Chapter 6 INVENTORIES AND COST OF SALES PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Winston Kwok, Ph.D., CA Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved. 6-2 C1 DETERMINING INVENTORY ITEMS Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Items requiring special attention include: Goods in Transit Goods on Consignment Goods Damaged or Obsolete 6-3 C1 GOODS IN TRANSIT FOB Shipping Point Public Carrier Seller Buyer Ownership passes to the buyer here. Public Carrier Seller FOB Destination Point Buyer 6-4 C1 GOODS ON CONSIGNMENT Merchandise is included in the inventory of the consignor, the owner of the inventory. Consignee Thanks for selling my inventory in your store. Consignor 6-5 C1 GOODS DAMAGED OR OBSOLETE Damaged or obsolete goods are not counted in inventory if they cannot be sold. Cost should be reduced to net realizable value if they can be sold. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. 6-6 C2 DETERMINING INVENTORY COSTS Include all expenditures necessary to bring an item to a salable condition and location. Minus Discounts and Allowances Plus Import Duties Invoice Cost Plus Freight Plus Insurance Plus Storage 6-7 C2 INTERNAL CONTROLS AND TAKING A PHYSICAL COUNT Most companies take a physical count of inventory at least once each year. When the physical count does not match the Merchandise Inventory account, an adjustment must be made. Good internal controls over count include: 1. Pre-numbered inventory tickets. 2. Counters have no inventory responsibility. 3. Counts confirm existence, amount, and quality of inventory item. 4. Second count is taken. 5. Manager confirms all items counted. 6-8 C2 INVENTORY COSTING UNDER A PERPETUAL SYSTEM Statement of Financial Position Inventory affects . . . Income Statement 6-9 C2 INVENTORY COST FLOW ASSUMPTIONS Management decisions in accounting for inventory involve the following: 1. Items included in inventory and their costs. 2. Costing method (specific identification, FIFO, or weighted average cost). 3. Inventory system (perpetual or periodic). 4. Use of market values or other estimates. LIFO is not allowed under IFRS. 6 - 10 P1 INVENTORY COST FLOW ASSUMPTIONS Specific Identification When each item can be identified with a specific purchase First-In, First-Out (FIFO) Assumes costs flow in the order incurred. Weighted Average Cost Assumes costs flow at an average of the costs available. 6 - 11 P1 INVENTORY COSTING ILLUSTRATION Here is information about the mountain bike inventory of Trekking for the month of August. 6 - 12 P1 SPECIFIC IDENTIFICATION 6 - 13 P1 SPECIFIC IDENTIFICATION Income Statement Cost of Goods Sold Statement of Financial Position Inventory 6 - 14 P1 SPECIFIC IDENTIFICATION Here are the entries to record the purchases and sales. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 6 - 15 P1 FIRST-IN, FIRST-OUT (FIFO) Oldest Costs Cost of Goods Sold Recent Costs Ending Inventory 6 - 16 P1 FIRST-IN, FIRST-OUT (FIFO) 6 - 17 P1 FIRST-IN, FIRST-OUT (FIFO) 6 - 18 P1 FIRST-IN, FIRST-OUT (FIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 6 - 19 P1 WEIGHTED AVERAGE COST 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 ÷ Units on hand on the date of sale 6 - 20 P1 WEIGHTED AVERAGE COST 6 - 21 P1 WEIGHTED AVERAGE COST 6 - 22 P1 WEIGHTED AVERAGE COST 6 - 23 P1 WEIGHTED AVERAGE COST Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 6 - 24 A1 FINANCIAL STATEMENT EFFECTS OF COSTING METHODS Because prices change, inventory methods nearly always assign different cost amounts. 