Inventory and Cost of Goods Sold

Inventory and Cost of Goods Sold
Chapter 7 Inventory and Cost of Goods Sold PowerPoint Author: Brandy Mackintosh, CA Chapter 7: Inventory and Cost of Goods Sold.

Describe the issues in managing different types of inventory.
Learning Objective 7-1 Describe the issues in managing different types of inventory. Learning objective number 7-1 is to describe the issues in managing different types of inventory.

Inventory Management Decisions
The primary goals of inventory managers are to: 1. Maintain a sufficient quantity of inventory to meet customers’ needs 2. Ensure quality meets customers’ expectations and company standards 3. Minimize the costs of acquiring and carrying the inventory As an inventory manager you must be sure there are sufficient quantities on hand to meet customer needs. Additionally, you must ascertain that the quality of your inventory meets customers’ expectations and your own company’s standards, and you must control the cost of acquiring and storing inventory.

Types of Inventory Merchandisers . . . Buy finished goods.
Sell finished goods. Manufacturers . . . Buy raw materials. Produce and sell finished goods. Raw Materials Work in Process Finished goods Merchandise inventory Materials waiting to be processed Partially complete products Completed products awaiting sale Part I Merchandising companies purchase finished goods from suppliers for resale to customers. Manufacturing companies purchase raw materials from suppliers and produce and sell finished goods to customers. Part II Manufacturing companies report three types of inventory on their balance sheets: raw materials, work in process and finished goods. Merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheet labeled merchandise inventory. Part III Raw materials are the materials used to make the product. Work in process consists of units of product that are partially complete, but will require further work to be saleable to customers. Finished goods consists of units of product that have been completed, but not yet sold to customers. We focus on merchandise inventory, but be aware that the concepts we cover apply equally to manufacturers’ inventory.

Explain how to report Inventory and Cost of Goods Sold.
Learning Objective 7-2 Explain how to report Inventory and Cost of Goods Sold. Learning objective number 7-2 is to explain how to report inventory and cost of goods sold.

Balance Sheet and Income Statement Reporting
Part I Because inventory will be used or converted into cash within one year, it is reported on the balance sheet as a current asset. Part II When a company sells goods, it removes their cost from the Inventory account and reports the cost on the income statement as the expense Cost of Goods Sold. Cost of Goods sold is deducted from Net Sales to obtain Gross Profit.

Cost of Goods Sold Equation
Periodic Updating: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold Perpetual Updating: Beginning Inventory + Purchases – Cost of Goods Sold = Ending Inventory Chapter 6 explained that the balance sheet account Inventory is related to the income statement account Cost of Goods Sold through the cost of goods sold equation. The cost of goods sold equation can take one of two forms, depending on whether the inventory costs are updated periodically at year-end (or month-end) when inventory is counted, or perpetually each time inventory is bought or sold.

Cost of Goods Sold Equation
A company has beginning inventory of 5 units that each cost $10, then purchases 20 units with a cost of $10 each, sells 15 units, and is left with 10 units in ending inventory. Part I This slide illustrates how to use these equations with a simple case where a company has beginning Inventory of 5 units that each cost $10, then purchases 20 units with a cost of $10 each, sells 15 units, and is left with 10 units in ending Inventory. Part II The first table shows that in a periodic inventory system, you must calculate the cost of ending Inventory and then use the cost of goods sold equation to “force out” the Cost of Goods Sold. Part III In a perpetual inventory system, the Cost of Goods Sold is updated with each inventory transaction, which “forces” out” the cost of ending Inventory.

Compute costs using four inventory costing methods.
Learning Objective 7-3 Compute costs using four inventory costing methods. Learning objective number 7-3 is to compute costs using four inventory costing methods.

Inventory Costing Methods
Specific identification First-in, first-out (FIFO) Last-in, first-out (LIFO) In the example presented in the previous slide, the cost of all units of the item was the same—$10. When the costs of inventory change over time, it is not obvious how to determine the cost of goods sold and the cost of ending inventory. For example, we may purchase several inventory items for $10 each. The next time we need to purchase the same item, the cost may have risen to $11 each. When we sell any of these items we must decide if we will use the $10 cost or the $11 cost, or some other cost between the two. There are four generally accepted inventory costing methods available for determining the cost of goods sold and the cost of goods remaining in ending inventory, regardless of whether a company uses a perpetual or periodic inventory system. They include specific identification, first-in, first-out, also called FIFO, last-in, first-out, also called LIFO, and weighted average cost. Weighted average

Consider the following information May 6 $95 cost May 3 May 5 May 6 May 8 Purchased 1 unit for $70 Purchased 1 more unit for $75 Purchased 1 more unit for $95 Sold 2 units for $125 each May 5 $75 cost May 3 $70 cost Specific Identification This method individually identifies and records the cost of each item sold as part of cost of goods sold. If the items sold were identified as the ones that cost $70 and $95, the total cost of those items ($ = $165) would be reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance sheet at the end of the period. The specific identification method individually identifies and records the cost of each item sold as part of cost of goods sold. This method requires accountants to keep track of the purchase cost of each item. In the example just given, if the items sold were identified as the ones that cost $70 and $95, the total cost of those items ($ = $165) would be reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance sheet at the end of the period. The specific identification method is used primarily to account for individually expensive and unique items. Toll Brothers, the country’s leading builder of luxury homes, reports the costs of home construction using the specific identification method. Car Max, a national auto dealership, also uses specific identification.

