Copyright © 2011 McGraw-Hill Ryerson Limited 8-1 PowerPoint Author: Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance FINANCIAL ACCOUNTING Fourth Canadian Edition LIBBY, LIBBY, SHORT, KANAAN, GOWING Reporting and Interpreting Cost of Sales and Inventory Chapter 8

8-2 Copyright © 2011 McGraw-Hill Ryerson Limited Understanding the Business Provide sufficient quantities of high- quality inventory. Minimize the costs of carrying inventory. Primary Goals of Inventory Management Provides accurate information Provides up-to-date information Provides information to help protect assets Roles of the Accounting System LO 1

8-3 Copyright © 2011 McGraw-Hill Ryerson Limited Items Included in Inventory Inventory tangible property held for sale in the normal course of business or used in producing goods or services for sale TangibleHeld for Sale Used to Produce Goods or Services Merchandise Inventory Raw Materials Inventory Work in Process Inventory Finished Goods Inventory LO 1

8-4 Copyright © 2011 McGraw-Hill Ryerson Limited Costs Included in Inventory Purchases cost principle The cost principle requires that inventory be recorded at the price paid or the consideration given. all costs Include all costs incurred to bring the asset to useable or saleable condition. Invoice Price Freight Inspection Costs Preparation Costs LO 1

8-5 Copyright © 2011 McGraw-Hill Ryerson Limited Flow of Inventory Costs Merchandise Purchases Cost of Sales Merchandise Inventory Merchandiser Raw Materials Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Cost of Sales Manufacturer Direct Labour Factory Overhead LO 1

8-6 Copyright © 2011 McGraw-Hill Ryerson Limited Nature of Cost of Sales Beginning Inventory Purchases for the Period Ending Inventory (Statement of Financial Position) Ending Inventory (Statement of Financial Position) Goods Available for Sale Cost of Sales (Income Statement) Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of sales Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of sales LO 1

8-7 Copyright © 2011 McGraw-Hill Ryerson Limited Internal Control of Inventory Separation of inventory accounting and physical handling of inventory. Storage in a manner that protects from theft and damage. Limiting access to authorized employees. Maintaining perpetual inventory records. Comparing perpetual records to periodic physical counts. LO 2

8-8 Copyright © 2011 McGraw-Hill Ryerson Limited Perpetual and Periodic Inventory Systems Provides up-to-date inventory records. Provides up-to-date cost of sales records. PerpetualSystemPerpetualSystem In a periodic inventory system, ending inventory and cost of sales are determined at the end of the accounting period based on a physical count. LO 2

8-9 Copyright © 2011 McGraw-Hill Ryerson Limited Perpetual and Periodic Inventory Systems LO 2

8-10 Copyright © 2011 McGraw-Hill Ryerson Limited Comparison of Periodic and Perpetual Systems Now, let’s compare the various entries that are made when using the periodic and perpetual inventory systems. LO 2

8-11 Copyright © 2011 McGraw-Hill Ryerson Limited Comparison of Periodic and Perpetual Systems LO 2 Purchases Returns and Allowances is subtracted from Purchases on the income statement.

8-12 Copyright © 2011 McGraw-Hill Ryerson Limited Comparison of Periodic and Perpetual Systems LO 2 This entry is recorded at retail. This entry is recorded at cost.

8-13 Copyright © 2011 McGraw-Hill Ryerson Limited Comparison of Periodic and Perpetual Systems LO 2 This is recorded at retail. This entry is recorded at cost.

8-14 Copyright © 2011 McGraw-Hill Ryerson Limited Comparison of Periodic and Perpetual Systems LO 2

8-15 Copyright © 2011 McGraw-Hill Ryerson Limited Methods for Estimating Inventory LO 2 I use the periodic inventory method. Can you help me estimate inventory? I sure can, if you can give me some information.

