1 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Inventory and Cost of Goods Sold Chapter 6 2 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Show how to account for inventory 3 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Merchandise Inventory Balance Sheet (partial) Current assets: Cash$$$$ Accounts receivable$$$$ Inventory (1 cost of $300)$300 4 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. Income Statement (partial) Sales (2 $500 selling price)$1,000 Cost of goods sold (2 $300 cost)600 Gross profit$400

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 5 The cost of inventory on hand = Inventory The cost of inventory that’s been sold = Cost of Goods Sold The cost of inventory that’s been sold = Cost of Goods Sold

Sales Price vs. Cost of Inventory Sales revenue based on sales price of inventory sold Cost of goods sold based on cost of inventory sold Inventory based on cost of inventory on hand Gross profit ▫Sales revenue minus cost of goods sold 6 Copyright © 2012 Pearson Education Inc. Publishing as Prentice Hall.

Number of units Determined from accounting records Evidenced by physical count at year end Consigned goods: ▫Does not include those held for another company ▫Does include those out on consignment In transit goods ▫Depends on shipping terms 7 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Shipping terms FOB Shipping Point FOB Destination Legal title passes to purchaser when items leave seller’s place of business Purchaser owns good while in transit ▫Included in purchaser’s inventory count Purchaser pays transportation costs Legal title passes to purchaser when items arrive at purchaser’s place of business Seller owns goods while in transit ▫Included in seller’s inventory count Seller pays transportation costs 8 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Inventory Systems PerpetualPeriodic Used for all types of goodsUsed for inexpensive goods Keeps a running total of all goods bought, sold and on hand Does not keep a running total of all goods bought, sold and on hand Inventory counted at least once a year 9 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Perpetual Inventory Bar codes on products provide information to record ▫Sale of item ▫Update of inventory record Two entries needed for each sale ▫Record revenue and asset received (cash or receivables) ▫Record cost of sale and reduction of inventory 10 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Recording Inventory (Amounts Assumed) Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 11 JOURNAL DateAccounts and explanationDebitCredit Inventory400,000 Accounts payable400,000 Purchased inventory on account Accounts receivable750,000 Sales750,000 Sold inventory on account Cost of goods sold380,000 Inventory380,000 Recorded cost of goods sold

Recording Inventory (Amounts Assumed) Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 12 Inventory Cost of Goods Sold Beginning balance Purchases Cost of goods sold Ending balance

Reporting in the Financial Statements Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 13 Balance Sheet (partial) Current assets: Cash$$$$ Accounts receivable$$$$ Inventory$70,000 Income Statement (partial) Sales$750,000 Cost of goods sold380,000 Gross profit$370,000

Cost of Net Purchases Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 14 Purchase price +Freight-in -Purchase returns -Purchase allowances -Purchase discounts =Net purchases

Net Sales Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 15 Sales -Sales returns -Sales allowances -Sales discounts =Net sales

Apply and compare the various inventory cost methods 16 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Inventory Methods Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 17 Specific unit Average cost First-in, first-out Last-in, first-out

Specific Unit Used for businesses with unique inventory items ▫Automobiles, fine jewelry, real estate Inventory costed at specific price of the particular unit Too expensive for inventories with common characteristics 18 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Average Cost Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 19 Average cost per unit Cost of goods available * Number of units available * * Goods available = Beginning inventory + Purchases Cost of goods sold Number of units sold Average cost per unit Ending inventory Number of units on hand Average cost per unit

First-in, First-out (FIFO) Oldest items assumed to be sold first Ending inventory consists of most recent purchase costs 20 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Last-in, First-out (LIFO) Most recent items purchased are assumed to be sold first Oldest costs in ending inventory 21 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Problem 6-60A DateUnitsCost per unit Total cost Beg. inventory75 tents$16$1,200 March 395 tents$18$1,710 March tents$20$3,300 March 2336 tents$21$ Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Problem 6-60A Average Cost Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 23 Average cost per unit Cost of goods available * Number of units available * * Goods available = Beginning inventory + Purchases

