Merchandise
Inventory and
Cost of Sales
CHAPTER
6
PowerPoint Slides to accompany
Fundamental Accounting Principles, 14ce
Prepared by
Joe Pidutti, Durham College
Learning Objectives
Identify the components and costs included in
merchandise inventory. (LO1)
Calculate cost of goods sold and merchandise
inventory using specific identification, moving
weighted average, and FIFO-perpetual. (LO2)
Analyze the effects of the costing methods on
financial reporting. (LO3)
1.
2.
3.
2
© 2013 McGraw-Hill Ryerson Limited.
Learning Objectives
Calculate the lower of cost and net realizable
value of inventory. (LO4)
Analyze the effects of merchandise inventory
errors on current and future financial
statements-perpetual. (LO5)
4.
5.
Apply both the gross profit and retail methods
to estimate inventory. (LO6)
6.
3
© 2013 McGraw-Hill Ryerson Limited.
Learning Objectives
7.
Calculate cost of goods sold and merchandise
inventory using FIFO –periodic, weighted
average , and specific identification (Appendix
6A). (LO7)
8.
Analyze the effects of merchandise inventory
errors on current and future financial
statements-periodic. (Appendix 6A). (LO8)
9.
Assess merchandise inventory management
using both merchandise turnover and days’
sales in inventory. (Appendix 6B) (LO9)
4
© 2013 McGraw-Hill Ryerson Limited.
Assigning Costs to Merchandise
Inventory
Accounting for merchandise inventory
requires several decisions which include:
Items included and their costs.
Costing Method. (specific identification, moving
weighted average or FIFO)
Merchandise Inventory System. (perpetual or
periodic)
Use of net realizable value or other estimates.
•
•
•
•
5
© 2013 McGraw-Hill Ryerson Limited.
LO 1
Items in Merchandise Inventory
Merchandise inventory includes all goods
owned by a company and held for sale.
Items requiring special attention:
• Goods in Transit
• Goods on Consignment
• Goods Damaged or Obsolete
6
© 2013 McGraw-Hill Ryerson Limited.
LO 1
Costs of Merchandise Inventory
All expenditures necessary to bring an
item to a saleable condition and location.
This includes:
•
•
•
•
•
7
Invoice price less discounts
Import duties
Transportation-in
Storage
Insurance
© 2013 McGraw-Hill Ryerson Limited.
LO 1
Assigning Costs to Merchandise
Inventory
Management must decide on method of
determining unit cost.
This will affect both the income statement
and the balance sheet.
Methods:
•
•
1.
2.
3.
8
First-in, first-out (FIFO)
Moving weighted average
Specific identification
© 2013 McGraw-Hill Ryerson Limited.
LO 2
First-In, First-Out (FIFO)
Based on the assumption that the items are
sold in the order acquired.
When a sale occurs:
• The earliest units purchased are
charged to Cost of Goods Sold.
• The cost of the most recent purchases
remain in merchandise inventory.
9
© 2013 McGraw-Hill Ryerson Limited.
LO 2
FIFO — Example
FIFO Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Cost
Cost
Units
Cost
Goods Sold
Units
Cost
Total Cost
Date
Units
8/1 Beginning Inventory
10 $
91 $
910
10 $ 91 $
910
10 $ 91 $
910
8/3
15 $ 106 $ 1,590
15 $ 106 $
1,590
25
$
2,500
5 $ 106
20 $ 115
$
$
$
530
530
2,300
25
$
2,830
11 $ 115
$
1,265
8/14
10 $
91 $
910
The
opening inventory consists
of
10
units
10 $ 106 $
1,060@ $91/unit.
5 $ 106
8/17
8/28
10
20 $
115
$ 2,300
5 $
9 $
106
115
$
$
© 2013 McGraw-Hill Ryerson Limited.
530
1,035
LO 2
FIFO — Example
FIFO Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Total
Cost
Cost
Units
Cost
Goods Sold
Units
Cost
Cost
Date
Units
8/1 Beginning inventory
10 $
91 $ 910
10 $
91 $
910
10 $
91 $
910
8/3
15 $ 106 $ 1,590
15 $ 106 $ 1,590
25
8/14
Additional
units
re are
Additional
units
purchased
@ $106/unit.
purchased
@ $106/unit.
8/17
20 $ 115 $ 2,300
10 $ 91 $
10 $ 106 $
910
This results1,060
in two layers
of $
5 $ 106
5 $ 106 $
merchandise inventory.
