2. Inventory Types
Finished inventory: held by retailers and
wholesalers
Merchandise inventory
Materials inventory: held by manufacturers
Raw materials
Work-in-progress
Finished goods
LO 1
3. Types of Manufacturing Costs
Direct materials: also called raw materials
Ingredients used in making a product
Direct labor: amounts paid to workers to
manufacture the product
Manufacturing overheads: all other costs that
are related to the manufacturing process but
cannot be directly matched to specific units of
output
Example: depreciation of building and salary of
supervisor
4. Three Forms of Inventory
Direct materials
The inventory of a manufacturer before the addition
of any direct labor or manufacturing overhead
Work in process
Cost of unfinished products in a manufacturing
company
Finished goods
A manufacturer’s inventory that is complete and
ready for sale
6. Account for Sales of Merchandise
LO 2
Sales revenue: representation of the inflow of
assets, either cash or accounts receivable, from
the sale of a product during the period
Gross Profit = Net Sales − Cost of Goods Sold
Net Sales = Sales −
Sales Return and
Allowances
− Sales Discount
8. Sales Returns and Allowances
Sales returns and allowances: contra-revenue
account used to record refunds to customers
and reductions of their accounts
Sales discounts: contra-revenue account used
to record discounts given to customers for early
payment of their accounts
Credit terms: firm’s policy for granting credit
Example: n/30; Net, 10 EOM; 1/10, n/30
9. Credit Terms and Sales Discounts
Credit terms: firm’s policy for granting credit
n/30: the net amount of the selling price is due
within 30 days of the date of the invoice
Net, 10 EOM: the net amount is due anytime within
ten days after the end of the month
1/10, n/30: the customer can deduct 1% from the
selling price if the bill is paid within ten days
Sales discounts: contra-revenue account used to
record discounts given to customers for early
payment of their accounts
10. Cost of Goods Sold
Recognition of cost of goods sold as an expense
is an excellent example of matching principle
Sales revenue: inflow of assets, cash or accounts
receivable
Cost of goods sold: outflow of asset, inventory
Cost of goods available for sale
Cost of goods sold
Beginning inventory + Cost of goods purchased
Cost of goods available for sale − Ending inventory
LO 3
14. Example 5.3—Recording Cost of Goods
Sold in a Perpetual System
Daisy’s sells a pair of running shoes that costs
$70. In addition to the entry to record the sale,
Daisy’s would also record an adjustment as
follows:
16. Example 5.4—Recording Purchase
in a Periodic System
Daisy’s buys shoes from Nike at a cost of $4,000. The
effect is to increase liabilities and increase cost of
goods sold, which is an expense
17. Example 5.5—Recording Purchase
Returns in a Periodic System
Daisy’s returns $850 of merchandise to Nike for credit
on Daisy’s account. The return decreases both
liabilities and purchases. Because a return reduces
purchases, it has the effect of reducing expenses and
increasing net income and stockholders’ equity
20. Purchase Discounts
A contra-purchases account used to record
reductions in purchase price for early payment
to a supplier
21. Shipping Terms and Transportation
Costs
Cost principle: All costs necessary to prepare an
asset for its intended use should be included in
its cost
FOB destination point: seller incurs the
transportation costs
FOB shipping point: buyer incurs the
transportation costs
FOB stands for ‘‘free on board’’
22. Example 5.7—Recording
Transportation-In in a Periodic System
Assume that on delivery of a shipment of goods,
Daisy’s pays an invoice for $300 from Rocky
Mountain Railroad. The terms of shipment are FOB
shipping point
24. The Gross Profit Ratio
Important measure of profitability
Indicates a company’s ability to cover operating
expenses and earn a profit
Relationship between gross profit and net sales
—measured by the gross profit ratio—one of
the most important measures to assess the
performance of a company
LO 4
Gross Profit
Net Sales
Gross Profit Ratio =
25. The Ratio Analysis Model
1. How much of the sales revenue is used for the
cost of the products, and thus, how much remains
to cover other expenses and to earn net income?
2. Gather the information about net sales and cost
of goods sold
3. Calculate the gross profit ratio
4. Compare the ratio with prior years and with
competitors
5. Interpret the ratios—showing increase or
decrease
26. The Business Decision Model
1. If you were an investor, would you buy stock in
a company?
