1. Chapter 7 Reporting and Interpreting Inventories and Cost of Goods Sold 1© McGraw-Hill Ryerson. All rights reserved.

2. Inventory Management © McGraw-Hill Ryerson. All rights reserved.2 LO1 The goals of inventory management are to: – Maintain a sufficient quantity to meet customers’ needs. – Ensure inventory quality. – Minimize the cost of acquiring and carrying inventory.

3. Types of Inventory © McGraw-Hill Ryerson. All rights reserved.3 Merchandise companies hold: LO1 Merchandise Inventory Finished Goods Inventory Work in Process Inventory Raw Materials Inventory Consignment inventory are goods held on behalf of the owner. Goods in transit are inventory items being transported. Manufacturing companies hold:

4. Balance Sheet and Income Statement Reporting © McGraw-Hill Ryerson. All rights reserved.4 Inventory is reported on the Balance Sheet as a current asset. When inventory is sold, its cost is removed from the Inventory account and recorded in Cost of Goods Sold on the Income Statement. LO2

5. Cost of Goods Sold Equation © McGraw-Hill Ryerson. All rights reserved.5 Beginning Inventory $4,800 Purchases $10,200 + = Goods Available for Sale $15,000 Still Here Sold Ending Inventory $6,000 (Balance Sheet) Cost of Goods Sold $9,000 (Income Statement) LO2

6. © McGraw-Hill Ryerson. All rights reserved.6 Beginning Inventory + Purchases = Goods Available for Sale – Cost of Goods Sold = Ending Inventory Income Statement Balance Sheet BI + P – CGS = EI LO2

7. Inventory Costing Methods © McGraw-Hill Ryerson. All rights reserved.7 Weighted Average First-in, first- out (FIFO) Specific Identification Consider the following information: May 3 purchased 1 unit for $70 May 5 purchased 1 more unit $75 May 6 purchased 1 more unit $95 May 8 sold 2 units for $125 each LO3

8. Specific Identification © McGraw-Hill Ryerson. All rights reserved.8 Specific Identification identifies the cost of the specific items that were sold. The items purchased May 3 and May 6 were sold. Therefore Cost of Goods Sold is $165. The item purchased May 5 is still in inventory. Therefore the ending balance in Inventory is $75. Cost of Goods Sold Ending Inventory LO3

9. First-in, first-out (FIFO) © McGraw-Hill Ryerson. All rights reserved.9 First-in, first-out (FIFO) assumes the cost of the first goods purchased is the cost of the first goods sold. The earliest items purchased are assumed to be sold. Therefore Cost of Goods Sold is $145. The last item purchased is assumed to be unsold. Therefore the ending balance in Inventory is $95. Cost of Goods Sold Ending Inventory LO3

10. Weighted Average © McGraw-Hill Ryerson. All rights reserved.10 Weighted average uses the weighted average unit cost for cost of goods sold and ending inventory. The weighted average is calculated $240/3 = $80. Two units were sold, so Cost of Goods Sold is $160. Cost of Goods Sold Ending Inventory LO3 $70 + $75 + $95 3 = $80 per unit One unit is unsold, so the ending balance in Inventory is $80. $160 $80

11. Let’s try it E7-12 © McGraw-Hill Ryerson. All rights reserved.11

12. Inventory Cost Flow Computations © McGraw-Hill Ryerson. All rights reserved.12 Inventory Activity: If FIFO is used: If Weighted Average is used: FIFO allocates the oldest costs to Cost of Goods Sold and the newest costs to Inventory. Weighted Average allocates an average cost to both Cost of Goods Sold and Inventory. LO3

13. © McGraw-Hill Ryerson. All rights reserved.13 Financial Statement Effects The costing method will determine Cost of Goods Sold, Net Income, Income Tax Expense, and Inventory. When costs are rising, FIFO produces a higher inventory value, a lower Cost of Goods Sold, a higher Net Income, and higher Income Tax Expense. When costs are falling, FIFO produces a lower inventory value, a higher Cost of Goods Sold, a lower Net Income, and lower Income Tax Expense. LO3

14. Lower of Cost and Net Realizable Value The value of Inventory can fall below its original cost because: – It can be replaced by identical goods at a lower cost. – It has become outdated or damaged. Lower of cost and net realizable value requires Inventory to be written down when its net realizable value or current replacement cost falls below its original historical cost. Provides conservative valuations and matches the decline in value to the period it occurred. © McGraw-Hill Ryerson. All rights reserved.14 LO4

