Inventories and the Cost of Goods Sold
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Inventories and the Cost of Goods Sold
- 1. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Inventories and the Cost of GoodsInventories and the Cost of Goods SoldSold otaleem.blogspot.comotaleem.blogspot.com for more presentation(follow me)for more presentation(follow me) Chapter 8
- 2. 8-2 INCOME STATEMENT Revenue Cost of goods sold Gross profit Expenses Net income as goods are sold BALANCE SHEET Asset Inventory Purchase costs (or manufacturing costs) The Flow of Inventory CostsThe Flow of Inventory Costs
- 3. 8-3 GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit Entry on Purchase Date Inventory $$$$ Accounts Payable $$$$ Entry on Sale Date Cost of Goods Sold $$$$ Inventory $$$$ In a perpetual inventory system, inventory entries parallel the flow of costs. The Flow of Inventory CostsThe Flow of Inventory Costs
- 4. 8-4 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. Which Unit Did We Sell?Which Unit Did We Sell?
- 5. 8-5 Inventory Subsidiary LedgerInventory Subsidiary Ledger A separate subsidiary account is maintained for each item in inventory. A separate subsidiary account is maintained for each item in inventory. How can we determine the unit cost for the Sept. 10 sale? Item LL002 Primary supplier Electronic City Description Laser Light Secondary supplier Electric Company Location Storeroom 2 Inventory level: Min: 25 Max: 200 Purchased Sold Balance Date Units Unit Cost Total Units Unit Cost Cost of Goods Sold Units Unit Cost Total Sept. 5 100 30$ 3,000$ 100 30$ 3,000$ Sept. 9 75 50 3,750 100 30 3,000 75 50 3,750 Sept. 10 10 ? ? ? ? ? ? ? ?
- 6. 8-6 Inventory Valuation Methods: A Summary Costs Allocated to: Valuation Method Cost of Goods 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 sold times the Number of units on hand times the Assigns all units the same average unit cost average unit cost average unit cost Current costs are averaged in with older costs First-in, First-out (FIFO) Cost of earliest purchases on Cost of most recently Cost of goods sold is based on older costs hand prior to the sale purchased units Inventory valued at current costs May overstate income during periods of rising prices; may increase income taxes due Last-in, First-out (LIFO) Cost of most recently Cost of earliest purchases Cost of goods sold shown at recent prices purchased units (assumed still in inventory) Inventory shown at old (and perhaps out of date) costs Most conservative method during periods of rising prices; often results in lower income taxes
- 7. 8-7 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. The Principle of ConsistencyThe Principle of Consistency
- 8. 8-8 The primary reason for taking a physical inventory is to adjust the perpetual inventory records for unrecorded shrinkage losses, such as theft, spoilage, or breakage. The primary reason for taking a physical inventory is to adjust the perpetual inventory records for unrecorded shrinkage losses, such as theft, spoilage, or breakage. Taking a Physical InventoryTaking a Physical Inventory
- 9. 8-9 Reduces the value of the inventory. Reduces the value of the inventory.ObsolescenceObsolescence Adjust inventory value to the lower of historical cost or current replacement cost (market). Adjust inventory value to the lower of historical cost or current replacement cost (market). Lower of Cost or Market (LCM) Lower of Cost or Market (LCM) LCM and Other Write-DownsLCM and Other Write-Downs of Inventoryof Inventory
- 10. 8-10 Year End A sale should be recorded when title to the merchandise passes to the buyer. A sale should be recorded when title to the merchandise passes to the buyer. F.O.B. shipping point title passes to buyer at the point of shipment. F.O.B. shipping point title passes to buyer at the point of shipment. F.O.B.F.O.B. destinationdestination pointpoint title passes to buyer at the point of destination. F.O.B.F.O.B. destinationdestination pointpoint title passes to buyer at the point of destination. Goods In TransitGoods In Transit
- 11. 8-11 In a periodic inventory system, inventory entries are as follows. Note that an entry is not made to inventory. Note that an entry is not made to inventory. Periodic Inventory SystemsPeriodic Inventory Systems
- 12. 8-12 In a periodic inventory system, inventory entries are as follows. Periodic Inventory SystemsPeriodic Inventory Systems
- 13. 8-13 Errors in Measuring Inventory Beginning Inventory Ending Inventory Effect on Income Statement Overstated Understated Overstated Understated Goods Available for Sale + - NE NE Cost of Goods Sold + - - + Gross Profit - + + - Net Income - + + - Effect on Balance Sheet Ending Inventory NE NE + - Retained Earnings - + + - An error in ending inventory in a year will result in the same error in the beginning inventory of the next year. An error in ending inventory in a year will result in the same error in the beginning inventory of the next year. Importance of an AccurateValuationImportance of an AccurateValuation of Inventoryof Inventory
- 14. 8-14 The Gross Profit MethodThe Gross Profit Method 1. Determine cost of goods available for sale. 2. Estimate cost of goods sold by multiplying the net sales by the cost ratio. 3. Deduct cost of goods sold from cost of goods available for sale to determine ending inventory. 1. Determine cost of goods available for sale. 2. Estimate cost of goods sold by multiplying the net sales by the cost ratio. 3. Deduct cost of goods sold from cost of goods available for sale to determine ending inventory.
- 15. 8-15 The Retail MethodThe Retail Method The retail method of estimating inventory requires that management determine the value of ending inventory at retail prices. The retail method of estimating inventory requires that management determine the value of ending inventory at retail prices. Goods available for sale at cost 32,500$ Goods available for sale at retail 50,000 Physical count of ending inventory priced at retail 22,000 Information for Matrix Company The Retail Method In March of 2009, Matrix Company’s inventory was destroyed by fire. At the time of the fire, Matrix’s management collected the following information: In March of 2009, Matrix Company’s inventory was destroyed by fire. At the time of the fire, Matrix’s management collected the following information:
- 16. 8-16 End of Chapter 8End of Chapter 8
Editor's Notes
- Chapter 8: Inventories and the Cost of Goods Sold
- 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. 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. 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. 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.
- 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. 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.
- 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. Let’s see how to determine the cost of a unit of inventory sold.
- 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? There are four ways to determine the cost of inventory sold: Specific Identification First-in, First-out -- also known as FIFO Last-in, First-out -- also known a LIFO, and Average Cost
- This slide provides a summary of some of the key differences among the four inventory valuation methods. Take a few minutes to review it.
- 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. 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.
- 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. 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.
- 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. 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.
- 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. 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. 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.
- 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.
- 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. 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. 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.
- 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.
- 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. Let’s look at two methods used to estimate inventory for interim financial statements: the gross profit method and the retail method. 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.
- 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. Now, let’s use the information provided for Matrix with the Retail Method to estimate Matrix’s inventory and cost of goods sold.
- End of chapter 8.