Merchandise Inventory and Cost of Sales PowerPoint Slides to accompany Fundamental Accounting Principles, 14ce Prepared by Joe Pidutti, Durham College CHAPTER 6

1. Identify the components and costs included in merchandise inventory. (LO 1 ) 2. Calculate cost of goods sold and merchandise inventory using specific identification, moving weighted average, and FIFO-perpetual. (LO 2 ) 3. Analyze the effects of the costing methods on financial reporting. (LO 3 ) © 2013 McGraw-Hill Ryerson Limited. Learning Objectives 2

4. Calculate the lower of cost and net realizable value of inventory. (LO 4 ) 5. Analyze the effects of merchandise inventory errors on current and future financial statements-perpetual. ( LO 5 ) 6. Apply both the gross profit and retail methods to estimate inventory. ( LO 6 ) © 2013 McGraw-Hill Ryerson Limited. Learning Objectives 3

7. Calculate cost of goods sold and merchandise inventory using FIFO –periodic, weighted average, and specific identification (Appendix 6A). ( LO 7 ) 8. Analyze the effects of merchandise inventory errors on current and future financial statements-periodic. (Appendix 6A). ( LO 8 ) 9. Assess merchandise inventory management using both merchandise turnover and days’ sales in inventory. (Appendix 6B) ( LO 9 ) © 2013 McGraw-Hill Ryerson Limited. Learning Objectives 4

Accounting for merchandise inventory requires several decisions which include: Assigning Costs to Merchandise Inventory Items included and their costs. Costing Method. (specific identification, moving weighted average or FIFO) Merchandise Inventory System. (perpetual or periodic) Use of net realizable value or other estimates. © 2013 McGraw-Hill Ryerson Limited. LO 1 5

Merchandise inventory includes all goods owned by a company and held for sale. Items requiring special attention: Goods in Transit Goods on Consignment Goods Damaged or Obsolete © 2013 McGraw-Hill Ryerson Limited. Items in Merchandise Inventory LO 1 6

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 © 2013 McGraw-Hill Ryerson Limited. Costs of Merchandise Inventory LO 1 7

Assigning Costs to Merchandise Inventory Management must decide on method of determining unit cost. This will affect both the income statement and the balance sheet. Methods: 1. First-in, first-out (FIFO) 2. Moving weighted average 3. Specific identification © 2013 McGraw-Hill Ryerson Limited. LO 2 8

© 2013 McGraw-Hill Ryerson Limited. 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 merchandise inventory. First-In, First-Out (FIFO) LO 2 9

FIFO — Example © 2013 McGraw-Hill Ryerson Limited. The opening inventory consists of 10 $91/unit. LO 2 10

FIFO — Example © 2013 McGraw-Hill Ryerson Limited. Additional units re $106/unit. This results in two layers of merchandise inventory. Additional units are $106/unit. LO 2 11

FIFO — Example © 2013 McGraw-Hill Ryerson Limited. 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. LO 2 12

FIFO — Example © 2013 McGraw-Hill Ryerson Limited. The remaining 10 units sold on August 14 th come from the next purchase, made on August 3 rd. Therefore, these units are removed from the inventory record based on their cost of $106. LO 2 13

FIFO — Example © 2013 McGraw-Hill Ryerson Limited. The ending inventory consists of the 5 remaining units from the August 3 purchase. LO 2 14

Moving Weighted Average Method Under this method, the cost of all units are averaged together. © 2013 McGraw-Hill Ryerson Limited. Cost of goods available for sale Number of units available for sale Average cost per unit = LO 2 16

Moving Weighted Average - Example © 2013 McGraw-Hill Ryerson Limited. The opening inventory consists of 10 $91/unit. LO 2 16

Moving Weighted Average- Example © 2013 McGraw-Hill Ryerson Limited. 15 additional units are $106/unit. This results in an average cost of $100/unit. (10 x $91) + (15 x $106) 25 units LO 2 17

Moving Weighted Average- Example © 2013 McGraw-Hill Ryerson Limited. These 20 units are sold at the average cost of $100/unit. LO 2 18

Moving Weighted Average- Example © 2013 McGraw-Hill Ryerson Limited. This leaves 5 units remaining at an average cost of $100/unit. LO 2 19

