Merchandise Inventory and Cost of Sales Electronic Presentations in Microsoft® PowerPoint® Merchandise Inventory and Cost of Sales C H A P T E R 7 Slides Content 1-4 Learning objectives 5-10 Inventory costing 11-15 Specific identification 16-20 Moving weighted average 21 Mini-quiz 22-27 FIFO 28 Mini quiz 29-34 LIFO 35 Mini-quiz 36-38 Financial reporting 39-40 Lower of cost or market 41-43 Inventory errors 44 Gross profit method 45 Retail method 46 Review 47-52 Appendix 7A 53-55 Appendix 7B 56 End of chapter

Learning Objectives Identify the components and costs included in merchandise inventory. Calculate the cost of goods sold and merchandise inventory using specific identification, moving weighted average, FIFO, and LIFO-perpetual. Analyze the effects of the costing methods on financial reporting.

Learning Objectives Calculate the lower of cost or market value of inventory. Analyze the effects of inventory errors on current and future financial statements-perpetual. Apply both the gross profit and retail methods to estimate inventory.

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

Assigning Costs to Inventory 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

Items in Merchandise Inventory 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

Costs of Merchandise Inventory 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

Assigning Costs to Inventory Management must decide on method of determining unit cost. This will affect both the income statement and the balance sheet. Methods: Specific Identification FIFO LIFO Average Cost

Merchandising Cost Flows Beginning Inventory Net Cost of Purchases Merchandise Available for Sale Balance Sheet Income Statement Ending Inventory Cost of Goods Sold

Use of Inventory Methods in Practice

Specific Identification 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 — Example The opening inventory consists of 10 units @ $91/unit.

Specific Identification — Example This results in two layers of inventory. Additional units are purchased @ $106/unit.

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.

Specific Identification — Example This leaves 2 units remaining from the original inventory and 3 units remaining from the August 3 purchase.

Moving Weighted Average Method Under this method, the cost of all units are averaged together. Average cost per unit Cost of goods available for sale Number of units available for sale =

Moving Weighted Average - Example The opening inventory consists of 10 units @ $91/unit.

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

Moving Weighted Average- Example These 20 units are sold at the average cost of $100/unit.

Moving Weighted Average- Example This leaves 5 units remaining at an average cost of $100/unit.

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 sold 430 Inventory 430 (100x10 + 60x12)/160 x 40

First-In, First-Out (FIFO) 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.

The opening inventory consists of 10 units @ $91/unit. FIFO — Example The opening inventory consists of 10 units @ $91/unit.

FIFO — Example This results in two layers of inventory. Additional units are purchased @ $106/unit. Additional units re purchased @ $106/unit.

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.

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

FIFO — Example The ending inventory consists of the 5 remaining units from the August 3 purchase.

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 sold 400 Inventory (40x10) 400

Last-In, First-Out (LIFO) 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.

The opening inventory consists of 10 units @ $91/unit. LIFO — Example The opening inventory consists of 10 units @ $91/unit.

LIFO — Example This results in two layers of inventory. Additional units are purchased @ $106/unit.

Of the 20 units sold, these units are assumed to be sold first. LIFO — Example Of the 20 units sold, these units are assumed to be sold first.

LIFO — Example Once the latest units purchased are sold, units are sold from the previous purchase.

This leaves 5 units remaining from the first purchase. LIFO — Example This leaves 5 units remaining from the first purchase.

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 sold 480 Inventory (40x12) 480

Financial Reporting Because prices change, the choice of an inventory method is important.

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

Financial Reporting 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).

Lower of Cost or Market 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 May be applied in one of three ways: Separately to each item. To major categories of items. To the inventory as a whole.

Inventory Errors 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- Effects on the Income Statement

Inventory Errors- Effects on the Balance Sheet

Gross Profit Method 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.

Retail Inventory Method Occasionally used for interim period reporting. Information required: Beginning inventory at cost and retail. Net purchases at cost and retail. Net sales.

Review Describe how management’s decisions can affect the determination of the cost of inventory. 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.

Periodic System-Appendix 7A 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.

Specific Identification- Appendix 7A Applied in same manner as periodic system. Yields same results as perpetual system since units are specifically identified.

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

FIFO-Appendix 7A Yields same results as perpetual system since most recent purchases are in ending inventory under both systems.

LIFO-Appendix 7A 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.

Inventory Errors in a Periodic System-Appendix 7A 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.

Ratios-Appendix 7B Inventory ratios may be used to assess: Short-term liquidity. Inventory management.

Ratios-Appendix 7B 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 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

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