6 - 25 A1 FINANCIAL STATEMENT EFFECTS OF COSTING METHODS Advantages of Methods Weighted Average Cost First-In, First-Out Smoothes out price changes. Ending inventory approximates current replacement cost. 6 - 26 CONSISTENCY IN USING COSTING METHODS A1 • • • The IASB’s Conceptual Framework states that comparability is an enhancing qualitative characteristic of financial information. Related to comparability is consistency which refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. When a change from one method to another will improve its financial reporting, the entity can do so, but the notes to the financial statements must report the type of change, its justification, and its effect on profit. 6 - 27 P2 LOWER OF COST AND NET REALIZABLE VALUE Inventory must be reported at NRV when NRV is lower than cost. NRV is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Can be applied two ways: (1) (2) separately to each individual item. to major categories of assets. 6 - 28 P2 LOWER OF COST AND NRV A motor sports retailer has the following items in inventory: Per Unit Inventory Items Cycles: Roadster Sprint Off-Road Trax-4 Blazer Totals Units on Hand 20 $ 10 8 5 Cost NRV 8,000 5,000 $ 7,000 6,000 5,000 9,000 6,500 7,000 Total Cost Total NRV $ 160,000 50,000 $ 140,000 60,000 40,000 45,000 295,000 52,000 35,000 $ 6 - 29 P2 LOWER OF COST AND NRV Here is how to compute lower of cost and NRV for individual inventory items. Lower of Cost and NRV Applied to Inventory Items Cycles: Roadster Sprint Off-Road Trax-4 Blazer Totals Units on Hand 20 10 8 5 Total Cost Total NRV $ 160,000 50,000 $ 140,000 60,000 $ $ 40,000 45,000 $ 295,000 Items $ 52,000 35,000 $ 140,000 50,000 40,000 35,000 265,000 6 - 30 P2 RECORDING THE LOWER OF COST AND NRV Lower of Cost and NRV Applied to Units on Inventory Items Hand Total Cost Total NRV $ 295,000 Totals $ Items 265,000 6 - 31 A2 FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS Income Statement Effects Inventory Error Understate ending inventory Understate beginning inventory Overstate ending inventory Overstate beginning inventory Cost of Goods Sold Overstated Understated Understated Overstated Net Income Understated Overstated Overstated Understated 6 - 32 A2 FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS Statement of Financial Position Effects Inventory Error Understate ending inventory Overstate ending inventory Assets Equity Understated Understated Overstated Overstated 6 - 33 A3 INVENTORY TURNOVER Shows how many times a company turns over its inventory during a period. Indicator of how well management is controlling the amount of inventory available. Inventory Turnover Average Inventory = = Cost of goods sold Avg. inventory (Beg. Inv. + End Inv.) ÷ 2 6 - 34 A3 DAYS’ SALES IN INVENTORY Reveals how much inventory is available in terms of the number of days’ sales. Days' Sales in Inventory = Ending Inventory Cost of goods sold ×365 6 - 35 P3 APPENDIX 6A: INVENTORY COSTING UNDER A PERIODIC SYSTEM WAC computation of COGS and ending inventory under a periodic system. 6 - 36 P4 APPENDIX 6B: INVENTORY ESTIMATION METHODS Inventory sometimes requires estimation for interim statements or if some casualty such as fire or flood makes taking a physical count impossible. Retail Inventory Method Gross Profit Method 6 - 37 P5 APPENDIX 6B: LAST-IN, FIRST-OUT (LIFO) Recent Costs Cost of Goods Sold Oldest Costs Ending Inventory 6 - 38 P5 LAST-IN, FIRST-OUT (LIFO) PERPETUAL SYSTEM 6 - 39 P5 LAST-IN, FIRST-OUT (LIFO) PERPETUAL SYSTEM 6 - 40 P5 LAST-IN, FIRST-OUT (LIFO) PERPETUAL SYSTEM Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 6 - 41 P5 LAST-IN, FIRST-OUT (LIFO) PERIODIC SYSTEM LIFO computation of COGS and ending inventory under a periodic system. 6 - 42 END OF CHAPTER 6