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

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

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

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

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

6. 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

7. 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

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

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

10. 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

11. 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

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

13. 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 ÷=

14. 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

15. 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

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

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

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

19. 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

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

21. Copyright © 2007 Prentice-Hall. All rights reserved 21 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 sold903921908* Gross profit$297$279$292 * Rounded

22. Copyright © 2007 Prentice-Hall. All rights reserved 22 Analysis of E6-13, 15, 16 How about the balance sheet? FIFOLIFOAVERAGE Inventory$237$219$233* * Rounded

23. Copyright © 2007 Prentice-Hall. All rights reserved 23 Accounting Principles Consistency Principle Disclosure Principle Materiality Concept Accounting Conservatism

24. Copyright © 2007 Prentice-Hall. All rights reserved 24 Consistency in Reporting A company should use the same accounting methods from period to period so that financial statements are comparable across periods

25. Copyright © 2007 Prentice-Hall. All rights reserved 25 Disclosure Principle Report enough information for outsiders to make wise decisions about the company

26. Copyright © 2007 Prentice-Hall. All rights reserved 26 Materiality Concept A company must perform strictly proper accounting only for significant items

27. Copyright © 2007 Prentice-Hall. All rights reserved 27 Accounting Conservatism Exercise caution in reporting items in the financial statements Report realistic figures

28. Copyright © 2007 Prentice-Hall. All rights reserved 28 Objective 3 Apply the lower-of-cost-or market rule to inventory

29. Copyright © 2007 Prentice-Hall. All rights reserved 29 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

30. Copyright © 2007 Prentice-Hall. All rights reserved 30 Lower-or-Cost-or-Market Rule Must disclose method of valuation in financial statements –As parenthetical in statements or –In notes to financial statements

31. Copyright © 2007 Prentice-Hall. All rights reserved 31 Objective 4 Measure the effects of inventory errors

32. Copyright © 2007 Prentice-Hall. All rights reserved 32 Inventory Errors Ending inventory becomes next year’s beginning inventory Results in misstatement of income statement over two years

33. Copyright © 2007 Prentice-Hall. All rights reserved 33 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

34. Copyright © 2007 Prentice-Hall. All rights reserved 34 Ethical Issues How might companies try to mislead readers of financial statements by manipulating inventory?

35. Copyright © 2007 Prentice-Hall. All rights reserved 35 Objective 5 Estimate ending inventory by the gross profit method

36. Copyright © 2007 Prentice-Hall. All rights reserved 36 Gross Profit Method Estimate ending inventory by applying the gross profit ratio to net sales Useful when inventory has been destroyed, lost, or stolen

37. Copyright © 2007 Prentice-Hall. All rights reserved 37 Things to Remember Compute Gross Profit: Sales - Cost of Goods Sold Gross Profit Compute Gross Profit Percent: Gross Profit / Net Sales

38. Copyright © 2007 Prentice-Hall. All rights reserved 38 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

39. Copyright © 2007 Prentice-Hall. All rights reserved 39 End of Chapter 6