7-1 M EASURING A ND R EPORTING I NVENTORIES CHAPTER 7.

7-2Inventory “Inventory is often the largest and most important asset owned by a merchandising company.” What is the biggest expense on the income statement? Cost of Goods Sold What are the two major factors in determining Cost of Goods Sold? (Beg. Inventory + Purchases - End. Inventory)

7-3Inventory l Inventory is where the action is! l It’s a real can of worms.

7-4 Balance Sheet Amount The inventory dollar amount on the balance sheet is the product of what two factors? (i.e., What? x What?) Balance Sheet Amount = Quantity x Cost “War stories” about inventory observations

7-5 Inventory Costs Include l Invoice price l Insurance while in transit l Transportation l Handling costs to get the inventory ready for sale e.g., washing cars (i.e., all costs to get the inventory into a position and condition for resale.) 251

7-6 l Errors in inventory may cause misstatements in the following areas: u Income Statement COGS, Gross Margin, Net Income u Balance Sheet Inventory, Retained Earnings Impact of Inventory Errors on Financial Statements

7-7 Impact of Inventory Errors on Financial Statements Assume that the inventory at the end of 19A is misstated. What is the impact of the error on the Income Statements and Balance Sheets for 19A and 19B? 19A19B Error Income Statement: Impact of Error? Year Ended A Year Ended B Balance Sheet: A B Wrong End Inv, COGS, GM, Net Income Wrong Beg Inv, COGS, GM, Net Income Wrong Inventory and Retained Earnings Nothing wrong! The error "washes out" (i.e., counterbalances)

7-8 Impact of Inventory Errors on Financial Statements O.K. 5k over O.K. 5k over 5k under O.K.

7-9 Impact of Inventory Errors on Financial Statements O.K. 5k over O.K. 5k over 5k under 5k over O.K.!!! O.K. 5k under

7-10 Impact of Inventory Errors on Financial Statements Additional proof that Retained Earnings at the end of Year 2 are O.K. Retained Earnings 5,000 over 5,000 under O.K.!!! 120,000 Balance ,000 Net Income ,500 Net Income ,500 Balance As recorded Proof that sometimes, in fact, two wrongs do make a right!

7-11 Effects of Errors in Inventory Ending InventoryBeginning Inventory UnderstatedOverstatedUnderstatedOverstated Cost of Goods SoldOverstatedUnderstated Overstated Net IncomeUnderstatedOverstated Understated Here is a summary of the the material we just finished. 250 W h y b o t h e r ? Impact of Inventory Errors on Financial Statements

7-12 Impact of Inventory Errors on Financial Statements There is a much simpler way of getting the effect of an error on net income. u I call it the “sneaky way” because it uses the balance sheet equation. u As before in ILL. 7.1, if inventory at is overstated by $5,000, determine the effect on 1998 net income as follows: A = L + S/E Overstated by 5K

7-13 Methods of Determining Inventory Cost Periodic method was discussed in Chapter 6

7-14 Perpetual Inventory Procedure The inventory account is continuously updated for... u Inventory purchases u Purchase returns u Inventory sales u Sales returns

7-15 Comparing Journal Entries sales under the perpetual method require two journal entries For comparison, let’s make the journal entries for each of the following transactions using both the periodic and perpetual methods. Keep in mind that sales under the perpetual method require two journal entries.

7-16 Comparing Journal Entries On September 5, Worley Co. purchased 100 units of inventory for $30 per unit. GENERAL JOURNAL Page 1 DateDescriptionPRDebitCredit PERIODIC PERPETUAL

7-17 Comparing Journal Entries On September 5, Worley Co. purchased 100 units of inventory for $30 per unit. GENERAL JOURNAL Page 1 DateDescriptionPRDebitCredit 9/5Purchases3,000 Accounts Payable3,000 9/5Merchandise Inventory3,000 Accounts Payable3,000 PERIODIC PERPETUAL

7-18 Comparing Journal Entries On September 7, Worley Co. sold 10 of the previously purchased units for $50 each. GENERAL JOURNALPage 1 DateDescriptionPRDebitCredit PERIODIC PERPETUAL

7-19 Comparing Journal Entries On September 7, Worley Co. sold 10 of the previously purchased units for $50 each. GENERAL JOURNALPage 1 DateDescriptionPRDebitCredit 9/7Accounts Receivable500 Sales500 9/7Accounts Receivable500 Sales500 Cost of Goods Sold300 Merchandise Inventory300 PERIODIC PERPETUAL AT SALES PRICE AT COST The Cost of Goods Sold account is an expense account and is closed to Income Summary at the end of the period just like all other expense accounts.