20 $ 115 $
25
8/28
11
$ 2,500
5 $ 106
9 $ 115
$
$
© 2013 McGraw-Hill Ryerson Limited.
530
1,035
11 $
530
530
2,300
$ 2,830
115 $ 1,265
LO 2
FIFO — Example
FIFO Computations - Perpetual Inventory System
Purchases
Sales (at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Total
Cost
Cost
Units
Cost
Goods Sold
Units
Cost
Cost
Date
Units
8/1 Beginning Inventory
$
910
10 $
91 $
910
10 $
91
10 $
91 $
910
8/3
15 $ 106 $ 1,590
15 $ 106 $ 1,590
25
8/14
10 $
10 $
91 $
106 $
910
1,060
5 $
5 $
20 $
$ 2,500
106 $
530
106 $
530
115 $ 2,300
8/17
$ 115 $ 2,300
Under
FIFO,20 units
are assumed to be sold in the order
acquired.
25
$ 2,830
8/28
5 $ 106 $14, the
530 first 10 units come
Therefore,
of the 20 units sold on August
9 $ 115 $
1,035
11 $ 115 $ 1,265
from beginning inventory. Therefore, those 10 units are removed
from the inventory record based on the cost of those units of $91.
12
© 2013 McGraw-Hill Ryerson Limited.
LO 2
FIFO — Example
FIFO Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Total
Cost
Cost
Units
Cost
Goods Sold
Units
Cost
Cost
Date
Units
8/1 Beginning inventory
10 $
91 $
910
10 $
91 $
910
10 $
91 $
910
8/3
15 $ 106 $ 1,590
15 $ 106 $ 1,590
25
8/14
10 $
10 $
91 $
106 $
910
1,060
$ 2,500
5 $ 106 $
530
5 $ 106 $
530
20 $ 115 $ 2,300
The8/17
remaining
sold on August 14th come from the next
20 $ 10
115units
$ 2,300
$ 2,830
purchase, made on August 3rd. Therefore, these units25are removed
8/28
5 $ 106 $
530
from the inventory record based
9 $ 115on
$ their
1,035cost of
11 $106.
$ 115 $ 1,265
13
© 2013 McGraw-Hill Ryerson Limited.
LO 2
FIFO — Example
FIFO Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Total
Cost
Cost
Cost
Goods Sold Units
Cost
Cost
Date
Units
Units
8/1 Beginning Inventory
10 $
91 $
910
10 $ 91 $ 910
10 $ 91 $ 910
8/3
15 $
106 $ 1,590
15 $ 106 $ 1,590
25
8/14
10 $
10 $
91 $
106 $
910
1,060
8/17
20 $
115 $ 2,300
The ending
inventory consists of the 5
8/28
5 $ 3
106purchase.
$
530
remaining
units from the August
9 $
14
115
$
© 2013 McGraw-Hill Ryerson Limited.
1,035
$ 2,500
5 $ 106 $ 530
5 $ 106 $ 530
20 $ 115 $ 2,300
25
$ 2,830
11 $ 115 $ 1,265
LO 2
Mini-Quiz
A company that uses a perpetual merchandise inventory
system made the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a FIFO
system is used.
Cash
Sales (40x $16)
15
640
Cost of goods sold
400
Merchandise Inventory (40x $10 )
© 2013 McGraw-Hill Ryerson Limited.
640
400
LO 2
Moving Weighted Average
Method
Under this method, the cost of all units are
averaged together.
Average cost per unit
=
16
Cost of goods available for sale
Number of units available for sale
© 2013 McGraw-Hill Ryerson Limited.
LO 2
Moving Weighted Average - Example
Moving Weighted Average Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
(a)+(b)
(a)
Unit
Total
Unit
Cost of
(b)
Average
Total
Cost
Cost
Cost
Goods Sold
Units
Cost/Unit
Cost
Date
Units
Units
8/1 Beginning inventory
10 $
91 $
910
10 $
91 $ 910
8/3
15 $ 106 $ 1,590
25 $
100 $ 2,500
8/14opening inventory consists
20 $of100
2,000
5 $
100
The
10 $units
@ $91/unit.
8/17
8/28
17
20 $
115 $ 2,300
14 $
112
© 2013 McGraw-Hill Ryerson Limited.
