2. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Inventory and Cost of Goods Sold Chapter 9 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

3. Inventory Time Line COMPUTE BUY Raw Materials or Goods for Resale Value ADD SELL Finished Inventory Ending Inventory Cost of Goods Sold

4. What is Inventory? Items held for resale in the normal course of business. For a manufacturing firm, a broad array of production costs is included as part of the cost of inventory. The terms raw materials, work in process, and finished goods refer to the inventories of a manufacturing enterprise.

5. Inventory Systems Two types of inventory systems which keep track of how much inventory has been sold and at what price. 1.Periodic system- requires a physical count of the inventory periodically, and at the point of sale only records the sale price. 2.Perpetual system- at point of sale records selling price and type of item sold. Example: a bar code scanning system.

6. Differences in Recording Purchases of Inventory- Periodic Purchases3,000 Accounts Payable3,000 Sales During the Period- Periodic Accounts Receivable4,125 Sales4,125 Accounts Receivable4,125 Sales4,125 Cost of Goods Sold2,750 Inventory2,750 Inventory3,000 Accounts Payable3,000 Purchases of Inventory- Perpetual Sales During the Period- Perpetual

7. Differences in Valuing Cost of Goods Sold Beginning Inventory$ 500 + Purchases 3,000 = Cost of Goods available for sale $3,500 - Ending Inventory 700* 750** = Preliminary cost of goods sold (COGS) $2,800$2,750 + Cost of missing inventoryUnknown 50 Reported cost of goods sold$2,800 Periodic System Perpetual System * From count ** From records

8. Stop and Think If perpetual inventory systems have so many clear advantages, why aren’t they used by all companies?

9. Whose Inventory Is It? Report on the balance sheet inventory to which the company holds legal title. Legal title is not determined by who has physical custody of the inventory Issues that develop: –Goods that are in transit. –Goods that are on consignment.

10. Goods in Transit Quality Produce Goods being shipped are included in inventory of buyer while in transit. FOB Shipping Point Seller Buyer

11. Goods in Transit FOB Destination Quality Produce Goods being shipped are included in inventory of seller until received by buyer. Seller Buyer

12. Goods on Consignment Shipper retains title and includes the goods in inventory until their sale or use by the dealer or customer. Consigned goods are reported by the shipper at the sum of: –The cost of the goods –The handling costs –The shipping costs incurred in their transfer to the dealer or customer.

13. What Is Inventory Cost? Inventory costs comprise of all expenditures both direct and indirect, relating to acquisition, preparation, and placement for sale. Discounts can change the total inventory costs. 1.Trade Discounts Convert the catalog price to the actual price. Record inventory at discounted price. 2.Cash Discounts Granted for payment of invoices within a limited time period. Record inventory using the net method or gross method.

14. Cash Discounts- Net Method Records inventory net of any purchase (cash) discounts. Example : June 1 Purchased merchandise for $10,000; Terms of payment: 2/10, n/30; Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8.

15. Cash Discounts Purchase Date End of Discount Period $9,800 Owed $10,000 Owed Final Payment Date 10 Days20 Days Supplier “Loan” Period

16. Cash Discounts- Net Method June 1 Inventory9,800 Accounts Payable (A/P) 9,800 June 8 A/P 9,800 Cash9,800 June 28 A/P9,800 Discounts Lost200 Cash10,000 June 30 Discounts Lost200 A/P 200 Assume that payment was not made until June 28. Assume no payment till end of the month (the discount period has lapsed) here is the adjustment:

17. Cash Discounts- Gross Method Records inventory gross cost; discounts are recorded only if taken. Example : June 1 Purchased merchandise for $10,000; Terms of payment: 2/10, n/30; Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8.

18. Cash Discounts- Gross Method June 1 Inventory10,000 Accounts Payable (A/P) 10,000 June 8 A/P 10,000 Inventory 200 Cash 9,800 June 28 A/P10,000 Cash10,000 Assume that payment was not made until June 28.

