Reporting and Interpreting Cost of Goods Sold and Inventory Chapter 7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-2 Understanding the Business Provide sufficient quantities of highquality inventory. Primary Goals of Inventory Management Minimize the costs of carrying inventory. 7-3 Learning Objectives Apply the cost principle to identify the amounts that should be included in inventory and the matching principle to determine cost of goods sold for typical retailers, wholesalers, and manufacturers. 7-4 Items Included in Inventory Inventory Tangible Held for Sale Merchandise Inventory Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Used to Produce Goods or Services 7-5 Costs Included in Inventory Purchases The cost principle requires that inventory be recorded at the price paid or the consideration given. Invoice Price Freight Inspection Costs Preparation Costs 7-6 Nature of Cost of Goods Sold Beginning Inventory Purchases for the Period Goods available for Sale Ending Inventory Cost of Goods Sold (Balance Sheet) (Income Statement) Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of goods sold 7-7 Inventory Costing Methods Specific Identification FIFO LIFO Weighted Average 7-8 Specific Identification When units are sold, the specific cost of the unit sold is added to cost of goods sold. 7-9 First-In, First-Out Method Oldest Costs Cost of Goods Sold Recent Costs Ending Inventory 7-10 First-In, First-Out Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 500 300 250 200 $ Total 5.25 $ 5,250.00 5.30 5.60 5.80 5.90 2,650.00 1,680.00 1,450.00 1,180.00 2,250 $ 12,210.00 Ending Inventory 1,200 ? Cost of Goods Sold 1,050 ? Remember: The costs of most recent purchases are in ending inventory. Start with 11/29 and add units purchased until you reach the number in ending inventory. 7-11 First-In, First-Out Given Information Ending Inventory Beg. Inv. 1,000 @ $ 5.25 Jan. 3 500 @ 5.30 June 20 300 @ 5.60 Sept. 15 250 @ 5.80 Nov. 29 200 @ 5.90 200 @ $5.90 200 Units Cost of Goods Sold Units 7-12 First-In, First-Out Given Information Ending Inventory Beg. Inv. 1,000 @ $ 5.25 Jan. 3 500 @ 5.30 450 @ $5.30 June 20 300 @ 5.60 300 @ $5.60 Sept. 15 250 @ 5.80 250 @ $5.80 Nov. 29 200 @ 5.90 200 @ $5.90 1,200 Units Cost of Goods Sold Units $ 6,695 Cost Now, we have allocated the cost to all 1,200 units in ending inventory. 7-13 First-In, First-Out Given Information Ending Inventory Beg. Inv. 1,000 @ $ 5.25 Jan. 3 500 @ 5.30 450 @ $5.30 June 20 300 @ 5.60 300 @ $5.60 Sept. 15 250 @ 5.80 250 @ $5.80 Nov. 29 200 @ 5.90 200 @ $5.90 1,200 Units $ 6,695 Cost Cost of Goods Sold 1,000 @ $ 5.25 50 @ 5.30 1,050 Units $ 5,515 Cost Now, we have allocated the cost to all 1,050 units sold. 7-14 First-In, First-Out Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 500 300 250 200 $ 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 2,650.00 1,680.00 1,450.00 1,180.00 2,250 $ 12,210.00 Ending Inventory 1,200 $ 6,695.00 Cost of Goods Sold 1,050 $ 5,515.00 Here is the cost of ending inventory and cost of goods sold using FIFO. 7-15 Last-In, First-Out Method Oldest Costs Ending Inventory Recent Costs Cost of Goods Sold 7-16 Last-In, First-Out Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 500 300 250 200 $ Total 5.25 $ 5,250.00 5.30 5.60 5.80 5.90 2,650.00 1,680.00 1,450.00 1,180.00 2,250 $ 12,210.00 Ending Inventory 1,200 ? Cost of Goods Sold 1,050 ? Remember: The costs of the oldest purchases are in ending inventory. Start with beginning inventory and add units purchased until you reach the number in ending inventory. 7-17 Last-In, First-Out Given Information Ending Inventory Beg. Inv. 1,000 @ $ 5.25 1,000 @ $5.25 Jan. 3 500 @ 5.30 June 20 300 @ 5.60 Sept. 15 250 @ 5.80 Nov. 29 200 @ 5.90 1,000 Units Cost of Goods Sold Units 7-18 Last-In, First-Out Given Information Ending Inventory Beg. Inv. 1,000 @ $ 5.25 1,000 @ $5.25 Jan. 3 500 @ 5.30 200 @ 5.30 June 20 300 @ 5.60 Sept. 15 250 @ 5.80 Nov. 29 200 @ 5.90 1,200 Units Cost of Goods Sold Units $ 6,310 Cost Now, we have allocated the cost to all 1,200 units in ending inventory. 