1. PowerPoint Author: Catherine Lumbattis 5 COPYRIGHT © 2011 South-Western/Cengage Learning Inventories and Cost of Goods Sold Introduction to Using Financial Accounting Information, 7/e

2. Inventory of Wholesalers and Retailers  Purchased in finished form  Resold without transformation  Classified as “Merchandise Inventory” on balance sheet LO1

3. Inventory of Manufacturers Manufacturing overhead Direct materials Direct labor Manufacture products Work in process Finished goods Raw material s Costs Included in Inventory Balance Sheet Classifications

4. Condensed Income Statement for a Merchandiser Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000 Selling and administrative expenses 29,300 Net income before tax $ 10,700 Income tax expense 4,280 Net income$ 6,420 LO2

5. Net Sales and Contra-Sales Accounts Normal balance normal debit balance normal debit balance Two deductions from sales:  sales returns and allowances  sales discounts Sales revenue  The inflow of either cash or accounts receivable from the sale of a product

6. Sales Returns and Allowances Normal balance normal debit balance  records inventory returned by customers who are not completely satisfied  a customer may be given an allowance for spoiled or damaged merchandise  single account used to record both returns and allowances

7. Credit Terms and Sales Discounts n/30 Payment due 30 days from invoice 1/10, n/30Deduct 1% of invoice amount if paid within 10 days; otherwise full invoice amount is due in 30 days 2/10, n/30Deduct 2% of invoice amount if paid within 10 days; otherwise full invoice amount is due in 30 days

8. Purchases of merchandise Beginning inventory The Cost of Goods Sold Model Cost of goods sold = Goods Available for Sale Less: Ending inventory LO3 + =

9. An increase in ending inventory means more was bought than sold The Cost of Goods Sold Model Beginning inventory $ 15,000 + Cost of goods purchased 63,000 = Cost of goods available for sale 78,000 – Ending inventory (18,000) = Cost of goods sold $ 60,000 “Pool” of goods available to sell during the period

10. Perpetual Inventory Systems  Point-of-sale terminals have improved the ability of mass merchandisers to maintain perpetual systems Inventory records are updated after each purchase or sale

11. Periodic Inventory Systems  Reduces record keeping but also decreases the ability to track theft, breakage, etc., and prepare interim financial statements Inventory records are updated periodically based on physical inventory counts

12. Cost of Goods Purchased  Cost of inventory purchased (invoice price): Less: Purchase returns and allowances Purchase discounts Plus: Transportation-in

13. FOB Destination Point  No sale or purchase until inventory reaches its destination  Seller responsible for inventory while in transit Title passes at destination

14. FOB Shipping Point  Both sale and purchase recorded upon shipment  Buyer responsible for inventory while in transit Title passes when shipped

15. Analysis of Profitability Gross Profit % Of particular interest to current and potential investors LO4

16. Inventory Valuation and Income Measurement Value assigned to inventory on balance sheet Value expensed as cost of goods sold on income statement When Sold = LO5

17. Inventory Costs Included  Any freight costs incurred by buyer  Cost of insurance for inventory in transit  Cost of storing inventory before selling  Excise and sales taxes

18. Inventory Costing Methods Four costing methods available: Specific Identification Weighted Average First-in, First-out (FIFO) Last-in, First-out (LIFO) LO6

19. Beginning inventory, Jan. 1: 500 units (unit cost $10) Inventory purchases: Date UnitsUnit Cost 1/20 300 $ 11 4/8 400 12 9/5 200 13 12/12 100 14 Total purchases1,000 units Ending inventory, Dec. 31: 600 units Detailed Costing Method Example Calculate the Cost of Goods Sold and Ending Inventory under each cost flow method

20. Specific Identification Method Step 1: Identify the specific units in inventory at the end of the year and their costs. Step 2: Identify the units sold and calculate the cost of goods sold.

21. Specific Identification Method Date purchasedUnits Cost Total Cost Beg. inventory 500 $10$5,000 1/20 200 11 2,200 4/8 100 12 1,200 12/12 100 14 1,400 Cost of goods sold 900$9,800 Units × Cost = Total cost

22. Weighted Average Method Step 1: Calculate the cost of goods available for sale. Step 2:Divide the cost of goods available for sale by the total units to determine the weighted average cost per unit.

23. Weighted Average Method Cost of Goods Available for Sale Units Available for Sale $17,100 1,500 = $11.40/unit

24. Weighted Average Method Step 3:Calculate ending inventory and cost of goods sold by multiplying the weighted average cost per unit by the number of units in ending inventory and the number of units sold. × Avg. Cost # of Units

25. Weighted Average Method ALLOCATE TO Ending Cost of Inventory Goods Sold Units on hand 600 Units sold 900 Weighted average cost × $11.40 $ 11.40 Totalcost of goods available of $17,100 allocated: $6,840 $10,260

26. First-in, First-out (FIFO) Method Step 1:Assign the cost of the beginning inventory to cost of goods sold. Step 2: Continue to work forward until you assign the total number of units sold during the period to cost of goods sold. Allocate the remaining costs to ending inventory.