19. Purchase Returns and Allowances Adjustments are also made when goods are damaged or not lesser in quality than ordered. Sometimes the customer returns the goods. Accounts Payable 400 Purchase Returns & Allowances 400 Periodic Inventory System Accounts Payable 400 Inventory 400 Perpetual Inventory System

20. Practice time 9-66 9-1, 2, 3, 5 9- 28, 29, 31, 32, 33

22. Inventory Valuation Methods Specific Identification FIFO Average Cost LIFO Cost Allocation Methods

23. Specific Identification Method Assigns the actual cost of the asset to Inventory and Cost of Goods Sold. Provides a highly objective method of matching costs because cost flow exactly matches physical goods flow. Is almost impossible to implement cost effectively.

24. Inventory Valuation Method Assume : Purchases: January 1200 @ $10$ 2,000 March 23300 @ $123,600 July 15500 @ $115,500 November 6 100 @ $13 1,300 Total purchases 1,100$12,400 Sales700 @ $15 Assume : Purchases: January 1200 @ $10$ 2,000 March 23300 @ $123,600 July 15500 @ $115,500 November 6 100 @ $13 1,300 Total purchases 1,100$12,400 Sales700 @ $15

25. Specific Identification Method 200units @ $10 per unit 300units @ $12 per unit 500units @ $11 per unit Sold 200 units from the January 1 and 500 from the July 15 purchase. 100units @ $13 per unit 1,100 units Jan. 1 Mar. 23 July 15 Nov. 6

26. Specific Identification Method 200units @ $10 per unit 500units @ $11 per unit SOLD 700 Jan. 1 July 15

27. Specific Identification Method 200units @ $10 per unit 500units @ $11 per unit Jan. 1 July 15 = $2,000 = 5,500 Total cost of goods sold$7,500

28. Specific Identification Method 300units @ $12 per unit 100units @ $13 per unit Mar. 23 Nov. 6 = $3,600 = 1,300 Ending inventory$4,900 Goods Not Sold

29. Average Cost Method Assigns the same average cost to each unit sold and each item in inventory. For periodic inventory, the unit cost is the weighted average for the entire period. For perpetual inventory, the unit cost is computed as a moving average, which changes with each new purchase of goods.

30. Average Cost Method Periodic 200units @ $10 per unit 300units @ $12 per unit 500units @ $11 per unit 100units @ $13 per unit 1,100 units Jan. 1 Mar. 23 July 15 Nov. 6 = $ 2,000 =3,600 =5,500 = 1,300 $12,400 $12,400  1,100 units = $11.27 per unit (rounded) Cost of goods sold = $11.27 x 700 = $7,890 Ending inventory = $11.27 x 400 = $4,510

31. First-In-First-Out (FIFO) Method Assigns historical unit cost to Cost of Goods Sold in the order the costs are incurred. Provides a close match between physical product flow and product cost flow. Results in the same inventory valuation and Cost of Goods Sold regardless of whether perpetual or periodic inventory is used.

32. FIFO Method--Periodic 200units @ $10 per unit 300units @ $12 per unit 500units @ $11 per unit 100units @ $13 per unit Jan. 1 Mar. 23 July 15 Nov. 6 Sold 200 = $2,000 Sold 300= 3,600 Sold 200 = 2,200 Total cost of goods sold$7,800

33. FIFO Method--Periodic 300units @ $11 per unit 100units @ $13 per unit Mar. 23 Nov. 6 = 3,300 = 1,300 Goods Not Sold Ending Inventory$4,600

34. Last-In-First-Out (LIFO) Method Assigns the most recent historical costs to Cost of Goods Sold and the oldest costs to Inventory. Is used primarily to minimize taxable income. Results in differences between Cost of Goods Sold and Inventory for perpetual inventory versus periodic inventory.