$
1,568
$
500
25 $
112 $ 2,800
11 $
112 $ 1,232
LO 2
Moving Weighted Average- Example
Moving Weighted Average Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
(a)+(b)
(a)
Unit
Total
Unit
Cost of
(b)
Average
Total
Cost
Cost
Units
Cost
Goods Sold Units Cost/Unit
Cost
Date
Units
8/1 Beginning inventory
10 $
91 $ 910
10 $
91 $
910
8/3
15 $ 106 $ 1,590
25 $
100 $ 2,500
8/14
$ 100 $
2,000
5 $
100 $
15 additional
units are
This20results
in an
average
cost
of 500
purchased
@ $106/unit.
8/17
20 $ 115 $ 2,300
25 $
112 $ 2,800
$100/unit.
8/28
14 $ 112
$
1,568
11 $
112
$ 1,232
(10 x $91) + (15 x $106)
25 units
18
© 2013 McGraw-Hill Ryerson Limited.
LO 2
Moving Weighted Average- Example
Moving Weighted Average Computations - Perpetual Merchandise Inventory System
Purchases
Sales ( at cost)
Inventory Balance
(a)+(b)
(a)
Unit
Total
Unit
Cost of
(b)
Average
Total
Cost
Cost
Units
Cost
Goods Sold
Units
Cost /Unit
Cost
Date
Units
8/1 Beginning inventory
10 $ 91 $
910
10 $
91 $ 910
8/3
15 $ 106 $ 1,590
25 $
100 $ 2,500
8/14
20 $ 100 $
8/17
$ 115are
$ sold
2,300 at the
These
2020units
average cost of $100/unit. 14
8/28
19
$ 112 $
© 2013 McGraw-Hill Ryerson Limited.
2,000
1,568
5 $
100
$
500
25 $
112
$ 2,800
11 $
112
$ 1,232
LO 2
Moving Weighted Average- Example
Moving Weighted Average Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
(a)+(b)
(a)
Unit
Unit
(b)
Average
Total
Cost
Total Cost
Units
Cost
Total
Units
Cost/Unit
Cost
Date
Units
8/1 Beginning inventory
10 $
91 $
910
10 $
91 $
910
8/3
15 $ 106 $
1,590
25 $
100 $ 2,500
8/14
8/17
8/28
20
20 $
100
$
2,000
This
leaves 5 2,300
units remaining at
20 $ 115 $
an average cost of $100/unit.
14 $
112
© 2013 McGraw-Hill Ryerson Limited.
$
1,568
5 $
100
$
500
25 $
112
$ 2,800
11 $
112
$ 1,232
LO 2
Mini-Quiz
A company that uses a perpetual merchandise inventory
system made the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a
Moving Weighted Average system is used.
Cash
Sales (40x $16)
640
640
Cost of goods sold
430
Merchandise Inventory
430
(100x$10 + 60x$12)/160 x 40
21
© 2013 McGraw-Hill Ryerson Limited.
LO 2
Specific Identification
This method is used when items:
• Can be directly identified.
• Can be directly identified with a specific
purchase and its invoice.
Examples: Automobiles, art, custom furniture.
22
© 2013 McGraw-Hill Ryerson Limited.
LO 2
Specific Identification - Example
Specific Identificaton Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Total
Cost
Cost
Units
Cost
Goods Sold
Units
Cost
Cost
Date
Units
8/1 Beginning inventory
10 $
91 $
910
10 $
91 $
910
10 $
91 $
910
8/3
15 $ 106 $ 1,590
15 $ 106 $ 1,590
25
106
$ 2,500
$
182
$
318
91
106
115
$
500
$
182
$
318
$ 2,300
106
115
$ 2,800
$
318
$
920
The
10$ units728@ $91/unit.
8/14 opening inventory consists
8 $of 91
2 $
91
12 $
8/17
8/28
23
20 $
115
106 $
1,272
3 $
5
2 $
3 $
20 $
$ 2,300
2 $
12 $
91 $
115 $
© 2013 McGraw-Hill Ryerson Limited.
182
1,380
25
3 $
8 $
LO 2
Specific Identification - Example
Specific Identificaton Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Total
Cost
Cost
Units
Cost
Goods Sold
Units
Cost
Cost
Date
Units
8/1 Beginning inventory
10 $ 91 $
910
10 $
91 $ 910
10 $
91 $ 910
8/3
15 $ 106 $ 1,590
15 $ 106 $ 1,590
25
8/14
15 additional
units are
purchased @ $106/unit.
8/17
8/28
24
20 $ 115 $
$ 2,500
8 $
91 $
728
2 $
91
This
results
in
two
layers
of
12 $ 106 $
1,272
3 $ 106
5
merchandise inventory.
