Chapter 10 Cost of Goods Sold and Inventory

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

What is Inventory?

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

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

6 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

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

8 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Inventory Ownership Legal title rule –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

9 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

10 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 SellerBuyer FOB Destination Seller owns goods in transit Ownership changes at destination

11 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

The Cost of Inventory

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

14 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 The Cost of Inventory

Accounting for Inventory and Cost of Goods Sold

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

17 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

18 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

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

Inventory Valuation Methods

21 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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)

22 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Example: Inventory Valuation Methods Assume the following data: UnitTotal UnitsCostCost January 1200$10$2,000 March 23300$123,600 July 15500$115,500 November 6 100$13 1,300 1,100$12,400 Sales: 700 $15 Ending Inventory: 400 units

23 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

24 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Example: Average Cost Method Ending Inventory400 Units × $11.27$4,510 Cost of Goods Sold700 Units × $11.277,890 Cost of Goods Available for Sale$12,400

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

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

27 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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$12,400=$4,400+$8,000 Average Cost $12,400=$4,510+$7,890

28 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

More About LIFO

30 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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

31 Financial Accounting, 7e Stice/Stice, 2006 © Thomson LIFO Layers Example 20 units from units from units from units from units from 2006

32 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

33 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 HW #E10-15

Inventory Estimation and Valuation

35 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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

36 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 3140,000 Sales, January 1 through January 3150,000 Historical gross profit percentage 40% HW # E10-17

37 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Gross Profit Method Sales (actual)$50,000100% Gross profit (estimate) 20,000 40% Cost of goods sold (estimate)$30,000 60% Beginning inventory (actual)$25,000 +Purchases (actual)40,000 =Cost of goods avail for sale (actual)65,000 =Ending inventory (estimate)35,000 - Cost of goods sold (estimate)30,000

38 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 HW # E10-18

39 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 1.historical cost, 2.replacement cost, or 3.net realizable value

40 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

Evaluating Inventory Levels and Budgeting Cash Disbursements

42 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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

43 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.

44 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

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

46 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

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

48 Financial Accounting, 7e Stice/Stice, 2006 © Thomson January Sales100,000 Cost of Goods Sold Percentage 80% Inventory required for estimated sales80,000 Adjustment for desired inventory levels 0 Required Purchases80,000 Pay in February $40,000 Pay in March $40,000

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

50 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