7-19 Last-In, First-Out Given Information Ending Inventory Beg. Inv. 1,000 @ $ 5.25 1,000 @ $5.25 Jan. 3 500 @ 5.30 200 @ 5.30 June 20 300 @ 5.60 Sept. 15 250 @ 5.80 Nov. 29 200 @ 5.90 1,200 Units $ 6,310 Cost Cost of Goods Sold 300 300 250 200 1,050 @ $ 5.30 @ 5.60 @ 5.80 @ 5.90 Units $ 5,900 Cost Now, we have allocated the cost to all 1,050 units sold. 7-20 Last-In, First-Out Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 500 300 250 200 $ 5.25 Total $ 5.30 5.60 5.80 5.90 5,250.00 2,650.00 1,680.00 1,450.00 1,180.00 2,250 $ 12,210.00 Ending Inventory 1,200 $ 6,310.00 Cost of Goods Sold 1,050 $ 5,900.00 Here is the cost of ending inventory and cost of goods sold using LIFO. 7-21 Average Cost Method 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 Number of Units Available for Sale 7-22 Average Cost Method Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 500 300 250 200 $ 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 2,650.00 1,680.00 1,450.00 1,180.00 Weighted Average Cost 2,250 Ending Inventory 1,200 Cost of Goods Sold 1,050 $ 12,210.00 $ 12,210 = $5.42667 2,250 7-23 Average Cost Method Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 500 300 250 200 $ 5.25 Total $ 5.30 5.60 5.80 5.90 5,250.00 2,650.00 1,680.00 1,450.00 1,180.00 Weighted Average Cost $ 12,210 = $5.42667 2,250 2,250 $ 12,210.00 Ending Inventory 1,200 $ 6,512.00 1,200 × $ 5.42667 Cost of Goods Sold 1,050 $ 5,698.00 1,050 × $ 5.42667 7-24 Comparison of Methods Computers, Inc. Income Statement For Year Ended December 31, 2006 Net sales Cost of goods sold: Merchandise inventory, beginning Net purchases Goods available for sale Merchandise inventory, ending Cost of goods sold Gross profit Operating expenses Income before taxes Income taxes expense (30%)* Net income FIFO $ 25,000 LIFO $ 25,000 Weighted Average $ 25,000 $ 5,250 6,960 $ 12,210 6,695 $ 5,515 $ 19,485 750 $ 18,735 5,621 $ 13,114 $ $ * Tax expense amounts were rounded. $ $ $ $ $ 5,250 6,960 12,210 6,310 5,900 19,100 750 18,350 5,505 12,845 $ $ $ $ $ 5,250 6,960 12,210 6,512 5,698 19,302 750 18,552 5,566 12,986 7-25 Financial Statement Effects of Costing Methods Advantages of Methods First-In, First-Out Last-In, First-Out Weighted Average Ending inventory approximates current replacement cost. Better matches current costs in cost of goods sold with revenues. Smoothes out price changes. 7-26 Learning Objectives Decide when the use of different inventory costing methods is beneficial to a company. 7-27 Managers Choice of Inventory Methods Net Income Effects Managers prefer to report higher earnings for their companies. Income Tax Effects Managers prefer to pay the least amount of taxes allowed by law as late as possible. 7-28 Choosing Inventory Costing Methods If . . . LIFO for taxes LIFO Conformity Rule Then . . . LIFO for books 7-29 Learning Objectives Report inventory at the lower of cost or market (LCM). 7-30 Valuation at Lower of Cost or Market Ending inventory is reported at the lower of cost or market (LCM). Replacement Cost The current purchase price for identical goods. The company will recognize a “holding” loss in the current period rather than the period in which the item is sold. This practice is conservative. 7-31 Valuation at Lower of Cost or Market Item Pentium chips Disk drives Quantity 1,000 400 Cost $ 250 100 Replacement Cost $ 200 110 LCM $ 200 100 Total LCM $ 200,000 40,000 GENERAL JOURNAL Date Description Cost of goods sold Inventory Debit 50,000 Credit 50,000 7-32 Learning Objectives Evaluate inventory management using the inventory turnover ratio and the effects of inventory on cash flows. 7-33 Effect on Cash Flows Inventory Decrease = (more sales….) Inventory Increase = (more purchases….) Increase + to Cash Decrease - to Cash Accounts Payable Increase = + to Cash ( Paying bills later….) Accounts Payable Decrease = - to Cash (Paid more bills……) 7-34 Inventory Turnover Inventory = Turnover Cost of Goods Sold Average Inventory Average Inventory is . . . (Beginning Inventory + Ending Inventory) ÷ 2 This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly thus reducing storage and obsolescence costs. 7-35 Learning Objectives Compare companies that use different inventory costing methods. 7-36 Inventory Methods and Financial Statement Analysis U.S. public companies using LIFO also report beginning and ending inventory on a FIFO basis if the FIFO values are materially different. Beginning inventory FIFO - Beginning inventory LIFO Beginning LIFO Reserve (Excess of FIFO over LIFO) Ending inventory FIFO - Ending inventory LIFO Ending LIFO Reserve (Excess of FIFO over LIFO) Beginning LIFO Reserve - Ending LIFO Reserve Difference in COGS Under FIFO 7-37 LIFO and International Comparisons LIFO Permitted? No Yes Singapore China Canada Australia Great Britain 7-38 Learning Objectives Understand methods for controlling and keeping track of inventory and analyze the effects of inventory errors on financial statements. 