Ch.5 Accounting for Inventories and Cost of Goods Sold Prof. J. Wang Chapter 5, Slide #1 Part I Introduction Chapter 5, Slide #2 • 1. merchandise inventory • 2. I/S of a merchandise company • 3. how companies keep track of their inventory: perpetual v. periodic systems • 4. purchase of inventory on account • 5. shipping cost Chapter 5, Slide #3 1.1 Inventory of Wholesalers and Retailers Purchased in finished form Resold without transformation Classified as “Merchandise Inventory” on balance sheet Chapter 5, Slide #4 LO1 1.2 Condensed Income Statement for a Merchandiser Net sales Cost of goods sold Gross profit Selling and administrative expenses Net income before tax Income tax expense Net income Chapter 5, Slide #5 $100,000 60,000 $ 40,000 29,300 $ 10,700 4,280 $ 6,420 1.3 how companies keep track of their inventory • Perpetual inventory system • Periodic inventory system Chapter 5, Slide #6 Perpetual Inventory Systems Inventory records are updated after each purchase or sale Point-of-sale terminals have improved the ability of mass merchandisers to maintain perpetual systems Company knows the cost of sales and ending inventory figure from their books Chapter 5, Slide #7 Periodic Inventory Systems Inventory records are updated periodically based on physical inventory counts Reduces record keeping but also decreases the ability to track theft, breakage, etc., and prepare interim financial statements Chapter 5, Slide #8 The Cost of Goods Sold Model Beginning inventory + Cost of goods purchased = Cost of goods available for sale – Ending inventory = Cost of goods sold “Pool” of goods available to sell during the period Chapter 5, Slide #9 $ 15,000 63,000 78,000 (18,000) $ 60,000 An increase in ending inventory means more was bought than sold 1.4 Purchase of inventory on account • Cash discount Chapter 5, Slide #10 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 Chapter 5, Slide #11 • On July 16, the company purchased merchandise inventory on account for $500. Term: 1/10, n/30. Dr. Purchases Cr. A/P Chapter 5, Slide #12 500 500 Recording Purchase Discounts On July 25, the company paid for the purchase, less discount. Accounts Payable 500 Cash 495 Purchase Discounts 5 To record payment within discount period to supplier who offers 1% purchase discount. ($ 500 × 1% = $5 discount) Chapter 5, Slide #13 Cost of Goods Purchased Includes invoice price: Less: Purchase returns and allowances Purchase discounts Plus: Transportation-in Chapter 5, Slide #14 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 Chapter 5, Slide #15 1.5 Shipping cost: FOB Destination Point Seller Buyer Title passes at destination No sale or purchase until inventory reaches its destination Seller responsible for inventory while in transit Chapter 5, Slide #16 1.5 Shipping cost: FOB Shipping Point Seller Buyer Title passes when shipped Both sale and purchase recorded upon shipment Buyer responsible for inventory while in transit Chapter 5, Slide #17 Analysis of Profitability Of particular interest to current and potential investors Gross Profit % Chapter 5, Slide #18 LO4 Daisy’s Profitability Net sales Cost of goods sold Gross profit Gross profit ratio Gross Profit Ratio = $100,000 60,000 $ 40,000 = 40% Gross Profit Net Sales (How many cents on every $ of sales are left over after covering the cost of the product) Chapter 5, Slide #19 Part II Inventory Costing Method How to determine the cost of inventory left on hand and cost of inventory sold in a period of inflation Chapter 5, Slide #20 Inventory Valuation and Income Measurement Value assigned to inventory on balance sheet Chapter 5, Slide #21 When Sold = Value expensed as cost of goods sold on income statement LO5 Detailed Costing Method Example What’re the cost of goods sold and ending inventory? Beginning inventory, Jan. 1: 500 units (unit cost $10) Inventory