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  • Chapter 8: Inventories and the Cost of Goods Sold <br />
  • Inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Inventory is reported as a current asset on the balance sheet. <br /> Companies that sell inventory report the value of the inventory they have in stock at the end of the period as a current asset on the balance sheet. <br /> Companies that sell inventory also have an additional expense item called Cost of Goods Sold on their income statements. The Cost of Goods Sold account represents the cost of the inventory sold during the period to help earn revenue. <br /> Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of inventory sold, to cover all other expenses and a profit. <br />
  • Remember that in a perpetual inventory system, inventory purchases are recorded by a debit to Inventory and a credit to Accounts Payable. This entry is similar to the entry made when any asset is purchased, such as a truck or land. <br /> The cost entry on the sale date requires a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold. <br />
  • On the sale date, a natural question arises: What is the unit cost of the inventory being sold? If all the inventory has the same unit cost, then this is not a difficult question to answer. However, in most cases, companies will have identical units of inventory in stock that have different unit costs. <br /> Let’s see how to determine the cost of a unit of inventory sold. <br />
  • In this example, ten laser lights are sold. There are 175 laser lights in stock. Of those in stock, the company paid $30 each for 100 units and $50 each for 75 units. So, how is the exact cost determined for the ten units we are selling on September 10th? <br /> There are four ways to determine the cost of inventory sold: <br /> Specific Identification <br /> First-in, First-out -- also known as FIFO <br /> Last-in, First-out -- also known a LIFO, and <br /> Average Cost <br />
  • Take a minute and review this chart for The Bike Company. This data will be used throughout the perpetual inventory examples to compare results. <br />
  • Part I <br /> When using the specific identification method, the specific cost of each unit that is sold is known. It is most commonly used in businesses that have low sales volume of high dollar items, like car dealerships, exclusive jewelry stores, and custom builders. <br /> On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 9 bikes that cost $91 each and 11 bikes that cost $106 each. <br /> Part II <br /> The Cost of Goods Sold for August 14th is $1,985. After this sale, TBC has 5 units in inventory: 1 unit that costs $91 and 4 units that cost $106 each. <br />
  • Remember that in a perpetual inventory system, two entries are required to record a sale. <br /> The first entry is to record the sale at retail and involves Cash or Accounts Receivable and Sales. In our example, we debit Cash for $2,600 ( 20 bikes at $130 each), and credit Sales for the same amount. <br /> The second entry is to record Cost of Goods Sold at cost and remove the items sold from Inventory. In our case, we debit Cost of Goods Sold for $1,985 and credit Inventory for the same amount. We determined the Cost of Goods Sold amount on the previous screen. We will make a similar set of entries each time we have a sale. <br />
  • Part I <br /> Next, TBC makes a purchase on August 17th and another on August 28th. On August 31st, TBC sell 23 bikes: 1 that cost $91; 3 that cost $106 each; 15 that cost $115 each; and 4 that cost $119 each. <br /> Part II <br /> The Cost of Goods Sold for the August 31st sale is $2,610. After the August 31st sale, TBC has 12 units in inventory: 1 unit that costs $106; 5 units that cost $115 each; and 6 units that cost $119 each. <br />
  • Using the specific identification method, TBC would report Cost of Goods Sold on their August income statement of $4,595 and they would report Ending Inventory on the balance sheet of $1,395. <br />
  • Part I <br /> When using average cost, assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand. <br /> On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes. <br /> Part II <br /> First, TBC needs to compute the average cost of the items in inventory. They do this by dividing the cost of goods available for sale of $2,500 by the total units in inventory of 25. The average cost per unit is $100. <br /> Then, to determine the Cost of Goods Sold for August 14th, multiply the number of units sold by the average cost. This calculation determines that the Cost of Goods Sold for August 14th is $2,000. <br />   <br /> After this sale, TBC has 5 units in inventory at an average cost of $100 each. <br />