8-16 Copyright © 2011 McGraw-Hill Ryerson Limited Methods for Estimating Inventory LO 2 I know sales, beginning inventory, purchases, and my gross margin is 30%. Let’s construct an income statement using your gross margin.

8-17 Copyright © 2011 McGraw-Hill Ryerson Limited Methods for Estimating Inventory LO 2 You told me that your sales are $200,000, beginning inventory is $4,500, and purchases are $150,000, so your income statement looks like this...

8-18 Copyright © 2011 McGraw-Hill Ryerson Limited Methods for Estimating Inventory LO 2 Estimated ending inventory must be $14,500 ($154,500 – $140,000).

8-19 Copyright © 2011 McGraw-Hill Ryerson Limited Errors in Measuring Ending Inventory LO 2 Beginning inventory + Purchases – Ending inventory = Cost of sales

8-20 Copyright © 2011 McGraw-Hill Ryerson Limited Exhibit 8.4: Inventory Error: Understatement of Ending Inventory LO 2

8-21 Copyright © 2011 McGraw-Hill Ryerson Limited If the 2011 ending inventory is understated by $3,000, which of the following is true for 2011? a. Beginning Inventory was understated. b. Cost of Sales will be understated. c. Gross Profit will be overstated. d. Profit will be understated. Question LO 2

8-22 Copyright © 2011 McGraw-Hill Ryerson Limited If the 2011 ending inventory is understated by $3,000, which of the following is true for 2011? a. Beginning Inventory was understated. b. Cost of Sales will be understated. c. Gross Profit will be overstated. d. Profit will be understated. If the 2011 ending inventory is understated by $3,000, which of the following is true for 2011? a. Beginning Inventory was understated. b. Cost of Sales will be understated. c. Gross Profit will be overstated. d. Profit will be understated. Question LO 2

8-23 Copyright © 2011 McGraw-Hill Ryerson Limited If the 2011 ending inventory is understated by $3,000, which of the following is true for 2012? a. Beginning Inventory was understated. b. Cost of Sales will be understated. c. Gross Profit will be overstated. d. All of the above. Question LO 2

8-24 Copyright © 2011 McGraw-Hill Ryerson Limited Question If the 2011 ending inventory is understated by $3,000, which of the following is true for 2012? a. Beginning Inventory was understated. b. Cost of Sales will be understated. c. Gross Profit will be overstated. d. All of the above. If the 2011 ending inventory is understated by $3,000, which of the following is true for 2012? a. Beginning Inventory was understated. b. Cost of Sales will be understated. c. Gross Profit will be overstated. d. All of the above. Remember: The ending inventory for 2011 becomes the beginning inventory for LO 2

8-25 Copyright © 2011 McGraw-Hill Ryerson Limited Inventory Costing Methods Total Dollar Amount of Goods Available for Sale Ending Inventory Inventory Costing Method Cost of Sales Inventory Costing Methods 1.Specific Identification 2.First-in, First-out (FIFO) 3.Weighted Average LO 3

8-26 Copyright © 2011 McGraw-Hill Ryerson Limited Specific Identification When units are sold, the specific cost of the unit sold is added to cost of sales. LO 3

8-27 Copyright © 2011 McGraw-Hill Ryerson Limited Cost Flow Assumptions The choice of an inventory costing method is not based on the physical flow of goods on and off the shelves. FIFO Weighted Average LO 3

8-28 Copyright © 2011 McGraw-Hill Ryerson Limited First-In, First-Out Method Cost of Sales Oldest Costs Ending Inventory Recent Costs LO 3

8-29 Copyright © 2011 McGraw-Hill Ryerson Limited First-In, First-Out Remember: The costs of most recent purchases are in ending inventory. Start with 11/29 and add units purchased until you reach the number in ending inventory. LO 3

8-30 Copyright © 2011 McGraw-Hill Ryerson Limited First-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory. LO 3

8-31 Copyright © 2011 McGraw-Hill Ryerson Limited First-In, First-Out Now, we have allocated the cost to all 1,050 units sold. LO 3 $12,210