FIFO LIFO Weighted average May 6 $95 cost May 5 $75 cost May 3 $70 cost May 6 $95 cost May 5 $75 cost May 3 $70 cost May 6 $95 cost May 5 $75 cost May 3 $70 cost Sold Still there Income Statement Net Sales Cost of Goods Sold Gross Profit $250 145 $105 Balance Sheet Inventory $95 Sold Still there Income Statement Net Sales Cost of Goods Sold Gross Profit $250 170 $ 80 Balance Sheet Inventory $70 $80 per unit Sold Still there $240 3 = Income Statement Net Sales Cost of Goods Sold Gross Profit $250 160 $ 90 Balance Sheet Inventory $80 Part I Here we see the three purchases. Note that the purchases amounts are the same for each cost flow method. Next we will see the differences in Cost of Goods Sold and ending Inventory for each of the three cost flow methods, beginning with FIFO. Part II First-in, first-out (FIFO) assumes that the inventory costs flow out in the order the goods are received. The earliest items received, the $70 and $75 units received on May 3 and 5, become the $145 Cost of Goods Sold on the income statement and the remaining $95 unit received on May 6 becomes ending Inventory on the balance sheet. Part III Last-in, first-out (LIFO) assumes that the inventory costs flow out in the opposite of the order the goods are received. The latest items received, the $95 and $75 units received on May 6 and 5, become the $170 Cost of Goods Sold on the income statement, and the remaining $70 unit received on May 3 becomes ending Inventory on the balance sheet. Part IV Weighted average uses the weighted average of the costs of goods available for sale for both the cost of each item sold and those remaining in inventory. The average of the costs [($ ) divided by 3 = $80] is assigned to the two items sold totaling $160 Cost of Goods Sold and to the one item in ending Inventory ($80).

Summary Cost of Goods Sold (Income Statement) Inventory (Balance Sheet) FIFO Oldest cost Newest cost LIFO Weighted Average Average cost Let’s consider a more complex example. Date Oct 1 Oct 3 Oct 5 Oct 6 Description Beginning Inventory Purchase Sales Ending Inventory # of Units 10 30 (35) 15 Cost per Unit $ 7 $ 8 $10 To calculate Total Cost $ 240 100 Part I The oldest costs are in Cost of Goods Sold and the newest costs are in Inventory using the FIFO method. The oldest costs are in Inventory and the newest costs are in Cost of Goods Sold using the LIFO method. Weighted average is a middle-of-the-road method. Part II Now that you’ve seen how these cost flow assumptions work and that they actually make a difference in a company’s balance sheet and income statement, we are ready for a more complex example. So, let’s assume that during the first week of October American Eagle entered into the following transactions for its Henley T-shirt product line. All sales were made at a selling price of $15 per unit. These sales occurred after American Eagle made two batches of T-shirt purchases, which were added to beginning Inventory.

Inventory Cost Flow Computations
FIFO + - = beginning Inventory purchases cost of goods available for sale ending Inventory Cost of Goods Sold units x $ = $ 70 units x $ = units x $ = $ 410 140 $ 270 (10 $10) + (5 $8) (10 $7) + (25 $8) Part I Cost of goods available for sale of $410 equals the dollar amount of beginning Inventory plus dollar amount of the two purchases. Part II The first-in, first-out (FIFO) method assumes that the costs of the newer goods are included in the cost of the ending Inventory (all 10 units from the 10-unit purchase at $10 plus 5 units remaining from the 30-unit purchase at $8 equals a total of $140). Part III The cost of the oldest goods (the first in to Inventory) are the first ones sold (the first out of Inventory). So to calculate the cost of the 35 units sold, use the costs of the first-in (oldest) goods (all 10 units from beginning Inventory at $7 plus 25 units of the 30-unit purchase at $8 equals a total of $270). Part IV You will notice that ending Inventory and Cost of Goods Sold when added together equal the cost of goods available for sale.