35. LIFO Method--Periodic 200units @ $10 per unit 300units @ $12 per unit 500units @ $11 per unit 100units @ $13 per unit Jan. 1 Mar. 23 July 15 Nov. 6 Sold 100= $1,300 Sold 500= $5,500 Sold 100= $1,200 Total cost of goods sold$8,000

36. LIFO Method--Periodic = 2,000 = 2,400 Ending Inventory$4,400 200units @ $10 per unit 200units @ $12 per unit Jan. 1 Mar. 23 Goods Not Sold

37. Comparison of Inventory Methods (Periodic) Cost of Goods Sold Ending Inventory Specific identification$7,500$4,900 Average cost$7,890$4,510 FIFO$7,800$4,600 LIFO$8,000$4,400

38. Practice Exercise 9-34

39. Perpetual Inventory Assume : Beginning inventory100@ $10$1,000 Purchases: April 1080 @ $11880 April 2070@ $12840 Sales: April 1890 @ $15 April 2750@ $16 Assume : Beginning inventory100@ $10$1,000 Purchases: April 1080 @ $11880 April 2070@ $12840 Sales: April 1890 @ $15 April 2750@ $16 FIFO periodic and FIFO perpetual provide identical results for cost of goods sold and inventory.

40. Average Cost Method- Perpetual Apr. 18Sales (90) units @ $10.44 (940) Apr. 18Balance90 units @ $10.44$ 940 Apr. 20Purchases 70 units @ $12 840 Apr.20Balance160 units @ $11.125 $1,780 Apr. 1Beginning Inventory100units @ $10$1,000 Apr.10Purchases 80units @ $11 880 Apr.10Balance180units @ $10.44$1,880 $1,880  180 Apr. 27Sales(50) units @ $11.125 (556) Apr. 30Balance110 units @ $11.125 $1,224 $1,780  160 Ending inventory, $1,224

41. Average Cost Method- Perpetual Cost of Goods Sold (140 units) $940 + $556 = $1,496 Apr. 18Sales (90) units @ $10.44 (940) Apr. 18Balance90 units @ $10.44$ 940 Apr. 20Purchases 70 units @ $12 840 Apr.20Balance160 units @ $11.125 $1,780 Apr. 1Beginning Inventory100units @ $10$1,000 Apr.10Purchases 80units @ $11 880 Apr.10Balance180units @ $10.44$1,880 Apr. 27Sales(50) units @ $11.125 (556) Apr. 30Balance110 units @ $11.125 $1,224

42. LIFO Method- Perpetual 100units @ $10 per unit 90units @ $10 per unit Apr. 1 80units @ $11 per unit Purchased 80 70units @ $12 per unit Perpetual Inventory System 20units @ $12 per unit Sold 80 80units @ $11 per unit 0units @ $11 per unit Sold 10Purchased 70Sold 50 Beginning inventory Apr. 10 Apr. 20

43. LIFO Method- Perpetual Ending inventory……………….. Beg. Inv. + Purchases – End. Inv. = Cost of Goods Sold = $ 900 =0 = 240 $1,140 $1,000 + $1,720 – $1,140 = $1,580 Perpetual Inventory System 100units @ $10 per unit 90units @ $10 per unit 80units @ $11 per unit 70units @ $12 per unit 20units @ $12 per unit 80units @ $11 per unit0units @ $11 per unit Apr. 1 Apr. 10 Apr. 20

44. Unique Aspects of LIFO LIFO liquidation- the effect of cost of goods sold and net income during periods of rising prices, when “old” inventory layers are sold. Low cost prices are matched with higher sales prices resulting in a lower than usual cost of goods sold and a higher net income. LIFO conformity rule- in the 1930s Congress specified that companies who use LIFO for financial reporting must use LIFO for income tax reporting as well. LIFO Tax effect can be significant over time. See Exhibit 9-14.

