7/e PowerPoint Author: Catherine Lumbattis 5 COPYRIGHT © 2011 South-Western/Cengage Learning Inventories and Cost of Goods Sold

Inventory of Wholesalers and Retailers  Purchased in finished form  Resold without transformation  Classified as “Merchandise Inventory” on balance sheet LO1

CURRENT ASSETS: Cash and cash equivalents $ 1,715$ 1,724 Short term investments Restricted cash Merchandise inventory 1,506 1,575 Other TOTAL CURRENT ASSETS 4,005 4,086 Gap, Inc. Consolidated Balance Sheets [Partial] January 31, February 2, ASSETS (in millions) More than 1/3 of current assets

Inventory of Manufacturers Manufacturing overhead Direct materials Direct labor Costs Included in Inventory

Inventory of Manufacturers Manufacturing overhead Direct materials Direct labor Manufacture products Work in process Finished goods Raw material s Costs Included in Inventory Balance Sheet Classifications

Current assets: Inventories: Raw materials $ 3,356 Work in progress 1,107 Finished goods 4,022 Supplies 296 Total inventories $ 8,781 IBM Consolidated Balance Sheets [Partial] 2008 ASSETS (in millions)

Condensed Income Statement for a Merchandiser Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000 Selling and administrative expenses 29,300 Net income before tax $ 10,700 Income tax expense 4,280 Net income$ 6,420 LO2

Contra-Sales Accounts Sales normal credit balance Sales Discounts Sales AllowancesSales Returns normal debit balance normal debit balance normal debit balance

Credit Terms and Sales Discounts n/30 Payment due 30 days from invoice 1/10, n/30Deduct 1% of invoice amount if paid within 10 days; otherwise full invoice amount is due in 30 days 2/10, n/30Deduct 2% of invoice amount if paid within 10 days; otherwise full invoice amount is due in 30 days

Purchases of merchandise Beginning inventory The Cost of Goods Sold Model Cost of goods sold = Goods Available for Sale Less: Ending inventory LO3 + =

An increase in ending inventory means more was bought than sold The Cost of Goods Sold Model Beginning inventory $ 15,000 + Cost of goods purchased 63,000 = Cost of goods available for sale 78,000 – Ending inventory (18,000) = Cost of goods sold $ 60,000 “Pool” of goods available to sell during the period

Perpetual Inventory Systems  Point-of-sale terminals have improved the ability of mass merchandisers to maintain perpetual systems Inventory records are updated after each purchase or sale

Periodic Inventory Systems  Reduces record keeping but also decreases the ability to track theft, breakage, etc., and prepare interim financial statements Inventory records are updated periodically based on physical inventory counts

Cost of Goods Purchased  Cost of inventory purchased (invoice price): Less: Purchase returns and allowances Purchase discounts Plus: Transportation-in

Recording Purchases Purchases 4,000 Accounts Payable 4,000 To record purchase of inventory on account

Recording Purchase Returns Accounts Payable 850 Purchase Returns and Allowances 850 To record inventory returned to supplier

Recording Purchase Discounts Accounts Payable 500 Cash 495 Purchase Discounts 5 To record payment within discount period to supplier who offers 1% purchase discount. ($ 500 × 1% = $5 discount)

FOB Destination Point  No sale or purchase until inventory reaches its destination  Seller responsible for inventory while in transit Title passes at destination

FOB Shipping Point  Both sale and purchase recorded upon shipment  Buyer responsible for inventory while in transit Title passes when shipped

Recording Shipping Costs Transportation-In 300 Cash 300 To record shipping costs on inventory purchased

Analysis of Profitability Gross Profit % Of particular interest to current and potential investors LO4

Gross Profit Ratio = Gross Profit Net Sales (How many cents on every $ of sales are left over after covering the cost of the product) Daisy’s Profitability Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000 Gross profit ratio = 40%

Inventory Valuation and Income Measurement Value assigned to inventory on balance sheet Value expensed as cost of goods sold on income statement When Sold = LO5

Inventory Costs Included  Any freight costs incurred by buyer  Cost of insurance for inventory in transit  Cost of storing inventory before selling  Excise and sales taxes