LIFO + - = beginning Inventory purchases cost of goods available for sale ending Inventory Cost of Goods Sold units x $ = $ 70 units x $ = units x $ = $ 410 110 $ 300 (10 $7) + (5 $8) (10 $10) + (25 $8) Part I Cost of goods available for Sale of $410 equals the dollar amount of beginning Inventory plus dollar amount of the two purchases. Part II The last-in, first-out (LIFO) method assumes that the costs of the older goods are included in the cost of the ending Inventory (all 10 units from beginning Inventory at $7 plus 5 units remaining from the 30-unit purchase at $8 equals a total of $110). Part III The cost of the newest goods (the last in to Inventory) are the first ones sold (the first out of Inventory). So to calculate the cost of the 35 units sold, use the costs of the last-in (newest) goods (10 units at $10 plus 25 of the 30 units at $8 equals a total of $300). Part IV You will notice that ending Inventory and Cost of Goods Sold when added together equal the cost of goods available for sale.

Weighted Average Description beginning Inventory purchase cost of goods available for sale # of Units 10 30 50 Cost per Unit $ 7 $ 8 $10 Total Cost $ 240 100 $ 410 Part I Cost of goods available for sale of $410 equals the dollar amount of beginning Inventory plus dollar amount of the two purchases. Fifty units are available for sale. Part II The weighted average unit cost is equal to the cost of goods available for sale divided by the number of units available for sale. Part III The weighted average unit cost is equal to $410 divided by 50 units, $8.20 per unit. Cost of Goods Sold and ending Inventory are both calculated using the same weighted average cost per unit. Weighted Average Cost Cost of goods Available for Sale Number of Units Available for Sale = Weighted Average Cost $ units = = $8.20 per unit

Weighted Average + - = Beginning Inventory Purchases Cost of Goods Available for Sale Ending Inventory Cost of Goods Sold units x $ = $ 70 units x $ = units x $ = $ 410 123 $ 287 15 $8.20 35 $8.20 Part I Cost of Goods Available for Sale of $410 equals the dollar amount of beginning Inventory plus dollar amount of the two purchases. Part II Ending Inventory of 15 units at the weighted average unit cost $8.20 is equal to $123. Part III Cost of Goods Sold of 35 units at the weighted average unit cost $8.20 is equal to $287. Part IV You will notice that ending Inventory and Cost of Goods Sold when added together equal the cost of goods available for sale.

Financial Statement Effects
Effects on the Income Statement Sales Cost of Goods Sold Gross Profit Operating Expenses Income from Operations Other Revenue (Expenses) Income before Income Tax Expense Income Tax Expense (30%) Net Income Effects on the Balance Sheet Inventory Weighted Average $ 287 238 125 113 20 133 40 $ $ LIFO 300 225 100 120 36 $ $ FIFO 270 255 130 150 45 $ $ The costing methods differ only in the way they split the cost of goods available for sale between ending Inventory and Cost of Goods Sold. If a cost goes into Inventory, it doesn’t go into Cost of Goods Sold. So, the method that assigns the highest cost to ending Inventory will assign the lowest cost to Cost of Goods Sold (and vice versa).

Depending on whether costs are rising or falling, different methods have different effects on the financial statements. When costs are rising, as they are in our example, FIFO produces a higher Inventory value (making the balance sheet appear to be stronger) and a lower Cost of Goods Sold (resulting in a higher gross profit, which makes the company look more profitable). When costs are falling, these effects are reversed; FIFO produces a lower ending Inventory value and a higher Cost of Goods Sold—a double whammy. These are not “real” economic effects, however, because the inventory cost flow assumption does not affect the number of units sold or held in ending Inventory.

Tax Implications and Cash Flow Effects
Effects on the Income Statement Sales Cost of Goods Sold Gross Profit Operating Expenses Income from Operations Other Revenue (Expenses) Income before Income Tax Expense Income Tax Expense (30%) Net Income Effects on the Balance Sheet Inventory Weighted Average $ 287 238 125 113 20 133 40 $ $ LIFO 300 225 100 120 36 $ $ FIFO 270 255 130 150 45 $ $ Let’s revisit our income statements and balance sheets for the three cost flow methods. Given the financial statement effects, you might wonder why a company would ever use a method that produces a lower Inventory amount and a higher Cost of Goods Sold. The answer is suggested in the line called Income Tax Expense. When faced with increasing costs per unit, as in our example, a company that uses FIFO will have a higher Income Tax Expense. This income tax effect is a real cost, in the sense that the company will actually have to pay more income taxes in the current year, thereby reducing the company’s cash.

Report inventory at the lower of cost or market.
Learning Objective 7-4 Report inventory at the lower of cost or market. Learning objective number 7-4 is to report inventory at the lower of cost or market.

Lower of Cost or Market The value of inventory can fall below its recorded cost for two reasons: it’s easily replaced by identical goods at a lower cost, or it’s become outdated or damaged. When the value of inventory falls below its recorded cost, the amount recorded for inventory is written down to its lower market value. This is known as the lower of cost or market (LCM) rule. Part I The value of inventory can fall below its recorded cost for two reasons: (1) it’s easily replaced by identical goods at a lower cost or (2) it’s become outdated or damaged. The first case is common for high-tech electronics. As companies become more efficient at making these cutting-edge products, they become cheaper to make. The second case commonly occurs with fad items or seasonal goods such as American Eagle ’s winter coats, which tend to drop in value at the end of the season. Part II Regardless of the inventory costing method used, all companies must report inventory at lower of cost or market. When the value of ending Inventory falls because of lower replacement costs or outdated items, we should report the inventory at its market value rather than the higher cost amount. This is known as the lower of cost or market (LCM) rule. When we write down inventory from cost to market, we recognize a loss that will appear on the income statement.

