Inventory and Cost of Goods Sold S t I c e | S t I c e | S k o u s e n Inventory and Cost of Goods Sold Chapter 9 Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Learning Objectives Define inventory for a merchandising business and identify the different types of inventory for a manufacturing business. Explain the advantages and disadvantages of both periodic and perpetual inventory systems. Determine when ownership of goods in transit changes hands and what circumstances require shipped inventory to be kept on the books.

Learning Objectives Compute total inventory acquisition cost. Use the four basic inventory valuation methods: specific identification, average cost, FIFO, and LIFO. Explain how LIFO inventory layers are created, and describe the significance of the LIFO reserve.

Learning Objectives Choose an inventory valuation method based on the trade-offs among income tax effects, book-keeping costs, and the impact on the financial statements. Apply the lower-of-cost-or-market (LCM) rule to reflect declines in the market value of inventory.

Learning Objectives Use the gross profit method to estimate ending inventory. Determine the financial statement impact of inventory recording errors. Analyze inventory using financial ratios, and properly compare ratios of different firms after adjusting for differences in inventory valuation methods.

Learning Objectives Expanded Material Compute estimates of FIFO, LIFO, average cost, and lower-or-cost-or market inventory using the retail inventory method. Use LIFO pools, dollar-value LIFO, and dollar-value LIFO retail to compute ending inventory. Account for the impact of changing prices on purchase commitments. Record inventory purchase transactions denominated in foreign currencies.

What is Inventory? Items held for resale in the normal course of business. For a manufacturing firm, a broad array of production costs is included as part of the cost of inventory. The terms raw materials, work in process, and finished goods refer to the inventories of a manufacturing enterprise.

Summary Income Statement Items Balance Sheet Items Merchandise Cost of Goods Sold Sale Retailer Manufacturer Raw Materials Work in Process Finished Goods Cost of Goods Sold Sale Overhead Direct Labor

Inventory Systems Two types of inventory systems which keep track of how much inventory has been sold and at what price. Periodic system- requires a physical count of the inventory periodically, and at the point of sale only records the sale price. Perpetual system- at point of sale records selling price and type of item sold. Example: a bar code scanning system.

Differences in Recording Purchases of Inventory- Periodic Purchases 3,000 Accounts Payable 3,000 Sales During the Period- Periodic Accounts Receivable 4,125 Sales 4,125 Purchases of Inventory- Perpetual Inventory 3,000 Accounts Payable 3,000 Sales During the Period- Perpetual Accounts Receivable 4,125 Sales 4,125 Cost of Goods Sold 2,750 Inventory 2,750

Whose Inventory Is It? Report on the balance sheet inventory to which the company holds legal title. Legal title is not determined by who has physical custody of the inventory Issues that develop: Goods that are in transit. Goods that are on consignment.

Goods on Consignment Shipper retains title and includes the goods in inventory until their sale or use by the dealer or customer. Consigned goods are reported by the shipper at the sum of: The cost of the goods The handling costs The shipping costs incurred in their transfer to the dealer or customer.

What Is Inventory Cost? Inventory costs comprise of all expenditures both direct and indirect, relating to acquisition, preparation, and placement for sale. Discounts can change the total inventory costs. Trade Discounts Convert the catalog price to the actual price. Record inventory at discounted price. Cash Discounts Granted for payment of invoices within a limited time period. Record inventory using the net method or gross method.

Specific Identification Method Assigns the actual cost of the asset to Inventory and Cost of Goods Sold. Provides a highly objective method of matching costs because cost flow exactly matches physical goods flow. Is almost impossible to implement cost effectively.

Average Cost Method Assigns the same average cost to each unit sold and each item in inventory. For periodic inventory, the unit cost is the weighted average for the entire period. For perpetual inventory, the unit cost is computed as a moving average, which changes with each new purchase of goods.

First-In-First-Out (FIFO) Method Assigns historical unit cost to Cost of Goods Sold in the order the costs are incurred. Provides a close match between physical product flow and product cost flow. Results in the same inventory valuation and Cost of Goods Sold regardless of whether perpetual or periodic inventory is used.

Last-In-First-Out (LIFO) Method Assigns the most recent historical costs to Cost of Goods Sold and the oldest costs to Inventory. Is used primarily to minimize taxable income. Results in differences between Cost of Goods Sold and Inventory for perpetual inventory versus periodic inventory.