Problem 6-60A Average Cost Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 24 Cost of goods sold Number of units sold Average cost per unit Ending inventory Number of units on hand Average cost per unit $18.78 (rounded) $18.78 (rounded) $18.78 (rounded) $18.78 (rounded)

Problem 6-60A FIFO Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 25 Cost of goods sold Ending inventory DateUnitsCost per unit Total cost Beg. inventory75 tents$16$1,200 March 395 tents$18$1,710 March tents$20$3,300 March 2336 tents$21$756

Cost of goods sold Ending inventory Problem 6-60A LIFO Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 26 DateUnitsCost per unit Total cost Beg. inventory75 tents$16$1,200 March 395 tents$18$1,710 March tents$20$3,300 March 2336 tents$21$756

Impact of Inventory Methods on Financial Statements Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 27 Increasing inventory prices Cost of goods sold Ending inventory FIFOLowest because based on older costs, which are less expensive Highest because based on more recent and expensive costs LIFOHighest because based on more recent costs, which are more expensive Lowest because based on older costs, which are less expensive

Impact of Inventory Methods on Financial Statements Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 28 Decreasing inventory prices Cost of goods sold Ending inventory FIFOHighest because based on older costs, which are more expensive Lowest because based on more recent, less expensive costs LIFOLowest because based on more recent costs which are less expensive Highest because based on older, more expensive costs

Tax Advantage of LIFO Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 29 Results in lowest income Increases cash available In periods of increasing prices

Comparison of Inventory Methods COST OF GOODS SOLD ENDING INVENTORY LIFO provides a better matching of expense to revenue ▫More recent costs included in Cost of Goods Sold FIFO provides a more up-to-date inventory cost ▫More recent costs on the Balance Sheet 30 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

LIFO Issues Allows manipulation of net income ▫Large quantities purchased at end of year to lower taxes Liquidation can occur ▫Quantities decrease from last year, companies must “dip into” older inventory layers Not allowed under International Standards 31 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Explain and apply underlying GAAP for inventory 32 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Principles Related to Inventories ConsistencyDisclosure Conservatism 33 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Disclosure Financial statement should disclose enough information for users to make informed decisions ▫Information should be relevant and representationally faithful Examples: ▫Accounting methods used ▫Substance of material transactions 34 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Lower-of-Cost-or-Market (LCM) Inventory is reported at the lower of: ▫Cost or ▫Market  Usually replacement cost If market is lower, inventory is written down 35 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. JOURNAL DateAccounts and explanationDebitCredit Cost of goods sold Inventory Wrote down inventory to market

Compute and evaluate gross profit (margin) and inventory turnover 36 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Gross Profit Percentage Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 37

Inventory Turnover Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 38 (Beginning Inventory + Ending Inventory)/2

Use the cost of goods sold (COGS) model to make management decisions 39 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Cost of Goods Sold Model Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 40 Cost of Goods Sold: + = - =

Using Cost of Goods Sold Model Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 41 What merchandise should the company offer its customers? How much inventory should the company buy ?

Rearranging the Cost of Goods Sold Model Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 42 Cost of goods sold (based on plan for next period) +Ending inventory (based on plan for next period) =Goods available as planned -Beginning inventory (actual amount) =Purchases (amount manager should buy)

Gross Profit Method Beginning inventory$$$$ Purchases$$$$ Goods available for sale$$$$ Estimated cost of goods sold: Net sales revenue$$$$ Less estimated gross profit($$$) Estimated cost of goods sold$$$$ Estimated cost of ending inventory$$$ 43 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Exercise 6-26A Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 44 Beginning inventory$44,300 Purchases33,300 Goods available for sale77,600 Estimated cost of goods sold: Net sales revenue$61,600 Less estimated gross profit Estimated cost of goods sold Estimated cost of ending inventory 45% x $61,600 $27,720 33,880 $43,720

Analyze effects of inventory errors 45 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Effect of Inventory Errors Period 1 Ending inventory overstated Period 2 Beginning inventory overstated SalesNo effect Cost of goods sold: Beginning inventoryNo effect PurchasesNo effect Goods availableNo effect Ending inventoryNo effect Cost of goods sold Gross profit 46 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

47 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

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