45. Special LIFO Concerns LIFO Layers are created each year when the number of units purchased exceeds the number of units sold; a new layer of inventory is created LIFO Reserve is the difference between LIFO ending inventory and FIFO or other inventory value. LIFO Reserves should be disclosed with the Balance Sheet Results are that older costs are associated with Sales in succeeding years, usually resulting in a lower matched COGS and misrepresenting the Gross Profit as higher

46. Practice 9-35 9-7 9-8 & 9

48. FIFO Advantages and Disadvantages Advantages: Usually corresponds with physical flow of goods. Ending inventory balance agrees closely with current replacement cost. Disadvantages: Can cause older costs to be matched with current revenues. Inventory holding gains and losses are included as part of gross profit. Yields higher taxable income in times of inflation if inventory levels are stable or increasing.

49. LIFO Advantages Advantages : Matches current costs with current revenues. Excludes inventory holding gains from gross profit. Yields lower taxable income in times of inflation if inventory levels are stable or increasing.

50. LIFO Disadvantages Disadvantages: Usually does not correspond with the physical flow of goods. Potential LIFO liquidation means old cost in LIFO layers can be drawn in to cost of goods sold. Ending inventory balance can be much lower than current replacement cost. LIFO liquidation can result in greatly increased tax payments when inventory levels decline.

51. FIFO and LIFO Comparison

52. Inventory Accounting Change If a company changes its method of valuing inventory, the change is accounted for as a change in accounting principle. Average Cost FIFO change to Report the effect of changing methods on the financial statements. Any Method change to LIFO No adjustment to financial statements for change to LIFO, but special disclosure required.

53. Review time Exercise 43

54. Lower of Cost or Market Accounting Principle of “Conservatism” applies LCM recognizes unrealized decreases in the value of assets, but not unrealized increases Market Value represents current replacement cost, constrained by a ceiling and floor value

55. Lower of Cost or Market The term “market” in lower of cost or market means replacement cost. Replacement Cost Ceiling: Estimated selling price – normal selling costs Ceiling: Also known as the net realizable value Floor: Net realizable value – a normal profit margin Market Historical Cost see p. 472 compare

56. $0.70 Lower of Cost or Market Ceiling: $0.80 Floor: $0.55 $0.70 $0.65 LCM = $0.65 Market Historical Cost Lower of Cost or Market p 473 CASE A

57. $0.60 Lower of Cost or Market Ceiling: $0.80 Floor: $0.55 $0.60 $0.65 LCM = $0.60 Lower of Cost or Market CASE B Market Historical Cost

58. $0.50 Lower of Cost or Market Ceiling: $0.80 Floor: $0.55 $0.55 $0.65 LCM = $0.55 Lower of Cost or Market Market Historical Cost CASE C

59. $0.45 Ceiling: $0.80 Floor: $0.55 $0.55 $0.50 LCM = $0.50 Lower of Cost or Market CASE D Market Historical Cost

60. $0.85 Ceiling: $0.80 Floor: $0.55 $0.80 $0.75 LCM = $0.75 Lower of Cost or Market Market Historical Cost CASE E

61. $1.00 Ceiling: $0.80 Floor: $0.55 $0.80 $0.90 LCM = $0.80 Lower of Cost or Market CASE F Market Historical Cost

62. Problem Solving Let’s practice with Exercise 11, 13, 14, 44, 47, 48

64. Gross Profit Inventory Method An estimation technique based on the relationship between gross profit and Sales Gross Profit percentage is applied to sales to estimate the COGS COGS is then subtracted COGA to arrive at the estimated inventory May be used to estimate missing inventory, verify counts, or use for interim statements

65. Gross Profit Method Beginning inventory, January 1 $25,000 Sales, January 1–January 31 50,000 Purchases, January 1–January 31 40,000 Historical gross profit percentage Last year40% Two years ago37 Three years ago42 Last year’s 40% is considered a good estimate.

