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

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

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

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

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

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

Condensed Income Statement for a Merchandiser
Net sales
Cost of goods sold
$100,000
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
Chapter 5, Slide #7

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

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

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

Beginning inventory
Purchases of merchandise
Ending inventory
Chapter 5, Slide #11
Cost of goods sold
LO3

The Cost of Goods Sold Model
Beginning inventory
+ Cost of goods purchased
= Cost of goods available for sale
– Ending inventory
= Cost of goods sold
$ 15,000
63,000
78,000
(18,000)
$ 60,000
“Pool” of goods available to sell during the period
Chapter 5, Slide #12
An increase in ending inventory means more was bought than sold

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
Chapter 5, Slide #13

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 #14

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

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 #16

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

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

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 #19

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

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

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

Inventory Valuation and Income
Measurement
Value assigned to inventory on balance sheet
When Sold =
Value expensed as cost of goods sold on income statement
Chapter 5, Slide #23
LO5

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 #24

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

Detailed Costing Method Example
Calculate the cost of goods sold and ending inventory under each method using the data below:
Beginning inventory, Jan. 1: 500 units (unit cost $10)
Inventory purchases:
Date
1/20
4/8
9/5
12/12
Total purchases
Units
300
400
200
100
1,000 units
Ending inventory, Dec. 31: 600 units
Unit Cost
$ 11
12
13
14

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

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

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

Specific Identification Method
Date purchased Units Cost Total Cost
Beg. inventory 500 $10 $5,000
1/20
4/8
200
100
11
12
2,200
1,200
12/12 100 14
Cost of goods sold 900
1,400
$9,800
Units × Cost = Total cost
Chapter 5, Slide #30

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

Date purchased Units Cost Total cost
Beg. inventory 500 $10 $ 5,000
1/20
4/8
300
400
11
12
3,300
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 #32
$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 #33

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

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.
Chapter 5, Slide #35

Weighted Average Method
Units on hand
Units sold
Weighted average cost ×
ALLOCATE TO
Ending Cost of
Inventory Goods Sold
600
$11.40
Total cost of goods available of $17,100 allocated: $6,840
900
$ 11.40
$10,260
Chapter 5, Slide #36

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

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

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.
3rd etc.
2nd
Chapter 5, Slide #39

First-in, First-out (FIFO) Method
1/1
Units Cost
500 $10
1/20 300 $11
4/8 300 / 100 $12
9/5 200
100 12/12
TOTALS
Chapter 5, Slide #40
$13
$14
ALLOCATE TO
Ending Cost of
Inventory Goods Sold
$5,000
$3,600
2,600
3,300
1,200
1,400
$7,600 $9,500

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

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

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

Last-in, First-out (LIFO) Method
1/1
Units Cost
500 $10
1/20 100 / 200 $11
4/8 400 $12
9/5 200
100 12/12
TOTALS
Chapter 5, Slide #44
$13
$14
ALLOCATE TO
Ending Cost of
Inventory Goods Sold
$5,000
1,100 $ 2,200
4,800
2,600
1,400
$6,100 $11,000

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

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

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
Chapter 5, Slide #47

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

Effect of Inventory Errors on the
Income Statement, 2007
Sales
Beginning inventory
Add: Purchases
Goods available for sale
Less: Ending inventory
Cost of goods sold
Gross margin
Operating expenses
Net income
Reported Corrected Effect
$1,000 $ 1,000
$ 200 $ 200
700
$ 900
300
$ 600
700
$ 900
250
$ 650
$50 OS
50 US
$ 400
100
$ 300
$ 350 50 OS
100
$ 250 50 OS
OS = overstatement
US = understatement
Chapter 5, Slide #49

Effect of Inventory Errors on the
Income Statement, 2008
Sales
Beginning inventory
Add: Purchases
Goods available for sale
Less: Ending inventory
Cost of goods sold
Gross margin
Operating expenses
Net income
OS = overstatement
US = understatement
Chapter 5, Slide #50
Reported Corrected Effect
$1,500 $1,500
$ 300 $ 250 $50 OS
1,100
$1,400
350
$1,050
1,100
$1,350 50 OS
350
$1,000 50 OS
$ 450
120
$ 330
$ 500 50 US
120
$ 380 50 US

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

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

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

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

Lower of Cost or Market
Selling price
Cost
Gross profit
Before
Price
Change
$100
75
$ 25
After
Price
Change
$ 80
60
$ 20
Gross profit % 25% 25%

Lower of Cost or Market

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
Chapter 5, Slide #56

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
Chapter 5, Slide #57
LO10

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
Chapter 5, Slide #58

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

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

Number of Days’ Sales in Inventory
Number of Days in the Period
Inventory Turnover Ratio
4
11
18
5
12
19
25 26
6 7
13 14
1
8
2
9
15 16
20 21 22 23
27 28 29 30
17
24
3
10
31
The average number of days inventory is on hand before its sold
Chapter 5, Slide #61

Statement of Cash Flows
Cash Flows from Operating Activities:
Net income
Increase in inventory
Decrease in inventory
Increase in accounts payable
Decrease in accounts payable xxx
–
+
+
–
Indirect
Method
- OR Direct
Method
Cash paid for inventory purchases
Chapter 5, Slide #62
–
LO12

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

FIFO Costing with a Perpetual
System
Same FIFO inventory total under periodic and perpetual systems
Chapter 5, Slide #64

LIFO Costing with a Perpetual
System
Different LIFO inventory total under periodic and

Moving Average with a Perpetual
System
Different inventory total under weighted average
(periodic) and moving average (perpetual)
Chapter 5, Slide #66

Chapter 5, Slide #67
End of Chapter 5