1. Inventories and cost of goods sold
Chapter 6
Inventories and cost of goods sold
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2. Assigning Costs to Inventory
Accounting for inventory requires several decisions which include:
Items to include in cost.
Inventory System.
Perpetual or Periodic
Costing Method.
FIFO, LIFO, Moving Weighted Average, Specific ID
Use of estimates.
Gross profit method, Retail inventory method
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3. Items in Merchandise Inventory
Inventory includes all goods owned by a company and held for sale.
Items requiring special attention:
Goods in Transit
Goods on consignment
Obsolete or damaged goods
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4. Costs of Merchandise Inventory
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
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5. Assigning Costs to Inventory
Management must decide on method of determining unit cost.
This will affect both the income statement and the balance sheet.
Methods:
Specific Identification
FIFO
LIFO
Average Cost
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6. Merchandising Cost Flows
Beginning
Inventory
Net Cost
of Purchases
Merchandise
Available
for Sale
Balance Sheet
Income Statement
Ending
Inventory
Cost of
Goods Sold
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7. Use of Inventory Methods in Practice
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8. Specific Identification
This method is used when items:
Are unique.
Can be directly identified with a specific purchase and its invoice.
Examples: Automobiles, art custom furniture.
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9. Specific Identification — Example
The opening inventory consists of 10 $91/unit.
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10. Specific Identification — Example
This results in two layers of inventory.
Additional units are $106/unit.
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11. Specific Identification — Example
On August 14, 20 units are sold. Eight of these units came from the opening inventory and the remaining 12 units came from the August 3 purchase.
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12. Specific Identification — Example
This leaves 2 units remaining from the original inventory and 3 units remaining from the August 3 purchase.
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13. Moving Weighted Average Method
Under this method, the cost of all units are averaged together.
Average cost per unit
Cost of goods available for sale
Number of units available for sale =
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14. Moving Weighted Average - Example
The opening inventory consists of 10 $91/unit.
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15. Moving Weighted Average- Example
Additional units are $106/unit.
This results in an average cost of $100/unit.
(10 x $91) + (15 x $106)
25 units
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16. Moving Weighted Average- Example
These 20 units are sold at the average cost of $100/unit.
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17. Moving Weighted Average- Example
This leaves 5 units remaining at an average cost of $100/unit.
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18. © 2007 McGraw-Hill Ryerson Ltd.
Mini-Quiz
A company that uses a perpetual inventory system made the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a Moving Weighted Average system is used.
Cash
Sales (40x16)
Cost of goods sold 430
Inventory
(100x x12)/160 x 40
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19. First-In, First-Out (FIFO)
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 inventory.
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20. FIFO — Example The opening inventory consists of 10 units @ $91/unit.
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21. © 2007 McGraw-Hill Ryerson Ltd.
FIFO — Example
This results in two layers of inventory.
Additional units are $106/unit.
Additional units re $106/unit.
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22. © 2007 McGraw-Hill Ryerson Ltd.
FIFO — Example
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.
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23. © 2007 McGraw-Hill Ryerson Ltd.
FIFO — Example
The remaining 10 units sold on August 14th come from the next purchase, made on August 3rd. Therefore, these units are removed from the inventory record based on their cost of $106.
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24. © 2007 McGraw-Hill Ryerson Ltd.
FIFO — Example
The ending inventory consists of the 5 remaining units from the August 3 purchase.
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25. © 2007 McGraw-Hill Ryerson Ltd.
Mini-Quiz
A company that uses a perpetual inventory system made the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a FIFO system is used.
Cash
Sales (40x16)
Cost of goods sold 400
Inventory (40x10)
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26. Last-In, First-Out (LIFO)
Based on the assumption that the most recently purchased items are sold first.
When a sale occurs:
The latest units purchased are charged to Cost of Goods Sold.
The cost of the earliest purchases remain in inventory.
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27. LIFO — Example The opening inventory consists of 10 units @ $91/unit.
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28. © 2007 McGraw-Hill Ryerson Ltd.
LIFO — Example
This results in two layers of inventory.
Additional units are $106/unit.
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29. LIFO — Example
Of the 20 units sold, these units are assumed to be sold first.