66. Gross Profit Method Sales (actual)$50,000100% Cost of goods sold (estimate) 30,000 60% Gross profit (estimate)$20,000 40% Beginning inventory (actual)$25,000

67. Gross Profit Method Sales (actual)$50,000100% Cost of goods sold (estimate) 30,000 60% Gross profit (estimate)$20,000 40% Beginning inventory (actual)$25,000 +Purchases (actual) 40,000

68. Gross Profit Method Sales (actual)$50,000100% Cost of goods sold (estimate) 30,000 60% Gross profit (estimate)$20,000 40% Beginning inventory (actual)$25,000 +Purchases (actual) 40,000 –Cost of goods available for sale (actual)$65,000

69. Gross Profit Method Sales (actual)$50,000100% Cost of goods sold (estimate) 30,000 60% Gross profit (estimate)$20,000 40% Beginning inventory (actual)$25,000 +Purchases (actual) 40,000 –Cost of goods available for sale (actual)$65,000 – Cost of goods sold (estimate) 30,000

70. Gross Profit Method Sales (actual)$50,000100% Cost of goods sold (estimate) 30,000 60% Gross profit (estimate)$20,000 40% Beginning inventory (actual)$25,000 +Purchases (actual) 40,000 –Cost of goods available for sale (actual)$65,000 –Cost of goods sold (estimate)$30,000 =Ending inventory (estimate) 35,000

71. Gross Profit Method Sales (actual)$50,000100% Cost of goods sold (estimate) 29,000 58% Gross profit (estimate)$21,000 42% Beginning inventory (actual)$25,000 +Purchases (actual) 40,000 –Cost of goods available for sale (actual)$65,000 –Ending inventory (estimate) 36,000 =Cost of goods sold (estimate)$29,000

72. Effects of Errors Misstated inventory will result in errors on both the Balance Sheet and Income Statement Multiple amounts may be effected on the Income Statement An error in one period effects the next Some errors may self-correct See p. 479

73. Effects of Errors in Recording Inventory

74. Correction of Errors Depends on when error is detected If found in current period, adjustments can be made to current accounts and the reported net income and balance sheet amounts will be correct. Cost of Goods Sold1,000 Inventory1,000

75. Correction of Errors If found in subsequent period and the net income of the prior period was misstated, the correcting entry qualifies as a prior-period adjustment and is made to beginning retained earnings of the subsequent period in which the error was discovered. Retained Earnings 1000 Inventory 1000

76. Practice 9-15, 16, 49, 51, 52

77. Inventory Turnover Appropriateness of inventory size and position can be measured by calculating the Inventory Turnover Ratio. Appropriateness of inventory size and position can be measured by calculating the Inventory Turnover Ratio. Inventory Turnover : Cost of Goods Sold ÷ Average Inventory

78. Inventory Turnover Determine the inventory turnover. Cost of Goods Sold$1,000 Beginning Inventory$ 90 Ending Inventory$ 110 Cost of Goods Sold$1,000 Beginning Inventory$ 90 Ending Inventory$ 110

79. Inventory Turnover Cost of Goods Sold$1,000 Beginning Inventory$ 90 Ending Inventory$ 110 Cost of Goods Sold$1,000 Beginning Inventory$ 90 Ending Inventory$ 110 $1,000 ($90 + $110)/2 = 10

80. Inventory Turnover The higher the Turnover, the faster a company is using its inventory, thus “turning a profit” The turnover ratio will be different based on what inventory method is used: Fifo vs. Lifo With an increased turnover, the investment needed for a given volume of business is smaller

81. Number of Days’ Sales in Inventory The average time it takes to turn over the inventory The type of inventory and nature of business determines what is acceptable Days = 365/Inventory Turnover

82. Number of Days’ Sales in Inventory $1,000 ($90 + $110)/2 = 10 365 10 Number of days’ sales in inventory is 36.5

83. Practice Exercise 9-17

84. Retail Inventory Method Used by retail firms to estimate inventory value. Can be used to estimate inventory under any valuation assumption. Cost amounts and retail amounts are tracked of the goods that have been purchased in the period. Cost percentage = goods available for sale at cost/ending inventory at retail

