ACCOUNTING FOR MERCHANDISE INVENTORY CHAPTER NINETEEN ACCOUNTING FOR MERCHANDISE INVENTORY

INVENTORY ERRORS Errors in inventory will cause errors on: Income Statement, Statement of Owner’s Equity and Balance Sheet For the current and the next year

EFFECT OF INVENTORY ERRORS INCOME STATEMENT 20-1 20-2 Sales 80 Cost of Goods Sold: Beginning Merch. Inventory 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 20 Let’s first look at the Income Statement with the ending inventory correctly stated at $20.

EFFECT OF INVENTORY ERRORS INCOME STATEMENT 20-1 20-2 Sales 80 Cost of Goods Sold: Beginning Merch. Inventory 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 20 Cost of Goods Sold (40) Gross Profit 40 Operating Expenses (10) Net Income 30 Now let’s look at the other financial statements.

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 30 Erv Bultman, capital, December 31 130 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 20 Owner’s Equity: Erv Bultman, Capital 130

EFFECT OF INVENTORY ERRORS INCOME STATEMENT 20-1 20-2 Sales 80 80 Cost of Goods Sold: Beginning Merch. Inventory 20 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 20 Cost of Goods Sold (40) Gross Profit 40 Operating Expenses 20-1’s ending inventory becomes 20-2’s beginning inventory. (10) Net Income 30

EFFECT OF INVENTORY ERRORS INCOME STATEMENT 20-1 20-2 Sales 80 80 Cost of Goods Sold: Beginning Merch. Inventory 20 20 Add Purchases (net) 40 40 Cost of Goods Available for Sale 60 60 Less: Ending Merch. Inventory 20 20 Cost of Goods Sold (40) (40) Gross Profit 40 40 Operating Expenses (10) (10) Net Income 30 30

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 130 Net Income 30 30 Erv Bultman, capital, December 31 130 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 20 20 Owner’s Equity: Erv Bultman, Capital 130 160

EFFECT OF INVENTORY ERRORS What would be the effect on the financial statements for 20-1 & 20-2 if the 12/31/-1 inventory was reported as $15 instead of $20? Ending inventory 20-1 & Beginning inventory 20-2 UNDERSTATED

EFFECT OF INVENTORY ERRORS INCOME STATEMENT 20-1 20-2 Sales 80 Cost of Goods Sold: Beginning Merch. Inventory 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 15 Cost of Goods Sold (45) Gross Profit 35 Operating Expenses (10) Net Income 25 Understated Ending Inventory results in understated Net Income.

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 25 Erv Bultman, capital, December 31 125 BALANCE SHEET (partial) Understated Net Income results in understated Owner’s Equity. Current Assets: Merchandise Inventory Owner’s Equity: Erv Bultman, Capital

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 25 Erv Bultman, capital, December 31 125 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 15 Owner’s Equity: Erv Bultman, Capital 125 Assets and Owner’s Equity will be understated.

EFFECT OF INVENTORY ERRORS INCOME STATEMENT 20-1 20-2 Sales 80 80 Cost of Goods Sold: Beginning Merch. Inventory 20 15 Add Purchases (net) 40 40 Cost of Goods Available for Sale 60 55 Less: Ending Merch. Inventory 15 20 Cost of Goods Sold (45) (35) Gross Profit 35 45 Operating Expenses (10) (10) Net Income 25 35 Understated Beginning Inventory results in overstated Net Income.

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 125 Net Income 25 35 Erv Bultman, capital, December 31 125 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 15 Owner’s Equity: Erv Bultman, Capital 125 Owner’s Equity is correct by the end of 20-2.

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 125 Net Income 25 35 Erv Bultman, capital, December 31 125 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 15 20 Owner’s Equity: Erv Bultman, Capital 125 160 Assets and Owner’s Equity will be correct.

EFFECT OF INVENTORY ERRORS What would be the effect on the financial statements for 20-1 & 20-2 if the 12/31/-1 inventory was reported as $25 instead of $20? Ending inventory 20-1 & Beginning inventory 20-2 OVERSTATED

EFFECT OF INVENTORY ERRORS INCOME STATEMENT 20-1 20-2 Sales 80 Cost of Goods Sold: Beginning Merch. Inventory 20 Add Purchases (net) 40 Cost of Goods Available for Sale 60 Less: Ending Merch. Inventory 25 Cost of Goods Sold (35) Gross Profit 45 Operating Expenses (10) Net Income 35 Overstated Ending Inventory results in overstated Net Income.