Inventory Costing Methods Four costing methods available: Specific Identification Weighted Average First-in, First-out (FIFO) Last-in, First-out (LIFO) LO6

Beginning inventory, Jan. 1: 500 units (unit cost $10) Inventory purchases: Date UnitsUnit Cost 1/ $ 11 4/ / / Total purchases1,000 units Ending inventory, Dec. 31: 600 units Detailed Costing Method Example Calculate the Cost of Goods Sold and Ending Inventory under each cost flow method

Specific Identification Method Step 1: Identify the specific units in inventory at the end of the year and their costs.

Specific Identification Method Units in ending inventory: Date purchased Units Cost Total Cost 1/ $11$ 1,100 4/ ,600 9/ ,600 Ending inventory 600$ 7,300 Units × Cost = Total cost

Specific Identification Method Step 2: Identify the units sold and calculate the cost of goods sold.

Specific Identification Method Date purchasedUnits Cost Total Cost Beg. inventory 500 $10$5,000 1/ ,200 4/ ,200 12/ ,400 Cost of goods sold 900$9,800 Units × Cost = Total cost

Weighted Average Method Step 1: Calculate the cost of goods available for sale.

Weighted Average Method Date purchasedUnits Cost Total cost Beg. inventory 500 $10 $ 5,000 1/ ,300 4/ ,800 9/ ,600 12/ ,400 Cost of goods available for sale 1,500 $17,100

Weighted Average Method Step 2:Divide the cost of goods available for sale by the total units to determine the weighted average cost per unit.

Weighted Average Method Cost of Goods Available for Sale Units Available for Sale $17,100 1,500 = $11.40/unit

Weighted Average Method Step 3:Calculate ending inventory and cost of goods sold by multiplying the weighted average cost per unit by the number of units in ending inventory and the number of units sold. × Avg. Cost # of Units

Weighted Average Method ALLOCATE TO Ending Cost of Inventory Goods Sold Units on hand 600 Units sold 900 Weighted average cost $11.40 $ × Totalcost of goods available of $17,100 allocated: $6,840 $10,260

First-in, First-out (FIFO) Method Step 1:Assign the cost of the beginning inventory to cost of goods sold.

First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units CostInventoryGoods Sold 1/1 500 $10 $5,000 1/ $11 4/8 400 $12 9/5 200 $13 12/ $14

First-in, First-out (FIFO) Method Step 2: Continue to work forward until you assign the total number of units sold during the period to cost of goods sold. Allocate the remaining costs to ending inventory.

First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units Cost InventoryGoods Sold 1/1 500 $10 $5,000 1/ $11 3,300 4/8 300 / 100 $12 $3,600 1,200 9/5 200 $13 2,600 12/ $14 1,400 TOTALS $7,600 $9,500

Last-in, First-out (LIFO) Method Step 1: Assign the cost of the last units purchased to cost of goods sold.

Last-in, First-out (LIFO) Method ALLOCATE TO Ending Cost of Units Cost InventoryGoods Sold 1/1 500 $10 1/ $11 4/8 400 $12 9/5 200 $13 12/ $14 $1,400

Step 2: Work backwards until you assign the total number of units sold during the period to cost of goods sold (allocate the remaining costs to ending inventory). Last-in, First-out (LIFO) Method

ALLOCATE TO Ending Cost of Units Cost InventoryGoods Sold 1/1 500 $10 $5,000 1/ /200 $11 1,100 $ 2,200 4/8 400 $12 4,800 9/5 200 $13 2,600 12/ $14 1,400 TOTALS$6,100 $11,000

Comparison of Costing Methods Cost of Goods Sold Ending Inventory 11,000 6,840 7,600 10,260 9,500 17,100 Weighted Average FIFO LIFO Goods Available for Sale 6,100 Specific Identification $7,300 $ 9,800 $17,100 LO7

Comparison of Costing Methods X X X X X Weighted AverageFIFO LIFO In periods of rising prices: Highest cost of goods sold? Lowest cost of goods sold? Highest gross profit? Lowest net income? Lowest income taxes?

