1. Reporting and Interpreting Cost of Goods Sold and Inventory Chapter 7 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

2. 7-2 Understanding the Business Provide sufficient quantities of high- quality inventory. Minimize the costs of carrying inventory. Primary Goals of Inventory Management

3. 7-3 Items Included in Inventory Inventory TangibleHeld for Sale Used to Produce Goods or Services Merchandise Inventory Raw Materials Inventory Work in Process Inventory Finished Goods Inventory

4. 7-4 Costs Included in Inventory Purchases cost principle The cost principle requires that inventory be recorded at the price paid or the consideration given. Invoice Price Freight Inspection Costs Preparation Costs

5. 7-5 Flow of Inventory Costs Merchandise Purchases Cost of Goods Sold Merchandise Inventory Merchandiser Raw Materials Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Manufacturer Direct Labor Factory Overhead

6. 7-6 Nature of Cost of Goods Sold Beginning Inventory Purchases for the Period Ending Inventory (Balance Sheet) Goods available for Sale Cost of Goods Sold (Income Statement) Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of goods sold Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of goods sold

7. 7-7 Inventory Costing Methods Total Dollar Amount of Goods Available for Sale Ending Inventory Cost of Goods Sold Inventory Costing Method Inventory Costing Methods 1.Specific Identification 2.First-in, First-out 3.Last-in, First-out 4.Weighted Average

8. 7-8 Specific Identification When units are sold, the specific cost of the unit sold is added to cost of goods sold.

9. 7-9 Cost Flow Assumptions The choice of an inventory costing method is not based on the physical flow of goods on and off the shelves. LIFO FIFO Weighted Average

10. 7-10 First-In, First-Out Method Cost of Goods Sold Oldest Costs Ending Inventory Recent Costs

11. 7-11 First-In, First-Out Remember: The costs of most recent purchases are in ending inventory. Start with 11/29 and add units purchased until you reach the number in ending inventory.

12. 7-12 First-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

13. 7-13 First-In, First-Out Now, we have allocated the cost to all 1,050 units sold.

14. 7-14 First-In, First-Out Here is the cost of ending inventory and cost of goods sold using FIFO.

15. 7-15 Last-In, First-Out Method Ending Inventory Cost of Goods Sold Oldest Costs Recent Costs

16. 7-16 Last-In, First-Out Remember: The costs of the oldest purchases are in ending inventory. Start with beginning inventory and add units purchased until you reach the number in ending inventory.

17. 7-17 Last-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

18. 7-18 Last-In, First-Out Now, we have allocated the cost to all 1,050 units sold.

19. 7-19 Last-In, First-Out Here is the cost of ending inventory and cost of goods sold using LIFO.

20. 7-20 Average Cost Method When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Cost of Goods Available for Sale Number of Units Available for Sale ÷

21. 7-21 Average Cost Method

22. 7-22 Comparison of Methods

23. 7-23 Financial Statement Effects of Costing Methods Advantages of Methods Better matches current costs in cost of goods sold with revenues. Ending inventory approximates current replacement cost. First-In, First-Out Last-In, First-Out Smoothes out price changes. Weighted Average

24. 7-24 Managers Choice of Inventory Methods Net Income Effects Managers prefer to report higher earnings for their companies. Income Tax Effects Managers prefer to pay the least amount of taxes allowed by law as late as possible. LIFO Conformity Rule If last-in, first-out is used on the income tax return, it must also be used to calculate inventory and cost of goods sold for financial statements.

25. 7-25 Valuation at Lower of Cost or Market Ending inventory is reported at the lower of cost or market (LCM). Replacement Cost The current purchase price for identical goods. The company will recognize a “holding” loss in the current period rather than the period in which the item is sold. This practice is conservative.

26. 7-26 Valuation at Lower of Cost or Market

27. 7-27 Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly thus reducing storage and obsolescence costs.

28. 7-28 Inventory and Cash Flows Add Subtract Cash Flows from Operations Net Income Decrease in Inventory Increase in Accounts Payable Decrease in Inventory Increase in Accounts Payable Increase in Inventory Decrease in Accounts Payable Increase in Inventory Decrease in Accounts Payable

29. 7-29 Inventory Methods and Financial Statement Analysis U.S. public companies using LIFO also report beginning and ending inventory on a FIFO basis if the FIFO values are materially different.

30. 7-30 LIFO and International Comparisons LIFO Permitted? Yes No China Singapore Canada Great Britain Australia

31. 7-31 Internal Control of Inventory Separation of inventory accounting and physical handling of inventory. Storage in a manner that protects from theft and damage. Limiting access to authorized employees. Maintaining perpetual inventory records. Comparing perpetual records to periodic physical counts.

32. 7-32 Perpetual and Periodic Inventory Systems Provides up-to-date inventory records. Provides up-to-date cost of sales records. PerpetualSystemPerpetualSystem In a periodic inventory system, ending inventory and cost of goods sold are determined at the end of the accounting period based on a physical count.

33. 7-33 Perpetual and Periodic Inventory Systems

34. 7-34 Errors in Measuring Ending Inventory

35. 7-35 Supplement A: LIFO Liquidations When a LIFO company sells more inventory than it purchases or manufactures, items from beginning inventory become part of cost of goods sold. This is called a LIFO liquidation. When inventory costs are rising, these lower cost items in beginning inventory produce a higher gross profit, higher taxable income, and higher taxes when they are sold.

36. 7-36 Supplement B: Additional Issues in Measuring Purchases Purchase returns and allowances are a reduction in the cost of purchases associated with unsatisfactory goods. A purchase discount is a cash discount received for prompt payment of an account.

37. 7-37 Supplement B: Additional Issues in Measuring Purchases Terms Time Due Discount Period Full amount less discount Credit Period Full amount due Purchase or Sale 2/10,n/30 Discount Percent Number of Days Discount Is Available Credit Period

38. 7-38 Supplement C: Comparison of Perpetual and Periodic Inventory Systems Perpetual Inventory System

39. 7-39 Supplement C: Comparison of Perpetual and Periodic Inventory Systems Periodic Inventory System

40. © 2009 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin End of Chapter 7