  • Part I <br /> Next, TBC makes two purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes. <br /> Part II <br /> To determine the average cost of the inventory items, TBC will divide the cost of goods available for sale of $3,990 by the total units in inventory of 35. The average cost per unit is $114. <br /> Part III <br /> The units on hand (35) is determined by taking the total units purchased (55) and subtracting the units sold (20). The Cost of Goods Sold for August 31st is $2,622. <br /> After this sale, TBC has 12 units in inventory at an average cost of $114 each. <br />   <br />
  • Using the weighted average method, TBC would report Cost of Goods Sold on their August income statement of $4,622. And they would report Ending Inventory on the balance sheet of $1,368. <br />
  • Part I <br /> When using the First-in, First-out (FIFO) method, the older costs are assigned to the units sold. That leaves the more recent costs to be used to value ending inventory. <br /> On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes. <br /> Part II <br /> Using FIFO, first TBC assigns the cost of the 10 oldest inventory items purchased on August 1st at $91 each. Now, they need 10 more units, so they move down to the next purchase on August 3rd and include the cost of 10 units from this purchase at $106 each. The Cost of Goods Sold for August 14th is $1,970. <br /> After this sale, TBC has 5 units in inventory at a cost of $106 each. <br />
  • Part I <br /> TBC makes 2 purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes. <br /> Part II <br /> To determine the cost of goods sold on August 31st using FIFO, TBC takes the cost of the 5 remaining units from the August 3rd purchase at $106 each. Then, they move down to the next purchase on August 17th and take the cost of 18 units at $115 dollars each. The Cost of Goods Sold for August 31st is $2,600. <br /> After the August 31st sale, TBC has 12 units in inventory: 2 units at $115 each and 10 units at $119 each. <br />
  • Using the FIFO method, TBC would report Cost of Goods Sold on their August income statement of $4,570. They would report Ending Inventory on the balance sheet of $1,420. <br />
  • Part I <br /> When using the Last-in, First-out (LIFO) method, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory. <br /> On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes. <br /> Part II <br /> Using LIFO, first TBC assigns the cost of the 15 most recent inventory items purchased on August 3rd at $106 each. Now, they need 5 more units, so they move up to the next most recent purchase on August 1st and include the cost of 5 units from this purchase at $91 each. The Cost of Goods Sold for August 14th is $2,045. <br />   <br /> After this sale, TBC has 5 units in inventory at a cost of $91 each. <br />
  • Part I <br /> TBC makes two purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes. <br /> Part II <br /> Using LIFO, TBC takes the cost of the 10 units from the most recent purchase on August 28th at $119 each. Then, they move up to the next most recent purchase on August 17th and take the cost of 13 units at $115 each. The Cost of Goods Sold for August 31st is $2,685. <br /> After the August 31st sale, TBC has 12 units in inventory: 5 units at $91 each and 7 units at $115 each. <br />
  • Using LIFO, TBC would report Cost of Goods Sold of $4,730 on their August income statement. They would report Ending Inventory on the balance sheet of $1,260. <br />
  • This slide provides a summary of some of the key differences among the four inventory valuation methods. Take a few minutes to review it. <br />
  • The Principle of Consistency limits companies’ ability to switch accounting methods from period to period. The goal of this principle is to provide users with financial statements prepared using consistent accounting principles from one period to the next. This allows users to more easily make comparisons from period to period. <br /> However, a company doesn’t have to use the same accounting principle forever. If a company has a good reason to change accounting principles, they can. <br />
  • Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in the inventory records. In reality, this is not the case. The physical count does not match the records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps get records up to date to reflect what is actually on hand. <br /> Remember from Chapter 6 that when a physical count identifies inventory shrinkage, an entry is made to debit Cost of Goods Sold and credit Inventory. This entry increases Cost of Goods Sold, an expense account, and decreases the Inventory account. <br />
  • Before reporting a value for Inventory on the balance sheet, companies consider any needed reductions for obsolescence. They also make sure to adjust the inventory value to the lower of cost or market. <br /> Cost is determined using one of the methods just discussed: specific identification, FIFO, LIFO or average cost. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market follows the conservatism principle by not overstating the value of assets. <br />