Lower of Cost or Market 1,000 items @ $165 1,000 items @ $150
Leather coats Vintage jeans Cost per $165 20 Market Value per Item $150 25 LCM Quantity 1,000 400 Total Lower of cost or Market $150,000 8,000 Total cost $165,000 Write- down $15,000 1,000 $150 400 $20 1 Analyze Liabilities Assets = Stockholders’ Equity + Inventory $15,000 Cost of Goods Sold (+E) $15,000 Part I Assume that American Eagle’s ending Inventory includes two items whose market values have recently changed: leather coats and vintage jeans. The estimated values of these items can be used as market value and compared to the original recorded cost per unit. You then take the lower of those two amounts (the lower of cost or market) and multiply it by the number of units on hand. The result ($150,000 for leather coats and $8,000 for vintage jeans) is the amount at which the Inventory should be reported after all adjustments have been made. Part II Because the market value of the 1,000 leather coats ($150 x 1,000) is lower than the recorded cost ($165 x 1,000), the recorded amount for ending Inventory should be written down by $15 per unit ($165 - $150). If American Eagle has 1,000 units in Inventory, the total write-down should be $15,000 ($15 × 1,000). Because the market value of the vintage jeans ($25) is higher than the original cost ($20) no write-down is necessary. The vintage jeans remain on the books at their cost of $20 per unit ($8,000 in total). Their value should not be increased based on the higher market value because GAAP requires that they be reported at the lower of cost or market. Most companies report their Inventory write-down expense as Cost of Goods Sold, even though the written-down goods may not have been sold. This reporting is appropriate because writing down goods that haven’t yet sold is a necessary cost of carrying the goods that did sell. By recording the write-down in the period in which a loss in value occurs, companies better match their revenues and expenses of that period. 2 Record Cost of Goods Sold Inventory 15,000

Lower of Cost or Market On June 10, 2013, Lululemon reported a $17.5 million LCM write-down for its recalled black yoga pants that became see-through when stretched during yoga. The write-down caused a major drop in gross profit percentage for the quarter (from 55 to 50 percent), and coincided with LULU’s CEO resigning. Investors reacted to this bad news by immediately selling their LULU shares. Within just one day of the announcement, the company’s stock price plunged by 17 percent, from $82 to $68. Because investors and analysts view an inventory LCM write-down as a sign of inventory management problems, some executives go out of their way to avoid them. The failure to follow inventory LCM rules is one of the most common types of financial statement misstatements.

Learning Objective 7-5 Evaluate inventory management by computing and interpreting the inventory turnover ratio. Learning objective number 7-5 is to evaluate inventory management by computing and interpreting the inventory turnover ratio.

Inventory Turnover Analysis
Part I As a company buys goods, its inventory balance goes up; as it sells goods, its inventory balance goes down. This process of buying and selling, which is called inventory turnover, is repeated over and over during each accounting period for each line of products. Part II The method most analysts use to evaluate such changes is called inventory turnover analysis. Analysts can assess how many times, on average, inventory has been bought and sold during the period by calculating the inventory turnover ratio (Cost of Goods Sold divided by Average Inventory). A higher ratio indicates that inventory moves more quickly from purchase to sale, reducing storage and obsolescence costs and tying up less money in inventory. Rather than evaluate the number of times inventory turns over during the year, some analysts prefer to think in terms of the length of time (in days) required to sell inventory. Converting the inventory turnover ratio to the number of days needed to sell the inventory is easy. You simply divide 365 days by the inventory turnover ratio to get the days to sell. More efficient purchasing and production techniques as well as high product demand will boost the inventory turnover ratio. A sudden decline in the inventory turnover ratio may signal an unexpected drop in demand for the company’s products or sloppy inventory management.

Comparison to Benchmarks
Inventory turnover ratios and the number of days to sell can be helpful in comparing different companies’ inventory management practices. But use them cautiously because these measures can vary significantly between industries. For merchandisers, inventory turnover refers to buying and selling goods, whereas for manufacturers, it refers to producing inventory and delivering it to customers. These differences are reflected in the company comparisons on the slide. McDonald’s has a turnover ratio of 51.7, which means it takes about 7 days to sell its entire food inventory (including the stuff in its freezers). The motorcycles at Harley-Davidson hog more time, as indicated by its inventory turnover ratio of 8.3, which equates to nearly 44 days to produce and sell. American Eagle’s inventory turned over only 7.1 times during the year, which is just once every days.