2,300
2 $
91 $
12 $ 115 $
© 2013 McGraw-Hill Ryerson Limited.
182
1,380
$
$
182
318
2 $
3 $
20 $
$ 500
91 $ 182
106 $ 318
115 $ 2,300
25
3 $
8 $
$ 2,800
106 $ 318
115 $ 920
LO 2
Specific Identification - Example
Specific Identificaton Computations - Perpetual Merchandise Inventory System
Purchases
Sales ( at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Total
Cost
Cost
Units
Cost
Goods Sold
Units
Cost
Cost
Date
Units
8/1 Beginning inventory
10 $
91 $
910
10 $
91 $
910
10 $
91 $
910
8/3
15 $ 106 $ 1,590
15 $ 106 $ 1,590
8/14
8 $
12 $
91 $
106 $
728
1,272
25
$ 2,500
2 $
91 $
182
3 $ 106 $
318
On August 14, 20 units are sold. Eight of these units 52
3
came8/17
from the
opening
merchandise
inventory
and
the
20 $ 115 $ 2,300
20
remaining 12 units came from the August 3 purchase.25
8/28
25
2 $
12 $
91 $
115 $
© 2013 McGraw-Hill Ryerson Limited.
182
1,380
$
500
$
91 $
182
$ 106 $
318
$ 115 $ 2,300
$ 2,800
3 $ 106 $
318
8 $ 115 $
920
LO 2
Specific Identification - Example
Specific Identificaton Computations - Perpetual Merchandise Inventory System
Purchases
Sales (at cost)
Inventory Balance
Unit
Total
Unit
Cost of
Unit
Total
Cost
Cost
Units
Cost
Goods Sold
Units
Cost
Cost
Date
Units
8/1 Beginning Inventory
10 $ 91 $
910
10 $
91 $
910
10 $
91 $
910
8/3
15 $ 106 $ 1,590
15 $ 106 $ 1,590
8/14
8 $
12 $
91 $
106 $
728
1,272
This leaves 2 units remaining from the
8/17 original
20 $mercandise
115 $ 2,300
inventory and 3 units
8/28 remaining from the August
2 $ 391purchase.
$
182
12 $
26
115 $
© 2013 McGraw-Hill Ryerson Limited.
1,380
25
2 $
3 $
5
2 $
3 $
20 $
25
3 $
8 $
91
106
$ 2,500
$
182
$
318
91
106
115
$
500
$
182
$
318
$ 2,300
106
115
$ 2,800
$
318
$
920
LO 2
Comparison of Methods
Because prices change, the choice of an
merchandise inventory method is
important.
Units
FIFO
Moving
Weighted
Specific
Average Identification
Cost of Goods Sold
34
$
3,535 $ 3,568 $
3,562
Ending Merchandise Inv.
11
$
1,265 $ 1,232 $
1,238
Goods Available for Sale
45
$
4,800 $ 4,800 $
4,800
27
© 2013 McGraw-Hill Ryerson Limited.
LO 3
Financial Reporting
Advantages of Each Method
Moving
Weighted
Average
First-In,
First-In,
First-Out
First-Out
Specific
Identification
Smoothes out
purchase price
changes
Ending
inventory
Most current
values
approximates
are
on the balance
sheet
as ending
current
inventorycost.
replacement
Exactly matches costs
and revenues
28
© 2013 McGraw-Hill Ryerson Limited.
LO 3
Financial Reporting
Disadvantages of Each Method
Moving
Weighted
Average
First-In,
First-In,
First-Out
First-Out
Specific
Identification
Does not
accurately match
revenues to
expenses
Ending inventory
approximates
CGS
does not reflect
current
costs
current
replacement cost.
Relatively more costly
to implement and
maintain
29
© 2013 McGraw-Hill Ryerson Limited.
LO 3
Financial Reporting
A company is required to use the same
accounting methods from period to period
(consistency principle).
A change is only acceptable when it improves
financial reporting.
The costing method used must be disclosed in
the notes to the financial statements (fulldisclosure principle).
•
•
•
30
© 2013 McGraw-Hill Ryerson Limited.
LO 3
Lower of Cost and Net Realizable
Value (LCNRV)
Merchandise Inventory must be reported at
net realizable value (NRV) when NRV is
lower than cost (principle of faithful
representation).
31
© 2013 McGraw-Hill Ryerson Limited.
LO 4
Lower of Cost and Net Realizable
Value (LCNRV)
May be applied in one of two ways:
1. Separately to each item.
2. To groups of similar or related items.
32
© 2013 McGraw-Hill Ryerson Limited.