purchases: Date Units 1/20 300 4/8 400 9/5 200 12/12 100 Total purchases 1,000 units Ending inventory, Dec. 31: 600 units Unit Cost $ 11 12 13 14 Inventory Costing Methods (in a period of inflation) Four costing methods available: Specific Identification Weighted Average First-in, First-out (FIFO) Last-in, First-out (LIFO) Chapter 5, Slide #23 LO6 Specific Identification Method Step 1: Chapter 5, Slide #24 Identify the specific units in inventory at the end of the year and their costs. Specific Identification Method Units in ending inventory: Date purchased Units 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 Chapter 5, Slide #25 Specific Identification Method Step 2: cost of goods sold = cost of goods available for sale – ending inventory = 17,100 – 7,300 = 9,800 * Few companies use this method Chapter 5, Slide #26 Weighted Average Method Step 1: Chapter 5, Slide #27 Calculate the cost of goods available for sale. Weighted Average Method Date purchased Units 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 Chapter 5, Slide #28 $17,100 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. : Chapter 5, Slide #29 Weighted Average Method Cost of Goods Available for Sale Units Available for Sale $17,100 = $11.40/unit 1,500 Chapter 5, Slide #30 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 Chapter 5, Slide #31 × # of Units Weighted Average Method Units on hand Units sold Weighted average cost × Total cost of goods available of $17,100 allocated: Chapter 5, Slide #32 ALLOCATE TO Ending Cost of Inventory Goods Sold 600 900 $11.40 $ 11.40 $6,840 $10,260 First-in, First-out (FIFO) Method Step 1: 1st in Chapter 5, Slide #33 Assign the cost of the beginning inventory to cost of goods sold. First-in, First-out (FIFO) Method Units Cost 1/1 500 $10 1/20 300 $11 4/8 400 $12 9/5 200 $13 12/12 100 $14 Chapter 5, Slide #34 ALLOCATE TO Ending Cost of Inventory Goods Sold $5,000 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 Chapter 5, Slide #35 3rd etc. First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Inventory Goods Sold Units Cost 1/1 500 $10 $5,000 1/20 300 $11 3,300 4/8 300 / 100 $12 $3,600 9/5 200 $13 2,600 12/12 100 $14 1,400 TOTALS Chapter 5, Slide #36 $7,600 1,200 $9,500 Last-in, First-out (LIFO) Method Step 1: 1st in Chapter 5, Slide #37 Assign the cost of the last units purchased to cost of goods sold. Last-in, First-out (LIFO) Method Units Cost 1/1 500 $10 1/20 300 $11 4/8 400 $12 9/5 200 $13 12/12 100 $14 Chapter 5, Slide #38 ALLOCATE TO Ending Cost of Inventory Goods Sold $1,400 Last-in, First-out (LIFO) Method Step 2: 1st in Chapter 5, Slide #39 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 ALLOCATE TO Ending Cost of Inventory Goods Sold Units Cost 1/1 500 $10 $5,000 1/20 100 / 200 $11 1,100 4/8 400 $12 4,800 9/5 200 $13 2,600 12/12 100 $14 1,400 TOTALS Chapter 5, Slide #40 $6,100 $ 2,200 $11,000 Comparison of Costing Methods Specific Identification Weighted Average FIFO LIFO Chapter 5, Slide #41 Ending Inventory Cost of Goods Sold Goods Available for Sale $7,300 $ 9,800 $17,100 6,840 10,260 17,100 7,600 9,500 17,000 6,100 11,000 17,100 Chapter 5, Slide #42 Comparison of Costing Methods Weighted Average FIFO 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? Chapter 5, Slide #43 X X X X X LO7 LIFO Conformity Rule LIFO conformity rule • If used for tax, LIFO must also be used for books • In general, companies can use one accounting method for financial reporting purpose and use a different method for tax purpose. Accounting choice should be made based on which method produces most useful information. Chapter 5, Slide #44 Lower of Cost or Market (for your information only) • If inventory’s market value has fallen below the cost, the inventory must be reported at the lower market value, and a loss must be recorded. Chapter 5, Slide #45