Chapter 7: Inventory and Cost of Goods Sold

Topics
Types of inventory Costs included in the acquisition cost of inventory (cost principle) Cost flow assumption used to trace movement of costs out of inventory (matching) Treatment of changes in market value of inventory subsequent to acquisition Effect of inventory errors

Types of Inventory
Merchandiser (retailer or wholesaler) WalMart, Macys
Merchandise inventory goods held for sale in the normal course of business goods are normally acquired in a finished condition

Manufacturer Alcoa, Boeing

Raw materials inventory Items acquired for future processing into finished goods Work in process goods in the process of being manufactured but not yet completed Finished goods manufactured goods that are ready for resale

Inventory Flows: Merchandiser

Balance Sheet Merchandise Purchases Merchandise Inventory Income Statement Cost of Goods Sold

Inventory Flows: Manufacturer

Raw Material Purchases Direct Labor Incurred Factory Overhead Incurred (utilities, depreciation, supervisors pay) Balance Sheet Raw Material Inventory Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Income Statement

Inventory Costs
Inventory is originally recorded at the price paid or the consideration given up
the cost principle

The amount recorded for inventory should include the invoice price plus any other expenditures necessary to ready the inventory for sale:
freight charges inspection costs preparation costs

Cost of Goods Sold (Merchandiser)

Beginning Inventory Purchases for the Period

Cost of Goods Available for Sale Ending Inventory

(Balance Sheet)

Cost of Goods Sold

(Income Statement)

Beginning inventory + Purchases Ending inventory = Cost of goods sold

Tracking Inventory Quantities & Costs

Periodic

Inventory System

no up-to-date record of inventory is maintained Inventory must be physically counted at the end of the accounting period in order to value both ending inventory and cost of goods sold
Perpetual

Inventory System

up-to-date records of inventory quantities and costs are maintained on an ongoing basis Cost of goods sold is recorded at the time of sale (see Chapter Supplement C)

Comparison of Perpetual and Periodic Systems

Source of Information Periodic System Carried over Beginning Inventory from prior period Accumulated in Add: Purchases the Purchases account Measured at end of period by Less: Ending Inventory physical inventory count Computed as a residual amount Cost of Goods Sold at end of period Model Perpetual System Carried over from prior period Accumulated in the Inventory account Perpetual record updated at every sale Measured at every sale based on perpetual record

Inventory costing methods

Cost

flow assumptions are used to assign unit costs to ending inventory and cost of goods sold When inventory prices are changing, different cost flow assumptions result in different amounts for cost of goods sold and net income

Inventory Costing Methods

First-In,

First-Out (FIFO) Last-In, First-Out (LIFO) Weighted-average cost Specific identification NOT physical flow concepts!

First-In, First-Out (FIFO)

Oldest Costs
earliest purchases

Costs of Goods Sold

Recent Costs
most recent purchases (relatively current costs)

Ending Inventory

FIFO
Beginning Inventory
(most recent purchases from earlier periods)

Purchases for the Period

Cost of Goods Available for Sale Ending Inventory

(most recently purchased)

Cost of Goods Sold

(oldest available for sale)

FIFO Example
The schedule on the next screen shows the mouse pad inventory for Computers, Inc. The physical inventory count shows 1,200 mouse pads in ending inventory. Use the FIFO inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

FIFO Example
Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 $ 300 150 200 150 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 1,590.00 840.00 1,160.00 885.00

1,800 1200 600

$ 9,725.00 ? ?