7-39 Internal Control of Inventory Separation of inventory accounting and physical handling of inventory. Storage in a manner that protects from theft and damage. Limiting access to authorized employees. Maintaining perpetual inventory records. Comparing perpetual records to periodic physical counts. 7-40 Perpetual and Periodic Inventory Systems Provides up-to-date inventory records. Perpetual System Provides up-to-date cost of sales records. In a periodic inventory system, ending inventory and cost of goods sold are determined at the end of the accounting period based on a physical count. 7-41 Perpetual and Periodic Inventory Systems Inventory System Periodic System Carried over Beginning Inventory from prior period Accumulated in Add: Purchases the Purchases account Measured at end of period by Less: Ending Inventory physical inventory count Computed as a residual amount Cost of Goods Sold at end of period Item Perpetual System Carried over from prior period Accumulated in the Inventory account Perpetual record updated at every sale Measured at every sale based on perpetual record 7-42 Errors in Measuring Ending Inventory Errors in Measuring Inventory Ending Inventory Beginning Inventory Overstated Understated Overstated Understated Effect on Current Period's Balance Sheet Ending Inventory Retained Earnings + + - N/A N/A - + N/A N/A + + + - + + - + + Effect on n Current Period's Income Statement Goods Available for Sale Cost of Goods Sold Gross Profit Net Income 7-43 Chapter Supplement A LIFO Liquidations 7-44 LIFO Liquidations When a LIFO company sells more inventory than it purchases or manufactures, items from beginning inventory become part of cost of goods sold. This is called a LIFO liquidation. When inventory costs are rising, these lower cost items in beginning inventory produce a higher gross profit, higher taxable income, and higher taxes when they are sold. 7-45 LIFO Liquidations Companies must disclose the effects of LIFO liquidations in the notes when they are material. Many companies avoid LIFO liquidations and the accompanying increase in tax expense by purchasing sufficient quantities of inventory at year-end to ensure that ending inventory quantities are greater than or equal to beginning inventory quantities. 7-46 Chapter Supplement B Additional Issues in Measuring Purchases 7-47 Purchase Returns and Allowances Purchase returns and allowances are a reduction in the cost of purchases associated with unsatisfactory goods. Returned goods require a reduction in the cost of inventory purchases and the recording of a cash refund or a reduction in the liability to the vendor. 7-48 Purchase Discounts A purchase discount is a cash discount received for prompt payment of an account. Terms Discount Period Credit Period Full amount less discount Full amount due Time Due Purchase or Sale 7-49 Purchase Discounts 2/10,n/30 Discount Percent Number of Days Discount Is Available Otherwise, Net (or All) Is Due Credit Period 7-50 Purchase Discounts Purchases paid for within the discount period reduce the Inventory account for the amount of the cash discount received. 7-51 Chapter Supplement C Comparison of Perpetual and Periodic Inventory Systems 7-52 Perpetual Inventory System Jan. 1 Apr. 14 Nov. 30 Dec. 31 Had beginning inventory of 800 units at a unit cost of $50. Purchased 1,100 units at a unit cost of $50. Inventory 55,000 Accounts payable 55,000 Sold 1,300 units at a sales price of $83. Accounts receivable 107,900 Sales revenue 107,900 Cost of goods sold 65,000 Inventory 65,000 Use cost of goods sold and inventory amounts. 7-53 Periodic Inventory System Jan. 1 Apr. 14 Nov. 30 Dec. 31 Had beginning inventory of 800 units at a unit cost of $50. Purchased 1,100 units at a unit cost of $50. Purchases 55,000 Accounts payable 55,000 Sold 1,300 units at a sales price of $83. Accounts receivable 107,900 Sales revenue 107,900 Count the number of units on hand. Compute the dollar valuation of the ending inventory. Compute and record the cost of goods sold. Cost of goods sold 95,000 Inventory (beginning) 40,000 Purchases 55,000 Inventory (ending) 30,000 Cost of goods sold 30,000 7-54 End of Chapter 7