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Inventories and Cost of Goods Sold 4/10/2012 Learning Objectives (LO) After studying this chapter, you should be able to CHAPTER 1. Link inventory valuation to gross profit Inventories and 2. Use both perpetual and periodic inventory systems Cost of Goods Sold 7 3. Calculate the cost of merchandise acquired 4. Compute income and inventory values using the three principal inventory valuation methods allowed under both U.S. GAAP and IFRS and the one method allowed only by U.S. GAAP 5. Use the lower-of-cost-or-market method to value inventories under U.S. GAAP and IRFS © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 2of 42 Learning Objectives (LO) LO – 1 Gross Profit and Cost of Goods Sold After studying this chapter, you should be able to Balance Sheet Income Statement 6. Show the effects of inventory errors on financial statements Sales 7. Evaluate the gross profit percentage and inventory Minus turnover Merchandise Merchandise Cost of Merchandise Purchases Sales Goods Sold 8. Describe characteristics of LIFO and how they Inventory (an expense) affect the measurement of income (App. 7A) Current Equals Gross Asset Profit Minus Selling Expenses and Administrative Expenses Equals operating Income © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 3of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 4of 42 LO – 2 Perpetual and Periodic Systems LO – 2 Perpetual and Periodic Systems • Purchase inventory (both systems) (LO 3) • Perpetual System – at each sale Merchandise Inventory 960 Cost of Goods Sold (COGS) 870 Accounts Payable 960 Merchandise Inventory 870 • Record rev enu e (both sy stems) w hen inv entory – Beginning balance 100 is sold – Purchases + 910 Accounts Receivable 1,740 – Available for sale 1,010 Sales Revenue 1,740 – Cost of goods sold –870 – Ending balance 140 (Derived) __________________________________________________________________ – Ending inventory count identifies spoilage, theft, etc. © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 5of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 6of 42 1 4/10/2012 LO – 2 Perpetual and Periodic Systems LO – 2 Perpetual and Periodic Systems • Periodic System – at each sale • Ending inventory count No entry is made so at year-end, do not have an up – Required under a periodic system to date inventory count or COGS. Must conduct an – A good control practice in a perpetual systems ending inventory count. • Firms often choose fiscal accounting periods so – Beginning balance 100 that the year ends when inventories are low – Purchases +910 • External auditors usually observe a sample of – Available for sale 1,010 the client’s physical count to confirm its accuracy – Ending Balance – 140 – Cost of Goods Sold 870 (Derived) ________________________________________________________________ – Spoilage/theft, etc. buried in COGS © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 7of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 8of 42 LO 3 - Cost of Merchandise Acquired LO 3 - Cost of Merchandise Acquired • Product Costs • Possible costs added to the inventory costs – Easily associated with a specific product or inventory besides the purchase price itself – Product costs attach to COGS/Inventory, thus making • Transportation (freight) in those accounts larger and expenses smaller. • Handling • Period Costs • Insurance – Easier to associate with the reporting period than with • Discounts that reduce these costs a specific product or inventory item • Quantity – Period costs do not get attached to COGS/Inventory. • Early/quick payment They become expenses on the income statement • Vendor rebates making them larger and COGS/Inventory smaller. • Purchase returns and allowances • Company policy determines which are which © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 9of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 10 of 42 LO 3 - Cost of Merchandise Acquired LO 3 - Cost of Merchandise Acquired • Transportation • Returns, Allowances – FOB (Free on Board) Destination - Seller pays for Merchandise Inventory (Purchases) 960 delivery to us, the buyer; title transfers on receipt Accounts Payable 960 No entry Accounts Payable 75 Purchase Returns/Allowances * 75 – FOB (Free on Board) Shipping – We pay for delivery * Contra account to inventory or purchases from the seller; title transfers when goods leave buyer • Discounts Freight in * 30 Accounts Payable 885 Freight Payable 30 Discounts on Purchases 5 Cash 880 *Adjunct account to COGS © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 11 of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 12 of 42 2 4/10/2012 LO 3 - Cost of Merchandise Acquired LO 4 – Inventory Valuation Methods • If inventory prices were not changing, all methods would produce the same COGS and ending inventory amounts. • Since prices do change, which are assigned to COGS and ending inventory? • Four methods are generally accepted: – Specific identification - U.S. and IFRS acceptable – First-in, first-out (FIF0) - U.S. and IFRS acceptable – Weighted-average - U.S. and IFRS acceptable – Last-in, first out (LIFO) - U.S. only acceptable © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 13 of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 14 of 42 LO 4 – Inventory Valuation Methods LO 4 – Inventory Valuation Methods Specific Identification FIFO – First In, First Out • The cost of each inventory item is known • Oldest costs are assigned to the income statement (COGS) • When an inventory item is sold, its cost becomes • Latest costs are assigned to the balance sheet part of COGS. Bar codes facilitate identifying (Inventory), making ratios computed there from more units and costs. Physical flow matches the reflective of current market value accounting flow • Perpetual and periodic systems produce the same • Relatively easy to use, especially for expensive COGS and ending inventory amounts low-volume merchandise • COGS can not be manipulated • COGS/ending inventory easily manipulated if • In periods of rising prices, FIFO leads to higher taxes inventory prices are changing paid and net income (by placing the lower costs in COGS) © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 15 of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 16 of 42 LO 4 – Inventory Valuation Methods LO 4 – Inventory Valuation Methods LIFO – Last In, First Out Weighted Average • Oldest costs are assigned to the balance sheet (Inventory). • Computes a unit cost by dividing the total • Latest costs are matched to revenue on the income statement acquisition cost of all items available for sale by (COGS), making ratios computed there from more reflective the number of units available for sale of current market value • Perpetual and periodic systems produce different COGS and • The weighted-average method produces gross ending inventory amounts profit somewhere between that obtained under • COGS can be manipulated by buying inventory at year-end FIFO and LIFO • In periods of rising prices, LIFO leads to lower net income and • Perpetual and periodic systems produce lower taxes paid different COGS and ending inventory amounts • The Internal Revenue Code requires LIFO users for tax purposes to also use LIFO for financial reporting purposes • Not permitted for IFRS users © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 17 of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 18 of 42 3 4/10/2012 LO 4 – Inventory Valuation Methods LO 4 – Inventory Valuation Methods Example Example • Assume a vendor of soft drinks starts out the week with no inventory • He buys and sells cola as follows: – Buys one can on Monday for 30 cents – Buys one can on Tuesday for 40 cents – Buys one can on Wednesday for 56 cents – Sells one can on Thursday for 90 cents • The next slide shows the vendor’s cost of goods sold and ending inventory under the four methods © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 19 of 42 © 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 20 of 42 LO 4 – Inventory Valuation Methods LO 5 – Lower of Cost or Market Miscellaneous • Accountants often refer to inventory methods as cost • Ending inventory should be valued at the lower flow assumptions of its cost ($45) or market value ($43) (Rarely • May choose any of the four flows. Over long run, all record holding gains – conservatism) produce essentially the same end results • Market value • Three out of the four flows are not linked to the physical flow of merchandise – Input market – replacement cost (i.e. LIFO cost) – Output market – net realizable value (NRV) or NRV • Consistency suggests the cost
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