Inventories and cost of goods sold Chapter 6 Inventories and cost of goods sold © 2005 McGraw-Hill Ryerson Limited.

Assigning Costs to Inventory Accounting for inventory requires several decisions which include: Items to include in cost. Inventory System. Perpetual or Periodic Costing Method. FIFO, LIFO, Moving Weighted Average, Specific ID Use of estimates. Gross profit method, Retail inventory method © 2007 McGraw-Hill Ryerson Ltd.

Items in Merchandise Inventory Inventory includes all goods owned by a company and held for sale. Items requiring special attention: Goods in Transit Goods on consignment Obsolete or damaged goods © 2007 McGraw-Hill Ryerson Ltd.

Costs of Merchandise Inventory All expenditures necessary to bring an item to a saleable condition and location. This includes: Invoice price less discounts Import duties Transportation-in Storage Insurance © 2007 McGraw-Hill Ryerson Ltd.

Assigning Costs to Inventory Management must decide on method of determining unit cost. This will affect both the income statement and the balance sheet. Methods: Specific Identification FIFO LIFO Average Cost © 2007 McGraw-Hill Ryerson Ltd.

Merchandising Cost Flows Beginning Inventory Net Cost of Purchases Merchandise Available for Sale Balance Sheet Income Statement Ending Inventory Cost of Goods Sold © 2007 McGraw-Hill Ryerson Ltd.

Use of Inventory Methods in Practice © 2007 McGraw-Hill Ryerson Ltd.

Specific Identification This method is used when items: Are unique. Can be directly identified with a specific purchase and its invoice. Examples: Automobiles, art custom furniture. © 2007 McGraw-Hill Ryerson Ltd.

Specific Identification — Example The opening inventory consists of 10 units @ $91/unit. © 2007 McGraw-Hill Ryerson Ltd.

Specific Identification — Example This results in two layers of inventory. Additional units are purchased @ $106/unit. © 2007 McGraw-Hill Ryerson Ltd.

Specific Identification — Example On August 14, 20 units are sold. Eight of these units came from the opening inventory and the remaining 12 units came from the August 3 purchase. © 2007 McGraw-Hill Ryerson Ltd.

Specific Identification — Example This leaves 2 units remaining from the original inventory and 3 units remaining from the August 3 purchase. © 2007 McGraw-Hill Ryerson Ltd.

Moving Weighted Average Method Under this method, the cost of all units are averaged together. Average cost per unit Cost of goods available for sale Number of units available for sale = © 2007 McGraw-Hill Ryerson Ltd.

Moving Weighted Average - Example The opening inventory consists of 10 units @ $91/unit. © 2007 McGraw-Hill Ryerson Ltd.

Moving Weighted Average- Example Additional units are purchased @ $106/unit. This results in an average cost of $100/unit. (10 x $91) + (15 x $106) 25 units © 2007 McGraw-Hill Ryerson Ltd.

Moving Weighted Average- Example These 20 units are sold at the average cost of $100/unit. © 2007 McGraw-Hill Ryerson Ltd.

Moving Weighted Average- Example This leaves 5 units remaining at an average cost of $100/unit. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Mini-Quiz A company that uses a perpetual inventory system made the following cash purchases and sales: Jan. 1-Purchased 100 units at $10 per unit. Feb. 5-Purchased 60 units at $12 per unit. Mar.16-Sold for cash 40 units for $16 per unit. Prepare journal entries to record the sale assuming a Moving Weighted Average system is used. Cash 640 Sales (40x16) 640 Cost of goods sold 430 Inventory 430 (100x10 + 60x12)/160 x 40 © 2007 McGraw-Hill Ryerson Ltd.

First-In, First-Out (FIFO) Based on the assumption that the items are sold in the order acquired. When a sale occurs: The earliest units purchased are charged to Cost of Goods Sold. The cost of the most recent purchases remain in inventory. © 2007 McGraw-Hill Ryerson Ltd.

FIFO — Example The opening inventory consists of 10 units @ $91/unit. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. FIFO — Example This results in two layers of inventory. Additional units are purchased @ $106/unit. Additional units re purchased @ $106/unit. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. FIFO — Example Under FIFO, units are assumed to be sold in the order acquired. Therefore, of the 20 units sold on August 14, the first 10 units come from beginning inventory. Therefore, those 10 units are removed from the inventory record based on the cost of those units of $91. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. FIFO — Example The remaining 10 units sold on August 14th come from the next purchase, made on August 3rd. Therefore, these units are removed from the inventory record based on their cost of $106. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. FIFO — Example The ending inventory consists of the 5 remaining units from the August 3 purchase. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Mini-Quiz A company that uses a perpetual inventory system made the following cash purchases and sales: Jan. 1-Purchased 100 units at $10 per unit. Feb. 5-Purchased 60 units at $12 per unit. Mar.16-Sold for cash 40 units for $16 per unit. Prepare journal entries to record the sale assuming a FIFO system is used. Cash 640 Sales (40x16) 640 Cost of goods sold 400 Inventory (40x10) 400 © 2007 McGraw-Hill Ryerson Ltd.