FIFO, LIFO, and Weighted Average in a Perpetual Inventory System
Supplement 7A FIFO, LIFO, and Weighted Average in a Perpetual Inventory System Supplement 7A: FIFO, LIFO, and Weighted Average in a Perpetual Inventory System.

Compute inventory costs in perpetual systems.
Learning Objective 7-S1 Compute inventory costs in perpetual systems. Learning objective number 7-S1 is to compute inventory costs in perpetual systems.

Perpetual Inventory System
This is the same information that we used earlier in the chapter to illustrate a periodic inventory system. The only difference is that we have assumed the sales occurred on October 4, prior to the final inventory purchase. To Illustrate a perpetual inventory system, we will use the same information that we used earlier in the chapter to illustrate a periodic inventory system. The only difference is that we have assumed the sales occurred on October 4, prior to the final inventory purchase.

FIFO (First-in, First-Out)
Part I The first-in, first-out (FIFO) method assumes that the oldest goods (the first in to inventory) are the first ones sold (the first out of inventory). So to calculate the cost of the 35 units sold, use the costs of the first-in (oldest) goods (10 units at $7 plus 25 of the 30 units at $8 equals a total of $270). Part II The costs of the newer goods are included in the cost of the ending Inventory (5 units remaining from the 30 units at $8 plus 10 units at $10 equals a total of $140). Part III Here you see the periodic computations for comparison. Using the periodic system, a physical count of ending inventory is used to compute the ending Inventory balance. As you can see, FIFO yields identical amounts under perpetual and periodic.

LIFO (Last-in, First-Out)
Part I The last-in, first-out (LIFO) method assumes that the newest goods (the last in to inventory) as of the date of the sale are the first ones sold (the first out of inventory). So to calculate the cost of the 35 units sold, use the costs of the last-in (newest) goods as of the October 4 sale (30 $8 plus 5 of the 10 $7 from beginning Inventory equals a total of $275). Part II The costs of the older goods (5 units remaining from the 10 units of beginning $7 equals $35) plus the October 5 purchase (10 $10 equals $100) are included in the cost of the ending Inventory ($35 + $100 = $135). Part III Here you see the periodic computations for comparison. Notice that LIFO–Perpetual calculates Cost of Goods Sold using the cost of goods last-in at the time of the sale, whereas LIFO–Periodic uses the cost of goods last-in at the end of the period.

Weighted Average Cost $310 ÷ 40 units = $7.75 per unit Part I
In a perpetual inventory system, the weighted average cost must be calculated each time a sale is recorded by dividing the total cost of the goods available for sale, at the time of the sale, by the number of units available for sale. The weighted average cost at the time of sale on October 4 is calculated by dividing $310 by the 40 units available for sale on October 4 ($310 ÷ 40 units = $7.75 per unit). This cost is then multiplied by the number of units sold to calculate Cost of Goods Sold (35 units × $7.75 per unit = $271.25). Part II The remaining 5 units are also valued at the same weighted average cost (5 units × $7.75 per unit = $38.75). Additional inventory purchases on October 5 ($100) are added to these inventory costs to calculate the cost of ending Inventory ($ $100 = $138.75). The new weighted average cost per unit after the October 5 purchase is $9.25. ($ ÷ 15 units = $9.25 per unit). Notice the change in weighted average cost from $7.75 to $9.25 per unit. Because the weighted average unit cost changes, weighted average perpetual is also called the moving average method. Part III Here you see the periodic computations for comparison. Notice that the weighted average unit cost is computed only once in a periodic system, at the end of the period.

Summary of Perpetual Inventory System Cost Flow Assumptions on Financial Statements Here you see a summary of the financial statement effects of using a perpetual inventory system with FIFO, LIFO, or weighted average cost methods. These methods differ only in the way they split the cost of goods available for sale between ending Inventory and Cost of Goods Sold. If a cost goes into Cost of Goods Sold, it must be taken out of Inventory. The method that assigns the highest cost to Cost of Goods Sold assigns the lowest cost to ending Inventory (and vice versa).

The Effects of Errors in Ending Inventory
Supplement 7B The Effects of Errors in Ending Inventory Supplement 7B: The Effects of Errors in Ending Inventory

Determine the effects of inventory errors.
Learning Objective 7-S2 Determine the effects of inventory errors. Learning objective number 7-S2 is to determine the effects of inventory errors.