FIFO Example continued

Ending Inventory = (150 @ 5.90) + (200 @ $5.80) + (150 @ $5.60) + (300 @ $5.30) + (400 @ $5.25) = $6,575 [Units in ending inventory total 1,200] Cost of goods sold = 600 @ $5.25 = $3,150 Note that Ending Inventory = Cost of goods available for sale - Cost of goods sold $6,575 = $9,725 - $3,150

Last-In, First-Out (LIFO)

Oldest Costs
earliest purchases

Ending Inventory

Recent Costs
most recent purchases (relatively current costs)

Cost of Goods Sold

Last-In, First-Out (LIFO)

Beginning Inventory
(oldest available from earlier period)

Purchases for the Period

Cost of Goods Available for Sale Ending Inventory

(oldest available)

Cost of Goods Sold

(most recently purchased)

Last-In, First-Out
Use the same information of Computers, Inc. Use the LIFO inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

LIFO Example
Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 $ 300 150 200 150 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 1,590.00 840.00 1,160.00 885.00

1,800 1200 600

$ 9,725.00 ? ?

LIFO Example continued

Ending Inventory = (1,000 @ $5.25) + (200 @ $5.30) = $6,310

Cost of goods sold = (150 @ 5.90) + (200 @ $5.80) + (150 @ $5.60) + (100 @ $5.30) = $3,415 Ending Inventory = Cost of goods available for sale - Cost of goods sold $6,310 = $9,725 - $3,415

LIFO
LIFO is not permitted under international accounting standards. If U.S. converges to international standards, what are the consequences of this ban?

Weighted-Average
Weighted-average cost (WAC) per unit = Beginning inventory cost + Current purchase cost Beginning inventory units + Current purchase units Or, WAC = COG Available / Units Available Ending Inventory
Ending Inv. = Units in Ending Inv. WAC per Unit

Cost of Good Sold

COGS = Units Sold WAC per Unit

Weighted-Average - Example
Use the same information of Computers, Inc. Use the weighted-average inventory method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

Weighted-Average - Example
Weighted-Average Cost per Unit: $9,725 / 1,800 = $5.403 Ending Inventory: 1,200 @ $5.403 = $6,483 Cost of Goods Sold: 600 @ $5.403 = $3,242 Note that EI = COGA - COGS

Comparison of Methods
Computers, Inc. Income Statement For Year Ended December 31, 20B Weighted Average FIFO $ 25,000 $ 25,000 $ $ $ $ $ $ 5,250 4,475 9,725 6,483 3,242 21,758 750 21,008 6,302 14,706 $ $ $ $ $ $ 5,250 4,475 9,725 6,575 3,150 21,850 750 21,100 6,330 14,770

Net sales Cost of goods sold: Merchandise inventory,12/31/20A Net purchases Goods available for sale Merchandise inventory,12/31/20B Cost of goods sold Gross profit from sales Operating expenses: Income before taxes Income taxes expense (30%) Net income

LIFO $ 25,000 $ $ $ $ $ $ 5,250 4,475 9,725 6,310 3,415 21,585 750 20,835 6,251 14,584

* Tax expense amounts were rounded.

Specific Identification
Specific

cost of each inventory item is

known.
Used

with small volume, high dollar inventory.

Important To Remember
Regardless

of the actual physical flow of goods, a company can use any of the inventory costing methods However, accounting rules require companies to apply their accounting methods on a consistent basis
when a company changes methods, it must disclose the reason for the change and the accounting effects of the change

Analyzing Financial Statements That Have Different Costing Methods

The ability of companies to choose different inventory costing methods makes comparison of financial results across companies difficult The effect on cost of goods sold and inventory of using LIFO can be calculated from information in the notes to the financial statements LIFO Reserve is the difference in inventory balances (in dollars) between LIFO and FIFO

Only firms who report inventory under LIFO have a LIFO reserve to show what the inventory balance would be if the firm had used the FIFO method

Inventory Disclosure Example

Coca
In NOTE 1:

Cola Inventory Note

Valuation (measurement) Lower of Cost or Market

The

cost principle requires that companies initially value inventory at historical cost Due to conservatism, inventories subsequently are required to be valued at the lower of cost or market (LCM)
this requires companies to mark down the value of inventories that have declined in value Why not let companies write up inventory to market if it s above cost?