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30. © 2007 McGraw-Hill Ryerson Ltd.
LIFO — Example
Once the latest units purchased are sold, units are sold from the previous purchase.
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31. LIFO — Example This leaves 5 units remaining from the first purchase.
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32. © 2007 McGraw-Hill Ryerson Ltd.
Mini-Quiz
A company that uses a perpetual inventory system made the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a LIFO system is used.
Cash
Sales (40x16)
Cost of goods sold 480
Inventory (40x12)
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33. © 2007 McGraw-Hill Ryerson Ltd.
Financial Reporting
Because prices change, the choice of an inventory method is important.
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34. Advantages of Each Method
Financial Reporting
Advantages of Each Method
Weighted Average
Smoothes out purchase price changes.
Last-In, First-Out
Better matches current costs in cost of goods sold with revenues.
First-In, First-Out
Ending inventory approximates current replacement cost.
First-In, First-Out
Ending inventory approximates current replacement cost.
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35. © 2007 McGraw-Hill Ryerson Ltd.
Financial Reporting
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).
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36. © 2007 McGraw-Hill Ryerson Ltd.
Lower of Cost or Market
Inventory must be reported at market value when market is lower than cost (conservatism principle).
Market may be defined as:
Net realizable value
Current replacement cost
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37. © 2007 McGraw-Hill Ryerson Ltd.
Lower of Cost or Market
May be applied in one of three ways:
Separately to each item.
To major categories of items.
To the inventory as a whole.
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38. © 2007 McGraw-Hill Ryerson Ltd.
Inventory Errors
Errors in the computation of or physical count of inventory will cause a misstatement of:
Cost of goods sold
Gross profit
Net income
Current assets
Owner’s equity
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39. Inventory Errors- Effects on the Income Statement
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40. Inventory Errors- Effects on the Balance Sheet
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41. © 2007 McGraw-Hill Ryerson Ltd.
Review
Describe how management’s decisions can affect the determination of the cost of inventory.
Choice of method –FIFO,LIFO, Moving weighted average, Specific item.
Choice of application of LCM -separate item, categories, whole inventory. Definition of market.
Choice of periodic or perpetual system.
Items to include in cost. Other.
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42. Periodic System-Appendix 7A
The periodic system also uses FIFO, LIFO, specific identification, and weighted average methods to assign costs to inventory and cost of goods sold.
The results may be the same or different under both systems.
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43. Specific Identification- Appendix 7A
Applied in same manner as periodic system.
Yields same results as perpetual system since units are specifically identified.
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44. Weighted Average-Appendix 7A
Steps:
Calculate weighted average unit cost.
(# units beg. Inv. X unit cost) + (#units purchased x unit cost)
# units available for sale
= weighted average unit cost
Use weighted average unit cost to assign costs to cost of goods sold and ending inventory.
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45. © 2007 McGraw-Hill Ryerson Ltd.
FIFO-Appendix 7A
Yields same results as perpetual system since most recent purchases are in ending inventory under both systems.
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46. Inventory Errors in a Periodic System-Appendix 7A
An error in the ending inventory affects the assets, net income, and owner’s equity of that period.
The ending inventory of one period becomes the opening inventory of the next period. The cost of goods sold and net income of the next period are affected as well.
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47. © 2007 McGraw-Hill Ryerson Ltd.
Ratios-Appendix 7B
Inventory ratios may be used to assess:
Short-term liquidity.
Inventory management.
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48. © 2007 McGraw-Hill Ryerson Ltd.
Ratios-Appendix 7B
Merchandise Turnover Ratio
Measures how many times a company turns its inventory over each period.
The ratio will vary from industry to industry.
Merchandise turnover cost of goods sold
average inventory
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49. © 2007 McGraw-Hill Ryerson Ltd.
Ratios-Appendix 7B
Days’ Sales in Inventory
Used to estimate how many days it will take to convert inventory to cash or receivables.
Used to assess if inventory levels can meet sales demand.
Days’ sales in inventory = Ending inventory x 365
Cost of goods sold
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50. © 2007 McGraw-Hill Ryerson Ltd.
End of Chapter
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