7-20 Comparing Journal Entries On Sept. 8, Worley Co. returned 2 of the previously purchased units as defective. GENERAL JOURNALPage 1 DateDescriptionPRDebitCredit Periodic Perpetual

7-21 Comparing Journal Entries On Sept. 8, Worley Co. returned 2 of the previously purchased units as defective. GENERAL JOURNALPage 1 DateDescriptionPRDebitCredit 9/8Accounts Payable60 Purchase Returns and Allowances60 ( $30 per units = $60) 9/8Accounts Payable60 Merchandise Inventory60 Periodic Perpetual

7-22 Inventory Cost Flow Methods  Specific identification  First-in, first-out (FIFO)  Last-in, first-out (LIFO)  Weighted average

7-23

7-24

7-25 Reminder from the “Saturday Night Page” Inventory Cost Flow Methods Calculation of Cost of Goods Sold Beginning Inventory + Purchases, etc Cost of Goods Available for Sale - Ending Inventory Cost of Goods Sold So, GAS - EI = CGS Or, GAS = EI + CGS (The top part is not relevant to this discussion.)

7-26 Ending InventoryCost of Goods Sold Cost of Goods Available for Sale Inventory Cost Flow Methods

7-27 Specific Identification l Attaches actual cost to an identifiable unit of product l Used for relatively large inventory items l Frequently identified by serial number

7-28 First-In, First-Out COST OF GOODS AVAILABLE FOR SALE

7-29 First-In, First-Out Cost of Goods Sold Ending Inventory Oldest Costs Newest Costs

7-30 First-In, First-Out Periodic Inventory Procedure The following schedule shows the mouse pad inventory for Computers, Inc. for September. 800 The physical inventory count shows 800 mouse pads in ending inventory. Use the FIFO procedure to determine: (1) Ending inventory (2) Cost of goods sold

7-31 First-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateUnitsUnit CostTotal BI1, $ 5,250.00$ 9/3 Pur /15 Pur /21 Pur , /29 Pur Goods available for sale1,550 8,370.00$ Ending inventory800 Cost of goods sold750

7-32 First-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateUnitsUnit CostTotal BI1, $ 5,250.00$ 9/ / /21 Pur , /29 Pur Goods available for sale1,550 8,370.00$ Ending inventory800 Cost of goods sold750 Remember: Remember: FIFO ending inventory is calculated using the cost of the newest purchases. Start with 9/29 and then add other purchases until you reach the number of units in ending inventory.

7-33 First-In, First-Out Periodic Inventory Procedure Cost of Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv.Goods Sold Units100

7-34 First-In, First-Out Periodic Inventory Procedure Cost of Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv.Goods Sold Units300

7-35 First-In, First-Out Periodic Inventory Procedure Cost of Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv.Goods Sold Units450

7-36 First-In, First-Out Periodic Inventory Procedure Cost of Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv.Goods Sold Units550

7-37 First-In, First-Out Periodic Inventory Procedure Cost of Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv.Goods Sold Units

7-38 First-In, First-Out Periodic Inventory Procedure Cost of Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv.Goods Sold Units Costs4,432.50$ 3,937.50$ Cost of Goods Available for Sale$8,370.00

7-39 First-In, First-Out Periodic Inventory Procedure Cost of Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv.Goods Sold Units Costs4,432.50$ 3,937.50$ Cost of Goods Available for Sale$8,370.00

7-40 Last-In, First-Out

7-41 Last-In, First-Out Ending Inventory Cost of Goods Sold Oldest Costs Newest Costs

7-42 Last-In, First-Out Periodic Inventory Procedure The following schedule shows the mouse pad inventory for Computers, Inc. for September. 800 The physical inventory count shows 800 mouse pads in ending inventory. Use the LIFO periodic procedure to determine: (1) Ending inventory (2) Cost of goods sold

7-43 Last-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateUnitsUnit CostTotal BI1, $ 5,250.00$ 9/3 Pur /15 Pur /21 Pur , /29 Pur Goods available for sale1,550 8,370.00$ Ending inventory800 Cost of goods sold750

7-44 Last-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateUnitsUnit CostTotal BI1, $ 5,250.00$ 9/3 Pur /15 Pur / , / Goods available for sale1,550 8,370.00$ Ending inventory800 Cost of goods sold750 Remember: Remember: LIFO ending inventory is calculated using the cost of the oldest purchases. Start with beginning inventory and then add other purchases until you reach the number of units in ending inventory.