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 35 Erv Bultman, capital, December 31 135 BALANCE SHEET (partial) Current Assets: Merchandise Inventory Overstated Net Income results in overstated Owner’s Equity. Owner’s Equity: Erv Bultman, Capital

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net Income 35 Erv Bultman, capital, December 31 135 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 25 Owner’s Equity: Erv Bultman, Capital 135 Assets and Owner’s Equity will be overstated.

EFFECT OF INVENTORY ERRORS INCOME STATEMENT 20-1 20-2 Sales 80 80 Cost of Goods Sold: Beginning Merch. Inventory 20 25 Add Purchases (net) 40 40 Cost of Goods Available for Sale 60 65 Less: Ending Merch. Inventory 25 20 Cost of Goods Sold (35) (45) Gross Profit 45 35 Operating Expenses (10) (10) Net Income 35 25 Overstated Beginning Inventory results in understated Net Income.

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 135 Net Income 35 25 Erv Bultman, capital, December 31 135 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 25 Owner’s Equity: Erv Bultman, Capital 135 Owner’s Equity is correct by the end of 20-2.

EFFECT OF INVENTORY ERRORS STMT OF OWNER’S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 135 Net Income 35 25 Erv Bultman, capital, December 31 135 160 BALANCE SHEET (partial) Current Assets: Merchandise Inventory 25 20 Owner’s Equity: Erv Bultman, Capital 135 160 Assets and Owner’s Equity will be correct.

RECORDING PURCHASES PERIODIC METHOD PERPETUAL METHOD Merch. Inv. account balance = most recent physical inventory Purchases account used for all merchandise purchases Current inventory and cost of goods sold only computed at end of period PERPETUAL METHOD Merch. Inv. Account reflects current inventory Purchases are debited to Merch. Inv., cost of sales are credited to Merch. Inv. Generally no need for end of year adjustments

COMPARING ENTRIES UNDER PERIODIC AND PERPETUAL SYSTEMS Example: Purchased $100 of merchandise on account

PERIODIC SYSTEM Purchases Accts Payable Periodic system uses a DATE DESCRIPTION DEBIT PR CREDIT 1 Purchases 100 00 2 Accts Payable 100 00 3 4 Periodic system uses a “Purchases” account. 5 6 7 8 9 10 11

PERPETUAL SYSTEM Merchandise Inventory Accts Payable DATE DESCRIPTION DEBIT PR CREDIT 1 Merchandise Inventory 100 00 2 Accts Payable 100 00 3 4 Perpetual system records purchases directly in the Merchandise Inventory account. 5 6 7 8 9 10 11

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Paid freight charges $30

Periodic system separates freight charges in to their own account. DATE DESCRIPTION DEBIT PR CREDIT 1 Frieight-In 30 00 2 Cash 30 00 3 4 5 Periodic system separates freight charges in to their own account. 6 7 8 9 10 11

PERPETUAL SYSTEM Merchandise Inventory Cash DATE DESCRIPTION DEBIT PR CREDIT 1 Merchandise Inventory 30 00 2 Cash 30 00 3 4 5 Perpetual system considers freight charges part of the cost of merchandise and includes them in the inventory account. 6 7 8 9 10 11

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Sold merchandise on account, $80. The cost of the merchandise was $50.

PERIODIC SYSTEM Accounts Receivable Sales DATE DESCRIPTION DEBIT PR CREDIT 1 Accounts Receivable 80 00 2 Sales 80 00 3 4 5 Periodic system only records the selling price of merchandise sold. No attempt is made to reduce the inventory account for items sold. 6 7 8 9 10 11

Perpetual system also records the selling price of merchandise sold. DATE DESCRIPTION DEBIT PR CREDIT 1 Accounts Receivable 80 00 2 Sales 80 00 3 4 5 Perpetual system also records the selling price of merchandise sold. 6 7 8 9 10 11

PERPETUAL SYSTEM Accounts Receivable Sales Cost of Goods Sold DATE DESCRIPTION DEBIT PR CREDIT 1 Accounts Receivable 80 00 2 Sales 80 00 3 4 Cost of Goods Sold 50 00 Merchandise Inventory 5 50 00 6 In addition, the perpetual system removes the cost of merchandise sold from inventory. 7 8 9 10 11

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Merchandise costing $10 was returned to the supplier.

