1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Chapter 06 I NVENTORIES AND C OST OF S ALES McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 6 - 2 D ETERMINING I NVENTORY I TEMS Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Items requiring special attention include: Goods in Transit Goods Damaged or Obsolete Goods on Consignment C1

3. 6 - 3 FOB Destination Point Public Carrier SellerBuyer G OODS IN T RANSIT Public Carrier SellerBuyer FOB Shipping Point Ownership passes to the buyer here. C1

4. 6 - 4 G OODS ON C ONSIGNMENT Merchandise is included in the inventory of the consignor, the owner of the inventory. Consignor Consignee Thanks for selling my inventory in your store. C1

5. 6 - 5 G OODS D AMAGED OR O BSOLETE Damaged or obsolete goods are not counted in inventory if they cannot be sold. Cost should be reduced to net realizable value if they can be sold. C1

6. 6 - 6 D ETERMINING I NVENTORY C OSTS Invoice Cost Include all expenditures necessary to bring an item to a salable condition and location. Minus Discounts and Allowances Plus Import Duties Plus Freight Plus Storage Plus Insurance C2

7. 6 - 7  Most companies take a physical count of inventory at least once each year. I NTERNAL C ONTROLS AND T AKING A P HYSICAL C OUNT  When the physical count does not match the Merchandise Inventory account, an adjustment must be made. Good internal controls over count include: 1.Pre-numbered inventory tickets. 2.Counters have no inventory responsibility. 3.Counts confirm existence, amount, and quality of inventory item. 4.Second count is taken. 5.Manager confirms all items counted. Good internal controls over count include: 1.Pre-numbered inventory tickets. 2.Counters have no inventory responsibility. 3.Counts confirm existence, amount, and quality of inventory item. 4.Second count is taken. 5.Manager confirms all items counted. C2

8. 6 - 8 I NVENTORY C OSTING UNDER A P ERPETUAL S YSTEM Inventory affects... The matching principle requires matching costs with sales. Balance Sheet Income Statement C2

9. 6 - 9 I NVENTORY C OST F LOW A SSUMPTIONS C2 Management decisions in accounting for inventory involve the following: 1.Items included in inventory and their costs. 2.Costing method (specific identification, FIFO, LIFO, or weighted average). 3.Inventory system (perpetual or periodic). 4.Use of market values or other estimates.

10. 6 - 10 I NVENTORY C OST F LOW A SSUMPTIONS First-In, First-Out (FIFO) Assumes costs flow in the order incurred. Last-In, First-Out (LIFO) Assumes costs flow in the reverse order incurred. Weighted Average Assumes costs flow at an average of the costs available. P1

11. 6 - 11 I NVENTORY C OSTING I LLUSTRATION Here is information about the mountain bike inventory of Trekking for the month of August. P1

12. 6 - 12 S PECIFIC I DENTIFICATION P1

13. 6 - 13 S PECIFIC I DENTIFICATION P1 Balance Sheet Inventory Income Statement Cost of Goods Sold

14. 6 - 14 S PECIFIC I DENTIFICATION Here are the entries to record the purchases and sales. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 P1

15. 6 - 15 F IRST -I N, F IRST -O UT (FIFO) Cost of Goods Sold Ending Inventory Oldest Costs Recent Costs P1

16. 6 - 16 F IRST -I N, F IRST -O UT (FIFO) P1

17. 6 - 17 F IRST -I N, F IRST -O UT (FIFO) P1

18. 6 - 18 F IRST -I N, F IRST -O UT (FIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 P1

19. 6 - 19 L AST -I N, F IRST -O UT (LIFO) Cost of Goods Sold Ending Inventory Recent Costs Oldest Costs P1

20. 6 - 20 L AST -I N, F IRST -O UT (LIFO) P1

21. 6 - 21 L AST -I N, F IRST -O UT (LIFO) P1

22. 6 - 22 L AST -I N, F IRST -O UT (LIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 P1

23. 6 - 23 W EIGHTED A VERAGE 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 Units on hand on the date of sale ÷ P1

24. 6 - 24 W EIGHTED A VERAGE P1

25. 6 - 25 W EIGHTED A VERAGE P1

26. 6 - 26 W EIGHTED A VERAGE P1

27. 6 - 27 W EIGHTED A VERAGE Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 P1

28. 6 - 28 F INANCIAL S TATEMENT E FFECTS OF C OSTING M ETHODS Because prices change, inventory methods nearly always assign different cost amounts. A1

