Chapter 7 Reporting and Interpreting Cost of Goods Sold and Inventory

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-2 Business Background Provides accurate information. Provides up-to-date information. Provides information to help protect assets. Roles of the Accounting System

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-3 Nature of Inventory and Cost of Goods Sold Beginning Inventory Purchases for the Period Ending Inventory (Balance Sheet) Goods available for Sale Cost of Goods Sold (Income Statement) Beginning inventory + Purchases – Ending inventory = Cost of goods sold

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-4 Flow of Inventory Costs Merchandise Purchases Cost of Goods Sold Merchandise Inventory Merchandiser Raw Materials Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Manufacturer Direct Labor Factory Overhead

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-5 Inventory Cost cost principle The cost principle requires that inventory be recorded at the price paid or the consideration given up.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-6 Inventory Costing Methods FIFOFIFOLIFOLIFO Weighted Average Specific Identification

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-7 Applying the Four Methods Total Dollar Amount of Goods Available for Sale Ending Inventory Cost of Goods Sold

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-8 First-In, First-Out (FIFO) Costs of Goods Sold Oldest Costs Ending Inventory Recent Costs

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-9 First-In, First-Out The schedule on the next screen shows the mouse pad inventory for Computers, Inc. The physical inventory count shows 1,200 mouse pads in ending inventory. Use the FIFO inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The schedule on the next screen shows the mouse pad inventory for Computers, Inc. The physical inventory count shows 1,200 mouse pads in ending inventory. Use the FIFO inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-10 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-11 First-In, First-Out

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-12 First-In, First-Out

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-13 First-In, First-Out

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-14 First-In, First-Out

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-15 First-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-16 First-In, First-Out

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-17 ANY QUESTIONS BEFORE WE DISCUSS LIFO?

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-18 Last-In, First-Out ?? ?? Oldest Costs Recent Costs

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-19 Last-In, First-Out Ending Inventory Cost of Goods Sold Oldest Costs Recent Costs

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-20 Last-In, First-Out The schedule on the next screen shows the mouse pad inventory for Computers, Inc. The physical inventory count shows 1,200 mouse pads in ending inventory. Use the LIFO inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The schedule on the next screen shows the mouse pad inventory for Computers, Inc. The physical inventory count shows 1,200 mouse pads in ending inventory. Use the LIFO inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-21 Last-In, First-Out Remember: The costs of the oldest purchases are in ending inventory. Start with beginning inventory and add units purchased until you reach the number in ending inventory.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-22 Last-In, First-Out

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-23 Last-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-24 Last-In, First-Out

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-25 Last-In, First-Out

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-26 Now let’s move on to the average cost inventory method. Average Cost Method

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-27 Average Cost Method The schedule on the next screen shows the mouse pad inventory for Computers, Inc. The physical inventory count shows 1,200 mouse pads in ending inventory. Use the average cost inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The schedule on the next screen shows the mouse pad inventory for Computers, Inc. The physical inventory count shows 1,200 mouse pads in ending inventory. Use the average cost inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-28 Average Cost Method

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-29 Weighted-Average Weighted-Average Cost per Unit: $9,725 1,800 Ending Inventory: 1,200 Units × $ = $6,483* Cost of Goods Sold: 600 Units × $ = $3,242* * Rounded Weighted-Average Cost per Unit: $9,725 1,800 Ending Inventory: 1,200 Units × $ = $6,483* Cost of Goods Sold: 600 Units × $ = $3,242* * Rounded = $

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-30 Comparison of Methods

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-31 Comparison of Methods In periods of rising prices, FIFO results in the highest ending inventory, gross profit, tax expense, and net income, and the lowest cost of goods sold.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-32 Comparison of Methods In periods of rising prices, LIFO results in the lowest ending inventory, gross profit, tax expense, and net income, and the highest cost of goods sold.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-33 Choosing Inventory Costing Methods Net Income Effects. Managers prefer to report higher earning for their companies. Income Tax Effects. Managers prefer to pay the least amount of taxes allowed by law as late as possible.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-34 Choosing Inventory Costing Methods LIFO for books LIFO for taxes If...Then... LIFO Conformity Rule

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-35 Inventory Costing Methods and Financial Statement Analysis

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-36 LIFO and International Comparisons LIFO Permitted? Yes No China Singapore Canada Great Britain Australia

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-37 Lower of Cost or Market Ending inventory is reported at the lower of cost or market (LCM). Net Realizable Value The expected sales price less selling costs. Replacement Cost The current purchase price of identical goods. Market is either... or

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-38 Lower of Cost or Market The mouse pads will be shown on the balance sheet at $6,640 (LCM). 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. The mouse pads will be shown on the balance sheet at $6,640 (LCM). 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-39 Measuring Efficiency in Inventory Management Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 This ratio is often used to measure the liquidity (nearness to cash) of the inventory.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-40 Measuring Efficiency in Inventory Management $1,915,547 $1,915,547 ($191,931 + $168,616) ÷ 2 ($191,931 + $168,616) ÷ 2 = 10.6 = 10.6 The 2000 inventory turnover ratio for Harley-Davidson: Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-41 Focus on Cash Flows Add Subtract Cash Payment to Suppliers Cost of Goods Sold Increase in Inventory Decrease in Accounts Payable Increase in Inventory Decrease in Accounts Payable Decrease in Inventory Increase in Accounts Payable Decrease in Inventory Increase in Accounts Payable

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-42 Errors in Measuring Inventory

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-43 If the 2002 ending inventory is understated by $3,000, which of the following is true for 2002? a. Beginning Inventory was understated. b. Cost of Goods Sold will be understated. c. Gross Profit will be overstated. d. Net Income will be understated. If the 2002 ending inventory is understated by $3,000, which of the following is true for 2002? a. Beginning Inventory was understated. b. Cost of Goods Sold will be understated. c. Gross Profit will be overstated. d. Net Income will be understated. Question

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-44 If the 2002 ending inventory is understated by $3,000, which of the following is true for 2003? a. Beginning Inventory was understated. b. Cost of Goods Sold will be understated. c. Gross Profit will be overstated. d. All of the above. If the 2002 ending inventory is understated by $3,000, which of the following is true for 2003? a. Beginning Inventory was understated. b. Cost of Goods Sold will be understated. c. Gross Profit will be overstated. d. All of the above. Question Remember: The ending inventory for 2002 becomes the beginning inventory for 2003.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-45 Perpetual and Periodic Inventory Systems Provides up-to-date inventory records. Provides up-to-date cost of sales records. PerpetualSystemPerpetualSystem

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-46 Comparison of Perpetual and Periodic Systems

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 7-47 The End of Chapter 7