Periodic system maintains a separate account for returns. DATE DESCRIPTION DEBIT PR CREDIT 1 Accounts Payable 10 00 2 Purchases Ret. & Allow. 10 00 3 4 5 Periodic system maintains a separate account for returns. 6 7 8 9 10 11

PERPETUAL SYSTEM Accounts Payable Merchandise Inventory DATE DESCRIPTION DEBIT PR CREDIT 1 Accounts Payable 80 00 2 Merchandise Inventory 80 00 3 4 5 Since the merchandise was recorded in the inventory account when purchased, it is removed from the account when returned. 6 7 8 9 10 11

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Customers returned merchandise sold for $20. The cost of the merchandise was $15.

Periodic system maintains a separate account for returns. DATE DESCRIPTION DEBIT PR CREDIT 1 Sales Returns & Allow. 20 00 2 Accounts Receivable 20 00 3 4 5 Periodic system maintains a separate account for returns. 6 7 8 9 10 11

PERPETUAL SYSTEM Sales Returns & Allow. Accounts Receivable DATE DESCRIPTION DEBIT PR CREDIT 1 Sales Returns & Allow. 20 00 2 Accounts Receivable 20 00 3 4 5 Perpetual system records the returned sale. It also must adjust the “Cost of Goods Sold” and “Merchandise Inventory” accounts. 6 7 8 9 10 11

PERPETUAL SYSTEM Sales Returns & Allow. Accounts Receivable DATE DESCRIPTION DEBIT PR CREDIT 1 Sales Returns & Allow. 20 00 2 Accounts Receivable 20 00 3 4 Merchandise Inventory 15 00 Cost of Goods Sold 5 15 00 6 7 8 9 10 11

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Paid for merchandise costing $100. The supplier granted a 2% discount for prompt payment.

Discounts are recorded in a PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT 1 Accounts Payable 100 00 2 Purchases Discounts 2 00 3 Cash 98 00 4 Discounts are recorded in a separate account. 5 6 7 8 9 10 11

PERPETUAL SYSTEM Sales Returns & Allow. Accounts Receivable DATE DESCRIPTION DEBIT PR CREDIT 1 Sales Returns & Allow. 20 00 2 Accounts Receivable 20 00 3 4 5 Perpetual system records the returned sale. It also must adjust the “Cost of Goods Sold” and “Merchandise Inventory” accounts. 6 7 8 9 10 11

COMPARING ENTRIES UNDER PERIODIC & PERPETUAL SYSTEMS Example: Adjusting entries made at the end of the accounting period.

Removing the old balance from the inventory account PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT 1 Income Summary XX 2 Merchandise Inventory XX 3 4 Removing the old balance from the inventory account 5 6 7 8 9 10 11

in the inventory account PERIODIC SYSTEM DATE DESCRIPTION DEBIT PR CREDIT 1 Income Summary XX 2 Merchandise Inventory XX 3 4 Merchandise Inventory XX 5 Income Summary XX 6 7 Recording new balance in the inventory account 8 9 10 11

No entry needed if physical inventory agrees with amount reported PERPETUAL SYSTEM DATE DESCRIPTION DEBIT PR CREDIT 1 2 3 No entry needed if physical inventory agrees with amount reported in inventory account. 4 5 6 7 8 9 10 11

TAKING A PHYSICAL INVENTORY Counting the goods on hand at the end of the period used in the PERIODIC system to allocate merchandise costs between sold and unsold goods in the PERPETUAL system it is compared to the accounting records to determine if what is actually held agrees with the records done after regular business hours ideally when inventory on hand is at its lowest level fiscal year that starts and ends when inventory is at its lowest level is called “natural business year”

TAKING A PHYSICAL INVENTORY Two special situations: Goods held for sale on CONSIGNMENT Goods held on consignment remain the property of the shipper (Consignor) Goods in TRANSIT if FOB Shipping point - goods belong to the BUYER while in transit if FOB Destination- goods belong to the SELLER while in transit

COMPUTING THE COST OF ENDING INVENTORY EXAMPLE: A physical inventory found 50 bicycles (Model ZX007) on hand. All of this model bicycle were purchased for $60 each. Number of bikes on hand Cost per unit Ending Inventory X = 50 $60 = $3000 X Computing ending inventory is simple if all purchases were made at the same price.

