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Learning Objectives (LO)

After studying this chapter, you should be able to CHAPTER 1. Link to gross and 2. Use both perpetual and periodic inventory systems of Goods Sold 7 3. Calculate the cost of merchandise acquired 4. Compute income and inventory values using the three principal 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

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Learning Objectives (LO) LO – 1 Gross Profit and Cost of Goods Sold

After studying this chapter, you should be able to 6. Show the effects of inventory errors on financial statements

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 ) affect the measurement of income (App. 7A) Current Equals Gross Profit Minus Selling and Administrative Expenses

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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) 870 960 Merchandise Inventory 870

• Record rev enu e (both sy stems) w hen inv entory – Beginning balance 100 is sold – Purchases + 910 1,740 – 1,010 Sales 1,740 – Cost of goods sold –870 – Ending balance 140 (Derived) ______– Ending inventory count identifies spoilage, theft, etc.

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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

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LO 3 - Cost of Merchandise Acquired LO 3 - Cost of Merchandise Acquired

• Product • 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

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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 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 5 880 *Adjunct account to COGS

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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

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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 (by placing the lower costs in COGS)

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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

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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

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LO 4 – Inventory Valuation Methods LO 5 – Lower of Cost or Market Miscellaneous

• 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 – (NRV) or NRV • Consistency suggests the cost flow assumption cannot less a normal profit margin be changed unless a substantive reason surfaces (must be disclosed) – Market value – middle of those three numbers Loss on write-down of inventory 2 Merchandise Inventory 2

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LO 6 – Inventory Errors LO 6 – Inventory Errors

• Revenue – recognized in the period when earned, realized, realizable • Expenses – recognized in the period when they helped to produce • Types of Errors – Accidental (wrong amounts, accounts, GAAP, etc.) – Intentional – Profit pressures may cause managers to • Delay the recording of purchases/expenses • Accelerate incomplete sales orders

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LO 6 – Inventory Errors LO 6 – Inventory Errors

• An undiscovered inventory error usually affects – All future periods if left undetected – Two reporting periods if detected and correctly counted by the end of the second year • The error will cause misstated amounts in the period in which the error occurred, but the effects will then be counterbalanced by identical offsetting amounts in the following period • If ending inventory is understated, retained earnings is understated • If ending inventory is overstated, retained earnings is overstated

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LO 7- Inventory Gross Profit and Turnover LO 7- Inventory Gross Profit and Turnover

• Gross profit – Sales Revenue less COGS • Can also be used to save time counting ending – Expressed in dollar or percentage terms inventory, assuming GPM is a constant 40% • Sales Revenue $100,000,000 100% – Sales Revenue $100 $100 • COGS $$,60,000, 000 60% – Cost of Goods Sold ? $60 • Gross Profit Margin $40,000,000 40% – Gross Profit Margin (40% x $100) $40 ------– Varies significantly by industry, wholesaler (lower due – Beginning Inventory $50 to volume) versus retailer (higher), presence of R&D, – Purchases +$70 etc. – Ending Inventory – ?? = $60 – Cost of Goods Sold $60

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LO 7- Inventory Gross Profit and Turnover LO 7- Inventory Gross Profit and Turnover

• Gross profit percentage can be used to check • the accuracy of the accounting records Cost of goods sold 100,000 – Unusually lower percentage may mean the company Average Inventory 20,000 + 30,000 = 4 has tried to avoid taxes by failing to record all sales • Some other factors that may cause a decline in 2 the percentage are – On average inventory is being stocked/sold four times per year – Higher turnover is associated with greater efficiency (lower costs – Price wars that reduce selling prices associated with stocking/handling inventory) – Shifting of the product mix sold – Effective in assessing companies in the same industry – Increase in shoplifting or embezzlement • Days in inventory 365 days / 4 = 91.25 – On average inventory is held 91.25 days before it is sold

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LO 7 – Inventory Valuation Methods LO 7 – Inventory Valuation Methods Miscellaneous Miscellaneous

• Inventory shrinkage can result from many • Shrinkage Example factors, including shoplifting or employee – Cost of inventory from a physical count ($8,000) embezzlement – Inventory balance in the general ($8,200) • The best deterrent for shoplifting is an alert • Periodic system employee at the point of sale Already included in COGS • Retail stores also use • Perpetual system – Sensitized tags on merchandise Inventory Shrinkage 200 – Surveillance cameras Merchandise Inventory 200 Cost of Goods Sold 200 Inventory Shrinkage 200

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LO 8 – LIFO Characteristics/Consequences LO 8 – LIFO Characteristics/Consequences

• Inflation • Holding Gains during periods of raising prices – When low, no significant impact on financial – Under LIFO, the latest costs (e.g. $1) appear on the accounting income statement so there are no “holding gains” – When high, companies using LIFO pass higher costs – Under FIFO, the lower/older inventory prices ($.60) onto taxable income which reduces taxes paid (also reduces net income) are moving to the income statement • Also presents net income at current prices – If the product sold for $2, under: • Major shift in the late 1970s to LIFO • LIFO, profit margin is $2 – $1 = $1 • Some with decreasing costs stayed with FIFO for • FIFO, profit margin is $2 – $.60 = $1.40, i.e.: the same reason, to have higher inventory costs – $1 gross profit margin on the sale itself reduce taxable income and thus taxes paid – $.40 holding gain ($1 – $.60) • Inventory Profits

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LO 8 – LIFO Characteristics/Consequences LO 8 – LIFO Characteristics/Consequences

• LIFO Layers • LIFO - The difference between a company’s LIFO and FIFO inventory level – As more inventory is bought than sold in a Begin End COGS – Older inventory costs remain in ending inventory • LIFO $10,121 $8,618 $127,103 – If inventoryygyg, costs have generally been raising, lower costs remain in inventory • LIFO R eserve $1, 100 891 209 • FIFO $11,221 $9,509 $127,312 • LIFO Liquidations – Reported in the notes to the financial statements – Later, when more inventory is sold than bought, those – At the end of the year, under FIFO ending inventory older layers (at lower than current costs) find their was $891 lower and COGS was $209 higher than it way into COGS. would have been under LIFO – COGS, with lower than current costs, produces an – Facilitates comparing LIFO and FIFO companies artificial (misleading) higher net income

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