units purchased are charged to Cost of Goods Sold.   The cost of the earliest purchases remain in inventory. Last-In, First-Out (LIFO) © 2007 McGraw-Hill Ryerson Ltd.

30. LIFO — Example The opening inventory consists of 10 units @ $91/unit. © 2007 McGraw-Hill Ryerson Ltd.

31. LIFO — Example Additional units are purchased @ $106/unit. This results in two layers of inventory. © 2007 McGraw-Hill Ryerson Ltd.

32. LIFO — Example Of the 20 units sold, these units are assumed to be sold first. © 2007 McGraw-Hill Ryerson Ltd.

33. LIFO — Example Once the latest units purchased are sold, units are sold from the previous purchase. © 2007 McGraw-Hill Ryerson Ltd.

34. LIFO — Example This leaves 5 units remaining from the first purchase. © 2007 McGraw-Hill Ryerson Ltd.

35. Mini-Quiz A company that uses a perpetual inventory system made the following cash purchases and sales: Jan. 1-Purchased 100 units at $10 per unit. Feb. 5-Purchased 60 units at $12 per unit. Mar.16-Sold for cash 40 units for $16 per unit. Prepare journal entries to record the sale assuming a LIFO system is used. Cash 640 Sales (40x16) 640 Cost of goods sold480 Inventory (40x12) 480 © 2007 McGraw-Hill Ryerson Ltd.

36. Because prices change, the choice of an inventory method is important. Financial Reporting © 2007 McGraw-Hill Ryerson Ltd.

37. Advantages of Each Method First-In, First-Out Ending inventory approximates current replacement cost. Weighted Average Smoothes out purchase price changes. Last-In, First-Out Better matches current costs in cost of goods sold with revenues. Financial Reporting First-In, First-Out Ending inventory approximates current replacement cost. © 2007 McGraw-Hill Ryerson Ltd.

38.  A company is required to use the same accounting methods from period to period (consistency principle).  A change is only acceptable when it improves financial reporting.  The costing method used must be disclosed in the notes to the financial statements (full- disclosure principle). Financial Reporting © 2007 McGraw-Hill Ryerson Ltd.

39.  Inventory must be reported at market value when market is lower than cost (conservatism principle).  Market may be defined as:  Net realizable value  Current replacement cost Lower of Cost or Market © 2007 McGraw-Hill Ryerson Ltd.

40. May be applied in one of three ways: 1. Separately to each item. 2. To major categories of items. 3. To the inventory as a whole. Lower of Cost or Market © 2007 McGraw-Hill Ryerson Ltd.

41. Errors in the computation of or physical count of inventory will cause a misstatement of:  Cost of goods sold  Gross profit  Net income  Current assets  Owner’s equity Inventory Errors © 2007 McGraw-Hill Ryerson Ltd.

42. Inventory Errors- Effects on the Income Statement © 2007 McGraw-Hill Ryerson Ltd.

43. Inventory Errors- Effects on the Balance Sheet © 2007 McGraw-Hill Ryerson Ltd.

44. Ending inventory is estimated by applying gross profit ratio to net sales. It is used:  when inventory has been destroyed, lost, or stolen.  for testing the reasonableness of the physical inventory count. Gross Profit Method © 2007 McGraw-Hill Ryerson Ltd.

45. Occasionally used for interim period reporting. Information required: 1. Beginning inventory at cost and retail. 2. Net purchases at cost and retail. 3. Net sales. Retail Inventory Method © 2007 McGraw-Hill Ryerson Ltd.

46. Q Describe how management’s decisions can affect the determination of the cost of inventory. A Choice of method –FIFO,LIFO, Moving weighted average, Specific item. Choice of application of LCM -separate item, categories, whole inventory. Definition of market. Choice of periodic or perpetual system. Items to include in cost. Other. Review © 2007 McGraw-Hill Ryerson Ltd.

47.  The periodic system also uses FIFO, LIFO, specific identification, and weighted average methods to assign costs to inventory and cost of goods sold.  The results may be the same or different under both systems. Periodic System-Appendix 7A © 2007 McGraw-Hill Ryerson Ltd.

48.  Applied in same manner as periodic system.  Yields same results as perpetual system since units are specifically identified. Specific Identification- Appendix 7A © 2007 McGraw-Hill Ryerson Ltd.

49. Steps: 1. Calculate weighted average unit cost. (# units beg. Inv. X unit cost) + (#units purchased x unit cost) # units available for sale = weighted average unit cost 2. Use weighted average unit cost to assign costs to cost of goods sold and ending inventory. Weighted Average-Appendix 7A © 2007 McGraw-Hill Ryerson Ltd.

50. Yields same results as perpetual system since most recent purchases are in ending inventory under both systems. FIFO-Appendix 7A © 2007 McGraw-Hill Ryerson Ltd.

51. Yields different results than perpetual system since:  LIFO periodic assigns costs at the end of period.  LIFO perpetual assigns most recent costs to cost of goods sold. LIFO-Appendix 7A © 2007 McGraw-Hill Ryerson Ltd.

52.  An error in the ending inventory affects the assets, net income, and owner’s equity of that period.  The ending inventory of one period becomes the opening inventory of the next period.The cost of goods sold and net income of the next period are affected as well. Inventory Errors in a Periodic System-Appendix 7A © 2007 McGraw-Hill Ryerson Ltd.

53. Inventory ratios may be used to assess: 1. Short-term liquidity. 2. Inventory management. Ratios-Appendix 7B © 2007 McGraw-Hill Ryerson Ltd.

54. Merchandise Turnover Ratio  Measures how many times a company turns its inventory over each period.  The ratio will vary from industry to industry. Merchandise turnover cost of goods sold average inventory Ratios-Appendix 7B © 2007 McGraw-Hill Ryerson Ltd.

55. Days’ Sales in Inventory  Used to estimate how many days it will take to convert inventory to cash or receivables.  Used to assess if inventory levels can meet sales demand. Days’ sales in inventory = Ending inventory x 365 Cost of goods sold Ratios-Appendix 7B © 2007 McGraw-Hill Ryerson Ltd.

56. End of Chapter © 2007 McGraw-Hill Ryerson Ltd.