Lower of Cost or Market

When

either replacement cost or net realizable value of inventory drops below the historical cost, then an adjusting entry must be recorded to reduce the book value of the inventory
Replacement cost - the current purchase price Net realizable value - the expected sales price less selling costs.

Lower of Cost or Market

When the market value (replacement cost or net realizable value) of the inventory is less than the historical cost at the end of an accounting period, the loss is immediately recorded. Example: At 12/31/07, Cost of inventory = $55,000 Market value of inventory = $50,000 Give the required adjusting entry.

Lower of Cost or Market

Example: At 12/31/07, Cost of inventory = $55,000 Market value of inventory = $50,000 12/31/07 Holding Loss 5,000 Inventory 5,000
Holding loss is sometimes called unrealized loss.

Lower of Cost or Market an alternative treatment of loss

Example: At 12/31/07, Cost of inventory = $55,000 Market value of inventory = $50,000 12/31/07 COGS Inventory 5,000 5,000

Holding loss is included with this year s COGS. Note that while this increases COGS in 2007, it will decrease COGS in 2008.

Focus on Cash Flows

Statement of Cash Flows Convert COGS to Cash Paid to Suppliers Example: 2007 COGS $100,000 12/31/07 $10,000 12,000

12/31/06 Inventory $8,000 Accounts payable 7,000

How much cash was paid to suppliers in 2007?

Focus on Cash Flows

Beg Inventory 8,000 100,000 COGS Accounts payable 7,000 Beg Purchases Payments 12,000 End

Purchases End 10,000

1st Plug: Purchases 2nd Plug: Payments to suppliers

Focus on Cash Flows

Beg Inventory 8,000 100,000 COGS Accounts payable 7,000 Beg 102,000 Purchases Payments 97,000 12,000 End

Purchases 102,000 End 10,000

1st Plug: Purchases 2nd Plug: Payments to suppliers = $97,000

Inventory Errors
Most

businesses validate their ending inventory by taking physical counts at the end of the accounting period
any difference between the book balance and the physical count is recorded to the Inventory account, with the offset recorded to Cost of Goods Sold

So

errors in the measurement of ending inventory will affect the balance sheet and the income statement

Question
If the 2007 ending inventory is understated by $3,000, what is the effect on: 2007 Cost of Goods Sold? 2007 Gross Profit? 2007 Net Income? 12/31/2007 Retained Earnings?
Remember: COGS = BI + Purchases EI

Question
If the 2007 ending inventory is understated by $3,000, what is the effect on: 2007 Cost of Goods Sold? Overstated by $3,000 2007 Gross Profit? Understated by $3,000 2007 Net Income? Understated by $3,000 12/31/2007 Retained Earnings? Understated by $3,000 Remember if ending assets (inventories) are understated by $3,000, then (assuming liabilities are not misstated) ending stockholders equity must be understated by $3,000.

Question
If the 2007 ending inventory is understated by $3,000, what is the effect on: 2008 Beginning Inventory? 2008 Cost of Goods Sold? 2008 Gross Profit? 2008 Net Income? 12/31/08 Retained Earnings? 2008 ending inventory is correctly counted and recorded.

Question
If the 2007 ending inventory is understated by $3,000, what is the effect on: [Note 2008 ending inventory is correctly counted and recorded] 2008 Beginning Inventory? Understated by $3,000 2008 Cost of Goods Sold? Understated by $3,000 2008 Gross Profit? Overstated by $3,000 2008 Net Income? Overstated by $3,000 12/31/08 Retained Earnings? Correctly stated* *Net income was understated in 2007 and overstated in 2008.

Inventory Turnover Ratio

Inventory turnover reflects the efficiency of inventory management a higher ratio => more turnover.
Inventory = Turnover Cost of Goods Sold Average Inventory

Netflix inventory turnover = 7.4 (inventory = content library ) Blockbuster inventory turnover = 3.3 (inventory = merchandise & rental library)