Chapter 7Reporting and Interpreting Inventories and Cost of Goods Sold
Learning Objectives1. Describe the issues in managing different types of inventory.2. Explain how to report inventory and cost of goods sold.3. Compute costs using four inventory costing methods.4. Report inventory at the lower of cost or market.5. Analyze and record inventory purchases, transportation, returns and allowances, and discounts.6. Evaluate inventory management by computing and interpreting the inventory turnover ratio.
Goals of Inventory ManagementThe primary goals of inventory managers are to: Maintain a sufficient quantity to meet customers’ needs Ensure quality meets customers’ expectations and company standards Minimize the costs of acquiring and carrying the inventory
Types of InventoryInventory includes:1. Merchandise inventory: Goods that are held for sale in the normal course of business.2. Manufacture inventory: Goods that are used to produce goods for sale.
Types of Inventory Inventory is acquired in a finishedMerchandiser condition and is ready for sale without further processing. Raw materials inventory includes materials that are processed further into finished goods. Work in process inventory includesManufacturer goods that are in the process of being manufactured. Finished goods inventory includes goods that are complete and ready to sell.
Balance Sheet Reporting Matrix, Inc. Partial Balance Sheet At December 31, 2008 Assets Current Assets Cash and Cash Equivalents $ 47,500 Accounts Receivable, net 94,800 Inventories 75,800 Prepaid Expenses 16,800 Total Current Assets $ 234,900 Inventory is reported on the balance sheet as a current asset because it normally is used or converted into cash within one year.
Income Statement Reporting Matrix, Inc. Income Statement For the Year Ended December 31, 2008 Sales, net $ 592,800 Cost of Goods Sold 377,500 Gross Profit 215,300 Operating Expenses: Selling Expenses $ 64,500 General and Administrative Expenses 119,400 183,900 Income Before Taxes 31,400 Income Tax Expense 9,420 Net Income $ 21,980Multiple-step income statement:1. Net sales – COGS = Gross Profit.2. Gross Profit – Operating expenses = Income before Taxes3. Income before Taxes – Tax expense = Net income
Cost of Goods Sold Equation Beginning Net cost of inventory + purchases = Merchandise Still here Sold available for sale Cost of goods Ending inventory + sold
QuestionRetail Company has the following amounts on its 2008 inventory operations: Purchases, $45,000; Beginning 2008 inventory, $15,000; and Cost of goods sold, $50,000. Therefore, the 2008 ending inventory was:a.$10,000.b.$25,000.c.$26,000.d.$27,000.
QuestionRichmond Company had the following information taken from its 2008 inventory operations: Sales, $200; Sales Return and Allowance, $4; Beginning Inventory, $10; and Purchases, $140. A physical count of the merchandise on hand at the end of the year showed $20. Compute the gross profit that would appear in the income statement.a.$70.b.$74.c.$66.d.$62.
Cost of Goods Sold Equation Schedule of Cost of Goods Sold Beginning inventory+ Purchases of merchandise= Cost of goods available for sale– Ending inventory= Cost of goods sold COGS = BI + P – EI EI = BI + P - COGS
Inventory Cost Flow MethodsExample In Feb 07, Young & Crazy Company starts from zero inventory balance and makes the following purchases: 1. One item on 2/2/07 for $10 2. One item on 2/15/07 for $15 3. One item on 2/25/07 for $20 Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow methods? Assume a tax rate of 30%.
Inventory Cost Flow Methods May not match physical movement of goods Allocates cost of goods available for sale between Cost of sales $10+15+20=45 Ending inventory Merchandise available for sale Cost of goods ? Ending inventory + sold ?
Inventory Cost Flow Methods Specific When units are sold, the specific cost of the unit sold is added to Identification cost of goods sold.First-In, First-Out Assumes costs flow in the order (FIFO) incurred.Last-In, First-Out Assumes costs flow in the (LIFO) reverse order incurred. Weighted Assumes costs flow at an Average average of the costs available.
Specific IdentificationWhen this method is used, the cost of each item sold is individually identified and recorded as cost of goods sold.
Specific Identification Young & Crazy Company Income Statement For the Month of Feb. 2007 Depends on which one is sold Sales $ 90 Cost of goods sold 0 Purchase on Gross profit 902/25/07 for $20 Expenses: Administrative 14 Selling 12 Purchase on Interest 7 Total expenses 332/15/07 for $15 Income before tax Taxes Net Income Purchase on 2/2/07 for $10
First In First Out (FIFO) Inventory Balance Young & Crazy Company = $ 35 Income Statement For the Month of Feb. 2007 Sales $ 90 Purchase on Cost of goods sold 102/25/07 for $20 Gross profit 80 Expenses: Administrative 14 Purchase on Selling 122/15/07 for $15 Interest 7 Total expenses 33 Income before tax 47 Purchase on Taxes 14 2/2/07 for $10 Net Income $ 33
Last In First Out (LIFO) Inventory Balance Young & Crazy Company = $ 25 Income Statement For the Month of Feb. 2007 Sales $ 90 Purchase on Cost of goods sold 20 2/25/07 for $20 Gross profit 70 Expenses: Administrative 14 Purchase on Selling 122/15/07 for $15 Interest 7 Total expenses 33 Income before tax 37 Purchase on Taxes 11 2/2/07 for $10 Net Income $ 26
Weighted AverageWhen a unit is sold, theaverage cost of each unit in inventory is assigned to cost of goods sold.Cost of Goods Units on hand Available for ÷ on the date of Sale sale $ 45 / 3 = $15
Weighted Average Inventory Balance Young & Crazy Company = $ 30 Income Statement For the Month of Feb. 2007 Sales $ 90 Purchase on Cost of goods sold 152/25/07 for $20 Gross profit 75 Expenses: Administrative 14 Purchase on Selling 122/15/07 for $15 Interest 7 Total expenses 33 Income before tax 42 Purchase on Taxes 12 2/2/07 for $10 Net Income $ 30
Comparison Financial Statement Summary FIFO LIFO Wtd. Avg Sales $ 90 $ 90 $ 90 Cost of goods sold 10 20 15 Gross profit 80 70 75 Net income 33 26 30 Ending Inventory 35 25 30 BalanceIn periods of rising prices, FIFO results inthe highest ending inventory, gross profit, and net income, and the lowest cost of goods sold.