LO 4
Merchandise Inventory Errors
Errors in the computation of or physical count
of merchandise inventory will cause a
misstatement of:
•
•
•
•
•
33
Cost of goods sold
Gross profit
Net income
Current assets
Equity
© 2013 McGraw-Hill Ryerson Limited.
LO 5
Inventory Errors- Effect on This
Period’s Income Statement
Inventory Error
Cost of Goods Sold Net Income
Understate ending inventory
Overstated
Understated
Understate beginning inventory
Understated
Overstated
Overstate ending inventory
Understated
Overstated
Overstate beginning inventory
34
Overstated
© 2013 McGraw-Hill Ryerson Limited.
Understated
LO 5
Inventory Errors- Effect on This
Period’s Balance Sheet
Inventory Error
Assets
Understate ending inventory
Understated
Overstate ending inventory
Overstated
35
© 2013 McGraw-Hill Ryerson Limited.
Equity
Understated
Overstated
LO 5
Gross Profit Method
Ending merchandise inventory is estimated
by applying the gross profit ratio to net
sales.
It is used:
•
•
36
When merchandise inventory has been
destroyed, lost, or stolen.
For testing the reasonableness of the physical
merchandise inventory count.
© 2013 McGraw-Hill Ryerson Limited.
LO 6
Retail Inventory Method
Occasionally used for interim period
reporting.
Information required:
1.
2.
3.
37
Beginning inventory at cost and retail.
Net purchases at cost and retail.
Net sales.
© 2013 McGraw-Hill Ryerson Limited.
LO 6
Review
Q Describe how management’s decisions can
affect the determination of the cost of
merchandise inventory.
A Choice of method –FIFO, moving weighted
average, specific identification.
Choice of application of LCNRV -separate item or
categories.
Choice of periodic or perpetual system.
Items to include in cost.
38
© 2013 McGraw-Hill Ryerson Limited.
Periodic System-Appendix 6A
•
•
The periodic system also uses FIFO,
specific identification, and weighted
average methods to assign costs to
merchandise inventory and cost of goods
sold.
The results may be the same or different
under both systems.
39
© 2013 McGraw-Hill Ryerson Limited.
LO 7
FIFO-Appendix 6A
Yields same results as perpetual system
since most recent purchases are in ending
merchandise inventory under both systems.
40
© 2013 McGraw-Hill Ryerson Limited.
LO 7
Weighted Average-Appendix 6A
1.
Steps:
Calculate weighted average unit cost.
(# units
beg. Inv.
X unit cost) + (#units purchased x unit cost)
# units available for sale
= weighted average unit cost
Use weighted average unit cost to assign
costs to cost of goods sold and ending
merchandise inventory.
2.
41
© 2013 McGraw-Hill Ryerson Limited.
LO 7
Specific IdentificationAppendix 6A
•
•
Applied in same manner as periodic
system.
Yields same results as perpetual system
since units are specifically identified.
42
© 2013 McGraw-Hill Ryerson Limited.
LO 7
Merchandise Inventory Errors in
a Periodic System-Appendix 6A
•
•
An error in the ending merchandise
inventory affects the assets, net income,
and equity of that period.
The ending merchandise inventory of one
period becomes the opening merchandise
inventory of the next period. The cost of
goods sold and net income of the next
period are affected as well.
43
© 2013 McGraw-Hill Ryerson Limited.
LO 8
Ratios-Appendix 6B
Merchandise Inventory ratios may be used
to assess:
1. Short-term liquidity.
2. Merchandise Inventory management.
44
© 2013 McGraw-Hill Ryerson Limited.
LO 9
Ratios-Appendix 6B
•
•
Merchandise Turnover Ratio
Measures how many times a company
turns its merchandise inventory over each
period.
The ratio will vary from industry to industry.
Merchandise turnover
45
=
Cost of goods sold
Average merchandise inventory
© 2013 McGraw-Hill Ryerson Limited.
LO 9
Ratios-Appendix 6B
Days’ Sales in Inventory
Used to estimate how many days it will take to
convert merchandise inventory to cash or
receivables.
Used to assess if merchandise inventory levels
can meet sales demand.
•
•
Days’ sales in inventory= Ending inventory
Cost of goods sold
46
© 2013 McGraw-Hill Ryerson Limited.
x 365
LO 9
End of Chapter
47
© 2013 McGraw-Hill Ryerson Limited.