2. Gather information from the financial
statements and other sources
3. Compare the company's gross profit ratio with
industry averages and look at trends
4. Buy stock or find an alternative use for the
money
5. Monitor the investment periodically
27. Inventory Valuation and the
Measurement of Income
Value assigned to inventory on balance sheet
determines the amount eventually recognized
as an expense on income statement
Incorrect ending inventory will affect cost of
goods sold and net income
LO 5
28. Inventory Costs
Cost: price paid or consideration given to
acquire an asset
Includes expenditures directly or indirectly incurred in
bringing to its existing condition and location
Examples:
Freight costs incurred to bring inventory to the place
of business
Cost of insurance when inventory is in transit
Cost of storing inventory before it is ready to be sold
Taxes paid—excise and sales taxes
29. Inventory Costing Methods
with a Periodic System
Specific
Identification
Weighted
Average
First-in, First-out
(FIFO)
Last-in, First-out
(LIFO)
LO 6
30. Specific Identification Method
Relies on matching unit costs with the actual
units sold
Example 5.10—Determining Ending Inventory
and Cost of Goods Sold Using Specific
Identification
32. Weighted Average Cost Method
Assigns the same unit cost to all units available
for sale during the period
Cost of Goods Available for Sale
Units Available for Sale
Weighted Average Cost =
Ending inventory =
Weighted
Average Cost
Number of Units in
Ending Inventory
×
34. First-In, First-Out Method (FIFO)
Assigns the most recent costs to ending
inventory
Example 5.12—Determining Ending Inventory
and Cost of Goods Sold Using FIFO
36. Last-In, First-Out Method (LIFO)
Assigns the most recent costs to cost of goods
sold
Example 5.13—Determining Ending Inventory
and Cost of Goods Sold Using LIFO
38. Selecting an Inventory Costing
Method
The choice of an inventory method will impact
cost of goods sold and thus net income
A company should choose the method that
results in the most accurate measure of net
income for the period
The primary determinant in selecting an
inventory costing method should be the ability
of the method to accurately reflect the net
income of the period
LO 7
40. Example 5.14—Computing Taxes Saved
by Using LIFO Instead of FIFO
Assume a 40% tax rate, income tax expense
under LIFO is only $2,000, compared with
$2,600 under FIFO, a savings of $600 in taxes
41. Result of FIFO and LIFO during a
Period of Raising Prices
42. LIFO Issues
LIFO Liquidation
The result of selling more units than are purchased
during the period
Negative tax consequences
LIFO Conformity rule
If LIFO is used on a tax return, it must also be used in
reporting income to stockholders
LIFO Reserve
The excess of the value of a company’s inventory
stated at FIFO over the value stated at LIFO
43. Costing Methods and Inventory
Profits
Replacement cost: current cost of a unit of
inventory
Inventory profit: the portion of the gross profit
that results from holding inventory during a
period of rising prices
45. Inventory Valuation in Other
Countries
Valuing inventory differ around the world
GAAP in the United States allows LIFO
IASB strictly prohibits the use of LIFO
Survival of LIFO is not only a matter of
convergence with international standards
LIFO allows companies with rising inventory costs to
report lower income
46. Inventory Errors
If ending inventory is overstated, cost of goods
sold will be understated and thus net income
for the period overstated
The opposite effects will occur when ending
inventory is understated
Different types of inventory errors
Mathematical errors
Physical count of inventory at year-end
Cutoff problems—in-transit—at year-end
LO 8
51. Lower-of-Cost-or Market Rule
A conservative inventory valuation approach
Require that inventory be written down at the
end of the period if the market value of the
inventory is less than its cost
Can be applied to:
Entire inventory
Individual items
Groups of items
LO 9
52. Lower-of-Cost-or-Market under
International Standards
Required under both U.S. GAAP and IFRS
Difference:
U.S.GAAP
• Define market value as replacement cost, subject to a
maximum and a minimum amount
• New amount becomes basis for future adjustments
IFRS
• Uses net realizable value with no upper or lower limits
• Write-downs of inventory can be reversed in later periods
54. Inventory Turnover Ratio
Measures company’s ability to sell its inventory
quickly
Number of times inventory is sold during a
period
LO 10
Cost of Goods Sold
Average Inventory
Inventory Turnover Ratio =
55. Number of Days’ Sales in Inventory
Measures of how long it takes to sell inventory
Number of Days in the Period
Inventory Turnover Ratio
=
Number of Days’ Sales
in Inventory
56. The Ratio Analysis Model
1. How liquid the company is?
2. Gather cost of goods sold from the income
statement and average inventory from balance
sheet at the end of the two most recent years
3. Calculate the inventory turnover ratio
4. Compare the ratio with other ratios
5. Interpret the ratios—measure of how long it
takes to sell inventory
57. The Business Decision Model
1. If you were an investor, would you buy stock in
the company?
2. Gather information from the financial
statements and other sources
3. Compare trends in inventory turnover ratios,
net income with industry averages
4. Buy stock or find an alternative
5. Monitor your decision periodically