COMPUTING THE COST OF ENDING INVENTORY What if each time we restocked this bicycle the price had changed? Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 Cost of these 200 sold? No. of units sold during period 200

COMPUTING THE COST OF ENDING INVENTORY What if each time we restocked this bicycle the price had changed? Units Unit Price Total Cost Depends on inventory method used On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

Let’s apply this method INVENTORY METHODS Method #1 - Specific Identification Method Used when each unit of inventory can be specifically identified examples: cars, motorcycles, furniture, appliances, fine jewelry Only practical for businesses in which sales volume is low and inventory unit value is high Let’s apply this method to the bicycle example.

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the Specific Identification Method. The 200 bikes sold are as follows: Units Unit Price Total Cost 30 of these were sold On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the Specific Identification Method. The 200 bikes sold are as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 50 of these were sold 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the Specific Identification Method. The 200 bikes sold are as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 60 of these were sold 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the Specific Identification Method. The 200 bikes sold are as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 2nd purchase 80 60 of these were sold 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Units Sold Unit Price Total Cost From beginning inventory 30 $62 $1,860 1st purchase 50 65 3,250 2nd purchase 60 67 4,020 3rd purchase 60 68 4,760 Total 200 $13,210 Cost of goods (the 200 bikes) sold

COMPUTING THE ENDING INVENTORY Units Remaining Unit Price Total Cost From beginning inventory 10 $62 $620 1st purchase 10 65 650 2nd purchase 20 67 1,340 3rd purchase 10 68 680 Total 50 $3,290 This ending inventory will be reported on the Income Statement and the Balance Sheet.

Let’s apply this method INVENTORY METHODS Method #2 - First-In, First-Out (FIFO) Method Assumes the first goods purchased were the first goods sold Leaving the most recently purchased goods in ending inventory Follows the natural flow of goods especially true of grocery stores, fresh fruit stands, and computer software businesses Let’s apply this method to the bicycle example.

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost All of these - assumed sold On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: All of these - assumed sold 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 All of these - assumed sold 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 40 1st purchase 60 65 3,900 60 2nd purchase 80 67 5,360 80 3rd purchase 180 considered 70 68 4,760 sold so far No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the FIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 2nd purchase 80 20 of these - assumed sold 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Units Sold Unit Price Total Cost All of the beginning inventory 40 $62 $2,480 All of the 1st purchase 60 65 3,900 All of the 2nd purchase 80 67 5,360 3rd purchase 20 The remaining units from this purchase are the 50 units in ending inventory.

COMPUTING THE COST OF GOODS SOLD Units Sold Unit Price Total Cost All of the beginning inventory 40 $62 $2,480 All of the 1st purchase 60 65 3,900 All of the 2nd purchase 80 67 5,360 3rd purchase 20 68 1,360 Total 200 $13,100 Cost of goods (the 200 bikes) sold

COMPUTING THE ENDING INVENTORY Units Remaining Unit Price Total Cost From beginning inventory $62 $ 0 1st purchase 65 2nd purchase 67 3rd purchase 50 68 3,400 Total 50 $3,400 This ending inventory will be reported on the Income Statement and the Balance Sheet.

Let’s apply this method INVENTORY METHODS Method #3 - Weighted -Average Method Computes an average cost per unit using the following formula: Total cost of units available for sale divided by the units available for sale Let’s apply this method to the bicycle example.

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the Weighted-Average method. Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 $16,500 = $66/unit No. of units sold during period 200 250

WEIGHTED-AVERAGE METHOD Cost of goods sold 200 units @ $66 = $13,200 Ending Inventory 50 units @ $66 = 3,300 One of the advantages of the Weighted-Average method is its simplicity.

