Chapter 8Inventories and Cost of     Goods Sold
Inventory and Cost of Goods Sold Inventory    Products purchased or manufactured for Sale to     Customers Beginning In...
Income Statement       Service Company             Merchandising Company     Century 21 Real Estate       General Motors C...
Balance Sheet       Service Company              Merchandising Company     Century 21 Real Estate        General Motors Co...
Inventory Accounting Systems Perpetual  Up-to-date record in inventory account  Cost of goods sold computed for each sa...
Recording Transactions in thePerpetual System  Purchase price of the inventory $600,000  + Freight-in (delivery charges)  ...
CalculationPeriodic System         Perpetual SystemBeginning Inventory     Beginning Inventory+Cost of Purchases      +Cos...
Periodic Vs. Perpetual System                     Periodic                 PerpetualPurchase             Debited as purcha...
Relationship between BalanceSheet and Income StatementIncome Statement Items:  Sales revenue is based on sale price of  ...
Accounting for Inventory      Sales             Number of units of        Sale price per unit                   =         ...
Recording Transactions and the T-Accounts                          General JournalDate       Accounts and Explanations    ...
Recording Transactions and the T-AccountsSale on account $900,000 of Inventory which cost $540,000:                       ...
Recording Transactions and the T-Accounts        Inventory      Cost of Goods SoldBeg. 100,000 540,000    540,000     560,...
Reporting in the FinancialStatements         Income Statement (partial)  Sales revenue                  $900,000  Cost of ...
Inventory Costing MethodMethods for determining per unit Inventory Cost  Specific unit cost  Average cost  First-in, f...
Which Method will a CompanyUse?Decision is up to Management  NOT based on Actual Inventory MovementsA tool for managing...
Illustrative Data Beginning inventory (10 units @ $10)     $ 100 No. 1 (25 units @ $14 per unit)     $350 No. 2 (25 units ...
Specific Unit Cost                     5 Units @ $10Cost of Goods Sold       $ 50        350          25 Units @ $14      ...
Weighted-Average, AverageCosting       Average Cost              Cost of Goods Available                           =      ...
Weighted-Average   $900 total cost   60 units = $15/unit   Ending inventory = 20    $15 = $300  Cost of goods sold = 40   ...
First In, First OutFirst costs into inventory are first costs assigned to cost ofgoods sold.                   Inventory (...
First In, First Out  Ending Inventory Cost:                           60 units       Less units sold     40       Ending i...
First In, First Out                      10 Units @ $10Cost of Goods Sold       $100        350           25 Units @ $14  ...
Last In, First OutLast costs into inventory are first costs assigned to cost ofgoods sold.                  Inventory (at ...
Last In, First Out Ending Inventory Cost:                           60 units      Less units sold      40      Ending inve...
Last In, First OutCost of Goods Sold   25 Units @ $18       $450        210       $660          15 Units @ $14
Income Effects of Inventory Methods                 Assumed          Cost of                  Sales           Goods       ...
Income EffectsWhen inventory costs are increasing  LIFO cost of goods sold is highest, gross profit   is lowest.  FIFO ...
Tax AdvantageTax advantages of LIFO in periods of rising prices   Higher Cost of Goods Sold = Lower Net Income    = Lowe...
Tax Advantage                         FIFO        LIFOGross profit             $460        $340Operating expenses        2...
Inventory in Balance SheetLIFO, The inventory will be recorded at the old cost considered to be valued low.FIFO, The inv...
Inventory ErrorsEach inventory error affects:  Inventory  Cost of goods sold  Gross profit  Net income
Inventory Errors                                  Period 1                  Period 2                          Cost of     ...
Accounting Principles Consistency principle    Same Accounting Methods from Period to Period    Accounting Changes must...
Lower of Cost or Market Lower-of-Cost-or-Market rule (LCM)   Inventory is reported at the lowest value        Historica...
Ratios     Gross Profit          Gross Profit                    =     Percentage         Net Sales Revenue      Inventory...
RatiosGross Profit  Profit indicatorInventory Turnover – Liquidity ratio  How quickly is Inventory Sold?
