Spiceland | Thomas | Herrmann Financial Accounting Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Inventory and Cost of Goods Sold Chapter 6

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-2 Learning Objectives Trace the flow of inventory costs from manufacturing companies to merchandising companies Understand how cost of goods sold is reported in a multiple-step income statement Determine the cost of goods sold and ending inventory using different inventory cost methods Explain the financial statement effects and tax effects of inventory cost flow assumptions

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-3 Learning Objectives Record inventory transactions using a perpetual inventory system Apply the lower-of-cost-or-market method for inventories Analyze management of inventory using the inventory turnover ratio and gross profit ratio Record inventory transactions using a periodic inventory system Determine the financial statement effects of inventory errors

Part A Understanding Inventory and Cost of Goods Sold Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-4

Learning Objective 1 Trace the flow of inventory costs from manufacturing companies to merchandising companies Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-5

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-6 Inventory Includes items a company intends for sale to customers Also includes items that are not yet finished products Reported as a current asset Cost of goods sold: Cost of the inventory that is sold during the period

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-7 Manufacturing and Merchandising Companies Inventory Merchandise company Merchandise company Manufacturing company Manufacturing company Wholesaler Retailer Raw material Raw material Work in Progress Work in Progress Finished goods Finished goods

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-8 Illustration 6.2— Types of Companies and Flow of Inventory Costs

Learning Objective 2 Understand how cost of goods sold is reported in a multiple-step income statement Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-9

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Illustration 6.4—Multiple-Step Income Statement

Learning Objective 3 Determine the cost of goods sold and ending inventory using different inventory cost methods Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-11

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Inventory Cost Methods Specific identification First-in, first-out (FIFO) Last-in, first-out (LIFO) Weighted-average cost

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Weighted-Average Cost Under this method, we assume: Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale Each unit of inventory has a cost equal to the weighted-average unit cost of all inventory items Calculated as: Cost of goods available for sale Number of units available for sale

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Illustration 6.9—Comparison of the Three Inventory Cost Flow Assumptions

Learning Objective 4 Explain the financial statement effects and tax effects of inventory cost flow assumptions Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-15

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Choice of Inventory Reporting Methods FIFO method Matches physical flow for most companies Ending inventory reflects today’s costs Balance-sheet approach LIFO method Cost of goods sold reflects today’s costs Income-statement approach LIFO conformity rule: requires companies that use LIFO for tax reporting to also use LIFO for financial reporting

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Reporting the LIFO Difference LIFO Difference Companies that choose LIFO must report the difference if it used FIFO instead of LIFO Example—Impact of the LIFO Difference on Reported Inventory

Part B Recording Inventory Transactions Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-18

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Perpetual Inventory System and Periodic Inventory System Perpetual Inventory System Maintains a continual track of inventory Helps a company better manage inventory levels Periodic Inventory System Does not maintain a continual track of inventory Periodically adjusts for purchase and sale of inventory Reports inventory based on a physical count

Learning Objective 5 Record inventory transactions using a perpetual inventory system Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-20

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education LIFO Adjustment Used to convert a company’s own inventory records maintained on a FIFO basis to LIFO basis for preparing financial statements The difference in reported inventory when using LIFO instead of FIFO is commonly referred to as the LIFO reserve

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Additional Inventory Transactions Freight charges Freight-in Freight-out Purchase discounts Purchase returns

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Illustration 6.15—Shipping Terms

Part C Lower-of-Cost-or-Market Method Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-24

Learning Objective 6 Apply the lower-of-cost-or-market method for inventories Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-25

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Lower-of-Cost-or-Market Method Reports inventory in the balance sheet at the lower of cost or market value Replacement cost Cost to replace an inventory item in its identical form

Learning Objective 7 Analyze management of inventory using the inventory turnover ratio and gross profit ratio Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-27

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Inventory Turnover Ratio Shows the number of times the firm sells its average inventory balance during a reporting period

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Average Days in Inventory Indicates the approximate number of days the average inventory is held

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Gross Profit Ratio Indicator of the company’s successful management of inventory Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales

Learning Objective 8 Record inventory transactions using a periodic inventory system Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-31

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Periodic Inventory System Does not continually modify inventory amounts Periodically adjust for purchases and sales of inventory At the end of the reporting period Based on a physical count of inventory on hand

Learning Objective 9 Determine the financial statement effects of inventory errors Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-33

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Illustration 6.26—Effects in the Current Year

End of Chapter 6 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-35