1. Cost of Goods Sold and Inventory
Chapter 9
Cost of Goods Sold and Inventory

2. Financial Statement Items Covered in this Chapter
Balance Sheet
Income Statement
Statement of Cash Flows
Current Assets
Inventory
Current Liabil
Accounts Payable
Cost of Goods Sold
Operating
Cash paid for inventory purchases
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3. What is Inventory?

4. Inventory
Represents goods that are either manufactured or purchased for resale in the normal course of business
Classified as an asset on the balance sheet
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5. Time Line of Business Issues Involving Inventory
BUY
raw materials or goods for resale
ADD
value
SELL
finished inventory
COMPUTE
ending
inventory
cost of goods sold
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6. Inventory: Manufacturing Firm
Three types:
Raw materials
Goods acquired in a raw state that will eventually be finished products
Work in process
Partially finished products
Finished goods
Completed products waiting for sale
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

7. Inventory Cost Flow: Manufacturing Company
Balance Sheet
Income Statement
Raw Materials
Work in Process
Finished Goods
Cost of Goods Sold
Manufacturing Overhead
Labor
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8. Inventory Ownership Legal title rule Goods in transit
Entity holding legal title to the goods
Report as an asset on the balance sheet
Goods in transit
Legal title depends upon the shipping terms
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9. Goods in Transit Shipping terms: FOB (free-on-board) destination
The seller is paying the shipping cost
The seller owns the inventory until it is delivered
FOB shipping point
The buyer is paying the shipping cost
The buyer owns the inventory during transit
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10. Ownership Transfer for Goods in Transit
FOB Shipping Point
Buyer owns goods in transit
Ownership changes at shipping point
Seller
Buyer
FOB Destination
Seller owns goods in transit
Ownership changes at destination
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

11. Goods on Consignment Dealer holds and sells merchandise
Has possession but not asset
Merchandise owned by supplier
Has asset but not possession
Dealer does not pay for the inventory unless it is sold
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12. The Cost of Inventory

13. The Cost of Inventory
The cost of inventory includes all costs of acquisition and preparation for sale
Purchase price
Freight
Receiving and storage costs
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14. The Cost of Inventory
The cost of work in process and finished goods inventory includes
Raw materials
Production labor
Some allocation of factory overhead
Activity-based cost (ABC) systems allocate overhead based on some clearly identified cost drivers
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

15. Accounting for Inventory and Cost of Goods Sold

16. Cost of Goods Sold Beginning Inventory + Inventory Purchases
= Goods Available for Sale
– Ending Inventory
= Cost of Goods Sold
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17. Overview of Perpetual and Periodic Systems
Perpetual system
Inventory records are updated whenever a purchase or a sale is made
Advances in information technology have made the cost of using this system practical
Periodic system
Inventory records are not updated when a sale is made
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

18. Taking a Physical Count of Inventory
The actual quantity on hand is determined by taking a physical count
A cost is attached to the quantity counted
With a perpetual system, a physical count can reveal inventory shrinkage
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

19. Ending Inventory Errors
If ending inventory is ...
Cost of Goods Sold is ...
Net Income is ...
Overstated
Understated
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20. Inventory Valuation Methods

21. Inventory Valuation Methods
Where specific identification is not possible, an assumption must be made about which cost is associated with the units remaining
Four assumptions are accepted under U.S. GAAP:
Specific identification
Average cost
FIFO (first-in, first-out)
LIFO (last-in, first-out)
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

22. Example: Inventory Valuation Methods
Assume the following data:
Unit Total
Units Cost Cost
January $10 $2,000
March $12 3,600
July $11 5,500
November $13 1,300
1,100 $12,400
Sales: 700 $15
Ending Inventory: 400 units
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23. Specific Identification
Requires no assumption about the flow of inventory units
Inventory items are specifically identified and valued
The actual cost of goods sold can be computed as inventory is sold
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24. Example: Average Cost Method
Ending Inventory 400 Units × $11.27 $4,510
Cost of Goods Sold 700 Units × $ ,890
Cost of Goods Available for Sale $12,400
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25. Example: FIFO Assumption: The units sold are the oldest units on hand.
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26. Example: LIFO Assumption: The units sold are the newest units on hand.
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27. Goods Available for Sale
Comparison of Methods
Goods Available for Sale =
Ending Inventory +
Goods Sold
1,100 units
400 units
700 units
FIFO
$12,400
$4,600
$7,800
LIFO
$4,400
$8,000
Average Cost
$4,510
$7,890
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