Techniques of Estimating Cost ofGoods Sold and Ending InventoryThe Gross Profit MethodThe Retail Method
Gross Profit MethodIt is assumed that rate of gross profit earned in the preceding year will remain the same in current y...
Estimate CGS using GP%We know Beginning Inventory = $14,000We know Purchases =          $ 66,000We know Sales =        ...
Gross Profit MethodBeginning inventory                $14,000Purchases                           66,000Goods available    ...
The Retail MethodIs quite similar to the gross profit method.Retail method is based on the cost ratio of the current per...
Estimate CGS using Cost%Cost of goods available for sale= $ 45,000Retail price =                   $100,000Annual Sales...
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Chapter 8

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Chapter 8

  1. 1. Chapter 8Inventories and Cost of Goods Sold
  2. 2. Inventory and Cost of Goods Sold Inventory  Products purchased or manufactured for Sale to Customers Beginning Inventory  Quantities of Merchandise on hand Purchases  New Purchases or Manufactured products Available for Sale = Beginning Inventory + Purchases  Most that a company can sell during an accounting period Ending Inventory  Remaining Unsold Merchandise Cost of Goods Sold  Cost of Inventory Sold during accounting Period
  3. 3. Income Statement Service Company Merchandising Company Century 21 Real Estate General Motors Corporation Income Statement Income Statement Year Ended December 31, 20xx Year Ended December 31, 20xxService revenue $XXX Sales revenue $185Expenses Cost of goods sold 146 Salary expense X Gross profit 39 Depreciation expense X Operating expenses: Income tax expense X Salary expense XNet income $ X Depreciation expense X Income tax expense $ X Net income $ 4
  4. 4. Balance Sheet Service Company Merchandising Company Century 21 Real Estate General Motors Corporation Balance Sheet Balance Sheet Year Ended December 31, 20xx Year Ended December 31, 20xxCurrent assets: Current assets: Cash $X Cash $X Short-term investments X Short-term investments X Accounts receivable, net X Accounts receivable, netX Prepaid expenses X Inventory 11 Prepaid expenses X
  5. 5. Inventory Accounting Systems Perpetual Up-to-date record in inventory account Cost of goods sold computed for each sale Periodic Inventory purchases are recorded as incurred Inventory and cost of goods sold determined at the end of each period Costs and benefits Perpetual requires more bookkeeping but provides more useful information
  6. 6. Recording Transactions in thePerpetual System Purchase price of the inventory $600,000 + Freight-in (delivery charges) 4,000 – Purchase returns – 25,000 – Purchase allowances – 5,000 – Purchase discounts – 14,000 = Net purchases of inventory $560,000 Net sales Sales revenue – Sales returns & allowances – Sales discounts
  7. 7. CalculationPeriodic System Perpetual SystemBeginning Inventory Beginning Inventory+Cost of Purchases +Cost of Purchases___________________ ___________________=Cost of Goods =Cost of Goods Available for Sale Available for Sale- Ending Inventory - Cost of Goods Sold___________________ ___________________=Cost of Goods Sold =Ending Inventory
  8. 8. Periodic Vs. Perpetual System Periodic PerpetualPurchase Debited as purchase Debited to InventorySales Sale Entry 2 Entries To record sale & to reduce the inventoryEnding Inventory Not Recorded until the Recorded end of a periodCost of Goods Sold Not Recorded until the Recorded end of a period
  9. 9. Relationship between BalanceSheet and Income StatementIncome Statement Items: Sales revenue is based on sale price of Inventory sold. Cost of goods sold is based on cost of Inventory sold. Gross profit (gross margin) is sales revenue less cost of goods sold.Balance Sheet Item: Inventory on the balance sheet is based on cost.