Errors in Ending Inventory will affect the Balance Sheet and the Income Statement. Cost of Goods Sold Equation BI + P – EI = CGS Assume that Ending Inventory was overstated in Year 1 by $10,000 due to an error that was not discovered until Year 2. Part I Errors in inventory can significantly affect both the balance sheet and the income statement. As the cost of goods sold equation indicates, a direct relationship exists between ending Inventory and Cost of Goods Sold because items not in the ending Inventory are assumed to have been sold. Any errors in ending Inventory will affect the balance sheet (current assets) and the income statement (Cost of Goods Sold, Gross Profit, and Net Income). The effects of inventory errors are felt in more than one year because the ending Inventory for one year becomes the beginning Inventory for the next year. Part II To determine the effects of inventory errors on the financial statements in both the current year and the following year, let’s assume that ending Inventory was overstated in Year 1 by $10,000 due to an error that was not discovered until Year 2. Because Cost of Goods Sold was understated, Gross Profit and Income before Income Tax Expense would be overstated by $10,000 in Year 1. The Year 1 ending Inventory becomes the Year 2 beginning Inventory, so even if Year 2 ending Inventory is calculated correctly, the error in Year 1 creates an offsetting error in Year 2. Year 1 + - = Beginning Inventory Purchases Ending Inventory Cost of Goods Sold Accurate Overstated $10,000 Understated $10,000

Now let’s examine the effects of the Year 1 Ending Inventory Error on Year 2. Assume that Ending Inventory was overstated in Year 1 by $10,000 due to an error that was not discovered until Year 2. Part I Now let’s examine the effects of the Year 1 Ending Inventory Error on Year 2. Part II Because Cost of Goods Sold is overstated in Year 2, that year’s Gross Profit and Income before Income Tax Expense would be understated by the same amount in Year 2. Because the Cost of Goods Sold is understated in Year 1 and overstated in Year 2, over the two years, these errors offset one another. Inventory errors will “self-correct” like this only if ending Inventory is accurately calculated at the end of the following year and adjusted to that correct balance. Year 2 + - = Beginning Inventory Purchases Ending Inventory Cost of Goods Sold Overstated $10,000 Accurate

Chapter 7 Solved Exercises
M7-6, M7-7, E7-5, E7-10, E7-13 Chapter 7 Solved Exercises: M7-6, M7-7, E7-5, E7-10, E7-13

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost Given the following information, calculate cost of goods available for sale and ending inventory, then sales, cost of goods sold, and gross profit, under (a) FIFO, (b) LIFO, and (c) weighted average. Assume a periodic inventory system is used. M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost Given the information on the screen, calculate cost of goods available for sale and ending inventory, then sales, cost of goods sold, and gross profit, under (a) FIFO, (b) LIFO, and (c) weighted average. Assume a periodic inventory system is used.

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost FIFO Beginning Inventory 50 units x $10 = $ 500 + Purchase units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (200 x $13) = $2,600 = Cost of Goods Sold (50 x $10) + (50 x $13) $1,150 Part I The FIFO method. Cost of Goods Available for Sale is the sum of the Beginning Inventory and the July 13 purchase (50 $10) + (250 $13) = $3,750. Part II The FIFO method assumes the oldest units are sold first and the newest units remain in Ending Inventory. The Ending Inventory is 200 $13 = $2,600. Part III Cost of Goods Sold is (50 $10) + (50 $13) = $1,150.

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost b. LIFO Beginning Inventory 50 units x $10 = $ 500 + Purchase units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (50 x $10) + (150 x $13) = $2,450 = Cost of Goods Sold (100 x $13) $1,300 Part I The LIFO method. Cost of Goods Available for Sale is the sum of the Beginning Inventory and the July 13 purchase (50 $10) + (250 $13) = $3,750. Notice that Cost of Goods Available for Sale using LIFO is the same as FIFO. Part II The LIFO method assumes the newest units are sold first and the oldest units remain in Ending Inventory. The Ending Inventory is (50 $10) + (150 $13) = $2,450. Part III Cost of Goods Sold is 100 $13 = $1,300.

c. Weighted Average Weighted Average Cost = $3,750 300 units
M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost c. Weighted Average Beginning Inventory 50 units x $10 = $ 500 + Purchase units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (200 x $12.50) = $2,500 = Cost of Goods Sold (100 x $12.50) $1,250 Part I The Weighted Average method. Cost of Goods Available for Sale is the sum of the Beginning Inventory and the July 13 purchase (50 $10) + (250 $13) = $3,750. Notice that Cost of Goods Available for Sale using Weighted Average is the same as LIFO and FIFO. Part II The weighted average unit cost is the Cost of Goods Available for Sale ($3,750) divided by the number of units available for sale (300). The result is $12.50 per unit. Part III. The Ending Inventory is 200 $12.50 = $2,500. Part IV Cost of Goods sold is 100 $12.50 = $1,250. Weighted Average Cost = $3, units = $12.50 per unit

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost FIFO LIFO Weighted Avg Sales (100 units at $15) $1,500 $1,500 $1,500 Cost of Goods Sold 1, , ,250 Gross Profit $ $ $ 250 We subtract Cost of Goods Sold as previously computed from Sales to obtain Gross Profit.