  • Part I <br /> We can apply the lower-of-cost-or-market rule to individual inventory items, the categories of inventory items, or to the total inventory. At TBC we have two broad categories of inventory items – Bicycles and Bicycle accessories. You can see the inventory items that are in each category. Let’s begin by applying LCM to the individual inventory items. <br /> Part IIWhen we apply the rule to individual items, we compare the cost and market of each item and select the lower. For example, for the Boy’s Bicycles total cost is $4,200 and total market value is $4,600, so we will select the lower amount, which is cost. We complete the process for all the other items in inventory. Inventory will be carried on the balance sheet at $14,054. <br /> Part III <br /> We have two major categories of inventory items at TBC. If we apply LCM by inventory categories, we will compare the total cost of Bicycles to total Market for Bicycles. Under this approach, inventory will be carried at $14,582. <br /> Part IV <br /> Finally, we can apply LCM to the entire inventory. Using this approach we compare total cost of $15,637, to total market of $14,582, and select the lower – market of $14,582. Inventory will be shown on the balance sheet at $14,582. <br />
  • FOB stands for Free On Board. FOB terms designate when titles pass and who pays transportation costs. If the shipping terms are Free On Board shipping point, that means ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that the buyer will pay the transportation cost. <br /> On the other hand, if the shipping terms are Free On Board destination, that means ownership transfers from the seller to buyer when the buyer receives the goods. It also means that the seller will pay the transportation cost. <br /> If goods are shipped FOB Shipping Point and the goods are in transit at year end, then the buyer owns the goods in transit and will pay the transportation costs. In this case, the transportation cost will be added to the merchandise inventory account. <br />
  • Recall that in a periodic inventory system, purchases of inventory are recorded with a debit to Purchases, not Inventory, and a credit to Accounts Payable. <br />
  • Remember that in a periodic inventory system, a sale of inventory requires only one entry: a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale. <br /> The cost entry that was made under the perpetual inventory system is not required because the periodic system does not attempt to keep the Inventory and Cost of Good Sold accounts up to date. <br /> A periodic system does not maintain a cost of goods sold account so cost of goods sold must be calculated at the end of the period. <br />
  • Now let’s see how to use the inventory valuation methods in a periodic inventory system. <br /> Take a minute to review this chart for Computers, Incorporated. This data will be used throughout the periodic inventory examples and to compare the results at the end. <br />
  • Part I <br /> First, let’s look at the specific identification method. Remember that in this method, the specific cost of each unit in inventory is known. At the end of the period, inventory is counted and cost is determined. <br /> Computers, Incorporated, counted 1,200 mouse pads with a cost of $6,400. <br /> Part II <br /> This is enough information to determine Cost of Goods Sold for the year. <br /> To calculate Cost of Goods Sold for the period, start with Goods Available for Sale of $9,725 dollars and subtract Ending Inventory, based on the physical count, of $6,400. <br />
  • Part I <br /> When using average cost, assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale for the period by the units available for sale for the period. <br /> First, determine the average cost by taking Goods Available for Sale for the period and divide it by the number of units available for sale during the period. In this example, this calculation would be $9,725 divided by 1,800 units. The average cost is 5.40278 dollars. <br /> Part II <br /> To determine Ending Inventory, take the number of units in inventory and multiply by the average cost. <br /> To determine Cost of Goods Sold, take the number of units sold and multiply by the average cost. <br />
  • When using FIFO, assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory. <br /> For Computers, Incorporated, there are 1,200 units in Ending Inventory. To determine their cost using FIFO, start with the most recent purchase and then add other purchases until 1,200 units are accounted for. <br />
