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

22 Inventory & Cost of Goods Sold Chapter 6

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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 4 Merchandise Inventory Balance Sheet (partial) Current assets: Cash$XXX Accounts receivableXXX Inventory (1 cost of $300)$300 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 Asset on the Balance Sheet Expense on the Income Statement

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 6 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, also called gross margin ▫Sales revenue minus cost of goods sold

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 7 Number of Units of Inventory 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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 8 FOB Shipping PointFOB 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 receiving dock Seller owns goods while in transit ▫Included in seller’s inventory count Seller pays transportation costs Shipping terms

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 9 Inventory Accounting Systems Perpetual Inventory System Periodic Inventory System 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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 10 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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 11 Recording Inventory (Amounts Assumed) JOURNAL DateAccounts and explanationDebitCredit Inventory560,000 Accounts payable560,000 Purchased inventory on account Accounts receivable900,000 Sales900,000 Sold inventory on account Cost of goods sold 540,000 Inventory540,000 Recorded cost of goods sold

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 12 Recording Inventory (Amounts Assumed) Inventory Cost of Goods Sold 100,000Beginning balance Purchases560,000 Cost of goods sold540,000 Cost of goods sold540,000 Ending balance120,000

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 13 Reporting in the Financial Statements Balance Sheet (partial) Current assets: Cash$ XXX Accounts receivableXXX Inventory120,000 Prepaid expensesXXX Income Statement (partial) Sales$900,000 Cost of goods sold540,000 Gross profit$360,000

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 14 Cost of Net Purchases Purchase price of the inventory$600,000 +Freight-in 4,000 −Purchase returns (25,000) −Purchase allowances (5,000) −Purchase discounts (14,000) =Net purchases of inventory $ 560,000

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

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

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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 18 Specific Unit Cost Used for businesses with unique inventory items ▫Automobiles, antique furniture, jewels, and real estate Businesses cost their inventories at the specific cost of the particular unit Too expensive for inventories with common characteristics

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 19 Average Cost 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

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

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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 22 Problem 6-60A DateUnitsCost per unit Total cost Beg. inventory75 tents$16$1,200 March 395 tents181,710 March tents203,300 March 2336 tents21756

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 23 Problem 6-60A Average Cost Average cost per unit Cost of goods available * Number of units available * * Goods available = Beginning inventory + Purchases $1,200 + $1,710 +$3,300 + $ $6, units $18.78 (rounded) $18.78 (rounded)

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 318 tents $18.78 (rounded) $18.78 (rounded) $5, tents $18.78 (rounded) $18.78 (rounded) $995 Problem 6-60A Average Cost

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 25 Problem 6-60A FIFO Cost of goods sold 75 tents$16$1, tents181, tents202, tents$5,870 Ending inventory 36 tents$21$ tents tents$1,096 Oldest items sold first Newest items on hand DateUnitsCost per unit Total cost Beg. inventory75 tents$16$1,200 March 395 tents181,710 March tents203,300 March 2336 tents21756

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 26 Cost of goods sold 36$21$ , , tents$6,118 Ending inventory 53 tents$16$848 Problem 6-60A LIFO Newest items sold first Oldest items on hand DateUnitsCost per unit Total cost Beg. inventory75 tents$16$1,200 March 395 tents181,710 March tents203,300 March 2336 tents21756

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 27 Impact of Inventory Methods on Financial Statements 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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 28 Impact of Inventory Methods on Financial Statements 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

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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 30 Cost of Goods SoldEnding 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 Comparison of Inventory Methods

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 31 LIFO Issues Allows manipulation of net income ▫When inventory prices are rising, 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 Financial Reporting Standards (IFRS)

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

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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 34 Disclosure Principle 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

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

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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 37 Gross Profit Percentage Gross profit Net sales revenue

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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 39 Use the COGS model to make management decisions

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 40 Use the COGS Model to Make Management Decisions Cost of Goods Sold: Beginning Inventory +Purchases =Cost of goods available for sale −Ending Inventory =Cost of goods sold

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 41 Computing Budgeted Purchases What merchandise should the company offer its customers? How much inventory should the company buy ?

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 42 Rearranging the Cost of Goods Sold Model 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)

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 43 Estimating Inventory by the Gross Profit Method Beginning inventory$XXX PurchasesXXX Goods available for saleXXX Estimated cost of goods sold: Net sales revenue$XXX Less estimated gross profit (XXX) Estimated cost of goods soldXXX Estimated cost of ending inventory lost$XXX

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 44 Exercise 6-26A Beginning inventory$45,300 Purchases33,300 Goods available for sale78,600 Estimated cost of goods sold: Net sales revenue$61,600 Less estimated gross profit Estimated cost of goods sold Estimated cost of ending inventory cost 45% × $61,600 $27,720 33,880 $44,720

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

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 46 Effects of Inventory Errors Period 1Period 2 Inventory Error Cost of Goods Sold Gross Profit and Net Income Cost of Goods Sold Gross Profit and Net Income Period 1 Ending inventory overstated UnderstatedOverstated Understated Period 1 Ending inventory understated OverstatedUnderstated Overstated

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