INVENTORY METHODS Method #4 - Last-In, First-Out Method Assumes that the sales in the period were made from the most recently purchased goods. While oldest goods remain in inventory Use of this method is justified because: LIFO is the actual physical flow of goods in some businesses it matches the most current costs of items purchased against the current sales revenue

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the LIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 2nd purchase 80 All of these - assumed sold 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the LIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 All of these - assumed sold 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the LIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 1st purchase 60 65 3,900 70 2nd purchase 80 67 5,360 80 3rd purchase 70 68 4,760 150 considered No. of units available for sale 250 $16,500 On hand at end of period sold so far 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Inventory was maintained using the LIFO method. The identity of the 200 bikes sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $2,480 Purchased during period: 50 of these - assumed sold 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 No. of units available for sale 250 $16,500 On hand at end of period 50 No. of units sold during period 200

COMPUTING THE COST OF GOODS SOLD Units Sold Unit Price Total Cost None of the beginning inventory $62 $ 0 1st purchase 50 65 3,250 All of the 2nd purchase 80 67 5,360 All of the 3rd purchase 70 68 4,760 200 $13,370

COMPUTING THE ENDING INVENTORY Units Remaining Unit Price Total Cost From beginning inventory 40 $62 $2,480 1st purchase 10 65 650 2nd purchase 67 3rd purchase 68 Total 50 $3,130 This ending inventory will be reported on the Income Statement and the Balance Sheet.

COMPARISON OF METHODS Assumed cost flows (FIFO, Weighed-Average, and LIFO) do not have to match the actual physical movement of goods. Any one of the methods may be used under any set of physical flow conditions.

Specific Identification Goods Available for Sale is the same COMPARISON OF METHODS Specific Identification FIFO Sales $18,000 $18,000 Cost of Goods Sold: Beg. Inventory $ 2,480 $ 2,480 Purchases 14,020 14,020 Goods Avail. for Sale $16,500 $16,500 Goods Available for Sale is the same for all four methods!

COMPARISON OF METHODS FIFO Weigthed-Average LIFO $18,000 $18,000 $ 2,480 $ 2,480 $ 2,480 14,020 14,020 14,020 $16,500 $16,500 $16,500

COMPARISON OF METHODS Ending Inventory & Cost of Goods Sold Specific Identification FIFO Sales $18,000 $18,000 Cost of Goods Sold: Beg. Inventory $ 2,480 $ 2,480 Purchases 14,020 14,020 Goods Avail. for Sale $16,500 $16,500 Less ending inventory 3,290 3,400 Cost of goods sold 13,210 13,100 Ending Inventory & Cost of Goods Sold differ with each method.

COMPARISON OF METHODS FIFO Weigthed-Average LIFO $18,000 $18,000 $ 2,480 $ 2,480 $ 2,480 14,020 14,020 14,020 $16,500 $16,500 $16,500 3,400 3,300 3,130 13,100 13,200 13,370

Specific Identification COMPARISON OF METHODS Specific Identification FIFO Sales $18,000 $18,000 Cost of Goods Sold: Beg. Inventory $ 2,480 $ 2,480 Purchases 14,020 14,020 Goods Avail. for Sale $16,500 $16,500 Less ending inventory 3,290 3,400 Cost of goods sold 13,210 13,100 Gross Profit $ 4,790 $ 4,900

COMPARISON OF METHODS When prices are rising (as with the bikes) FIFO Weigthed-Average LIFO $18,000 $18,000 $18,000 $ 2,480 $ 2,480 $ 2,480 14,020 14,020 14,020 $16,500 $16,500 $16,500 3,400 3,300 3,130 13,100 13,200 13,370 $ 4,900 $ 4,800 $ 4,630 When prices are rising (as with the bikes) FIFO results in the largest Gross Profit.

COMPARISON OF METHODS LIFO results in the smallest Gross Profit, FIFO Weigthed-Average LIFO $18,000 $18,000 $18,000 $ 2,480 $ 2,480 $ 2,480 14,020 14,020 14,020 $16,500 $16,500 $16,500 3,400 3,300 3,130 13,100 13,200 13,370 $ 4,900 $ 4,800 $ 4,630 LIFO results in the smallest Gross Profit, therefore creating the smallest tax liability.

PERPETUAL SYSTEM Merchandise Inventory is a controlling account. Subsidiary ledger maintained for each product Costs can be assigned on a FIFO, moving-average or LIFO basis.

There were 40 bicycles in inventory at the beginning of the year. PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS Jan. 1 (BI) There were 40 bicycles in inventory at the beginning of the year.

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 Each of the 40 units were purchased at $62.

The 30 bikes sold came from the $62 bikes in beginning inventory. PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS Jan. 1 (BI) Feb. 15 30 $ 62 The 30 bikes sold came from the $62 bikes in beginning inventory.

