Copyright © 2007 Prentice-Hall. All rights reserved 1 Merchandise Inventory Chapter 6

Copyright © 2007 Prentice-Hall. All rights reserved 2 Objective 1 Account for inventory by the FIFO, LIFO, and average cost methods.

Copyright © 2007 Prentice-Hall. All rights reserved 3 Inventory Costing Methods Specific Unit Cost FIFO LIFO Average Cost

Specific Unit Cost When units are sold, the specific cost of the unit sold is added to cost of goods sold

First-In, First-Out (FIFO) Cost of Goods Sold Ending Inventory Oldest Costs Recent Costs

First-In, First-Out (FIFO) $10 Beginning Inventory $12 Purchase 5 shirts Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold? First-In, First-Out Cost of good sold = $42Inventory = $48

First-In, First-Out (FIFO) GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Accounts Receivable ($20 x 4)80 Sales Revenue80 To record sales on account Cost of Goods Sold42 Inventory42 To record cost of sales

First-In, First-Out (FIFO) Sales$80 Cost of Goods Sold42 Gross Profit$38

Copyright © 2007 Prentice-Hall. All rights reserved 9 Last-In, First-Out (LIFO) Recent Costs Cost of Goods Sold Oldest Costs Ending Inventory

Copyright © 2007 Prentice-Hall. All rights reserved 10 Last-In, First-Out (LIFO) $10 Beginning Inventory $12 Purchase 5 shirts Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold? Last-In, First-Out Cost of good sold = $48Inventory = $42 $12

Copyright © 2007 Prentice-Hall. All rights reserved 11 Last-In, First-Out (LIFO) GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Accounts Receivable ($20 x 4)80 Sales Revenue80 To record sales on account Cost of Goods Sold48 Inventory48 To record cost of sales

Copyright © 2007 Prentice-Hall. All rights reserved 12 Last-In, First-Out (LIFO) Sales$80 Cost of Goods Sold48 Gross Profit$32

Copyright © 2007 Prentice-Hall. All rights reserved 13 Average Cost The average cost of each unit in inventory is assigned to cost of goods sold Average Cost Cost of Inventory on Hand Number of Units on Hand ÷=

Copyright © 2007 Prentice-Hall. All rights reserved 14 Average Cost $10 Beginning Inventory $12 Purchase 5 shirts Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold? Compute the Average Cost UnitsCost Beginning inventory3$30 Purchases560 Total8$90 Average = $90/8 = $11.25 Cost of good sold = $11.25 x 4 = $45Inventory = $11.25 x 4 = $45 $12

Copyright © 2007 Prentice-Hall. All rights reserved 15 Average Cost GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Accounts Receivable ($20 x 4)80 Sales Revenue80 To record sales on account Cost of Goods Sold45 Inventory45 To record cost of sales

Copyright © 2007 Prentice-Hall. All rights reserved 16 Average Cost Sales$80 Cost of Goods Sold45 Gross Profit$35

Copyright © 2007 Prentice-Hall. All rights reserved 17 Objective 2 Compare the effects of FIFO, LIFO, and average cost

Copyright © 2007 Prentice-Hall. All rights reserved 18 ComparisonComparison FIFOLIFOAverage Ending Inventory$48$42$45 Gross Profit$38$32$35

Copyright © 2007 Prentice-Hall. All rights reserved 19 Advantage of Each Method Smoothes out price changes Better matching of current costs in cost of goods sold with revenues Ending inventory approximates current replacement cost First-In, First-Out Weighted Average Last-In, First-Out

Copyright © 2007 Prentice-Hall. All rights reserved 20 Use of Inventory Methods in Practice

Copyright © 2007 Prentice-Hall. All rights reserved 21 E6-13E6-13 Nov 1 Bal.5$70$ $70 $ $79$ $ Notice: We keep separate cost layers as inventory is acquired Notice: This is not the selling price, but the cost of goods sold Total cost of goods sold for November = $903 Cost of ending inventory for November = $237

Copyright © 2007 Prentice-Hall. All rights reserved 22 E6-14E6-14 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Nov8Inventory790 Accounts Payable790 Purchased inventory on account Nov17Cash480 Sales Revenue480 To record sales for cash 17Cost of Goods Sold298 Inventory298 To record cost of sales

Copyright © 2007 Prentice-Hall. All rights reserved 23 E6-15E6-15 Nov 1 Bal.5$70$ $70 $ $79$ Total cost of goods sold for November = $921 Cost of ending inventory for November = $219 The last inventory costs incurred are the first inventory costs to be assigned to cost of goods sold

Copyright © 2007 Prentice-Hall. All rights reserved 24 E6-16E6-16 Nov 1 Bal.5$70.00$ $70.00 $ $79$ Total cost of goods sold for November = $ Cost of ending inventory for November = $ Every time the company purchases inventory, a new average price per unit is computed: Total cost of goods available for sale Total number of units available for sale $140 + $790 / 12 units = $77.50

Copyright © 2007 Prentice-Hall. All rights reserved 25 Analysis of E6-13, 15, 16 In this illustration, prices are rising. What impact do these different methods have on the income statement? Lets assume that all items were sold for $100 each FIFOLIFOAVERAGE Sales$1,200 Cost of goods sold * Gross profit$297$279$292 During rising prices FIFO gives you the highest net income, LIFO the lowest. Average will always be in between * Rounded