7-45 Last-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv. Cost of Goods Sold Units800

7-46 Last-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv. Cost of Goods Sold Units800200

7-47 Last-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv. Cost of Goods Sold

7-48 Last-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv. Cost of Goods Sold Units800750

7-49 Last-In, First-Out Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Inv.PurchasesEnd Inv. Cost of Goods Sold Units Costs4,200.00$ 4,170.00$ Cost of goods available for sale$8,370.00

7-50 Weighted-Average Periodic Inventory Procedure

7-51 Weighted-Average Periodic Inventory Procedure Cost per unit Goods Available for Sale in $_ Goods Available for Sale in units Ending Inventory Ending Inv. = Cost per unit x No. Units in Ending Inv.

7-52 Weighted-Average Periodic Inventory Procedure The following schedule shows the mouse pad inventory for Computers, Inc. for September. 800 The physical inventory count shows 800 mouse pads in ending inventory. Use the weighted-average periodic procedure to determine: (1) Ending inventory (2) Cost of goods sold

7-53 Weighted-Average Periodic Inventory Procedure Computer, Inc. Mouse Pad Inventory DateUnits$/UnitTotal Beg. Inventory1,000 $5.25$5, / / / , / Goods Available for Sale1,550 $8, Ending Inventory- 800 Goods Sold750

7-54 Computer, Inc. Mouse Pad Inventory DateUnits$/UnitTotal Beg. Inventory1,000 $5.25$5, / / / , / Goods Available for Sale1,550 $8, Ending Inventory- 800 Goods Sold750 Weighted-Average Periodic Inventory Procedure $8,370 ÷ 1,550 = $5.40 weighted-average

7-55 Weighted-Average Periodic Inventory Procedure $8,370 ÷ 1,550 = $5.40 weighted-average

7-56 Effect of Different Cost Flow Methods on Inventory and CGS FIFOLIFOWtd. Avg. Goods Available for Sale $8, Ending Inventory 4, Cost of Goods Sold $4, $8, , $4, $8, , $3, Computer, Inc. Mouse Pad Inventory In the previous examples of the three cost flow methods, what are the two possibilities for what happened to GAS as of year end? Became either: (1) Ending Inventory or (2) Cost of Goods Sold

7-57 Effect of Different Cost Flow Methods on Inventory and CGS 255 Facts for all 4 Cost Flow Examples Goods Available for Sale Also see Illustrations 7.7, 7.8, 7.10 & 7.12

7-58 Effect of Different Cost Flow Methods on Inventory and CGS ILL (Periodic) 264

7-59 Effect of Different Cost Flow Methods on Inventory and CGS

7-60 Perpetual Inventory Procedure Now let’s turn our attention to the perpetual inventory procedure.

7-61 FIFO Perpetual Inventory Procedure 1,200 Let’s start with some fresh information. Computers, Inc. has 1,200 units in inventory on November 30. The company started the month of November with 1,000 units on hand at a cost of $5.25 per unit. The company uses the FIFO perpetual procedure to determine: (1) Ending inventory (2) Cost of goods sold

7-62 FIFO Perpetual Inventory Procedure we must know when each unit was sold To calculate the FIFO cost for ending inventory and cost of goods sold, we must know when each unit was sold. In this example we will provide information for purchases and sales as it is needed.

7-63 Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold FIFO Perpetual Inventory Procedure On November 3rd, 300 units were purchased at $5.30 per unit. We need to update the inventory. On November 3rd, 300 units were purchased at $5.30 per unit. We need to update the inventory.

7-64 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold

7-65 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold On November 5th, 600 units were sold. We need to update the inventory. On November 5th, 600 units were sold. We need to update the inventory.

7-66 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold

7-67 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5 On November 10th, 150 units were purchased at $5.60 per unit. We need to update the inventory. On November 10th, 150 units were purchased at $5.60 per unit. We need to update the inventory.

7-68 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5

7-69 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5 On November 14th, 200 units were purchased at $5.80 per unit. We need to update the inventory. On November 14th, 200 units were purchased at $5.80 per unit. We need to update the inventory.

7-70 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5

7-71 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5 On November 17th, 500 units were sold. We need to update the inventory. On November 17th, 500 units were sold. We need to update the inventory.

7-72 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5 11/17

7-73 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5 11/17 On November 23rd, 400 units were sold. We need to update the inventory. On November 23rd, 400 units were sold. We need to update the inventory.

7-74 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5 11/17 11/23

7-75 DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5 11/17 11/23 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory On November 30th, 150 units were purchased at $5.90 per unit. We need to update the inventory. On November 30th, 150 units were purchased at $5.90 per unit. We need to update the inventory.

