1. Chapter 5, Slide #1 Using Financial Accounting Information: The Alternative to Debits and Credits Fifth Edition Gary A. Porter and Curtis L. Norton Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

2. Chapter 5, Slide #2 CURRENT ASSETS: Cash and cash equivalents $ 47,488 $ 55,991 Marketable securities 49,075 57,175 Accounts receivable 11,999 14,230 Merchandise inventory 268,590 241,242 Other 4,375 3,162 TOTAL CURRENT ASSETS $381,527 371,800 The Finish Line, Inc. Consolidated Balance Sheets [Partial] February 25, February 26, 2006 2005 ASSETS (in thousands) More than 60% of current assets

3. Chapter 5, Slide #3 Inventory of Wholesalers and Retailers  Purchased in finished form  Resold without transformation  Classified as “Merchandise Inventory” on balance sheet LO1

4. Chapter 5, Slide #4 Inventory of Manufacturers Manufacturing overhead Direct materials Direct labor Costs Included in Inventory

5. Chapter 5, Slide #5 Inventory of Manufacturers Manufacturing overhead Direct materials Direct labor Manufacture products Work in process Finished goods Raw materials Costs Included in Inventory Balance Sheet Classifications

6. Chapter 5, Slide #6 Current assets: Inventories: Finished goods $ 108.7 In-process products 12.9 Raw materials 43.4 $ 165.0 Jacuzzi Brands’ Consolidated Balance Sheets [Partial] 2005 ASSETS (in millions)

7. Chapter 5, Slide #7 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

8. Chapter 5, Slide #8 Sales and Contra-Sales Accounts LO2 Sales Returns and Allowances Contra-revenue used to record both refunds to customers and reductions of their accounts Sales revenue The inflow of either cash or accounts receivable from the sale of a product during the period

9. Chapter 5, Slide #9 Credit Terms and Sales Discounts n/30 Payment due 30 days from invoice date 1/10, n/30 Deduct 1% of invoice amount if paid within 10 days; otherwise full invoice amount is due in 30 days 2/10, n/30 Deduct 2% of invoice amount if paid within 10 days; otherwise full invoice amount is due in 30 days

10. Chapter 5, Slide #10 Net Sales Net Sales Section of the Income Statement: Sales revenue$103,500 Less: Sales returns and Allowances 2,000 Sales discounts 1,500 3,500 Net Sales$100,000

11. Chapter 5, Slide #11 Purchases of merchandise Beginning inventory The Cost of Goods Sold Model Cost of goods sold Ending inventory LO3

12. Chapter 5, Slide #12 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

13. Chapter 5, Slide #13 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

14. Chapter 5, Slide #14 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

15. Chapter 5, Slide #15 Cost of Goods Purchased  Includes invoice price: Less: Purchase returns and allowances Purchase discounts Plus: Transportation-in

16. Chapter 5, Slide #16 FOB Shipping Point  Both sale and purchase recorded upon shipment  Buyer responsible for inventory while in transit Seller Buyer Title passes when shipped

17. Chapter 5, Slide #17 Recording Purchases Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Accounts Payable 500 + Purchases (500) To record purchase of $500 inventory

18. Chapter 5, Slide #18 Recording Purchase Discounts Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Cash Acct. Pay. Purchase (495) = (500) + Discounts 5 To record payment within discount period to supplier who offers 1% purchase discount. ($ 500 × 1% = $5 discount)

19. Chapter 5, Slide #19 FOB Destination Point  No sale or purchase until inventory reaches its destination  Seller responsible for inventory while in transit Seller Buyer Title passes at destination

20. Chapter 5, Slide #20  No sale or purchase until inventory is shipped  Buyer responsible for inventory while in transit FOB Shipping Point Seller Buyer Title passes when shipped

21. Chapter 5, Slide #21 Analysis of Profitability Gross Profit % Of particular interest to current and potential investors LO4

22. Chapter 5, Slide #22 Gross Profit Ratio = Gross Profit Net Sales (How many cents on every $ of sales are left over after covering the cost of the product) Daisy’s Profitability Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000 Gross profit ratio = 40%

23. Chapter 5, Slide #23 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

24. Chapter 5, Slide #24 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

25. Chapter 5, Slide #25 Inventory Costing Methods Four costing methods available: Specific Identification Weighted Average First-in, First-out (FIFO) Last-in, First-out (LIFO) LO6

26. 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 method using the data below:

27. Chapter 5, Slide #27 Specific Identification Method Step 1: Identify the specific units in inventory at the end of the year and their costs.

28. Chapter 5, Slide #28 Specific Identification Method Units in ending inventory: Date purchasedUnits Cost Total Cost 1/20 100 $11$1,100 4/8 300 12 3,600 9/5 200 13 2,600 Ending inventory 600$7,300 Units × Cost = Total cost

29. Chapter 5, Slide #29 Specific Identification Method Step 2: Identify the units sold and calculate the cost of goods sold.

30. Chapter 5, Slide #30 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

31. Chapter 5, Slide #31 Weighted Average Method Step 1: Calculate the cost of goods available for sale.

32. Chapter 5, Slide #32 Weighted Average Method Date purchasedUnits Cost Total cost Beg. inventory 500 $10 $ 5,000 1/20 300 11 3,300 4/8 400 12 4,800 9/5 200 13 2,600 12/12 100 14 1,400 Cost of goods available for sale 1,500 $17,100

33. Chapter 5, Slide #33 Weighted Average Method Step 2:Divide the cost of goods available for sale by the total units to determine the weighted average cost per unit.