85. Retail Inventory Method

86. Inventory, Jan 1$30,000 $50,000 Purchases in Jan 30,000 40,000 Goods Available for Sale $60,000 $90,000 Inventory, Jan 31, at estimated cost: FIFO ($25,000 x 75%) $ 18,750 LIFO ($25,000 x 60%) $ 15,000 COST RETAIL Beginning inventory ($30,000/$50,000) = 60.0% Purchases ($30,000/$40,000) = 75.0% Cost Percentage: –Sales for January 65,000 Inventory, Jan 31, at retail $25,000

87. Learning Objectives 1.Define inventory for a merchandising business and identify the different types of inventory for a manufacturing business. 2.Explain the advantages and disadvantages of both periodic and perpetual inventory systems. 3.Determine when ownership of goods in transit changes hands and what circumstances require shipped inventory to be kept on the books.

88. Learning Objectives 4.Compute total inventory acquisition cost. 5.Use the four basic inventory valuation methods: specific identification, average cost, FIFO, and LIFO. 6.Explain how LIFO inventory layers are created, and describe the significance of the LIFO reserve.

89. Learning Objectives 7.Choose an inventory valuation method based on the trade-offs among income tax effects, book- keeping costs, and the impact on the financial statements. 8.Apply the lower-of-cost-or-market (LCM) rule to reflect declines in the market value of inventory.

90. Learning Objectives 9.Use the gross profit method to estimate ending inventory. 10.Determine the financial statement impact of inventory recording errors. 11.Analyze inventory using financial ratios, and properly compare ratios of different firms after adjusting for differences in inventory valuation methods.

91. Learning Objectives Expanded Material 12.Compute estimates of FIFO, LIFO, average cost, and lower-or-cost-or market inventory using the retail inventory method. 13.Use LIFO pools, dollar-value LIFO, and dollar-value LIFO retail to compute ending inventory. 14.Account for the impact of changing prices on purchase commitments. 15.Record inventory purchase transactions denominated in foreign currencies.

92. Raw Materials Raw Materials are goods acquired for use in the production process. Materials that are used directly in the production of goods are frequently referred to as direct materials. Materials that are necessary in the production process but are not directly incorporated into the product are referred to as indirect materials.

93. Work in Process Work in Process (WIP) consists of materials partly processed and requiring further work before they can be sold. The three cost elements that make up WIP are direct materials, direct labor and manufacturing overhead. Direct labor refers to the cost of labor directly identified with goods in production. Manufacturing overhead refers to the proportion of factory overhead assignable to goods in production.

94. Finished Goods Finished goods are the manufactured products awaiting sale. Raw Materials Finished Goods Cost of Goods Sold Balance Sheet Income Statement Direct Labor Work in Process Manufacturing Overhead

95. Summary MerchandiseMerchandise Balance Sheet Items Income Statement Items Retailer Cost of Goods Sold Sale Manufacturer Raw Materials Cost of Goods Sold Sale Finished Goods Work in Process Overhead Direct Labor

96. Schedule of Cost of Goods Manufactured Bartlett Corporation Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2005 Direct materials: Raw materials $ 21,350 Purchases 107,500 Cost of raw materials available for use 128,850 Less raw materials inventory, Dec. 31 22,350 Raw materials used in production $106,500 Direct labor 96,850 Manufacturing overhead :

97. Schedule of Cost of Goods Manufactured Manufacturing overhead: Indirect labor$ 40,000 Factory supervision29,000 Depr.—factory building and equipment 20,000 Light, heat, and power18,000 Factory supplies15,000 Miscellaneous manufacturing overhead 12,055 134,055 Total manufacturing costs $337,405 Add work in process inventory, January 1 99,400 $366,805 Less work in process inventory, December 31 26,500 Cost of goods manufactured $340,305