7-76 FIFO Perpetual Inventory Procedure Computer, Inc. Mouse Pad Inventory DateBeg. Bal.PurchasesBalance Cost of Goods Sold 11/5 11/17 11/23

7-77 LIFO Perpetual Inventory Procedure You are not responsible for this method. 260

7-78 First-In, First-Out Periodic Inventory System Periodic Inventory System Perpetual Inventory System Perpetual Inventory System Cost of Goods Sold Same Ending Inventory Ending Inventory Same

7-79 Last-In, First-Out Periodic Inventory System Periodic Inventory System Perpetual Inventory System Perpetual Inventory System Cost of Goods Sold Different Ending Inventory Cost of Goods Sold Different Ending Inventory

7-80 Weighted-Average Perpetual Inventory Procedure You are not responsible for this method. 261

7-81 Advantages and Disadvantages of FIFO Advantages l Easy to apply. l Inventory value approximates current cost. l Flow of costs tends to be consistent with usual physical flow of goods. l Systematic and objective. l Not subject to manipulation. 262

7-82 Advantages and Disadvantages of FIFO Advantages l Easy to apply. l Inventory value approximates current cost. l Flow of costs tends to be consistent with usual physical flow of goods. l Systematic and objective. l Not subject to manipulation.Disadvantages l Does not match current cost of goods sold with current revenues. l Inventory (or paper) profits. l In periods of rising prices, pay higher income taxes.

7-83 Advantages and Disadvantages of LIFO Advantages l In periods of rising prices, pay less taxes. l Matches latest inventory costs with current revenues. Disadvantages l LIFO conformity rule for tax and book purposes. l Cost of record keeping higher. l Inventory valuation is at older costs.

7-84 In Periods of Rising Prices... LIFO l Matches high (newer) costs with current (higher) sales. l Values inventory on low (older) cost basis. l Results in lower taxable income.FIFO l Matches low (older) costs with current (higher) sales. l Values inventory approximating higher current costs. l Results in higher taxable income.

7-85 GAAP requires inventory be valued at the Lower of Cost or Market (LCM). u Cost u Cost refers to the invoice price and other costs such as transportation. It is determined by one of the four inventory cost flow methods previously discussed. u Market u Market generally refers to the replacement cost of the inventory. u LCM is called the inventory “valuation method” Departures From Cost Basis of Inventory Valuation

7-86 Departures From Cost Basis of Inventory Valuation Lower-of-Cost-or-Market Method (LCM) ItemQuantityUnit Cost Unit Market Total Cost Total Market LCM** Mouse pad $ 4.50$ 4,600$ 3,600$ $ Diskettes1, ,190 2,250 2,190 Keyboard ,025 2,175 2,025 8,815$ 8,025$ 7,815$ **LCM applied on an item-by-item basis.

7-87 Estimating Inventory Necessary due to fire, theft, and interim reporting, primarily when using the periodic inventory method. Methods for Estimating u Gross Margin Method u Retail Inventory Method Not responsible for this one

7-88 Gross Margin Method To use this method we must know the following: Ê Net sales for the period. Ë Cost of beginning inventory. Ì Net purchases for the period. Í The historical gross margin rate.    

7-89 Because of a May 31st fire at its warehouse, DonCo, Inc. must use the gross margin method to estimate the value of its lost inventory. The controller develops the following information: gross profit 43% of sales; Inventory at May 1 $237,400; net purchases for May $728,300; net sales for May $1,213,000. Let’s estimate inventory at May 31. Gross Margin Method

7-90 Gross Margin Method Beginning inventory, May 1237,400$ Net purchases for May728,300 Cost of goods available for sale965,700$

7-91 Gross Margin Method Beginning inventory, May 1237,400$ Net purchases for May728,300 Cost of goods available for sale965,700$ Net sales for May1,213,000$ Estimated gross profit percentage43% Estimated gross profit521,590$

7-92 Gross Margin Method Beginning inventory, May 1237,400$ Net purchases for May728,300 Cost of goods available for sale965,700$ Net sales for May1,213,000$ Estimated gross profit percentage43% Estimated gross profit521,590$ Net sales for May1,213,000$ Estimated gross profit521,590 Estimated cost of goods sold691,410$

7-93 Gross Margin Method Beginning inventory, May 1237,400$ Net purchases for May728,300 Cost of goods available for sale965,700$ Net sales for May1,213,000$ Estimated gross profit percentage43% Estimated gross profit521,590$ Net sales for May1,213,000$ Estimated gross profit521,590 Estimated cost of goods sold691,410$ Cost of goods available for sale965,700$ Less: Estimated cost of goods sold691,410 Estimated inventory, May 31274,290$

7-94 Gross Margin Method Proof of Estimate Sales for May1,213,000$ Cost of goods sold: Beginning inventory237,400$ Net purchases728,300 Cost of goods available for sale965,700 Estimated ending inventory274,290 Cost of goods sold691,410 Gross profit for May521,590$ 269

7-95 THE END (Almost)