Last-In, First-Out (LIFO) Based on the assumption that the most recently purchased items are sold first. When a sale occurs: The latest units purchased are charged to Cost of Goods Sold. The cost of the earliest purchases remain in inventory. © 2007 McGraw-Hill Ryerson Ltd.

LIFO — Example The opening inventory consists of 10 units @ $91/unit. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. LIFO — Example This results in two layers of inventory. Additional units are purchased @ $106/unit. © 2007 McGraw-Hill Ryerson Ltd.

LIFO — Example Of the 20 units sold, these units are assumed to be sold first. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. LIFO — Example Once the latest units purchased are sold, units are sold from the previous purchase. © 2007 McGraw-Hill Ryerson Ltd.

LIFO — Example This leaves 5 units remaining from the first purchase. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Mini-Quiz A company that uses a perpetual inventory system made the following cash purchases and sales: Jan. 1-Purchased 100 units at $10 per unit. Feb. 5-Purchased 60 units at $12 per unit. Mar.16-Sold for cash 40 units for $16 per unit. Prepare journal entries to record the sale assuming a LIFO system is used. Cash 640 Sales (40x16) 640 Cost of goods sold 480 Inventory (40x12) 480 © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Financial Reporting Because prices change, the choice of an inventory method is important. © 2007 McGraw-Hill Ryerson Ltd.

Advantages of Each Method Financial Reporting Advantages of Each Method Weighted Average Smoothes out purchase price changes. Last-In, First-Out Better matches current costs in cost of goods sold with revenues. First-In, First-Out Ending inventory approximates current replacement cost. First-In, First-Out Ending inventory approximates current replacement cost. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Financial Reporting A company is required to use the same accounting methods from period to period (consistency principle). A change is only acceptable when it improves financial reporting. The costing method used must be disclosed in the notes to the financial statements (full-disclosure principle). © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Lower of Cost or Market Inventory must be reported at market value when market is lower than cost (conservatism principle). Market may be defined as: Net realizable value Current replacement cost © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Lower of Cost or Market May be applied in one of three ways: Separately to each item. To major categories of items. To the inventory as a whole. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Inventory Errors Errors in the computation of or physical count of inventory will cause a misstatement of: Cost of goods sold Gross profit Net income Current assets Owner’s equity © 2007 McGraw-Hill Ryerson Ltd.

Inventory Errors- Effects on the Income Statement © 2007 McGraw-Hill Ryerson Ltd.

Inventory Errors- Effects on the Balance Sheet © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Review Describe how management’s decisions can affect the determination of the cost of inventory. Choice of method –FIFO,LIFO, Moving weighted average, Specific item. Choice of application of LCM -separate item, categories, whole inventory. Definition of market. Choice of periodic or perpetual system. Items to include in cost. Other. © 2007 McGraw-Hill Ryerson Ltd.

Periodic System-Appendix 7A The periodic system also uses FIFO, LIFO, specific identification, and weighted average methods to assign costs to inventory and cost of goods sold. The results may be the same or different under both systems. © 2007 McGraw-Hill Ryerson Ltd.

Specific Identification- Appendix 7A Applied in same manner as periodic system. Yields same results as perpetual system since units are specifically identified. © 2007 McGraw-Hill Ryerson Ltd.

Weighted Average-Appendix 7A Steps: Calculate weighted average unit cost. (# units beg. Inv. X unit cost) + (#units purchased x unit cost) # units available for sale = weighted average unit cost Use weighted average unit cost to assign costs to cost of goods sold and ending inventory. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. FIFO-Appendix 7A Yields same results as perpetual system since most recent purchases are in ending inventory under both systems. © 2007 McGraw-Hill Ryerson Ltd.

Inventory Errors in a Periodic System-Appendix 7A An error in the ending inventory affects the assets, net income, and owner’s equity of that period. The ending inventory of one period becomes the opening inventory of the next period. The cost of goods sold and net income of the next period are affected as well. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Ratios-Appendix 7B Inventory ratios may be used to assess: Short-term liquidity. Inventory management. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Ratios-Appendix 7B Merchandise Turnover Ratio Measures how many times a company turns its inventory over each period. The ratio will vary from industry to industry. Merchandise turnover cost of goods sold average inventory © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Ratios-Appendix 7B Days’ Sales in Inventory Used to estimate how many days it will take to convert inventory to cash or receivables. Used to assess if inventory levels can meet sales demand. Days’ sales in inventory = Ending inventory x 365 Cost of goods sold © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. End of Chapter © 2007 McGraw-Hill Ryerson Ltd.