Cost of Goods Sold and Inventory Chapter 9 Cost of Goods Sold and Inventory

Financial Statement Items Covered in this Chapter Balance Sheet Income Statement Statement of Cash Flows Current Assets Inventory Current Liabil Accounts Payable Cost of Goods Sold Operating Cash paid for inventory purchases Financial Accounting, 7e Stice/Stice, 2006 © Thomson

What is Inventory?

Inventory Represents goods that are either manufactured or purchased for resale in the normal course of business Classified as an asset on the balance sheet Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Time Line of Business Issues Involving Inventory BUY raw materials or goods for resale ADD value SELL finished inventory COMPUTE ending inventory cost of goods sold Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Inventory: Manufacturing Firm Three types: Raw materials Goods acquired in a raw state that will eventually be finished products Work in process Partially finished products Finished goods Completed products waiting for sale Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Inventory Cost Flow: Manufacturing Company Balance Sheet Income Statement Raw Materials Work in Process Finished Goods Cost of Goods Sold Manufacturing Overhead Labor Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Inventory Ownership Legal title rule Goods in transit Entity holding legal title to the goods Report as an asset on the balance sheet Goods in transit Legal title depends upon the shipping terms Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Goods in Transit Shipping terms: FOB (free-on-board) destination The seller is paying the shipping cost The seller owns the inventory until it is delivered FOB shipping point The buyer is paying the shipping cost The buyer owns the inventory during transit Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Ownership Transfer for Goods in Transit FOB Shipping Point Buyer owns goods in transit Ownership changes at shipping point Seller Buyer FOB Destination Seller owns goods in transit Ownership changes at destination Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Goods on Consignment Dealer holds and sells merchandise Has possession but not asset Merchandise owned by supplier Has asset but not possession Dealer does not pay for the inventory unless it is sold Financial Accounting, 7e Stice/Stice, 2006 © Thomson

The Cost of Inventory

The Cost of Inventory The cost of inventory includes all costs of acquisition and preparation for sale Purchase price Freight Receiving and storage costs Financial Accounting, 7e Stice/Stice, 2006 © Thomson

The Cost of Inventory The cost of work in process and finished goods inventory includes Raw materials Production labor Some allocation of factory overhead Activity-based cost (ABC) systems allocate overhead based on some clearly identified cost drivers Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Accounting for Inventory and Cost of Goods Sold

Cost of Goods Sold Beginning Inventory + Inventory Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Overview of Perpetual and Periodic Systems Perpetual system Inventory records are updated whenever a purchase or a sale is made Advances in information technology have made the cost of using this system practical Periodic system Inventory records are not updated when a sale is made Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Taking a Physical Count of Inventory The actual quantity on hand is determined by taking a physical count A cost is attached to the quantity counted With a perpetual system, a physical count can reveal inventory shrinkage Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Ending Inventory Errors If ending inventory is ... Cost of Goods Sold is ... Net Income is ... Overstated Understated Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Inventory Valuation Methods

Inventory Valuation Methods Where specific identification is not possible, an assumption must be made about which cost is associated with the units remaining Four assumptions are accepted under U.S. GAAP: Specific identification Average cost FIFO (first-in, first-out) LIFO (last-in, first-out) Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Example: Inventory Valuation Methods Assume the following data: Unit Total Units Cost Cost January 1 200 $10 $2,000 March 23 300 $12 3,600 July 15 500 $11 5,500 November 6 100 $13 1,300 1,100 $12,400 Sales: 700 units @ $15 Ending Inventory: 400 units Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Specific Identification Requires no assumption about the flow of inventory units Inventory items are specifically identified and valued The actual cost of goods sold can be computed as inventory is sold Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Example: Average Cost Method Ending Inventory 400 Units × $11.27 $4,510 Cost of Goods Sold 700 Units × $11.27 7,890 Cost of Goods Available for Sale $12,400 Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Example: FIFO Assumption: The units sold are the oldest units on hand. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Example: LIFO Assumption: The units sold are the newest units on hand. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Goods Available for Sale Comparison of Methods Goods Available for Sale = Ending Inventory + Goods Sold 1,100 units 400 units 700 units FIFO $12,400 $4,600 $7,800 LIFO $4,400 $8,000 Average Cost $4,510 $7,890 Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Comparison of Methods In period of rising prices, highest Net Income with FIFO LIFO favored for tax purposes Must also use for financial reporting Choice: High profits and high taxes with FIFO Low profits and low taxes with LIFO Financial Accounting, 7e Stice/Stice, 2006 © Thomson