  • Part I <br /> Start with the November 29th purchase of 150 units. <br /> Part II <br /> Add the units from the September 15th purchase, the June 20th purchase, the January 3rd purchase, and 400 units from the beginning inventory. This accounts for all 1,200 units on hand. The cost of these units is determined by taking the units times their respective cost amount. <br /> Part III <br /> Ending Inventory is $6,575. <br /> The Cost of Goods Sold value for the 600 units sold is determined using the first costs in. Start with the beginning inventory and account for all 600 units. The Cost of Goods Sold is $3,150. <br /> As a double check, when you add together the Ending Inventory and the Cost of Goods Sold, you should get the Cost of Goods Available for Sale. <br />
  • Here is the completed table using FIFO in a periodic inventory valuation system. <br />
  • When using LIFO, assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory. <br /> For Computers, Incorporated, there are 1,200 units in Ending Inventory. To determine their cost using LIFO, start with the beginning inventory and then add other purchases until 1,200 units are accounted for. <br />
  • Part I <br /> Start with the beginning inventory of 1,000 units. <br /> Part II <br /> Add 200 units from the January 3rd purchase. This accounts for all 1,200 units on hand. The cost of these units is determined by taking the units times their respective cost amount. <br /> Part III <br /> Ending Inventory is $6,310. <br /> The Cost of Goods Sold value for the 600 units sold is determined using the last costs in. Start with the November 29th purchase of 150 units. Then add the units from the September 15th purchase, the June 20th purchase, and 100 units from the January 3rd purchase. The Cost of Goods Sold is $3,415. <br /> As a double check, when Ending Inventory and the Cost of Goods Sold are added together, they should equal the Cost of Goods Available for Sale. <br />
  • Here is the completed table using LIFO in a periodic inventory valuation system. <br />
  • Take a few minutes to review this chart. It shows the impact of inventory errors on the income statement and balance sheet. For example, an understated Ending Inventory will result in an overstatement of Cost of Goods Sold, an understatement of Gross Profit, and an understatement of Net Income. On the balance sheet it will result in understated Ending Inventory and understated Retained Earnings due to the understatement in Net Income. <br />
  • It is expensive and time consuming to take a physical count of inventory. As a result, in interim financial statements, most companies estimate ending inventory and cost of goods sold. Using this estimate helps avoid having to shut down production or close the doors to the business to do a physical count. <br /> Let’s look at two methods used to estimate inventory for interim financial statements: the gross profit method and the retail method. <br /> When using the gross profit method, follow these three steps. First, determine the Cost of Goods Available for Sale. This can be done using accounting data. Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio. The cost ratio is based on past history of the company. Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory. <br />
  • In March of 2009, Matrix’s inventory was destroyed by fire. Past history shows that Matrix’s normal Gross Profit ratio is 30% of Net Sales. Here are some other balances in Matrix’s accounting records: Sales were $31,500; Sales Returns were $1,500; Beginning Inventory was $12,000, and the Net Cost of Goods Purchased was $20,500. Let’s estimate the amount of the inventory lost in the fire. <br />
  • Part I <br /> First, determine the Cost of Goods Available for Sale. This is calculated by adding Beginning Inventory and the Net Cost of Goods Purchased. The Cost of Goods Available for Sale is $32,500. <br /> Part II <br /> Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio. To accomplish this, remember that Net Sales minus Cost of Goods Sold equals Gross Profit. Since the Gross Profit ratio is 30%, then the Cost of Goods Sold Ratio has to be 70%. Net Sales is calculated as Sales minus Sales Returns and Sales Discounts. In this problem, there are only Sales Returns. Seventy percent of $30,000 is $21,000, which is the estimate of the Cost of Goods Sold. <br /> Part III <br /> Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory, which in this case is $11,500. <br />
  • Now let’s look at how to use the Retail Method to estimate inventory using Matrix again. To use this method, management must determine the value of ending inventory at retail prices and then convert from retail prices to cost. <br /> Now, let’s use the information provided for Matrix with the Retail Method to estimate Matrix’s inventory and cost of goods sold. <br />
  • First, we need to determine the cost ratio. This is calculated by dividing Goods Available for Sale at Cost by Goods Available for Sale at Retail. Matrix’s cost ratio is 65%. <br /> Next, take Matrix’s ending inventory at retail of $22,000 and multiply it by the cost ratio to arrive at Estimated Ending Inventory at cost. For Matrix, this is $14,300. <br />
