PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

Chapter 06

INVENTORIES AND COST OF SALES

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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DETERMINING INVENTORY ITEMS

Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where

the goods are located when inventory is counted.

Items requiring special attention include:

Goods in Transit

Goods Damaged or

Obsolete Goods on Consignment

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FOB Destination Point

Public Carrier

Seller Buyer

GOODS IN TRANSIT

Public Carrier

Seller Buyer

FOB Shipping Point

Ownership passes to the buyer here.

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GOODS ON CONSIGNMENT

Merchandise is included in the inventory of the consignor, the owner of the inventory.

Consignor

Consignee

Thanks for selling my inventory in your

store.

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GOODS DAMAGED OR OBSOLETE

Damaged or obsolete goods are not counted in inventory if they cannot be sold.

Cost should be reduced to net realizable value if they can be sold.

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DETERMINING INVENTORY COSTS

Invoice Cost

Include all expenditures necessary to bring an item to a salable condition and location.

Minus Discounts

and Allowances

Plus Import Duties Plus

Freight

Plus Storage

Plus Insurance

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Most companies take a physical count of inventory at least once each year.

INTERNAL CONTROLS AND TAKING A PHYSICAL COUNT

When the physical count does not match the Merchandise Inventory account, an adjustment must be made.

Good internal controls over count include: 1.Pre-numbered inventory tickets. 2.Counters have no inventory responsibility. 3.Counts confirm existence, amount, and

quality of inventory item. 4.Second count is taken. 5.Manager confirms all items counted.

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INVENTORY COSTING UNDER A PERPETUAL SYSTEM

Inventory affects . . .

The matching principle requires matching costs

with sales.

Balance Sheet

Income Statement

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INVENTORY COST FLOW ASSUMPTIONS C2

Management decisions in accounting for inventory involve the following: 1. Items included in inventory and their costs. 2. Costing method (specific identification, FIFO, LIFO,

or weighted average). 3. Inventory system (perpetual or periodic). 4. Use of market values or other estimates.

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INVENTORY COST FLOW ASSUMPTIONS

First-In, First-Out (FIFO)

Assumes costs flow in the order incurred.

Last-In, First-Out (LIFO)

Assumes costs flow in the reverse order incurred.

Weighted Average

Assumes costs flow at an average of the costs available.

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INVENTORY COSTING ILLUSTRATION Here is information about the mountain bike inventory of Trekking

for the month of August.

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SPECIFIC IDENTIFICATION P1

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SPECIFIC IDENTIFICATION P1

Balance Sheet Inventory Income Statement Cost of Goods Sold

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SPECIFIC IDENTIFICATION Here are the entries to record the purchases and sales. The

numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit. The selling price of inventory was as follows:

8/14 $130 8/31 150

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FIRST-IN, FIRST-OUT (FIFO)

Cost of Goods Sold

Ending Inventory

Oldest Costs

Recent Costs

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FIRST-IN, FIRST-OUT (FIFO) P1

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FIRST-IN, FIRST-OUT (FIFO) P1

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FIRST-IN, FIRST-OUT (FIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit. The selling price of inventory was as follows:

8/14 $130 8/31 150

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LAST-IN, FIRST-OUT (LIFO)

Cost of Goods Sold

Ending Inventory

Recent Costs

Oldest Costs

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LAST-IN, FIRST-OUT (LIFO) P1

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LAST-IN, FIRST-OUT (LIFO) P1

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LAST-IN, FIRST-OUT (LIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit. The selling price of inventory was as follows:

8/14 $130 8/31 150

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WEIGHTED AVERAGE

When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.

Cost of Goods Available for

Sale

Units on hand on the date of

sale ÷

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WEIGHTED AVERAGE P1

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WEIGHTED AVERAGE P1

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WEIGHTED AVERAGE P1

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WEIGHTED AVERAGE Here are the entries to record the purchases and sales entries for Trekking.

The numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit. The selling price of inventory was as follows:

8/14 $130 8/31 150

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FINANCIAL STATEMENT EFFECTS OF COSTING METHODS

Because prices change, inventory methods nearly always assign different cost amounts.

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FINANCIAL STATEMENT EFFECTS OF COSTING METHODS

Advantages of Methods

Smoothes out price changes.

Better matches current costs in cost of goods sold with

revenues.

Ending inventory approximates

current replacement cost.