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) Aircard Corporation tracks the number of units purchased and sold throughout each accounting period, but applies its inventory costing method at the end of each period as if it uses a periodic inventory system. Given the following information, calculate the cost of goods available for sale, ending inventory, and cost of goods sold, if Aircard uses (a) FIFO, (b) LIFO, or (c) weighted average cost. M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) Aircard Corporation tracks the number of units purchased and sold throughout each accounting period, but applies its inventory costing method at the end of each period as if it uses a periodic inventory system. Given the following information, calculate the cost of goods available for sale, ending inventory, and cost of goods sold, if Aircard uses (a) FIFO, (b) LIFO, or (c) weighted average cost.

Goods Available for Sale – same for all methods Units Unit Total
M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) Goods Available for Sale – same for all methods Units Unit Total Cost Cost Beginning Inventory 2,000 $40 $ 80,000 + Purchase (July 13) 6,000 $ ,000 + Purchase (July 25) 8,000 $ ,000 Goods Available for Sale 16, $744,000 The number of units available for sale and the Cost of Goods Available for Sale are the same for all methods. Cost of Goods Available for Sale is the sum of the Beginning Inventory, the July 13 purchase, and the July 25 purchase (2,000 $40) + (6,000 $44) + (8,000 $50) = $744,000.

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) a. FIFO Ending Inventory (7,000 units x $50) = $350,000 Cost of Goods Sold (2,000 units x $40) (6,000 units x $44) (1,000 units x $50) = $394,000 b. LIFO Ending Inventory (2,000 units x $40) (5,000 units x $44) = $300,000 Cost of Goods Sold (8,000 units x $50) (1,000 units x $44) = $444,000 Part I The FIFO Method. The FIFO method assumes the oldest units are sold first and the newest units remain in Ending Inventory. The Ending Inventory is 7,000 $50 = $350,000. Cost of Goods Sold is (2,000 $40) + (6,000 $44) + (1,000 $50) = $394,000. Part II The LIFO method. The LIFO method assumes the newest units are sold first and the oldest units remain in Ending Inventory. The Ending Inventory is (2,000 $40) + (5,000 $44) = $300,000. Cost of Goods Sold is (8,000 $50) + $44) = $444,000.

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) c. Weighted Average Average Unit Cost $744,000 / 16,000 = $46.50 Ending Inventory (7,000 units x $46.50) = $325,500 Cost of Goods Sold (9,000 units x $46.50) = $418,500 The Weighted Average method. The weighted average unit cost is the Cost of Goods Available for Sale ($744,000) divided by the number of units available for sale (16,000). The result is $46.50 per unit. The Ending Inventory is 7,000 $46.50 = $325,500. Cost of Goods sold is 9,000 $46.50 = $418,500.

Goods Available for Sale – same for all methods Units Unit Total
E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Oahu Kiki tracks the number of units purchased and sold throughout each accounting period but applies its inventory costing method at the end of each month, as if it uses a periodic inventory system. Assume Oahu Kiki’s records show the following for the month of January. Sales totaled 240 units. Required: Calculate the number and cost of goods available for sale. Goods Available for Sale – same for all methods Units Unit Total Cost Cost Beginning Inventory $80 $ 9,600 + Purchase (Jan 15) $90 34,200 + Purchase (Jan 24) $ ,000 Goods Available for Sale $65,800 Part I Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, as shown on the screen for the month of January. Sales totaled 240 units. Part II Requirement I. Calculate the number and cost of goods available for sale. Part III. The number of units available for sale and the Cost of Goods Available for Sale are the same for all methods. Cost of Goods Available for Sale is the sum of the Beginning Inventory, the Jan 15 purchase, and the Jan 24 purchase (120 $80) + (380 $90) + (200 $110) = $65,800 for a total 700 available units.

2. Calculate the number of units in ending inventory.
E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 2. Calculate the number of units in ending inventory. Units in Ending Inventory = Units Available – Units Sold Units in Ending Inventory = 700 – 240 = 460 units Part I Requirement 2. Calculate the number of units in ending inventory. Part II The number of units in Ending Inventory equals the number of units available less the number of units sold. (700 units – 240 units = 460 units)

E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending Inventory and Cost of Goods Sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. a. FIFO ending Inventory (200 units x $110) (260 units x $ 90) = $45,400 Cost of Goods Sold (120 units x $80) (120 units x $90) = $20,400 Part I Requirement 3. Calculate the cost of ending Inventory and Cost of Goods Sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. Part II (a) The FIFO method assumes the oldest units are sold first and the newest units remain in ending Inventory. The ending Inventory is (200 $110) + (260 $90) = $45,400. Cost of Goods Sold is (120 $80) + (120 $90) = $20,400.

E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. b. LIFO Ending Inventory (120 units x $80) (340 units x $90) = $40,200 Cost of Goods Sold (200 units x $110) ( 40 units x $ 90) = $25,600 Part I Requirement 3 (b) The LIFO method. Part II The LIFO method assumes the newest units are sold first and the oldest units remain in Ending Inventory. The Ending Inventory is (120 $80) + (340 $90) = $40,200. Cost of Goods Sold is (200 $110) + $90) = $25,600.