27. First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units Cost InventoryGoods Sold 1/1 500 $10 $5,000 1/20 300 $11 3,300 4/8 300 / 100 $12 $3,600 1,200 9/5 200 $13 2,600 12/12 100 $14 1,400 TOTALS $7,600 $9,500

28. Last-in, First-out (LIFO) Method Step 1: Assign the cost of the last units purchased to cost of goods sold. Step 2: Work backwards until you assign the total number of units sold during the period to cost of goods sold (allocate the remaining costs to ending inventory).

29. Last-in, First-out (LIFO) Method ALLOCATE TO Ending Cost of Units Cost InventoryGoods Sold 1/1 500 $10 $5,000 1/20 100 /200 $11 1,100 $ 2,200 4/8 400 $12 4,800 9/5 200 $13 2,600 12/12 100 $14 1,400 TOTALS$6,100 $11,000

30. LIFO Issues  LIFO liquidation Liquidation can result in high gross profit (and large tax bill)  LIFO conformity rule If used for tax, LIFO must also be used for books  LIFO reserve Difference between inventory value stated at FIFO and value stated at LIFO

31. International Inventory Valuation Methods  Acceptable methods of costing inventory in the United States may not be acceptable in other countries LIFO is generally accepted in the United States IASB (international standards) prohibit the use of LIFO by companies that follow international standards  It is uncertain whether LIFO will survive as an acceptable inventory valuation method

32. Reasons for Inventory Errors  Mathematical mistakes  Physical inventory counting errors  Cutoff problems – in-transit  Goods on consignment LO8

33. Effect of Inventory Errors on the Income Statement, 2010 Reported Corrected Effect Sales $1,000 $1,000 Beginning inventory $ 200 $ 200 Add: Purchases 700 700 Goods available for sale $ 900 $ 900 Less: Ending inventory 300 250 $50 OS Cost of goods sold $ 600 $ 650 50 US Gross margin $ 400 $ 350 50 OS Operating expenses 100 100 Net income $ 300 $ 250 50 OS OS = overstatement US = understatement

34. Effect of Inventory Errors on the Income Statement, 2011 Reported Corrected Effect Sales $1,500 $1,500 Beginning inventory $ 300 $ 250 $50 OS Add: Purchases 1,100 1,100 Goods available for sale $1,400 $1,350 50 OS Less: Ending inventory 350 350 Cost of goods sold $1,050 $1,000 50 OS Gross margin $ 450 $ 500 50 US Operating expenses 120 120 Net income $ 330 $ 380 50 US OS = overstatement US = understatement

35. Counterbalancing Errors –50 +50 The 2010 error reverses in 2011 (but 2010 inventory both 2010 and 2011 profits are misstated by 50): 2010 2011 Beginning inventory $xxx $+50 Add: Purchases xxx xxx = Goods available for sale xxx +50 Less: Ending inventory +50 xxx = Cost of goods sold

36. Lower of Cost or Market Before After Price Price ChangeChange Cost $100,000 $85,000 Report loss in year market falls below cost… LO9

37. Before After Price Price ChangeChange Selling price $100 $ 80 Cost 75 60 Gross profit $ 25 $ 20 Lower of Cost or Market Gross profit % 25% 25% …to maintain normal gross profit % when sold

38.  Market = replacement cost (not retail value)  Cost determined under one of the costing methods  Justified on basis of conservatism  Can be applied to: Entire inventory Individual items Groups of items Lower of Cost or Market

39.  Both U.S. GAAP and international financial reporting standards (IFRS) require lower- of-cost-or-market  Differences between U.S. GAAP and IFRS How market value is defined Recording changes in market value in future periods Lower of Cost or Market under International Standards

40. Cost of Goods Sold Average Inventory Inventory Turnover Ratio LO10 The number of times per period inventory is turned over (i.e., sold)

41. Number of Days’ Sales in Inventory The average number of days inventory is on hand before its sold Number of Days in the Period Inventory Turnover Ratio

42. Statement of Cash Flows Cash Flows from Operating Activities: Net income xxx Increase in inventory – Decrease in inventory + Increase in accounts payable + Decrease in accounts payable – Indirect Method LO11

43. Appendix Accounting Tools: Inventory Costing Methods with the Use of a Perpetual Inventory System

44. FIFO Costing with a Perpetual System FIFO applied at time of sale Same FIFO inventory total under periodic and perpetual systems

45. LIFO Costing with a Perpetual System LIFO applied at time of sale Different LIFO inventory total under periodic and perpetual systems because of pricing gap

46. Moving Average with a Perpetual System Different inventory total under weighted average (periodic) and moving average (perpetual) New weighted average cost is computed for each purchase

47. End of Chapter 5