  • Inventory Turnover measures how quickly a company sells its inventory. A ratio that is low compared to competitors suggests inefficient use of assets. To calculate this ratio, take Cost of Goods Sold and divide by Average Inventory. <br /> The Average Number of Days to Sell Inventory ratio measures how many days on average it takes to sell inventory. It is calculated as Number of Days in the Year divided by Inventory Turnover. <br />
  • Most businesses sell merchandise on account. Therefore, the sale of inventory often does not provide an immediate source of cash. To determine how quickly inventory is converted into cash, the number of days required to sell the inventory must be combined with the number of days required to collect the accounts receivable. <br /> The receivables turnover is computed by dividing net sales by the average accounts receivable. The number of days required to collect these receivables then is determined by dividing 365 days by the turnover rate. <br />
  • End of chapter 8. <br />

Chap008 Chap008 Presentation Transcript

  • Inventories and the Cost of Goods Sold Chapter 8 McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
  • The Flow of Inventory Costs BALANCE SHEET Purchase costs (or manufacturing costs) Asset Inventory INCOME STATEMENT as goods are sold Revenue Cost of goods sold Gross profit Expenses Net income 8-2
  • The Flow of Inventory Costs In a perpetual inventory system, inventory entries parallel the flow of costs. GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit Entry on Purchase Date Inventory $$$$ Accounts Payable $$$$ Entry on Sale Date Cost of Goods Sold Inventory $$$$ $$$$ 8-3
  • Which Unit Did We Sell? When identical units of inventory have different unit costs, a question naturally arises as to which of these costs should be used in recording a sale of inventory. 8-4
  • Inventory Subsidiary Ledger A separate subsidiary account is maintained A separate subsidiary account is maintained for each item in inventory. for each item in inventory. Item LL002 Description Laser Light Location Storeroom 2 Purchased Date Sept. 5 Sept. 9 Sept. 10 Units 100 75 Unit Cost Total $ 30 $ 3,000 50 3,750 Sold Units Unit Cost 10 ? Primary supplier Electronic City Secondary supplier Electric Company Inventory level: Min: 25 Max: 200 Balance Cost of Goods Unit Sold Units Cost Total 100 $ 30 $ 3,000 100 30 3,000 75 50 3,750 ? ? ? ? ? ? ? How can we determine the unit cost for the Sept. 10 sale? 8-5
  • Data for an Illustration The Bike Company (TBC) 8-6
  • Specific Identification On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each. Of the bikes sold 9 originally cost $91 and Of the bikes sold 9 originally cost $91 and 11 cost $106. 11 cost $106. Purchases Date Units Unit Cost Total Cost of Goods Sold Unit Cost Units Total Inventory Balance Unit Cost Units Total Aug. 1 10 @ $ 91 = $ 910 10 @ $ 91 = Aug. 3 15 @ $ 106 = $ 1,590 10 @ $ 91 15 @ $ 106 Aug. 14 9 @ $ 91 11 @ $ 106 = $ 1,985 1 @ $ 91 4 @ $ 106 $ 910 = $ 2,500 = $ 515 The Cost of Goods Sold for the August 14 sale is $1,985. The Cost of Goods Sold for the August 14 sale is $1,985. This leaves 5 units, with a total cost of $515, in inventory: This leaves 5 units, with a total cost of $515, in inventory: 1 unit that costs $91 and 4 units that cost $106 each. 1 unit that costs $91 and 4 units that cost $106 each. 8-7
  • Specific Identification Retail (20 × $130) Retail (20 × $130) Cost Cost A similar entry is made after each sale. A similar entry is made after each sale. 8-8
  • Specific Identification Additional purchases were made on August 17 and 28. Additional purchases were made on August 17 and 28. Date Aug. 1 Aug. 3 Purchases Unit Cost Units Total Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 = $ 910 10 @ $ 91 = 15 @ $ 106 = $ 1,590 10 @ $ 91 15 $ 106 Aug. 14 $ 119 = @ $ 106 = $ 1,985 = $ 2,300 1 @ $ 4 $ 106 @ 91 1 @ $ 1,190 $ @ $ 106 @ 3 @ $ 106 15 @ $ 115 4 @ $ 106 @ $ 115 @ = $ 515 $ 106 5 @ $ 115 6 @ = $ 2,815 $ 119 1 @ 91 @ 10 $ $ 20 @ = $ 2,500 $ 115 1 @ 1 910 91 4 Aug. 31 @ $ 115 91 20 10 @ $ 4 Aug. 28 20 @ 11 Aug. 17 9 @ $ 91 $ 119 = $ 4,005 $ 119 = $ 2,610 = $ 1,395 8-9
  • Specific Identification Cost of Goods Sold Unit Cost Units Total Inventory Balance Unit Cost Units Total 10 @ 11 @ $ 106 = $ 1,985 $ 91 15 @ $ 91 91 = 10 @ 9 @ $ $ 106 1 @ 910 = $ 2,500 = $ 515 106 = $ 2,815 $ 91 4 @ $ 106 1 @ $ 4 @ $ Income Statement $ 20 @ $ 115 91 3 @ $ 106 15 @ $ 115 4 @ $ 91 4 @ $ 106 115 10 @ $ 1 @ $ $ 20 @ $ COGS = $4,595 1 @ 91 119 = $ 4,005 5 @ $ 115 = $ 1,395 6 @ $ 119 1 @ 119 = $ 2,610 $ 106 Balance Sheet Inventory = $1,395 8-10