Perpetual Inventory Assume: Beginning inventory 100 @ $10 $1,000 Purchases: April 10 80 @ $11 880 April 20 70 @ $12 840 Sales: April 18 90 @ $15 April 27 50 @ $16 FIFO periodic and FIFO perpetual provide identical results for cost of goods sold and inventory.

Average Cost Method- Perpetual Apr. 1 Beginning Inventory 100 units @ $10 $1,000 Apr. 10 Purchases 80 units @ $11 880 Apr. 10 Balance 180 units @ $10.44 $1,880 Apr. 18 Sales (90) units @ $10.44 (940) Apr. 18 Balance 90 units @ $10.44 $ 940 Apr. 20 Purchases 70 units @ $12 840 Apr. 20 Balance 160 units @ $11.125 $1,780 $1,880  180 Apr. 27 Sales (50) units @ $11.125 (556) Apr. 30 Balance 110 units @ $11.125 $1,224 $1,780  160 Ending inventory, $1,224

Average Cost Method- Perpetual Apr. 18 Sales (90) units @ $10.44 (940) Apr. 18 Balance 90 units @ $10.44 $ 940 Apr. 20 Purchases 70 units @ $12 840 Apr. 20 Balance 160 units @ $11.125 $1,780 Apr. 1 Beginning Inventory 100 units @ $10 $1,000 Apr. 10 Purchases 80 units @ $11 880 Apr. 10 Balance 180 units @ $10.44 $1,880 Apr. 27 Sales (50) units @ $11.125 (556) Apr. 30 Balance 110 units @ $11.125 $1,224 Cost of Goods Sold (140 units) $940 + $556 = $1,496

LIFO Method- Perpetual Perpetual Inventory System Beginning inventory Apr. 1 100 units @ $10 per unit 90 units @ $10 per unit Sold 10 Apr. 10 0 units @ $11 per unit 80 units @ $11 per unit Sold 80 Purchased 80 80 units @ $11 per unit Apr. 20 20 units @ $12 per unit Sold 50 Purchased 70 70 units @ $12 per unit

LIFO Method- Perpetual Perpetual Inventory System = $ 900 = 0 = 240 $1,140 Apr. 1 Apr. 10 Apr. 20 100 units @ $10 per unit 90 units @ $10 per unit 80 units @ $11 per unit 70 units @ $12 per unit 20 units @ $12 per unit 0 units @ $11 per unit Ending inventory……………….. Beg. Inv. + Purchases – End. Inv. = Cost of Goods Sold $1,000 + $1,720 – $1,140 = $1,580

Unique Aspects of LIFO LIFO liquidation- the effect of cost of goods sold and net income during periods of rising prices, when “old” inventory layers are sold. Low cost prices are matched with higher sales prices resulting in a lower than usual cost of goods sold and a higher net income. LIFO conformity rule- in the 1930s Congress specified that companies who use LIFO for financial reporting must use LIFO for income tax reporting as well. Dollar-value LIFO- LIFO layers are determined based on total dollar changes rather than quantity changes.

FIFO Advantages and Disadvantages Usually corresponds with physical flow of goods. Ending inventory balance agrees closely with current replacement cost. Disadvantages: Can cause older costs to be matched with current revenues. Inventory holding gains and losses are included as part of gross profit. Yields higher taxable income in times of inflation if inventory levels are stable or increasing.

LIFO Advantages Advantages: Matches current costs with current revenues. Excludes inventory holding gains from gross profit. Yields lower taxable income in times of inflation if inventory levels are stable or increasing.

LIFO Disadvantages Disadvantages: Usually does not correspond with the physical flow of goods. Potential LIFO liquidation means old cost in LIFO layers can be drawn in to cost of goods sold. Ending inventory balance can be much lower than current replacement cost. LIFO liquidation can result in greatly increased tax payments when inventory levels decline.

Lower of Cost or Market The term “market” in lower of cost or market means replacement cost. Ceiling: Also known as the net realizable value Ceiling: Estimated selling price – normal selling costs Replacement Cost Market compare Floor: Net realizable value – a normal profit margin Historical Cost

Inventory Turnover Ratio. Appropriateness of inventory size and position can be measured by calculating the Inventory Turnover Ratio. Inventory Turnover: Cost of Goods Sold ÷ Average Inventory

Retail Inventory Method Used by retail firms to estimate inventory value. Can be used to estimate inventory under any valuation assumption. Cost amounts and retail amounts are tracked of the goods that have been purchased in the period. Cost percentage = goods available for sale at cost/ending inventory at retail