More About LIFO

LIFO Layers Any year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending inventory The creation of LIFO layers results in ending inventory at very old prices Financial Accounting, 7e Stice/Stice, 2006 © Thomson

20 units from 2004 + 30 units from 2005 + 40 units from 2006 LIFO Layers Example 20 units from 2004 + 30 units from 2005 20 units from 2004 + 30 units from 2005 + 40 units from 2006 Financial Accounting, 7e Stice/Stice, 2006 © Thomson

LIFO Reserve The difference between the LIFO ending inventory amount and the amount obtained using another method (e.g., FIFO or average cost) Disclosed to aid in comparing companies that use different inventory cost flow assumptions Financial Accounting, 7e Stice/Stice, 2006 © Thomson

LIFO Liquidation Occurs when the number of units purchased does not exceed the number of units sold The old LIFO layer costs to flow through cost of goods sold, reducing cost of goods sold and increasing net income Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Inventory Estimation and Valuation

Gross Profit Method Used to estimate inventory without actually taking a physical count The gross profit percentage is applied to estimate cost of goods sold, and ultimately gross profit Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Example: Gross Profit Method Assume the following data: Beginning inventory, January 1 $25,000 Purchases, January 1 through January 31 40,000 Sales, January 1 through January 31 50,000 Historical gross profit percentage 40% Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Gross Profit Method Sales (actual) $50,000 100% Gross profit (estimate) 20,000 40% Cost of goods sold (estimate) $30,000 60% - Cost of goods sold (estimate) 30,000 Beginning inventory (actual) $25,000 + Purchases (actual) 40,000 = Cost of goods avail for sale (actual) 65,000 = Ending inventory (estimate) 35,000 Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Lower of Cost or Market Recognizes inventory price declines, but not price increases until the inventory is sold Market value is defined as Replacement cost or Net realizable value Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Lower of Cost or Market Replacement cost is the cost to buy equivalent new inventory items Net realizable value is the amount expected to be received when the inventory is sold Rule of thumb: Inventory is valued on the balance sheet at the lowest of historical cost, replacement cost, or net realizable value Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Lower of Cost or Market An inventory write-down when market value is lower than cost recognizes the economic loss when it happens rather than when the inventory is sold This is another example of the principle of conservatism Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Evaluating Inventory Levels and Budgeting Cash Disbursements

Evaluating the Level of Inventory Inventory turnover Measures how many times a company turns over its inventory during the year Number of days’ sales in inventory Measures the number of days’ sales represented in the inventory value Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Evaluating the Level of Inventory These ratios are compared with those of other firms in the same industry and with comparable ratios for the same firm in previous years. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Number of Days’ Purchases in Accounts Payable Indicates how long it takes for a company to pay its suppliers Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Number of Days’ Sales in Inventory Average Collection Period Managing Cash Flow Number of Days’ Sales in Inventory Average Collection Period Operating Cycle Detailed cash payment forecasting is used to plan the specific timing of loan receipts and repayments Number of Days’ Purchases in Accounts Payable External financing needed Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Budgeting Cash Outflows A cash budget is an important tool in helping management plan its cash needs Estimating cash and credit sales, as well as estimating the pattern of collection of accounts receivable, are key to the cash receipts budgeting process Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Cash Budgeting Example Cost of Goods Sold = 80% of sales Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Pay in March $40,000 Pay in February $40,000 January Sales 100,000 Cost of Goods Sold Percentage 80% Inventory required for estimated sales 80,000 Adjustment for desired inventory levels 0 Required Purchases 80,000 Pay in March $40,000 Pay in February $40,000 Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Third Quarter Cash Disbursements for Inventory Financial Accounting, 7e Stice/Stice, 2006 © Thomson

In Summary ... Retailer inventory: purchased for resale Manufacturer inventory: raw materials purchased for further processing; work in process, and finished goods held for resale Inventory cost: all costs necessary to bring to a point of readiness Cost flow assumptions: LIFO, FIFO, and average cost LIFO creates layers; inventory is carried at oldest (lowest) costs which results in higher cost of sales, lower profit, and lower taxes Gross profit method is an estimation tool for inventory value Financial Accounting, 7e Stice/Stice, 2006 © Thomson