  10. 10. Accounting for Inventory Sales Number of units of Sale price per unit = X(income statement) inventory sold of inventoryCost of Goods Sold Number of units of Cost per unit = X(income statement) inventory sold of inventory Inventory Number of units of Cost per unit = X (balance sheet) inventory on hand of inventory
  11. 11. Recording Transactions and the T-Accounts General JournalDate Accounts and Explanations LF Debit Credit Inventory 560,000 Accounts Payable 560,000 Purchased inventory on account Inventory Accounts PayableBeg. 100,000 560,000 560,000
  12. 12. Recording Transactions and the T-AccountsSale on account $900,000 of Inventory which cost $540,000: General JournalDate Accounts and Explanations LF Debit Credit Accounts Receivable 900,000 Sales Revenue 900,000 Cost of Goods Sold 540,000 Inventory 540,000
  13. 13. Recording Transactions and the T-Accounts Inventory Cost of Goods SoldBeg. 100,000 540,000 540,000 560,000 120,000
  14. 14. Reporting in the FinancialStatements Income Statement (partial) Sales revenue $900,000 Cost of goods sold 540,000 Gross profit $360,000 Ending Balance Sheet (partial) Current assets: Cash $ XXX Short-term investments XXX Accounts receivable, net XXX Inventory 120,000 Prepaid expenses XXX
  15. 15. Inventory Costing MethodMethods for determining per unit Inventory Cost Specific unit cost Average cost First-in, first-out (FIFO) cost Last-in, first-out (LIFO) cost
  16. 16. Which Method will a CompanyUse?Decision is up to Management NOT based on Actual Inventory MovementsA tool for managing EarningsA tool for managing Taxes
  17. 17. Illustrative Data Beginning inventory (10 units @ $10) $ 100 No. 1 (25 units @ $14 per unit) $350 No. 2 (25 units @ $18 per unit) 450 Total purchases 800 Cost of 60 goods available for sale $ 900 Ending inventory: 20 units Cost of goods sold: 40 units
  18. 18. Specific Unit Cost 5 Units @ $10Cost of Goods Sold $ 50 350 25 Units @ $14 180 $580 10 Units @ $18$900 – $580 = $320
  19. 19. Weighted-Average, AverageCosting Average Cost Cost of Goods Available = per unit Number of units available Inventory (at average cost)Beg Bal (10 units @ $10) 100Purchases:25 units @ $14 350 Cost of goods sold (40 units25 units @ $18 450 @ average cost of $15 per unit 600Ending Bal (20 units@ average cost of $15per unit 300
  20. 20. Weighted-Average $900 total cost 60 units = $15/unit Ending inventory = 20 $15 = $300 Cost of goods sold = 40 $15 = $600
  21. 21. First In, First OutFirst costs into inventory are first costs assigned to cost ofgoods sold. Inventory (at FIFO cost)Beg Bal (10 units @ $10) 100Purchases: Cost of goods sold (40 units):25 units @ $14 350 (10 units @ $10 = 100)25 units @ $18 450 (25 units @ $14 = 350) ( 5 units @ $18 = 90) 540Ending Bal(20 units @ $18) 360
  22. 22. First In, First Out Ending Inventory Cost: 60 units Less units sold 40 Ending inventory 20 units 20 units $18 per unit = $360
  23. 23. First In, First Out 10 Units @ $10Cost of Goods Sold $100 350 25 Units @ $14 90 $540 5 Units @ $18
  24. 24. Last In, First OutLast costs into inventory are first costs assigned to cost ofgoods sold. Inventory (at LIFO cost)Beg Bal (10 units @ $10) 100Purchases:25 units @ $14 350 Cost of goods sold (40 units):25 units @ $18 450 (25 units @ $18 = 450) (15 units @ $14 = 210) 660Ending Bal(10 units @ $10 = 100)(10 units @ $14 = 140) 240
  25. 25. Last In, First Out Ending Inventory Cost: 60 units Less units sold 40 Ending inventory 20 units 10 units 10 =$100 10 units 14 = 140 Total $240
  26. 26. Last In, First OutCost of Goods Sold 25 Units @ $18 $450 210 $660 15 Units @ $14
  27. 27. Income Effects of Inventory Methods Assumed Cost of Sales Goods Gross Revenue Sold ProfitSpecific unit cost $1,000 – 640 = $360Weighted-average $1,000 – 600 = $400FIFO $1,000 – 540 = $460LIFO $1,000 – 660 = $340
  28. 28. Income EffectsWhen inventory costs are increasing LIFO cost of goods sold is highest, gross profit is lowest. FIFO cost of goods sold is lowest, gross profit is highest.When inventory costs are decreasing FIFO cost of goods sold is highest. LIFO cost of goods sold is lowest.