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS Jan. 1 (BI) Feb. 15 30 $ 62 $ 1,860 $ 1,860

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 (1) 30 $ 62 $ 1,860 $ 1,860 10 $62 620 $ 620

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS Jan. 1 (BI) Feb. 15 30 $ 62 $ 1,860 $ 1,860 Mar. 1 60 $ 65 $ 3,900

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 (1) 30 $ 62 $ 1,860 $ 1,860 10 $62 620 $ 620 (1) 10 $62 620 (2) 60 65 3,900 $4,520 Now there are two layers in inventory… 10 bikes from the beginning inventory and the 60 bikes just purchased.

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS Jan. 1 (BI) Feb. 15 30 $ 62 $ 1,860 $ 1,860 Mar. 1 60 $ 65 $ 3,900 April 1 On April 1, 40 units were sold.

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 (1) 30 $ 62 $ 1,860 $ 1,860 10 $62 620 $ 620 (1) 10 $62 620 (2) 60 65 3,900 $4,520 FIFO assumes the first-in are the first sold…. 40 sold = 10 from the beginning inventory and the 30 from the 3/1 purchase.

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS Jan. 1 (BI) Feb. 15 30 $ 62 $ 1,860 $ 1,860 Mar. 1 60 $ 65 $ 3,900 April 1 10 $ 62 $ 620 30 65 1,950 $ 4,430

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 (1) 30 $ 62 $ 1,860 $ 1,860 10 $62 620 $ 620 (1) 10 $62 620 (2) 60 65 3,900 $4,520 10 $ 62 $ 620 (2) 30 $65 1,950 30 65 1,950 $ 4,430 $1,950

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS Jan. 1 (BI) Feb. 15 30 $ 62 $ 1,860 $ 1,860 Mar. 1 60 $ 65 $ 3,900 April 1 10 $ 62 $ 620 30 65 1,950 $ 4,430 May15 80 $ 67 $ 5,360

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 (1) 30 $ 62 $ 1,860 $ 1,860 10 $62 620 $ 620 (1) 10 $62 620 (2) 60 65 3,900 $4,520 10 $ 62 $ 620 (2) 30 $65 1,950 30 65 1,950 $ 4,430 $1,950 (2) 30 $65 1,950 (3) 80 67 5,360 $7,310

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS May 15 80 $ 67 $ 5,360 June 30 On June 30, 90 units were sold.

90 bikes sold = 30 (layer 2) + 60 (layer 3) PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (2) 30 $65 1,950 (3) 80 67 5,360 $7,310 90 bikes sold = 30 (layer 2) + 60 (layer 3)

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS May 15 80 $ 67 $ 5,360 June 30 30 $65 1,950 60 67 4,020 $ 10,400

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (2) 30 $65 1,950 (3) 80 67 5,360 $7,310 30 $65 1,950 (3) 20 67 1,340 60 67 4,020 $ 10,400 $1,340

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS May 15 80 $ 67 $ 5,360 June 30 30 $65 1,950 60 67 4,020 $ 10,400 Aug. 28 70 $ 68 $ 4,760

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (2) 30 $65 1,950 (3) 80 67 5,360 $7,310 30 $65 1,950 (3) 20 $67 1,340 60 67 4,020 $ 10,400 $1,340 (3) 20 $67 1,340 (4) 70 68 4,760 $6,100

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS May 15 80 $ 67 $ 5,360 June 30 30 $65 1,950 60 67 4,020 $ 10,400 Aug. 28 70 $ 68 $ 4,760 Oct. 30 40 units were sold on Oct. 30.

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (2) 30 $65 1,950 (3) 80 67 5,360 $7,310 30 $65 1,950 (3) 20 $67 1,340 60 67 4,020 $ 10,400 $1,340 (3) 20 $67 1,340 (4) 70 68 4,760 $6,100 40 units sold = 20 (layer 3) + 20 (layer 4)

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Date Purchases Cost of Goods Sold Cost/ Cost/ Cumulative Units Unit Total Units Unit CGS CGS May 15 80 $ 67 $ 5,360 June 30 30 $65 $1,950 60 67 4,020 $ 10,400 Aug. 28 70 $ 68 $ 4,760 Oct. 30 20 $67 $1,340 20 68 1,360 $ 13,100

Cost of Goods Sold for the year PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (2) 30 $65 1,950 (3) 80 67 5,360 $7,310 30 $65 1,950 (3) 20 $67 1,340 60 67 4,020 $ 10,400 $1,340 (3) 20 $67 1,340 (4) 70 68 4,760 $6,100 20 $67 $1,340 (4) 50 $68 3,400 20 68 1,360 $ 13,100 $3,400 Cost of Goods Sold for the year