  • Average-Cost Method On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each. Purchases Date Units Unit Cost Total Cost of Goods Sold Unit Cost Units Total Inventory Balance Units Unit Cost Aug. 1 10 @ $ 91 = $ 910 10 @ $ Aug. 3 15 @ $ 106 = $ 1,590 25 @ $ 5 @ $ Aug. 14 The average cost per The average cost per unit must be computed unit must be computed prior to each sale. prior to each sale. 20 @ $ 100 = $ 2,000 Total 91 = $ 910 100 = $ 2,500 100 = $ 500 $2,500 ÷ 25 = $100 avg. cost $2,500 ÷ 25 = $100 avg. cost 8-11
  • Average-Cost Method Additional purchases were made on August 17 and Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units August 28. On August 31, an additional 23 units were sold. were sold. Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Purchases Unit Cost Units Total Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 = $ 910 10 @ $ 15 @ $ 106 = $ 1,590 25 @ $ 100 = $ 2,500 5 @ $ 100 = $ 20 @ $ 100 = $ 2,000 91 = $ 910 500 20 @ $ 115 = $ 2,300 25 @ $ 112 = $ 2,800 10 @ $ 119 = $ 1,190 35 @ $ 114 = $ 3,990 12 @ $ 114 = $ 1,368 23 @ $ 114 = $ 2,622 $114 = $3,990 ÷ 35 $114 = $3,990 35 8-12
  • Average-Cost Method Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ 25 @ Income Statement $ 100 = $ 2,000 COGS = $4,622 23 @ $ 114 = $ 2,622 = $ 2,500 5 @ $ 100 = $ $ 112 = $ 2,800 35 @ @ $ 100 25 @ 20 $ 91 = $ 910 $ 114 = $ 3,990 12 @ $ 114 = $ 1,368 500 Balance Sheet Inventory = $1,368 8-13
  • First-In, First-Out Method (FIFO) On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each. Date Aug. 1 Aug. 3 Purchases Unit Cost Units Total Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units @ $ 91 = $ 910 10 @ $ 91 15 @ $ 106 = $ 1,590 10 @ $ 91 15 Aug. 14 10 @ $ 106 5 @ $ 106 10 @ $ 91 10 @ $ 106 = $ 1,970 = $ 910 = $ 2,500 = $ 530 The Cost of Goods Sold for the August 14 sale is $1,970, The Cost of Goods Sold for the August 14 sale is $1,970, leaving 5 units, with a total cost of $530, in inventory. leaving 5 units, with a total cost of $530, in inventory. 8-14
  • First-In, First-Out Method (FIFO) Additional purchases were made on Aug. 17 and Aug. 28. Additional purchases were made on Aug. 17 and Aug. 28. On August 31, an additional 23 units were sold. On August 31, an additional 23 units were sold. Date Aug. 1 Aug. 3 Purchases Unit Cost Units Total Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 = $ 910 10 @ $ 91 15 @ $ 106 = $ 1,590 10 @ $ 91 15 @ $ 106 5 @ $ 106 Aug. 14 20 @ $ 115 = @ $ 10 Aug. 17 10 91 @ $ 106 = $ 1,970 $ 2,300 5 @ 20 Aug. 28 10 @ $ 119 = $ 106 $ 115 5 @ $ 1,190 @ @ $ 106 18 @ $ 115 = $ 2,600 @ $ 115 10 5 910 = $ 2,500 = $ 530 = $ 2,830 $ 106 20 Aug. 31 = $ @ $ 119 2 @ $ 115 = $ 4,020 10 @ $ 119 = $ 1,420 8-15
  • First-In, First-Out Method (FIFO) Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 10 @ $ 106 = $ 1,970 $ 91 15 @ 91 10 @ 10 $ @ $ 106 5 @ $ 106 5 @ Income Statement COGS = $4,570 20 $ 106 @ $ 115 5 @ @ $ 106 18 @ $ 115 = $ 2,600 910 = $ 2,500 = $ 530 = $ 2,830 $ 106 20 @ $ 115 10 5 = $ @ $ 119 2 @ $ 115 = $ 4,020 10 @ $ 119 Balance Sheet = $ 1,420 Inventory = $1,420 8-16
  • Last-In, First-Out Method (LIFO) On August 14, TBC sold 20 bikes for On August 14, TBC sold 20 bikes for $130 each. $130 each. Date Aug. 1 Aug. 3 Purchases Unit Cost Units Total $ 91 = 15 @ $ 106 = 910 10 @ $ 91 $ 1,590 10 @ $ 91 15 @ Aug. 14 10 @ $ Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units $ 106 15 @ 5 @ $ 106 $ 91 = $ 2,045 5 @ $ = $ = 91 = 910 $ 2,500 $ 455 The Cost of Goods Sold for the August 14 sale is $2,045, The Cost of Goods Sold for the August 14 sale is $2,045, leaving 5 units, with a total cost of $455, in inventory. leaving 5 units, with a total cost of $455, in inventory. 8-17
  • Last-In, First-Out Method (LIFO) Additional purchases were made on Aug. 17 and Additional purchases were made on Aug. 17 and Aug. 28. On Aug. 31, an additional 23 units were Aug. 28. On Aug. 31, an additional 23 units were sold. sold. Date Aug. 1 Aug. 3 Purchases Unit Cost Units Total Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 91 = $ 910 10 @ $ 91 15 @ $ 106 = $ 1,590 10 @ $ 91 15 @ $ 106 5 @ $ 91 $ 91 Aug. 14 20 @ $ 115 = @ $ 106 5 Aug. 17 15 @ $ 91 = $ 2,045 $ 2,300 5 @ 20 Aug. 28 10 @ $ 119 = $ 1,190 @ 5 @ $ 115 $ @ $ 119 13 @ $ 115 = $ 2,685 @ $ 115 10 10 910 = $ 2,500 = $ 455 = $ 2,755 91 20 Aug. 31 = $ @ = $ 3,945 $ 119 5 @ $ 7 $ 115 @ 91 = $ 1,260 8-18
  • Last-In, First-Out Method (LIFO) Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units 10 @ $ 106 5 @ $ 91 = $ 2,045 $ 91 15 @ 91 10 @ 15 $ @ $ 106 5 @ $ 91 $ 91 5 @ Income Statement COGS = $4,730 20 @ 5 @ $ 115 $ @ $ 119 13 @ $ 115 = $ 2,685 910 = $ 2,500 = $ 455 = $ 2,755 91 20 @ $ 115 10 10 = $ @ = $ 3,945 $ 119 5 @ $ 7 $ 115 @ 91 = $ 1,260 Balance Sheet Inventory = $1,260 8-19