  29. 29. Tax AdvantageTax advantages of LIFO in periods of rising prices  Higher Cost of Goods Sold = Lower Net Income = Lower Income TaxesTax advantages of FIFO in periods of falling prices Higher Cost of Goods Sold = Lower Net Income = Lower Income Taxes
  30. 30. Tax Advantage FIFO LIFOGross profit $460 $340Operating expenses 260 260Income before taxes $200 $ 80Income tax expense (40%) $ 80 $ 32 The most attractive feature of LIFO is low income tax payments when prices are increasing.
  31. 31. Inventory in Balance SheetLIFO, The inventory will be recorded at the old cost considered to be valued low.FIFO, The inventory will be recorded at the latest cost, increasing accuracy of balance sheet.
  32. 32. Inventory ErrorsEach inventory error affects: Inventory Cost of goods sold Gross profit Net income
  33. 33. Inventory Errors Period 1 Period 2 Cost of Gross Profit Cost of Gross Profit Inventory Error Goods Sold and Net Income Goods Sold and Net IncomePeriod 1 Ending inventory overstated Understated Overstated Overstated UnderstatedPeriod 1 Ending inventory understated Overstated Understated Understated Overstated
  34. 34. Accounting Principles Consistency principle  Same Accounting Methods from Period to Period  Accounting Changes must be disclosed  Effect of accounting Change must be disclosed Disclosure principle  Enough information must be reported for stakeholders to make informed decisions  Relevant, Reliable, and Comparable Information Accounting conservatism  Anticipate or disclose all likely losses, but gains are not reported until they occur  Assets are recorded as lowest reasonable amount  Liabilities are recorded at highest reasonable amount:
  35. 35. Lower of Cost or Market Lower-of-Cost-or-Market rule (LCM) Inventory is reported at the lowest value  Historical Cost  Or Market (Replacement Cost) Inventory is below cost  Record an increase in Cost of Goods Sold (debit)  Record the reduction in Inventory (credit) To record a $1,000 decline in inventory value Cost of Goods Sold 1,000 Inventory 1,000 Wrote inventory down to market value
  36. 36. Ratios Gross Profit Gross Profit = Percentage Net Sales Revenue Inventory Cost of goods sold = Turnover Average Inventory
  37. 37. RatiosGross Profit Profit indicatorInventory Turnover – Liquidity ratio How quickly is Inventory Sold?
  38. 38. Techniques of Estimating Cost ofGoods Sold and Ending InventoryThe Gross Profit MethodThe Retail Method
  39. 39. Gross Profit MethodIt is assumed that rate of gross profit earned in the preceding year will remain the same in current year.Is based on the gross margin ratio of the previous year.Also called gross margin method.
  40. 40. Estimate CGS using GP%We know Beginning Inventory = $14,000We know Purchases = $ 66,000We know Sales = $100,000We know Gross Profit % = 43%We Don’t know Cost of Goods SoldWe Don’t know Ending Inventory
  41. 41. Gross Profit MethodBeginning inventory $14,000Purchases 66,000Goods available 80,000Cost of goods sold: Net sales revenue $100,000 Less estimated gross profit 43% (43,000) Estimated cost of goods sold 57,000Estimated cost of ending inventory $23,000
  42. 42. The Retail MethodIs quite similar to the gross profit method.Retail method is based on the cost ratio of the current period.
  43. 43. Estimate CGS using Cost%Cost of goods available for sale= $ 45,000Retail price = $100,000Annual Sales = $ 80,000Cost % = $45,000 ÷ $100,000 = 45 %CGS = Annual Sales * Cost %CGS = $80,000 * 45% = $36,000

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