First-In, First-Out

Weighted Average

Last-In, First-Out

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FINANCIAL STATEMENT AFFECTS When purchase price is the same all inventory methods same results When costs rise: FIFO highest inventory value, lowest COGS highest Gross Margin and Net Income LIFO lowest inventory value, highest COGS and lowest Gross Margin and Net Income Weighted Average In between When costs decline: the opposite

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FINANCIAL STATEMENT AFFECTS When purchase price is the same all inventory methods same results When costs decline: FIFO Lowest inventory value, highest COGS lowest Gross Margin and Net Income LIFO Highest inventory value, lowest COGS and highest Gross Margin and Net Income Weighted Average In between When costs rise: the opposite

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TAX EFFECTS OF COSTING METHODS

The Internal Revenue Service (IRS) identifies several acceptable inventory costing methods for reporting

taxable income.

If LIFO is used for tax purposes, the IRS requires

it be used in financial statements.

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CONSISTENCY IN USING COSTING METHODS

The consistency principle requires a company to use the same accounting

methods period after period so that financial statements are comparable across periods.

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Can only change if it will improve financial reporting Justification and disclosure in notes to financial statements required

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LOWER OF COST OR MARKET Inventory must be reported at market value

when market is lower than cost.

Can be applied three ways: (1) separately to each individual item. (2) to major categories of assets. (3) to the whole inventory.

Defined as current replacement cost (not sales price). Consistent with

the conservatism principle.

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LOWER OF COST OR MARKET

A motor sports retailer has the following items in inventory:

Per Unit

Inventory ItemsUnits on

Hand Cost Market Total Cost Total

Market Cycles:Roadster 20 8,000$ 7,000$ $ 160,000 $ 140,000 Sprint 10 5,000 6,000 50,000 60,000

Off-RoadTrax-4 8 5,000 6,500 40,000 52,000 Blazer 5 9,000 7,000 45,000 35,000 Totals $ 295,000

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LOWER OF COST OR MARKET Here is how to compute lower of cost or

market for individual inventory items.

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LCM Applied to

Inventory ItemsUnits on

Hand Total Cost Total

Market ItemsCycles:Roadster 20 $ 160,000 $ 140,000 140,000$ Sprint 10 50,000 60,000 50,000

Off-RoadTrax-4 8 $ 40,000 $ 52,000 40,000 Blazer 5 45,000 35,000 35,000 Totals $ 295,000 265,000$

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FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS

Inventory Error Cost of Goods Sold Net IncomeUnderstate ending inventory Overstated UnderstatedUnderstate beginning inventory Understated OverstatedOverstate ending inventory Understated OverstatedOverstate beginning inventory Overstated Understated

Income Statement Effects

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Inventory errors are self correcting over a two year period Inventory adjustment for Lower of Cost or Market DR COGS CR Merchandise Inventory No adjustment if inventory value increases

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FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS

Inventory Error Assets EquityUnderstate ending inventory Understated UnderstatedOverstate ending inventory Overstated Overstated

Balance Sheet Effects

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INVENTORY TURNOVER

Inventory Turnover =

Cost of goods sold Avg. inventory

Shows how many times a company turns over its inventory during a period. Indicator of how well management is

controlling the amount of inventory available.

Average Inventory = (Beg. Inv. + End Inv.) ÷ 2

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DAYS’ SALES IN INVENTORY

Reveals how much inventory is available in terms of the number of days’ sales.

Days' Sales in Inventory =

Ending Inventory

Cost of goods sold × 365

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GLOBAL VIEW Items and Costs Making Up Inventory

Both U.S. GAAP and IFRS include in inventory all items that a company owns and holds for sale and include in the cost expenditures necessary to bring those

items to a salable condition and location.

Assigning Costs to Inventory Both U.S. GAAP and IFRS allow companies to use specific identification, FIFO,

and Weighted Average. IFRS does not currently allow use of LIFO.

Estimating Inventory Costs Both U.S. GAAP and IFRS require companies to write down inventory when its

value falls below recorded cost. U.S. GAAP prohibits any later increase in value. IFRS does allow reversals of write downs up to the original acquisition cost. Neither allow inventory to be adjusted upward beyond the original cost.

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APPENDIX 6A: INVENTORY COSTING UNDER A PERIODIC SYSTEM

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LIFO computation of COGS and ending inventory under a periodic system.

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APPENDIX 6B: INVENTORY ESTIMATION METHODS

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Inventory sometimes requires estimation for interim statements or if some casualty such as fire or flood makes taking a physical

count impossible.

Retail Inventory Method Gross Profit Method

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END OF CHAPTER 06