  • Inventory Valuation Methods: A Summary Costs Allocated to: Valuation Cost of Goods Method Sold Inventory Comments Specific Actual cost of Actual cost of units Parallels physical flow identification the units sold remaining Logical method when units are unique May be misleading for identical units Average cost Number of units Number of units on Assigns all units the same sold times the hand times the average unit cost average unit cost average unit cost Current costs are averaged in with older costs First-in, First-out Cost of earliest Cost of most Cost of goods sold is based (FIFO) purchases on recently on older costs hand prior to the purchased units Inventory valued at current sale costs May overstate income during periods of rising prices; may increase income taxes due Last-in, First-out Cost of most Cost of earliest Cost of goods sold shown at (LIFO) recently purchases recent prices purchased units (assumed still in Inventory shown at old (and inventory) perhaps out of date) costs Most conservative method during periods of rising prices; often results in lower income taxes 8-20
  • The Principle of Consistency Once a company has adopted a particular accounting method, it should follow that method consistently rather than switch methods from one year to the next. 8-21
  • Taking a Physical Inventory The primary reason for taking a physical The primary reason for taking a physical inventory is to adjust the perpetual inventory inventory is to adjust the perpetual inventory records for unrecorded shrinkage losses, records for unrecorded shrinkage losses, such as theft, spoilage, or breakage. such as theft, spoilage, or breakage. 8-22
  • LCM and Other Write-Downs of Inventory Obsolescence Obsolescence Lower of Cost Lower of Cost or Market or Market (LCM) (LCM) Reduces the value Reduces the value of the inventory. of the inventory. Adjust inventory Adjust inventory value to the lower value to the lower of historical cost or of historical cost or current current replacement cost replacement cost (market). (market). 8-23
  • LCM and Other Write-Downs of Inventory LCM Applied on the Basis of . . . Cost Bicycles: Boy's bicycles Girls bicycles Junior bicycle Total Bicycle accessories: Training wheels Headlamps Protective helmets Gloves Kneepads Total Total inventory Market $ 4,200 3,800 5,700 $ 13,700 $ 4,600 3,100 5,000 $ 12,700 $ Individual Items $ 485 312 700 245 195 $ 1,937 $ 15,637 525 400 600 212 145 $ 1,882 $ 14,582 Inventory Category Total Inventory 4,200 3,100 5,000 12,700 485 312 600 212 145 $ 14,054 1,882 $ 14,582 $ 14,582 8-24
  • Goods In Transit A sale should be recorded when title to A sale should be recorded when title to the merchandise passes to the buyer. the merchandise passes to the buyer. F.O.B. F.O.B. shipping shipping point  title point  title passes to passes to buyer at the buyer at the point of point of shipment. shipment. Year End F.O.B. F.O.B. destination destination point  title point  title passes to passes to buyer at the buyer at the point of point of destination. destination. 8-25
  • Periodic Inventory Systems In a periodic inventory system, inventory entries are as follows. Note that an entry is not Note that an entry is not made to inventory. made to inventory. 8-26
  • Periodic Inventory Systems In a periodic inventory system, inventory entries are as follows. 8-27
  • Information for the Following Inventory Examples Computers, Inc. Mouse Pad Inventory Units $/Unit Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 ? 600 ? 8-28
  • Specific Identification Computers, Inc. Mouse Pad Inventory Units $/Unit Date Beginning Inventory 1,000 $ 5.25 Purchases: Jan. 3 300 5.30 June 20 150 5.60 Sept. 15 200 Cost of Goods Sold5.80 Cost of Goods Sold Nov. 29 150 5.90 Goods $9,725 $6,400 = $3,325 $9,725 $6,400 = $3,325 Available for Sale 1,800 -- Ending Inventory Cost of Goods Sold Total $ 5,250.00 1,590.00 840.00 1,160.00 885.00 $ 9,725.00 1,200 $ 6,400.00 600 $ 3,325.00 8-29
  • Average-Cost Method Avg. Cost $9,725 ÷ 1,800 Avg. Cost $9,725 ÷ 1,800 = $5.40278 = $5.40278 Ending Inventory Ending Inventory Avg. Cost $5.40278 × 1,200 = Avg. Cost $5.40278 × 1,200 = $6,483 $6,483 Cost of Goods Sold Cost of Goods Sold Avg. Cost $5.40278 × 600 = Avg. Cost $5.40278 × 600 = $3,242 $3,242 Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 1,200 $ 6,483.00 ? 600 $ 3,242.00 ? 8-30
  • First-In, First-Out Method (FIFO) Remember: Start with the 11/29 purchase and then add other purchases until you reach the number of units in ending inventory. Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 ? 600 ? 8-31
  • First-In, First-Out Method (FIFO) Date Jan. 3 June 20 Sept. 15 Nov. 29 Units Beg. Inv. Purchases 1,000@$5.25 300@$5.30 150@$5.60 200@$5.80 150@$5.90 End. Inv. Cost of Goods Sold 600@$5.25 400@$5.25 300@$5.30 150@$5.60 200@$5.80 150@$5.90 1,200 150 600 $6,575 $3,150 Now, Costs we have allocated the cost to all 1,200 units in ending Now, let’s complete the Now, let’s complete the inventory. table. table. Cost of Goods Available for Sale $9,725 8-32