LIFO Issues  LIFO liquidation Liquidation can result in high gross profit (and large tax bill)  LIFO conformity rule If used for tax, LIFO must also be used for books  LIFO reserve Difference between inventory value stated at FIFO and value stated at LIFO

International Inventory Valuation Methods  Acceptable methods of costing inventory in the United States may not be acceptable in other countries LIFO is generally accepted in the United States IASB (international standards) prohibit the use of LIFO by companies that follow international standards  It is uncertain whether LIFO will survive as an acceptable inventory valuation method

Reasons for Inventory Errors  Mathematical mistakes  Physical inventory counting errors  Cutoff problems – in-transit  Goods on consignment LO8

Effect of Inventory Errors on the Income Statement, 2010 Reported Corrected Effect Sales $1,000 $1,000 Beginning inventory $ 200 $ 200 Add: Purchases Goods available for sale $ 900 $ 900 Less: Ending inventory $50 OS Cost of goods sold $ 600 $ US Gross margin $ 400 $ OS Operating expenses Net income $ 300 $ OS OS = overstatement US = understatement

Effect of Inventory Errors on the Income Statement, 2011 Reported Corrected Effect Sales $1,500 $1,500 Beginning inventory $ 300 $ 250 $50 OS Add: Purchases 1,100 1,100 Goods available for sale $1,400 $1, OS Less: Ending inventory Cost of goods sold $1,050 $1, OS Gross margin $ 450 $ US Operating expenses Net income $ 330 $ US OS = overstatement US = understatement

Counterbalancing Errors Assume ending inventory is overstated (+) by $50 in 2010: 2010 Beginning inventory xxx Add: Purchases xxx = Goods available for sale xxx Less: Ending inventory +50 = Cost of goods sold –50

Counterbalancing Errors 2010 ending inventory becomes 2011 beginning inventory: Beginning inventory $xxx +50 Add: Purchases xxx = Goods available for sale xxx Less: Ending inventory +50 = Cost of goods sold –50

Counterbalancing Errors – The 2010 error reverses in 2011 (but 2010 inventory both 2010 and 2011 profits are misstated by 50): Beginning inventory $xxx $+50 Add: Purchases xxx xxx = Goods available for sale xxx +50 Less: Ending inventory +50 xxx = Cost of goods sold

Lower of Cost or Market Before After Price Price ChangeChange Cost $100 $ 85 Report loss in year market falls below cost… LO9

Before After Price Price ChangeChange Selling price $100 $ 80 Cost Gross profit $ 25 $ 20 Lower of Cost or Market Gross profit % 25% 25% …to maintain normal gross profit % when sold

 Market = replacement cost (not retail value)  Cost determined under one of the costing methods  Justified on basis of conservatism  Can be applied to: Entire inventory Individual items Groups of items Lower of Cost or Market

 Both U.S. GAAP and international financial reporting standards (IFRS) require lower- of-cost-or-market  Differences between U.S. GAAP and IFRS How market value is defined Recording changes in market value in future periods Lower of Cost or Market under International Standards

Cost of Goods Sold Average Inventory Inventory Turnover Ratio LO10 The number of times per period inventory is turned over (ie. sold)

Number of Days’ Sales in Inventory The average number of days inventory is on hand before its sold Number of Days in the Period Inventory Turnover Ratio

Statement of Cash Flows Cash Flows from Operating Activities: Net income xxx Increase in inventory – Decrease in inventory + Increase in accounts payable + Decrease in accounts payable – Indirect Method LO11

Appendix Accounting Tools: Inventory Costing Methods with the Use of a Perpetual Inventory System

FIFO Costing with a Perpetual System FIFO applied at time of sale Same FIFO inventory total under periodic and perpetual systems

LIFO Costing with a Perpetual System LIFO applied at time of sale Different LIFO inventory total under periodic and perpetual systems because of pricing gap

Moving Average with a Perpetual System Different inventory total under weighted average (periodic) and moving average (perpetual) New weighted average cost is computed for each purchase

End of Chapter 5