15. Let’s try it E7-10 © McGraw-Hill Ryerson. All rights reserved.15

16. © McGraw-Hill Ryerson. All rights reserved.16 Inventory Information: Record 2 Analyze 1 No entry required LO4

17. Recording Inventory Transactions © McGraw-Hill Ryerson. All rights reserved.17 Inventory Purchases American Eagle Outfitters purchases $10,500 of vintage jeans on credit with terms 2/10 n/30. 1 Analyze 2 Record LO5

18. © McGraw-Hill Ryerson. All rights reserved.18 Transportation Cost American Eagle Outfitters pays $400 cash to a trucker who delivers the vintage jeans to one of its stores: 1 Analyze 2 Record All costs needed to get inventory into a condition and location ready for sale should be included in Inventory. All costs incurred after the sale, such as delivery of goods to customers, should be treated as selling expenses. LO5

19. © McGraw-Hill Ryerson. All rights reserved.19 Purchase Returns and Allowances American Eagle Outfitters returned some of the vintage jeans to the supplier and received a $500 reduction in the balance owed: LO5 1 Analyze 2 Record Purchase Returns and Allowances are a reduction in the cost of inventory purchases associated with unsatisfactory goods.

20. © McGraw-Hill Ryerson. All rights reserved.20 Purchase Discounts American Eagle Outfitters pays the supplier for the $10,500 purchase of vintage jeans. Remember, the terms were 2/10 n/30 and inventory costing $500 has been returned, so the amount paid within the discount period will be ($10,500 - $500) – 2% = $9,800. Purchase Discounts are cash discounts received for prompt payment of a purchase on account. A purchase discount reduces the cost of inventory. 1 Analyze 2 Record LO5

21. Inventory Turnover Analysis Inventory turnover is the process of buying and selling inventory. © McGraw-Hill Ryerson. All rights reserved.21 The Inventory Turnover Ratio calculates the number of times inventory turns over during one year. Days to sell measures the average number of days from the time inventory is bought until it is sold. LO6

22. © McGraw-Hill Ryerson. All rights reserved.22 Inventory Turnover Ratio Cost of Goods Sold Average Inventory 365 Inventory Turnover Ratio Days to Sell The number of times inventory turns over during the period A higher ratio means faster turnover Average number of days from purchase to sale A higher number means a longer time to sell LO6 Comparison to Benchmarks

23. Supplement 7A Recording Inventory Transactions Using Last-In, First-Out (LIFO) ASPE and IFRS do not permit LIFO. U.S. GAAP does allow LIFO. © McGraw-Hill Ryerson. All rights reserved.23 S-7A

24. Supplement 7B FIFO, LIFO, and Weighted Average in a Perpetual Inventory System © McGraw-Hill Ryerson. All rights reserved.24 Specific Identification and FIFO calculations will not differ between periodic and perpetual systems. Weighted Average and LIFO calculations may differ between periodic and perpetual systems. S-7B

25. FIFO Periodic and Perpetual Comparison © McGraw-Hill Ryerson. All rights reserved.25 Inventory Activity: Cost of Goods Sold will be calculated on October 4 at the time of the sale. Cost of Goods Sold will be calculated at the end of the period. The result of the calculations will be the same. Perpetual Periodic S-7B

26. Weighted Average Periodic and Perpetual Comparison © McGraw-Hill Ryerson. All rights reserved.26 Inventory Activity: Cost of Goods Sold will be calculated on October 4 at the time of the sale. Cost of Goods Sold will be calculated at the end of the period. The result of the calculations will be different. Perpetual Periodic S-7B

27. Financial Statement Effects © McGraw-Hill Ryerson. All rights reserved.27 When prices are rising, LIFO will provide the highest Cost of Goods Sold, lowest Net Income and lowest Income Tax Expense. S-7B

28. Supplement 7C The Effects of Errors in Ending Inventory © McGraw-Hill Ryerson. All rights reserved.28 If Lower of Cost and Net Realizable Value is not applied, or inappropriate quantities or unit costs are used, the ending balance in Inventory may be incorrect. S-7C

29. © McGraw-Hill Ryerson. All rights reserved.29 Assume ending inventory was overstated in 2011 by $10,000 due to an error that was not discovered until 2012. In 2011, Net Income will be overstated by $10,000. In 2012, Net Income will be understated by $10,000. These are errors even though there is no net effect over two years. S-7C