PERPETUAL FIFO METHOD Let’s return to the example of the 200 bicycles sold. Cost of Goods Sold Inventory on Hand Cost/ Cumulative Cost/ Layer Units Unit CGS CGS Layer Units Unit Cost Total (2) 30 $65 1,950 (3) 80 67 5,360 $7,310 30 $65 1,950 (3) 20 $67 1,340 60 67 4,020 $ 10,400 $1,340 (3) 20 $67 1,340 (4) 70 68 4,760 $6,100 20 $67 $1,340 (4) 50 $68 3,400 20 68 1,360 $ 13,100 $3,400 Ending Inventory

PHYSICAL INVENTORY Perpetual system does not eliminate the need for a physical inventory. Records are compared with the physical inventory. If a difference is found, an adjusting entry must be prepared differences are recorded in “Inventory Short and Over” account

PHYSICAL INVENTORY $130 short Example: A physical inventory shows $3,710 worth of merchandise, but the inventory account has a balance of $3,840. $130 short

GENERAL JOURNAL If physical count had shown $3,900… $60 overage DATE DESCRIPTION DEBIT PR CREDIT 1 Dec 31 Inventory Short and Over 130 2 Merchandise Inventory 130 3 To adjust inventory per 4 physical count 5 If physical count had shown $3,900… $60 overage 6 7 8 9 10 11

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Dec 31 Merchandise Inventory 60 2 Inventory Short and Over 60 3 To adjust inventory per 4 physical count 5 6 7 8 9 10 11

CONSERVATISM PRINCIPLE Assets that increase in value while being held…. No formal entry of the gain is made until asset is sold Assets that decrease in value while being held…. An entry is made to recognize the loss We never anticipate gains, but we should always anticipate and account for losses.

LOWER OF COST OR MARKET If the value of inventory declines while it is being held, the loss should be recognized in the period of the decline. “Cost” the dollar amount calculated using one of the four costing methods “Market” the cost to replace the inventory

This company sells three products. LOWER OF COST OR MARKET Recorded Purchase Cost End-of-Period Market Value Lower-of-Cost-or-Market Item 1 2 3 This company sells three products.

The inventory of product #1 LOWER OF COST OR MARKET Recorded Purchase Cost End-of-Period Market Value Lower-of-Cost-or-Market Item 1 $ 8,000 2 3 The inventory of product #1 cost $8,000.

But the price has fallen, it now could be replaced LOWER OF COST OR MARKET Recorded Purchase Cost End-of-Period Market Value Lower-of-Cost-or-Market Item 1 $ 8,000 $ 7,000 2 3 But the price has fallen, it now could be replaced for $7,000.

LOWER OF COST OR MARKET 1 $ 8,000 $ 7,000 $ 7,000 2 3 Recorded Purchase Cost End-of-Period Market Value Lower-of-Cost-or-Market Item 1 $ 8,000 $ 7,000 $ 7,000 2 3 “Market” is the lowest

Lower-of-Cost-or-Market Recorded Purchase Cost End-of-Period Market Value Lower-of-Cost-or-Market Item 1 $ 8,000 $ 7,000 $ 7,000 2 9,000 10,000 9,000 3 7,000 6,500 6,500 $24,000 $23,500 $22,500 Two ways to calculate Lower-of-Cost-or-Market

LOWER OF COST OR MARKET 1 $ 8,000 $ 7,000 $ 7,000 2 9,000 10,000 9,000 Recorded Purchase Cost End-of-Period Market Value Lower-of-Cost-or-Market Item 1 $ 8,000 $ 7,000 $ 7,000 2 9,000 10,000 9,000 3 7,000 6,500 6,500 $24,000 $23,500 $22,500 #1 - Applied to Total Inventory The lower of all items at their cost or all items at their market value

lowest amount is selected for each item LOWER OF COST OR MARKET Recorded Purchase Cost End-of-Period Market Value Lower-of-Cost-or-Market Item 1 $ 8,000 $ 7,000 $ 7,000 2 9,000 10,000 9,000 3 7,000 6,500 6,500 $24,000 $23,500 $22,500 #2 - Applied to Each Item Each item is evaluated, lowest amount is selected for each item

LOWER OF COST OR MARKET 1 $ 8,000 $ 7,000 $ 7,000 2 9,000 10,000 9,000 Recorded Purchase Cost End-of-Period Market Value Lower-of-Cost-or-Market Item 1 $ 8,000 $ 7,000 $ 7,000 2 9,000 10,000 9,000 3 7,000 6,500 6,500 $24,000 $23,500 $22,500 Let’s assume it was applied to Total Inventory. A journal entry is needed to reduce Merchandise Inventory to $23,500.