  • First-In, First-Out Method (FIFO) Completing the table summarizes the computations just made. Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 $ 6,575.00 600 $ 3,150.00 8-33
  • Last-In, First-Out Method (LIFO) Remember: Start with beginning inventory and then add other purchases until you reach the number of units in ending inventory. Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 ? 600 ? 8-34
  • Last-In, First-Out Method (LIFO) Date Jan. 3 June 20 Sept. 15 Nov. 29 Units Beg. Inv. Purchases End. Inv. 1,000@$5.25 1,000@$5.25 300@$5.30 200@$5.30 150@$5.60 200@$5.80 150@$5.90 Now, Costs we have allocated the cost to all 1,200 units in ending inventory. Cost of Goods Available for Sale 1,200 1,000 Cost of Goods Sold 100@$5.30 150@$5.60 200@$5.80 150@$5.90 600 100 Next, let’s complete $6,310let’scomplete $3,415 Next, the table. the table. $9,725 8-35
  • Last-In, First-Out Method (LIFO) Completing the table summarizes the computations just made. Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 $ 6,310.00 600 $ 3,415.00 8-36
  • Importance of an Accurate Valuation of Inventory Errors in Measuring Inventory Beginning Inventory Ending Inventory Effect on Income Statement Overstated Understated Overstated Understated Goods Available for Sale Cost of Goods Sold Gross Profit Net Income + + - + + NE NE + + + - NE NE - + + + - Effect on Balance Sheet Ending Inventory Retained Earnings An error in ending inventory in a year will result in the An error in ending inventory in a year will result in the same error in the beginning inventory of the next same error in the beginning inventory of the next year. year. 8-37
  • The Gross Profit Method 1. Determine cost of goods 1. Determine cost of goods available for sale. available for sale. 2. Estimate cost of goods 2. Estimate cost of goods sold by multiplying the net sold by multiplying the net sales by the cost ratio. sales by the cost ratio. 3. Deduct cost of goods sold 3. Deduct cost of goods sold from cost of goods from cost of goods available for sale to available for sale to determine ending determine ending inventory. inventory. 8-38
  • The Gross Profit Method In March of 2009, Matrix Company’s In March of 2009, Matrix Company’s inventory was destroyed by fire. Matrix inventory was destroyed by fire. Matrix normal gross profit ratio is 30% of net normal gross profit ratio is 30% of net sales. At the time of the fire, Matrix sales. At the time of the fire, Matrix showed the following balances: showed the following balances: Sales $ 31,500 Sales returns 1,500 Beginning Inventory 12,000 Net cost of goods purchased 20,500 8-39
  • The Gross Profit Method Estimating Inventory The Gross Profit Method Goods Available for Sale: $ 12,000 Step Beginning Inventory 1 Net cost of goods purchased 20,500 Goods available for sale $ 32,500 Less estimated cost of goods sold: Sales $ 31,500 Step Less sales returns (1,500) × 70% 2 Net sales $ 30,000 Estimated cost goods sold (21,000) Step Estimated cost ofof goods sold 3 Estimated March inventory loss $ 11,500 8-40
  • The Retail Method The retail method of estimating inventory The retail method of estimating inventory requires that management determine the requires that management determine the value of ending inventory at retail prices. value of ending inventory at retail prices. In March of 2009, Matrix Company’s inventory was In March of 2009, Matrix Company’s inventory was destroyed by fire. At the time of the fire, Matrix’s destroyed by fire. At the time of the fire, Matrix’s management collected the following information: management collected the following information: Information for Matrix Company The Retail Method Goods available for sale at cost Goods available for sale at retail Physical count of ending inventory priced at retail $ 32,500 50,000 22,000 8-41
  • The Retail Method Matrix would follow the steps below to estimate Matrix would follow the steps below to estimate their ending inventory using the retail method. their ending inventory using the retail method. Estimating Inventory The Retail Method a b c d e Goods available for sale at cost Goods available for sale at retail Cost ratio [a ÷ b] Physical count of ending inventory priced at retail Estimated ending inventory at cost [ c × d] $ 32,500 50,000 65% 22,000 $ 14,300 8-42
  • Financial Analysis Inventory Turnover = Cost of Goods Sold Average Inventory (Beginning Inventory + Ending Inventory) ÷ 2 (Beginning Inventory + Ending Inventory) ÷ 2 Average Days to Sell Inventory = 365 Inventory Turnover 8-43
  • Financial Analysis Receivables Turnover = Net Sales Average Accounts Receivable (Beginning Receivables + Ending Receivables) ÷ 2 (Beginning Receivables + Ending Receivables) ÷ 2 365 Average Days to = Collect Receivables Receivables Turnover 8-44
  • End of Chapter 8 8-45