Comparison Financial Statement Summary FIFO LIFO Wtd. Avg Sales $ 90 $ 90 $ 90 Cost of goods sold 10 20 15 Gross profit 80 70 75 Net income 33 26 30 Ending Inventory 35 25 30 Balance In periods of rising prices, LIFO results in the lowest ending inventory, gross profit, and net income, and the highest cost of goods sold.
Financial Statement Effects of CostingMethods Advantages of Methods Weighted First-In, Last-In, Average First-Out First-Out Ending inventory Better matchesSmoothes out approximates current costs in costprice changes. current of goods sold with replacement cost. revenues.
QuestionWhen the prices are rising:a. LIFO will result in lower net income and a higher inventory valuation than will FIFO.b. LIFO will result in higher net income and lower inventory valuation than will FIFO.c. FIFO will result in lower net income and a lower inventory valuation than will LIFO.d. FIFO will result in higher net income and a higher inventory valuation than will LIFO.
Reporting Inventory at the Lower ofCost or Market The value of inventory can fall below its recorded cost for two reasons:1. It’s easily replaced by identical goods at a lower cost, or2. It’s become outdated or damaged.
Reporting Inventory at the Lower ofCost or MarketWhen the value of inventory falls below its recorded cost, the amount recordedfor inventory is written down to its lower market value. This is known as the lower of cost or market (LCM) rule. This method is an application of Accounting Conservatism.
Reporting Inventory at the Lower ofCost or Market Replacement Cost (Market Item Quantity Cost Value) LCM Total LCMPentium chips 1,000 $ 250 $ 200 $ 200 $ 200,000Disk drives 400 100 110 100 40,000Pentium chips: total cost 1,000 $250 = $250,000 total replacement cost 1,000 × $200 = $200,000 write-down $250,000 - $200,000 = $50,000Disk drives: No write-downs.
Reporting Inventory at the Lower of Cost or Market Accounts Debit CreditInventory Write-down (+E, -SE) 50,000 Inventory (-A) 50,000Expense account, listed inthe income statement aspart of operating expenses.
Recording Inventory Transactions We will now look at the accounting for purchases, transportation costs, purchase returns and allowances, and purchase discounts. We will record all inventory-related transactions in the Inventory account.
Inventory Purchases American Eagle Outfitters purchases $10,500 of vintage jeans on credit.1 Analyze Assets = Liabilities + Stockholders Equity Inventory –10,500 Accounts Payable +10,5002 Record
Transportation Cost American Eagle pays $400 cash to a trucker who delivers the $10,500 of vintage jeans to one of its stores.1 Analyze Assets = Liabilities + Stockholders Equity Cash - 400 Inventory + 4002 Record
Purchase Returns and Allowances American Eagle returned some of the vintage jeans to thesupplier and received a $500 reduction in the balance owed.1 Analyze Assets = Liabilities + Stockholders Equity Inventory - 500 Accounts Payable - 5002 Record
Purchase Discounts American Eagle’s vintage jeans purchase for $10,500 had terms of 2/10, n/30. Recall that American Eagle returnedinventory costing $500 and received a $500 reduction in its Accounts Payable. American Eagle paid within the discount period.1 Analyze Assets = Liabilities + Stockholders Equity Cash - 9,800 Accounts Payable -10,000 Inventory -2002 Record
In class problem #1: rising priceThe following information is available from the firm s inventoryrecord. Units Unit Cost January 1, 2007 (beginning inventory) 1,500 @ $18.00 Purchases: January 5, 2007 2,500 @$18.00 February 16, 2007 1,000 @$22.00 March 15, 2007 1,000 @$23.00A physical inventory count on March 31, 2007 shows 2,500 unitson hand. Compute the COGS for the first three months, and theending inventory at March 31, 2007, under each of the followinginventory methods:(a) FIFO.(b) LIFO.(c) Weighted-average.
In class problem #2: decreasing priceCGL’s sales revenue is $6,000 and operating expense is $1,000. CGL’s income tax rate is 35%. Prepare income statements using following inventory cost flow method:1. FIFO2. LIFO3. Weighted-Average method. Purchase Sale # of units price/unit price/unit Beginning balance 100 $15 1st Purchase 500 $13 2nd Purchase 200 $10 Sale (300) $20 Ending balance 500
In class problem #3Calculate COGS and inventory balance at the end of the year using FIFO, LIFO and weighted average costing methods:Beginning inventory of the year 1,000 units @ $15 each Mar: Purchase inventory on account 3,000 units@ $18 each. Jun: Sold 2,000 units @ $30 each on account. Oct: Purchase inventory on account 2,000 units@ $21 each. Nov: Sold 1,000 units @ $32 each on accountThe company uses a periodic inventory system.