29. 6 - 29 F INANCIAL S TATEMENT E FFECTS OF C OSTING M ETHODS Advantages of Methods Smoothes out price changes. Better matches current costs in cost of goods sold with revenues. Ending inventory approximates current replacement cost. First-In, First-Out Weighted Average Last-In, First-Out A1

30. 6 - 30 F INANCIAL STATEMENT AFFECTS When purchase price is the same all inventory methods same results When costs rise: FIFO highest inventory value, lowest COGS highest Gross Margin and Net Income LIFO lowest inventory value, highest COGS and lowest Gross Margin and Net Income Weighted Average In between When costs decline: the opposite

31. 6 - 31 F INANCIAL STATEMENT AFFECTS When purchase price is the same all inventory methods same results When costs decline: FIFO Lowest inventory value, highest COGS lowest Gross Margin and Net Income LIFO Highest inventory value, lowest COGS and highest Gross Margin and Net Income Weighted Average In between When costs rise: the opposite

32. 6 - 32 T AX E FFECTS OF C OSTING M ETHODS The Internal Revenue Service (IRS) identifies several acceptable inventory costing methods for reporting taxable income. If LIFO is used for tax purposes, the IRS requires it be used in financial statements. A1

33. 6 - 33 C ONSISTENCY IN U SING C OSTING M ETHODS The consistency principle requires a company to use the same accounting methods period after period so that financial statements are comparable across periods. A1 Can only change if it will improve financial reporting Justification and disclosure in notes to financial statements required

34. 6 - 34 L OWER OF C OST OR M ARKET Inventory must be reported at market value when market is lower than cost. Can be applied three ways: (1)separately to each individual item. (2)to major categories of assets. (3)to the whole inventory. Can be applied three ways: (1)separately to each individual item. (2)to major categories of assets. (3)to the whole inventory. Defined as current replacement cost (not sales price). Consistent with the conservatism principle. Defined as current replacement cost (not sales price). Consistent with the conservatism principle. P2

35. 6 - 35 L OWER OF C OST OR M ARKET A motor sports retailer has the following items in inventory: P2

36. 6 - 36 L OWER OF C OST OR M ARKET Here is how to compute lower of cost or market for individual inventory items. P2

37. 6 - 37 F INANCIAL S TATEMENT E FFECTS OF I NVENTORY E RRORS Income Statement Effects A2 Inventory errors are self correcting over a two year period Inventory adjustment for Lower of Cost or Market DR COGS CR Merchandise Inventory No adjustment if inventory value increases

38. 6 - 38 F INANCIAL S TATEMENT E FFECTS OF I NVENTORY E RRORS Balance Sheet Effects A2

39. 6 - 39 I NVENTORY T URNOVER Inventory Turnover = Cost of goods sold Avg. inventory Shows how many times a company turns over its inventory during a period. Indicator of how well management is controlling the amount of inventory available. Average Inventory = (Beg. Inv. + End Inv.) ÷ 2 A3

40. 6 - 40 D AYS ’ S ALES IN I NVENTORY Reveals how much inventory is available in terms of the number of days’ sales. Days' Sales in Inventory = Ending Inventory Cost of goods sold × 365 A3

41. 6 - 41 G LOBAL V IEW Items and Costs Making Up Inventory Both U.S. GAAP and IFRS include in inventory all items that a company owns and holds for sale and include in the cost expenditures necessary to bring those items to a salable condition and location. Assigning Costs to Inventory Both U.S. GAAP and IFRS allow companies to use specific identification, FIFO, and Weighted Average. IFRS does not currently allow use of LIFO. Estimating Inventory Costs Both U.S. GAAP and IFRS require companies to write down inventory when its value falls below recorded cost. U.S. GAAP prohibits any later increase in value. IFRS does allow reversals of write downs up to the original acquisition cost. Neither allow inventory to be adjusted upward beyond the original cost.

42. 6 - 42 A PPENDIX 6A: I NVENTORY C OSTING UNDER A P ERIODIC S YSTEM P3 LIFO computation of COGS and ending inventory under a periodic system.

43. 6 - 43 A PPENDIX 6B: I NVENTORY E STIMATION M ETHODS P4 Inventory sometimes requires estimation for interim statements or if some casualty such as fire or flood makes taking a physical count impossible. Retail Inventory Method Gross Profit Method

44. 6 - 44 END OF CHAPTER 06