StIce | StIce |Skousen Inventory and Cost of Goods Sold Chapter 9 Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College 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 Time Line BUY Raw Materials or Goods for Resale ADD Value SELL COMPUTE Finished Inventory Cost of Goods Ending Sold Inventory 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. 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. Differences in Recording Purchases of Inventory- Periodic Purchases 3,000 Accounts Payable Sales During the Period- Periodic Accounts Receivable Sales 3,000 4,125 4,125 Purchases of Inventory- Perpetual Inventory Accounts Payable Sales During the Period- Perpetual Accounts Receivable Sales Cost of Goods Sold Inventory 3,000 3,000 4,125 4,125 2,750 2,750 Differences in Valuing Cost of Goods Sold * From count ** From records Beginning Inventory + Purchases = Cost of Goods available for sale - Ending Inventory Periodic System $ 500 Perpetual System $ 500 3,000 3,000 $3,500 $3,500 700* 750** = Preliminary cost of goods sold $2,800 (COGS) + Cost of missing inventory Unknown $2,750 Reported cost of goods sold $2,800 $2,800 50 Stop and Think If perpetual inventory systems have so many clear advantages, why aren’t they used by all companies? 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. Goods in Transit FOB Shipping Point Buyer Seller Quality Produce Goods being shipped are included in inventory of buyer while in transit. Goods in Transit FOB Destination Buyer Seller Quality Produce Goods being shipped are included in inventory of seller until received by buyer. 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. 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. 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. Cash Discounts $10,000 Owed $9,800 Owed 10 Days 20 Days Supplier “Loan” Period Purchase Date End of Discount Period Final Payment Date Cash Discounts- Net Method June 1 Inventory 9,800 Accounts Payable (A/P) 9,800 June 8 A/P Cash June 28 A/P Discounts Lost Cash June 30 Discounts Lost A/P Assume that payment was not made until June 28. 9,800 9,800 9,800 200 10,000 200 200 Assume no payment till end of the month (the discount period has lapsed) here is the adjustment: 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. Cash Discounts- Gross Method June 1 Inventory 10,000 Accounts Payable (A/P) 10,000 June 8 A/P Inventory Cash June 28 A/P Cash 10,000 200 9,800 10,000 10,000 Assume that payment was not made until June 28. Purchase Returns and Allowances • Adjustments Periodic Inventory System are also made Accounts Payable 400 when goods are damaged Purchase Returns & or not lesser Allowances in quality than 400 ordered. Perpetual Inventory System • Sometimes the Accounts Payable 400 customer returns the Inventory goods. 400 Practice time • 9-66 • 9-1, 2, 3, 5 • 9- 28, 29, 31, 32, 33 Inventory Valuation Methods Specific Identification Cost Allocation Methods FIFO Average Cost LIFO 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. Inventory Valuation Method Assume: Purchases: January 1 March 23 July 15 November 6 Total purchases Sales 200 300 500 100 1,100 700 @ @ @ @ $10 $12 $11 $13 @ $15 $ 2,000 3,600 5,500 1,300 $12,400 Specific Identification Method Jan. 1 200 units @ $10 per unit Mar. 23 July 15 300 units @ $12 per unit 500 units @ $11 per unit Nov. 6 100 units @ $13 per unit 1,100 units Sold 200 units from the January 1 and 500 from the July 15 purchase. Specific Identification Method Jan. 1 200 units @ $10 per unit July 15 500 units @ $11 per unit SOLD 700 Specific Identification Method Jan. 1 200 units @ $10 per unit = $2,000 July 15 500 units @ $11 per unit = 5,500 Total cost of goods sold $7,500 Specific Identification Method Goods Not Sold Mar. 23 300 units @ $12 per unit = $3,600 Nov. 6 100 units @ $13 per unit = 1,300 Ending inventory $4,900 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. Average Cost Method Periodic Jan. 1 200 units @ $10 per unit Mar. 23 July 15 300 units @ $12 per unit 500 units @ $11 per unit Nov. 6 100 units @ $13 per unit 1,100 units = $ 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 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. FIFO Method--Periodic Jan. 1 200 units @ $10 per unit Mar. 23 July 15 300 units @ $12 per unit 500 units @ $11 per unit Nov. 6 100 units @ $13 per unit Total cost of goods sold Sold 200 = $2,000 = 3,600 Sold 300 Sold 200 = 2,200 $7,800 FIFO Method--Periodic Goods Not Sold Mar. 23 300 units @ $11 per unit = 3,300 Nov. 6 100 units @ $13 per unit = 1,300 Ending Inventory $4,600 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. LIFO