E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. c. Weighted Average Average Unit Cost $65,800 / 700 units = $94 Ending Inventory (460 units x $94) = $43,240 Cost of Goods Sold (240 units x $94) = $22,560 Part I Requirement 3 (c) The Weighted Average method. Part II The weighted average unit cost is the Cost of Goods Available for Sale ($65,800) divided by the number of units available for sale (700 units). The result is $94 per unit. Part III The Ending Inventory is 460 $94 = $43,240. Cost of Goods sold is 240 $94 = $22,560.

E7-10 Reporting Inventory at Lower of Cost or Market
Peterson Furniture Designs is preparing the annual financial statements dated December 31. Ending inventory information about the five major items stocked for regular sale follows: Required: 1. Complete the two columns of the table and then compute the amount that should be reported for the ending inventory using the LCM rule applied to each item. Part I E7-10 Reporting Inventory at Lower of Cost or Market Peterson Furniture Designs is preparing the annual financial statements dated December 31. Ending inventory information about the five major items stocked for regular sale follows: Part II Requirement 1. Complete the two columns of the table and then compute the amount that should be reported for the ending inventory using the LCM rule applied to each item. Part III The completed table is as shown. The amount that that should be reported for the ending inventory using the LCM rule applied to each item is $10,400. Peterson will need to write down its inventory from its cost of $11,900 to $10,400, a decrease of $1,500. $1,500 Total $11, $10,400 Item Alligator Armoires Bear Bureaus Cougar Beds Dingo Cribs Elephant Dressers Qty 50 75 10 30 400 Total Cost x $30 = $1,500 x $40 = $3,000 x $50 = $ 500 x $30 = $ 900 x $15 = $6,000 Total Market x $24 = $1,200 x $52 = $ 520 x $12 = $4,800 LCM Per Item LCM Valuation $24 40 12 $1,200 3,000 500 900 4,800

Cost of Goods Sold 1,500 Inventory 1,500
E7-10 Reporting Inventory at Lower of Cost or Market Peterson Furniture Designs is preparing the annual financial statements dated December 31. Ending inventory information about the five major items stocked for regular sale follows: Required: 2. Prepare the journal entry that Peterson Furniture Designs would record on December 31 to write-down its inventory to LCM. Cost of Goods Sold 1,500 Inventory 1,500 Part I Requirement 2. Prepare the journal entry that Peterson Furniture Designs would record on December 31 to write-down its inventory to LCM. Part II To write down its inventory from its cost of $11,900 to $10,400, Peterson would debit Cost of Goods Sold and Credit Inventory for $1,500 each.

E7-13 Analyzing and Interpreting the Inventory Turnover Ratio
Polaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the following amounts in its financial statements (in millions): Required: 1. Calculate to one decimal place the inventory turnover ratio and average days to sell inventory for 2012, 2011, and 2010. *7.1 = $2,280 ÷ $ **7.0 = $1,900 ÷ $ ***7.0 = $1,460 ÷ $210 Inventory Turnover Ratio Days to Sell = Cost of Goods Sold Average Inventory 365 Days Inventory Turnover 7.1* 7.0** 7.0*** Times per year days Part I E7-13 Analyzing and Interpreting the Inventory Turnover Ratio Polaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the amounts shown on the screen in its financial statements (in millions): Requirement 1. Calculate to one decimal place the inventory turnover ratio and average days to sell inventory for 2012, 2011, and 2010. Part II The Inventory Turnover Ratio is equal to Cost of Goods sold divided by Average Inventory. For example, in 2012, the Inventory Turnover Ratio of 7.1 is obtained by dividing Cost of Goods sold of $2,280 by Average Inventory of $320.

E7-13 Analyzing and Interpreting the Inventory Turnover Ratio
Polaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the following amounts in its financial statements (in millions): Required: 2. Comment on any trends, and compare the effectiveness of inventory managers at Polaris to inventory managers at its main competitor, Arctic Cat, where inventory turns over 5.4 times per year in 2012 (67.6 days to sell) Both companies use the same inventory costing method (FIFO). Part I Requirement 2. Comment on any trends, and compare the effectiveness of inventory managers at Polaris to inventory managers at its main competitor, Arctic Cat, where inventory turns over 5.4 times per year in 2012 (67.6 days to sell). Both companies use the same inventory costing method (FIFO). Part II The inventory turnover ratio reflects how many times average inventory was acquired and sold during the year. The inventory turnover ratio for Polaris Industries has been consistent throughout 2010 to Polaris is performing better than Arctic Cat, where the inventory turnover is 5.4 times per year or every 67.6 days. The inventory turnover ratio reflects how many times average inventory was acquired and sold during the year. The inventory turnover ratio for Polaris Industries has been consistent throughout 2010 to Polaris is performing better than Arctic Cat, where the inventory turnover is 5.4 times per year or every 67.6 days.

End of Chapter 7 End of chapter 7.

Inventory and Cost of Goods Sold

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