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
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
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
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
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
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
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
Relationship between BalanceSheet and Income StatementIncome 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.
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
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
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
Recording Transactions and the T-Accounts Inventory Cost of Goods SoldBeg. 100,000 540,000 540,000 560,000 120,000
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
Inventory Costing MethodMethods for determining per unit Inventory Cost Specific unit cost Average cost First-in, first-out (FIFO) cost Last-in, first-out (LIFO) cost
Which Method will a CompanyUse?Decision is up to Management NOT based on Actual Inventory MovementsA tool for managing EarningsA tool for managing Taxes
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
Specific Unit Cost 5 Units @ $10Cost of Goods Sold $ 50 350 25 Units @ $14 180 $580 10 Units @ $18$900 – $580 = $320
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
Weighted-Average $900 total cost 60 units = $15/unit Ending inventory = 20 $15 = $300 Cost of goods sold = 40 $15 = $600
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
First In, First Out Ending Inventory Cost: 60 units Less units sold 40 Ending inventory 20 units 20 units $18 per unit = $360
First In, First Out 10 Units @ $10Cost of Goods Sold $100 350 25 Units @ $14 90 $540 5 Units @ $18
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
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
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 Gross Revenue Sold ProfitSpecific unit cost $1,000 – 640 = $360Weighted-average $1,000 – 600 = $400FIFO $1,000 – 540 = $460LIFO $1,000 – 660 = $340
Income EffectsWhen 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.
Tax AdvantageTax advantages of LIFO in periods of rising prices Higher Cost of Goods Sold = Lower Net Income = Lower Income TaxesTax advantages of FIFO in periods of falling prices Higher Cost of Goods Sold = Lower Net Income = Lower Income Taxes
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.
Inventory in Balance SheetLIFO, 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.
Inventory ErrorsEach inventory error affects: Inventory Cost of goods sold Gross profit Net income
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
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:
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
Ratios Gross Profit Gross Profit = Percentage Net Sales Revenue Inventory Cost of goods sold = Turnover Average Inventory
RatiosGross Profit Profit indicatorInventory Turnover – Liquidity ratio How quickly is Inventory Sold?
Techniques of Estimating Cost ofGoods Sold and Ending InventoryThe Gross Profit MethodThe Retail Method
Gross Profit MethodIt 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.
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
The Retail MethodIs quite similar to the gross profit method.Retail method is based on the cost ratio of the current period.
Estimate CGS using Cost%Cost of goods available for sale= $ 45,000Retail price = $100,000Annual Sales = $ 80,000Cost % = $45,000 ÷ $100,000 = 45 %CGS = Annual Sales * Cost %CGS = $80,000 * 45% = $36,000