8-32 Copyright © 2011 McGraw-Hill Ryerson Limited First-In, First-Out Here is the cost of ending inventory and cost of sales using FIFO. LO 3

8-33 Copyright © 2011 McGraw-Hill Ryerson Limited Average Cost Method When a unit is sold, the average cost of each unit in inventory is assigned to cost of sales. Cost of Goods Available for Sale Number of Units Available for Sale ÷ LO 3 Ending Inventory Units in Ending Inventory x Average Cost per Unit Cost of Good Sold Units Sold x Average Cost per Unit

8-34 Copyright © 2011 McGraw-Hill Ryerson Limited Average Cost Method LO 3

8-35 Copyright © 2011 McGraw-Hill Ryerson Limited Comparison of Methods LO 3 In periods of rising prices, FIFO results in the highest ending inventory, gross profit, income tax expense, and profit, and the lowest cost of sales.

8-36 Copyright © 2011 McGraw-Hill Ryerson Limited Financial Statement Effects of Costing Methods Advantages of Methods Ending inventory approximates current replacement cost. First-In, First-Out LO 3 Weighted Average Smoothes out price changes.

8-37 Copyright © 2011 McGraw-Hill Ryerson Limited International Perspective LIFO and International Comparisons While U.S. GAAP allows companies to choose between FIFO, LIFO, and weighted average inventory methods, International Financial Reporting Standards (IFRS) and Canadian Accounting Standards for Private Enterprises (ASPE) prohibit the use of LIFO. These differences can create comparability problems when one attempts to compare companies across international borders. IFRS requires that the same method be used for all inventory items that have a similar nature and use. GAAP allows different inventory accounting methods to be used for different types of inventory items. LO 3

8-38 Copyright © 2011 McGraw-Hill Ryerson Limited Managers Choice of Inventory Methods Profit Effects Managers prefer to report higher earnings for their companies. Income Tax Effects Managers prefer to pay the least amount of taxes allowed by law as late as possible. LO 4

8-39 Copyright © 2011 McGraw-Hill Ryerson Limited Valuation at Lower of Cost or Net Realizable Value Ending inventory is reported at the lower of cost or net realizable value (LCNRV). Net Realizable Value (NRV) is the expected sales price less estimated selling costs (e.g., repair and disposal costs). The company will recognize a “holding” loss in the current period rather than the period in which the item is sold. This practice is conservative. LO 5

8-40 Copyright © 2011 McGraw-Hill Ryerson Limited Valuation at Lower of Cost or Net Realizable Value (1,000 Intel chips × $50) = $50,000 LO 5

8-41 Copyright © 2011 McGraw-Hill Ryerson Limited Inventory Turnover Cost of Sales = Average Inventory Inventory Turnover Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly thus reducing storage and obsolescence costs. LO 6

8-42 Copyright © 2011 McGraw-Hill Ryerson Limited Inventory and Cash Flows Add Subtract Cash Flows from Operations ProfitProfit Decrease in Inventory Increase in Trade Payables Decrease in Inventory Increase in Trade Payables Increase in Inventory Decrease in Trade Payables Increase in Inventory Decrease in Trade Payables LO 6

8-43 Copyright © 2011 McGraw-Hill Ryerson Limited Appendix 8A: Additional Issues in Measuring Purchases Purchase returns and allowances are a reduction in the cost of purchases associated with unsatisfactory goods. A purchase discount is a cash discount received for prompt payment of an account. Appendix 8A

8-44 Copyright © 2011 McGraw-Hill Ryerson Limited Appendix 8B: Additional Issues in Measuring Purchases Terms Time Due Discount Period Full amount less discount Credit Period Full amount due Purchase or Sale 2/10,n/30 Discount Percent Number of Days Discount Is Available Credit Period Appendix 8A

8-45 Copyright © 2011 McGraw-Hill Ryerson Limited End of Chapter 8