Specific Identification This method is used when items: Can be directly identified. Can be directly identified with a specific purchase and its invoice. © 2013 McGraw-Hill Ryerson Limited. Examples: Automobiles, art, custom furniture. LO 2 22

Specific Identification - Example © 2013 McGraw-Hill Ryerson Limited. The opening inventory consists of 10 $91/unit. LO 2 21

Specific Identification - Example © 2013 McGraw-Hill Ryerson Limited. This results in two layers of merchandise inventory. 15 additional units are $106/unit. LO 2 22

Specific Identification - Example © 2013 McGraw-Hill Ryerson Limited. On August 14, 20 units are sold. Eight of these units came from the opening merchandise inventory and the remaining 12 units came from the August 3 purchase. LO 2 23

Specific Identification - Example © 2013 McGraw-Hill Ryerson Limited. This leaves 2 units remaining from the original mercandise inventory and 3 units remaining from the August 3 purchase. LO 2 24

Because prices change, the choice of an merchandise inventory method is important. © 2013 McGraw-Hill Ryerson Limited. Comparison of Methods LO 3 27

Advantages of Each Method First-In, First-Out Ending inventory approximates current replacement cost. Moving Weighted Average Smoothes out purchase price changes Specific Identification Exactly matches costs and revenues Financial Reporting First-In, First-Out Most current values are on the balance sheet as ending inventory © 2013 McGraw-Hill Ryerson Limited. LO 3 28

Disadvantages of Each Method First-In, First-Out Ending inventory approximates current replacement cost. Moving Weighted Average Does not accurately match revenues to expenses Specific Identification Relatively more costly to implement and maintain Financial Reporting First-In, First-Out CGS does not reflect current costs © 2013 McGraw-Hill Ryerson Limited. LO 3 29

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). © 2013 McGraw-Hill Ryerson Limited. Financial Reporting LO 3 28

Merchandise Inventory must be reported at net realizable value (NRV) when NRV is lower than cost (principle of faithful representation). © 2013 McGraw-Hill Ryerson Limited. Lower of Cost and Net Realizable Value (LCNRV) LO 4 31

May be applied in one of two ways: 1. Separately to each item. 2. To groups of similar or related items. © 2013 McGraw-Hill Ryerson Limited. Lower of Cost and Net Realizable Value (LCNRV) LO 4 32

Errors in the computation of or physical count of merchandise inventory will cause a misstatement of: Cost of goods sold Gross profit Net income Current assets Equity © 2013 McGraw-Hill Ryerson Limited. Merchandise Inventory Errors LO 5 33

Inventory Errors- Effect on This Period’s Income Statement © 2013 McGraw-Hill Ryerson Limited. LO 5 32

© 2013 McGraw-Hill Ryerson Limited. Inventory Errors- Effect on This Period’s Balance Sheet LO 5 33

Ending merchandise inventory is estimated by applying the gross profit ratio to net sales. It is used: When merchandise inventory has been destroyed, lost, or stolen. For testing the reasonableness of the physical merchandise inventory count. © 2013 McGraw-Hill Ryerson Limited. Gross Profit Method LO 6 34

Occasionally used for interim period reporting. Information required: 1. Beginning inventory at cost and retail. 2. Net purchases at cost and retail. 3. Net sales. © 2013 McGraw-Hill Ryerson Limited. Retail Inventory Method LO 6 37

Merchandise Inventory ratios may be used to assess: 1. Short-term liquidity. 2. Merchandise Inventory management. © 2013 McGraw-Hill Ryerson Limited. Ratios-Appendix 6B LO 9 44

Merchandise Turnover Ratio Measures how many times a company turns its merchandise inventory over each period. The ratio will vary from industry to industry. Merchandise turnover Cost of goods sold Average merchandise inventory © 2013 McGraw-Hill Ryerson Limited. Ratios-Appendix 6B LO 9 45 =

Days’ Sales in Inventory Used to estimate how many days it will take to convert merchandise inventory to cash or receivables. Used to assess if merchandise inventory levels can meet sales demand. Days’ sales in inventory Ending inventory x 365 Cost of goods sold © 2013 McGraw-Hill Ryerson Limited. Ratios-Appendix 6B LO 9 46 =

End of Chapter © 2013 McGraw-Hill Ryerson Limited. 47