Method--Periodic Jan. 1 200 units @ $10 per unit Mar. 23 July 15 300 units @ $12 per unit 500 units @ $11 per unit = $1,200 Sold 100 = $5,500 Sold 500 Nov. 6 100 units @ $13 per unit = $1,300 Sold 100 Total cost of goods sold $8,000 LIFO Method--Periodic Goods Not Sold Jan. 1 200 units @ $10 per unit = 2,000 Mar. 23 200 units @ $12 per unit = 2,400 Ending Inventory $4,400 Comparison of Inventory Methods (Periodic) Ending Cost of Goods Inventory Sold Specific identification $7,500 $4,900 Average cost $7,890 $4,510 FIFO $7,800 $4,600 LIFO $8,000 $4,400 Practice • Exercise 9-34 Perpetual Inventory Assume: Beginning inventory Purchases: April 10 April 20 Sales: April 18 April 27 100 @ $10 $1,000 80 70 @ $11 @ $12 880 840 90 50 @ $15 @ $16 FIFO periodic and FIFO perpetual provide identical results for cost of goods sold and inventory. Average Cost MethodPerpetual Apr. 1 Apr. 10 Apr. 10 Beginning Inventory 100 units @ $10 $1,000 Purchases 80 units @ $11 880 Balance 180 units @ $10.44 $1,880 Apr. Apr. Apr. Apr. Sales Balance Purchases Balance 18 18 20 20 Apr. 27 Apr. 30 Sales Balance (90) 90 70 160 units @ $10.44 (940) units @ $10.44 $ 940 units @ $12 840 units @ $11.125 $1,780 $1,880 180 (50) units @ $11.125 (556) 110 units @ $11.125 $1,224 $1,780 160 Ending inventory, $1,224 Average Cost Method- Perpetual Apr. 1 Apr. 10 Apr. 10 Beginning Inventory 100 units @ $10 $1,000 Purchases 80 units @ $11 880 Balance 180 units @ $10.44 $1,880 Apr. Apr. Apr. Apr. Sales Balance Purchases Balance (90) 90 70 160 Sales Balance (50) units @ $11.125 (556) 110 units @ $11.125 $1,224 18 18 20 20 Apr. 27 Apr. 30 units units units units @ @ @ @ $10.44 (940) $10.44 $ 940 $12 840 $11.125 $1,780 Cost of Goods Sold (140 units) $940 + $556 = $1,496 LIFO Method- Perpetual Perpetual Inventory System Apr. 1 100 units @ 90 units @$10 $10per perunit unit Apr. 10 0 units units @@$11 $11per perunit unit 80 Beginning Sold 10 inventory Purchased Sold 80 80 Apr. 20 70 units units @ 20 @$12 $12per perunit unit Purchased Sold 50 70 LIFO Method- Perpetual Perpetual Inventory System 90 units @ $10 per unit Apr. 1 100 Apr. 10 Apr. 20 = = = 80 0 units @ $11 per unit 20 70 units @ $12 per unit Ending inventory……………….. $ 900 0 240 $1,140 Beg. Inv. + Purchases – End. Inv. = Cost of Goods Sold $1,000 + $1,720 – $1,140 = $1,580 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. 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 Practice • 9-35 • 9-7 • 9-8 & 9 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. 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. 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. FIFO and LIFO Comparison 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 change to FIFO 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. Review time •Exercise 43 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 Lower of Cost or Market • The term Ceiling: Ceiling: “market” Also Estimated known in lower asselling ofthe cost net or marketprice means – normal replacement selling cost. costs realizable value Replacement Cost Market compare Historical Cost see p. Floor: Net realizable value – 472 a normal profit margin Lower of Cost or Market Lower of Cost or Market p 473 CASE A Ceiling: $0.80 Market $0.70 $0.70 $0.65 Floor: $0.55 Historical Cost LCM = $0.65 Lower of Cost or Market Lower of Cost or Market CASE B Ceiling: $0.80 Market $0.60 $0.60 $0.65 Floor: $0.55 Historical Cost LCM = $0.60 Lower of Cost or Market Lower of Cost or Market CASE C Ceiling: $0.80 Market $0.55 $0.50 $0.65 Floor: $0.55 Historical Cost LCM = $0.55 Lower of Cost or Market Lower of Cost or Market CASE D Ceiling: $0.80 Market $0.55 $0.45 $0.50 Floor: $0.55 Historical Cost LCM = $0.50 Lower of Cost or Market Lower of Cost or Market CASE E Ceiling: $0.80 Market $0.80 $0.85 $0.75 Floor: $0.55 Historical Cost LCM = $0.75 Lower of Cost or Market Lower of Cost or Market CASE F Ceiling: $0.80 Market $0.80 $1.00 $0.90 Floor: $0.55 Historical Cost LCM = $0.80 Problem Solving •Let’s practice with Exercise 11, 13, 14, 44, 47, 48 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 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 year 40 % Two years ago 37 Three years ago 42 Last year’s 40% is considered a good estimate. Gross Profit Method Sales (actual) $50,000 Cost of goods sold (estimate) 30,000 Gross profit (estimate) $20,000 Beginning inventory (actual) 100 % 60 % 40 % $25,000 Gross Profit Method Sales (actual) $50,000 Cost of goods sold (estimate) 30,000 Gross profit (estimate) $20,000 Beginning inventory (actual) + Purchases (actual) 100 % 60 % 40 % $25,000 40,000 Gross Profit Method Sales (actual) $50,000 Cost of goods sold (estimate) 30,000 Gross profit (estimate) $20,000 Beginning inventory (actual) + Purchases (actual) – Cost of goods available for sale (actual) 100 % 60 % 40 % $25,000 40,000 $65,000 Gross Profit Method Sales (actual) $50,000 Cost of goods sold (estimate) 30,000 Gross profit (estimate) $20,000 Beginning inventory (actual) + Purchases (actual) – Cost of goods available for sale (actual) – Cost of goods sold (estimate) 100 % 60 % 40 % $25,000 40,000 $65,000 30,000 Gross Profit Method Sales (actual) $50,000 Cost of goods sold (estimate) 30,000 Gross profit (estimate) $20,000 Beginning inventory (actual) + Purchases (actual) – Cost of goods available for sale (actual) – Cost of goods sold (estimate) =Ending inventory (estimate) 100 % 60 % 40 % $25,000 40,000 $65,000 $30,000 35,000 Gross Profit Method Sales (actual) $50,000 Cost of goods sold (estimate) 29,000 Gross profit (estimate) $21,000 Beginning inventory (actual) + Purchases (actual) – Cost of goods available for sale (actual) – Ending inventory (estimate) = Cost of goods sold (estimate) 100 % 58 % 42 % $25,000 40,000 $65,000 36,000 $29,000 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 Effects of Errors in Recording Inventory 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 Sold 1,000 Inventory 1,000 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 Practice • 9-15, 16, 49, 51, 52 Inventory Turnover Appropriateness of inventory size and position can be measured by calculating the Inventory Turnover Ratio. Inventory Turnover: Cost of Goods Sold ÷ Average Inventory Inventory Turnover • Cost of Goods Sold • Beginning Inventory • Ending Inventory $1,000 $ 90 $ 110 Determine the inventory turnover. Inventory Turnover • Cost of Goods Sold • Beginning Inventory • Ending Inventory $1,000 $ 90 $ 110 $1,000 ($90 + $110)/2 = 10 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 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 Number of Days’ Sales in Inventory $1,000 ($90 + $110)/2 = 10 365 10 Number of days’ sales in inventory is 36.5 Practice • Exercise 9-17 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 Retail Inventory Method Retail Inventory Method Inventory, Jan 1 Purchases in Jan Goods Available for Sale COST RETAIL $30,000 $50,000 30,000 40,000 $60,000 $90,000 Cost Percentage: Beginning inventory ($30,000/$50,000) = 60.0% Purchases ($30,000/$40,000) =75.0% –Sales for January 65,000 Inventory, Jan 31, at retail $25,000 Inventory, Jan 31, at estimated cost: FIFO ($25,000 x 75%) $ 18,750 LIFO ($25,000 x 60%) $ 15,000 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. 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. Learning Objectives 7. Choose an inventory valuation method based on the trade-offs among income tax effects, bookkeeping 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. 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. 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. Raw Materials Raw Materials are Materials that are goods acquired for necessary in the use in the Materials that are production process production process. used directly in the but are not directly production of goods incorporated into are frequently the product are referred to as direct referred to as materials. indirect materials. Work in Process Work in Process (WIP) consists ofDirect labor refers to the cost of labor materials partly The three cost directly identified processed and elements that make Manufacturing with goods in requiring further up overhead WIP are direct refers to production. work before they can materials, direct of the proportion be sold. labor and factory overhead manufacturing assignable to goods overhead. in production. Finished Goods Finished goods are the manufactured products awaiting sale. Balance Sheet Income Statement Direct Labor Raw Materials Work in Process Manufacturing Overhead Finished Goods Cost of Goods Sold Summary Income Statement Items Balance Sheet Items Retailer Merchandise Sale Cost of Goods Sold Finished Goods Cost of Goods Sold Manufacturer Raw Materials Work in Process Direct Overhead Labor Sale 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: Schedule of Cost of Goods Manufactured Manufacturing overhead: Indirect labor Factory supervision $ 40,000 29,000 Depr.—factory building and equipment 20,000 Light, heat, and power 18,000 Factory supplies 15,000 Miscellaneous manufacturing overhead 12,055 Total manufacturing costs Add work in process inventory, January 1 Less work in process inventory, December 31 Cost of goods manufactured 134,055 $337,405 99,400 $366,805 26,500 $340,305