34. Chapter 5, Slide #34 Weighted Average Method Cost of Goods Available for Sale Units Available for Sale $17,100 1,500 = $11.40/unit

35. Chapter 5, Slide #35 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

36. Chapter 5, Slide #36 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

37. Chapter 5, Slide #37 First-in, First-out (FIFO) Method Step 1:Assign the cost of the beginning inventory to cost of goods sold. 1st in

38. Chapter 5, Slide #38 First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units CostInventoryGoods Sold 1/1 500 $10 $5,000 1/20 300 $11 4/8 400 $12 9/5 200 $13 12/12 100 $14

39. Chapter 5, Slide #39 First-in, First-out (FIFO) Method 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. 2nd 3rd etc.

40. Chapter 5, Slide #40 First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units CostInventoryGoods 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

41. Chapter 5, Slide #41 Last-in, First-out (LIFO) Method Step 1: Assign the cost of the last units purchased to cost of goods sold. 1st in 1st in

42. Chapter 5, Slide #42 Last-in, First-out (LIFO) Method ALLOCATE TO Ending Cost of Units CostInventoryGoods Sold 1/1 500 $10 1/20 300 $11 4/8 400 $12 9/5 200 $13 12/12 100 $14 $1,400

43. Chapter 5, Slide #43 1st in 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). Last-in, First-out (LIFO) Method

44. Chapter 5, Slide #44 Last-in, First-out (LIFO) Method ALLOCATE TO Ending Cost of Units CostInventoryGoods 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

45. Chapter 5, Slide #45 Comparison of Costing Methods Cost of Goods Sold Ending Inventory 11,000 6,840 7,600 10,260 9,500 17,100 17,000 17,100 Weighted Average FIFO LIFO Goods Available for Sale 6,100 Specific Identification $7,300 $ 9,800 $17,100

46. Chapter 5, Slide #46 Comparison of Costing Methods X X X X X Weighted AverageFIFO LIFO In periods of rising prices: Highest cost of goods sold? Lowest cost of goods sold? Highest gross profit? Lowest net income? Lowest income taxes? LO7

47. Chapter 5, Slide #47 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

48. Chapter 5, Slide #48 Reasons for Inventory Errors  Mathematical mistakes  Physical inventory counting errors  Cutoff problems – in-transit  Goods on consignment LO8

49. Chapter 5, Slide #49 Effect of Inventory Errors on the Income Statement, 2007 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

50. Chapter 5, Slide #50 Effect of Inventory Errors on the Income Statement, 2008 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

51. Chapter 5, Slide #51 Counterbalancing Errors Assume ending inventory is overstated (+) by $50 in 2007: 2007 Beginning inventory$ xxx Add: Purchases xxx = Goods available for sale xxx Less: Ending inventory +50 = Cost of goods sold –50

52. Chapter 5, Slide #52 Counterbalancing Errors 2007 ending inventory becomes 2008 beginning inventory: 2007 2008 Beginning inventory $ xxx +50 Add: Purchases xxx = Goods available for sale xxx Less: Ending inventory +50 = Cost of goods sold –50

53. Chapter 5, Slide #53 Counterbalancing Errors –50 +50 The 2007 error reverses in 2008 (but 2007 inventory and both 2007 and 2008 profits are misstated by $50,000): 2007 2008 Beginning inventory $xxx $+50 Add: Purchases xxx xxx = Goods available for sale xxx +50 Less: Ending inventory +50 xxx = Cost of goods sold

54. Lower of Cost or Market Before After Price Price ChangeChange Cost $150 $120 Report loss in year market falls below cost… LO9

55. 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

56. Chapter 5, Slide #56  Market = replacement cost (not retail value)  Cost determined under one of the four costing methods  Justified on basis of conservatism  Can be applied to: Entire inventory Individual items Groups of items Lower of Cost or Market

57. Chapter 5, Slide #57 Estimating Inventory Value  Sometimes impossible or impractical to measure inventory at cost Estimation is necessary  Two methods used to estimate ending inventory values: Gross profit method Retail inventory method LO10

58. Chapter 5, Slide #58 Gross Profit Method Beginning Inventory + Purchases = Cost of Goods Available for Sale – Ending Inventory = Cost of Goods Sold Use income statement model but reverse last two steps

59. Chapter 5, Slide #59 Gross Profit Method Beginning inventory $1,200 +Purchases 3,500 =Cost of goods available for sale 4,700 – Cost of goods sold (estimated)* 4,200 =Ending inventory (estimated) $ 500 * Cost of goods sold is estimated as a percentage of sales

60. Chapter 5, Slide #60 Cost of Goods Sold Average Inventory Inventory Turnover Ratio The number of times per period inventory is turned over (i.e., sold) LO11

61. Chapter 5, Slide #61 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 123 45678910 11121314151617 18192021222324 25262829303127

62. Chapter 5, Slide #62 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 – - OR - Cash paid for inventory purchases – Indirect Method Direct Method LO12

63. Chapter 5, Slide #63 Appendix Accounting Tools: Inventory Costing Methods with the Use of a Perpetual Inventory System

64. Chapter 5, Slide #64 FIFO Costing with a Perpetual System FIFO applied at time of sale Same FIFO inventory total under periodic and perpetual systems

65. Chapter 5, Slide #65 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

66. Chapter 5, Slide #66 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

67. Chapter 5, Slide #67 End of Chapter 5