GENERAL JOURNAL Expense DATE DESCRIPTION DEBIT PR CREDIT 1 Loss on Write-Down of Inventory 500 2 Merchandise Inventory 500 3 To recognize loss in value of 4 inventory held 5 6 7 8 9 10 11

ESTIMATING INVENTORY Not needed under Perpetual system Used in a Periodic system when a physical inventory is not practical monthly, quarterly financial statements Two Methods Gross Profit method Retail Inventory method

GROSS PROFIT METHOD 3 steps A business’s normal gross profit (Net Sales - Cost of Goods Sold) is used to estimate the cost of goods sold and ending inventory. 3 steps

GROSS PROFIT METHOD Example: Inventory, start of period $80,000 Net Purchases, first month $70,000 Net Sales, first month $110,000 Normal gross profit as a percentage of sales 40% Step #1 Compute the cost of goods available for sale. Inventory, start of period $80,000 Net Purchases, first month 70,000 Cost of Goods Available for Sale $150,000

GROSS PROFIT METHOD Example: Inventory, start of period $80,000 Net Purchases, first month $70,000 Net Sales, first month $110,000 Normal gross profit as a percentage of sales 40% Step #2 Estimate cost of goods sold by deducting the normal gross profit from net sales. Net Sales $110,000 Normal Gross Profit 44,000 $110,000 x 40%

GROSS PROFIT METHOD Example: Inventory, start of period $80,000 Net Purchases, first month $70,000 Net Sales, first month $110,000 Normal gross profit as a percentage of sales 40% Step #2 Estimate cost of goods sold by deducting the normal gross profit from net sales. Net Sales $110,000 Normal Gross Profit 44,000 Estimated cost of goods sold 66,000

GROSS PROFIT METHOD Example: Inventory, start of period $80,000 Net Purchases, first month $70,000 Net Sales, first month $110,000 Normal gross profit as a percentage of sales 40% Step #3 Estimate the ending inventory by deducting cost of goods sold from the cost of goods available for sale. Cost of goods available for sale $150,000 Estimated cost of goods sold 66,000 $ 84,000 Estimated end-of-month inventory

RETAIL INVENTORY METHOD Used by many retail businesses. Requires keeping records of both the cost and selling (retail) prices of all goods purchased. 5 steps

GROSS PROFIT METHOD Step #1 Compute the cost of goods available for sale at cost and retail. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $ 186,000 $ 248,000

GROSS PROFIT METHOD Step #2 Compute the ending inventory at retail by subtracting sales at retail from goods available for sale at retail. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $ 186,000 $ 248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000

GROSS PROFIT METHOD Step #3 Compute the cost-to-retail ratio by dividing the cost of goods available for sale by retail value of goods available for sale. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $ 186,000 $ 248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Ratio ($186,000 ÷ $248,000) 75%

GROSS PROFIT METHOD Step #4 Estimate the cost of ending inventory by multiplying the ending inventory at retail by the cost-to-retail ratio. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $ 186,000 $ 248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Ratio ($186,000 ÷ $248,000) 75% Inventory, end of period, at cost ($68,000 x 75%) $ 51,000

GROSS PROFIT METHOD Step #5a Estimate cost of goods sold by multiplying sales at retail by the cost-to-retail ratio. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $ 186,000 $ 248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Ratio ($186,000 ÷ $248,000) 75% Inventory, end of period, at cost ($68,000 x 75%) $ 51,000 Estimated cost of goods sold $ 135,000

GROSS PROFIT METHOD Step #5b Estimate cost of goods sold by subtracting the estimated ending inventory from the cost of goods available for sale. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $ 186,000 $ 248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Ratio ($186,000 ÷ $248,000) 75% Inventory, end of period, at cost ($68,000 x 75%) $ 51,000 Estimated cost of goods sold $ 135,000