Copyright © 2007 Prentice-Hall. All rights reserved 26 Analysis of E6-13, 15, 16 How about the balance sheet? FIFOLIFOAVERAGE Inventory$237$219$233* During rising prices FIFO gives you the highest inventory valuation, LIFO the lowest Average will always be in between * Rounded

Copyright © 2007 Prentice-Hall. All rights reserved 27 Accounting Principles Consistency Principle Disclosure Principle Materiality Concept Accounting Conservatism

Copyright © 2007 Prentice-Hall. All rights reserved 28 Consistency in Reporting A company should use the same accounting methods from period to period so that financial statements are comparable across periods

Copyright © 2007 Prentice-Hall. All rights reserved 29 Disclosure Principle Report enough information for outsiders to make wise decisions about the company

Copyright © 2007 Prentice-Hall. All rights reserved 30 Materiality Concept A company must perform strictly proper accounting only for significant items

Copyright © 2007 Prentice-Hall. All rights reserved 31 Accounting Conservatism Exercise caution in reporting items in the financial statements Report realistic figures

Copyright © 2007 Prentice-Hall. All rights reserved 32 Objective 3 Apply the lower-of-cost-or market rule to inventory

Copyright © 2007 Prentice-Hall. All rights reserved 33 Lower-or-Cost-or-Market Rule Example of Accounting Conservatism Inventory is reported at whichever is lower – historical cost or market value (current replacement cost) If market is lower than cost – write inventory down –Debit Cost of Goods Sold –Credit Inventory

Copyright © 2007 Prentice-Hall. All rights reserved 34 Lower-or-Cost-or-Market Rule Must disclose method of valuation in financial statements –As parenthetical in statements or –In notes to financial statements

Copyright © 2007 Prentice-Hall. All rights reserved 35 E6-22E6-22 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Dec31Cost of Goods Sold1,000 Inventory1,000 LCM adjustment Cost of Goods Sold 72,000 1,000 Bal 73,000 Inventory 14,000 1,000 Bal 13,000 When market value of inventory is below cost, you must decrease the inventory account. The corresponding debit increases cost of goods sold

Copyright © 2007 Prentice-Hall. All rights reserved 36 E6-22E6-22 Eagle Resources Income Statement (partial) For the Year Ended December 31, 2006 Sales revenue$118,000 Cost of goods sold 73,000 Gross profit$45,000

Copyright © 2007 Prentice-Hall. All rights reserved 37 Objective 4 Measure the effects of inventory errors.

Copyright © 2007 Prentice-Hall. All rights reserved 38 Inventory Errors Ending inventory becomes next year’s beginning inventory Results in misstatement of income statement over two years Misstatement of balance sheet in first year and then error counterbalances itself

Copyright © 2007 Prentice-Hall. All rights reserved 39 Inventory Errors If ending inventory is overstated, so is net income and gross profit. Cost of Goods sold is understated If ending inventory is understated, so is net income and gross profit. Cost of Goods sold is overstated In year two, the effects of year one are reversed Hint: Remember, the two I’s are affected the same way I – Inventory I – Income

Copyright © 2007 Prentice-Hall. All rights reserved 40 E6-25 E6-25 Notice: Net income for the two years combined is the same in both cases. The error in 2006 counterbalances the error in 2005 Sales revenue$137,000$120,000 Cost of Goods Sold Beginning inventory$14,000$12,000 Net purchases72,00066,000 Cost of goods available$86,000$78,000 Ending inventory(16,000)(14,000) Cost of goods sold70,00064,000 Gross profit$67,000$56,000 Operating expenses25,00020,000 Net income$42,000$36,000 (11,000) 67,000 $53,000 $33,000 $11,000 $83,000 67,000 $45,000 $70,000

Copyright © 2007 Prentice-Hall. All rights reserved 41 Objective 5 Estimate ending inventory by the gross profit method

Copyright © 2007 Prentice-Hall. All rights reserved 42 Gross Profit Method Estimate ending inventory by applying the gross profit ratio to net sales Useful when inventory has been destroyed, lost, or stolen

Copyright © 2007 Prentice-Hall. All rights reserved 43 Things to Remember Compute Gross Profit: Sales - Cost of Goods Sold Gross Profit Compute Gross Profit Percent: Gross Profit / Net Sales

Copyright © 2007 Prentice-Hall. All rights reserved 44 Things to Remember Compute Cost of Goods Sold Beginning inventory + Purchases - Purchases returns + Freight-in Goods available for sale - Ending inventory Cost of goods sold

Copyright © 2007 Prentice-Hall. All rights reserved 45 E6-26E6-26 Sales - Cost of Goods Sold Gross Profit Sales - Cost of Goods Sold Gross Profit 100% 60% 40% $1,000, ,000 ???? 600,000

Copyright © 2007 Prentice-Hall. All rights reserved 46 E6-25E6-25 Beginning inventory$150,000 + Purchases800,000 Goods available for sale$950,000 - Ending inventory Cost of goods sold$400, ,000 ????

Copyright © 2007 Prentice-Hall. All rights reserved 47 End of Chapter 6