28. Comparison of Methods
In period of rising prices, highest Net Income with FIFO
LIFO favored for tax purposes
Must also use for financial reporting
Choice:
High profits and high taxes with FIFO
Low profits and low taxes with LIFO
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

29. More About LIFO

30. LIFO Layers
Any year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending inventory
The creation of LIFO layers results in ending inventory at very old prices
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31. 20 units from 2004 + 30 units from 2005 + 40 units from 2006
LIFO Layers Example
20 units from units from 2005
20 units from units from units from 2006
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32. LIFO Reserve
The difference between the LIFO ending inventory amount and the amount obtained using another method (e.g., FIFO or average cost)
Disclosed to aid in comparing companies that use different inventory cost flow assumptions
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

33. LIFO Liquidation
Occurs when the number of units purchased does not exceed the number of units sold
The old LIFO layer costs to flow through cost of goods sold, reducing cost of goods sold and increasing net income
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34. Inventory Estimation and Valuation

35. Gross Profit Method
Used to estimate inventory without actually taking a physical count
The gross profit percentage is applied to estimate cost of goods sold, and ultimately gross profit
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

36. Example: Gross Profit Method
Assume the following data:
Beginning inventory, January 1 $25,000
Purchases, January 1 through January 31 40,000
Sales, January 1 through January 31 50,000
Historical gross profit percentage 40%
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37. Gross Profit Method Sales (actual) $50,000 100%
Gross profit (estimate) , %
Cost of goods sold (estimate) $30, %
- Cost of goods sold (estimate) 30,000
Beginning inventory (actual) $25,000
+ Purchases (actual) 40,000
= Cost of goods avail for sale (actual) 65,000
= Ending inventory (estimate) 35,000
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38. Lower of Cost or Market
Recognizes inventory price declines, but not price increases until the inventory is sold
Market value is defined as
Replacement cost or
Net realizable value
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39. Lower of Cost or Market
Replacement cost is the cost to buy equivalent new inventory items
Net realizable value is the amount expected to be received when the inventory is sold
Rule of thumb: Inventory is valued on the balance sheet at the lowest of
historical cost,
replacement cost, or
net realizable value
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

40. Lower of Cost or Market
An inventory write-down when market value is lower than cost recognizes the economic loss when it happens rather than when the inventory is sold
This is another example of the principle of conservatism
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

41. Evaluating Inventory Levels and Budgeting Cash Disbursements

42. Evaluating the Level of Inventory
Inventory turnover
Measures how many times a company turns over its inventory during the year
Number of days’ sales in inventory
Measures the number of days’ sales represented in the inventory value
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43. Evaluating the Level of Inventory
These ratios are compared with those of other firms in the same industry and with comparable ratios for the same firm in previous years.
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44. Number of Days’ Purchases in Accounts Payable
Indicates how long it takes for a company to pay its suppliers
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45. Number of Days’ Sales in Inventory Average Collection Period
Managing Cash Flow
Number of Days’ Sales in Inventory
Average Collection Period
Operating Cycle
Detailed cash payment forecasting is used to plan the specific timing of loan receipts and repayments
Number of Days’ Purchases in Accounts Payable
External financing needed
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46. Budgeting Cash Outflows
A cash budget is an important tool in helping management plan its cash needs
Estimating cash and credit sales, as well as estimating the pattern of collection of accounts receivable, are key to the cash receipts budgeting process
Financial Accounting, 7e Stice/Stice, 2006 © Thomson

47. Cash Budgeting Example
Cost of Goods Sold = 80% of sales
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48. Pay in March $40,000 Pay in February $40,000
January Sales 100,000
Cost of Goods Sold Percentage %
Inventory required for estimated sales 80,000
Adjustment for desired inventory levels
Required Purchases 80,000
Pay in March $40,000
Pay in February $40,000
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49. Third Quarter Cash Disbursements for Inventory
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50. In Summary ... Retailer inventory: purchased for resale
Manufacturer inventory: raw materials purchased for further processing; work in process, and finished goods held for resale
Inventory cost: all costs necessary to bring to a point of readiness
Cost flow assumptions: LIFO, FIFO, and average cost
LIFO creates layers; inventory is carried at oldest (lowest) costs which results in higher cost of sales, lower profit, and lower taxes
Gross profit method is an estimation tool for inventory value
Financial Accounting, 7e Stice/Stice, 2006 © Thomson