RETAIL ACCOUNTING AND AUDIT

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

Purchases consist of the following:

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

Calculation
Cost of Beginning Inventory +Cost of Purchases ___________________ =Cost of Goods Available for Sale - Cost of Ending Inventory ___________________ =Cost of Goods Sold Cost of Beginning Inventory +Cost of Purchases ___________________ =Cost of Goods Available for Sale - Cost of Goods Sold ___________________ =Cost of Ending Inventory

Inventory vs Cost of Goods Sold

Inventory
Beginning Purchases Ending Inventory Sold

Cost of Goods Sold

Inventory Sold

As Inventory is Sold we remove its cost from the Asset side of A=L+E and Insert its cost into an Expense on the Equity side of A = L + E This property exists for all Assets: As they are used up or sold the cost Transfers from the Balance Sheet as a Future Economic Resource (Asset) To the Income Statement as an Expense incurred to generate Revenue

Relationship between Balance Sheet and Income Statement

Income 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.

Income Statement Service Company

Balance Sheet Service Company

Income Statement Retail Company

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Balance Sheet Retail Company

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Inventory Accounting Systems

Periodic system
Does not keep a running record of all goods bought and sold. Inventory counted at least once a year Used for inexpensive goods

Perpetual system
Keeps a running record of all goods bought and sold. Inventory counted at least once a year. Used for all types of goods.

Accounting for Inventory

Inventory (balance sheet) Number of units of inventory on hand Cost per unit of inventory

Cost of Goods Sold Number of units of = (income statement) inventory sold

Cost per unit of inventory

Recording Transactions and the T-Accounts

General Journal Accounts and Explanations PR

Date

Debit

Credit

Inventory Accounts Payable Purchased inventory on account

560,000 560,000

Inventory Beg. 100,000 560,000

Accounts Payable 560,000

Recording Transactions and the T-Accounts

Sale on account $900,000 of Inventory which cost $540,000:

Date General Journal Accounts and Explanations PR Accounts Receivable Debit 900,000 Credit

Sales Revenue Cost of Goods Sold Inventory 540,000

900,000

540,000

Recording Transactions and the T-Accounts

Inventory Beg. 100,000 540,000 560,000 120,000

Cost of Goods Sold 540,000

Reporting in the Financial Statements

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
Sum of all costs incurred to bring asset to its intended use Methods 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 Company Use?

Decision is up to Management
NOT based on Actual Inventory Movements

A tool for managing Earnings A 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 goods available for sale $ 900

Ending inventory: Cost of goods sold:

20 units 40 units

Specific Unit Cost

Identify each inventory unit and determine the cost
Of the 20 Units left, how many came from the: Of the 40 Units sold, how many came from the:
$10, $14, or $18 purchase

Multiply each unit by that specific units cost

For example if we assume:

Inventory: 10@10, 5@14 and 5@18
Inventory = $260

Cost of Goods Sold: 20@14 and 20@18

CGS = $640

Average Costing
Average Cost per unit Cost of Goods Available =

Number of units available

Inventory (at average cost)

Beg Bal (10 units @ $10) Purchases: 25 units @ $14 25 units @ $18 Ending Bal (20 units @ average cost of $15 per unit 100 350 450 Cost of goods sold (40 units @ average cost of $15 per unit 600

300

Weighted-Average

$900 total cost 60 units = $15/unit Ending inventory = 20 $15 = $300 Cost of goods sold = 40 $15 = $600

FIFO
First costs into inventory are first costs assigned to cost of goods sold.

Inventory (at FIFO cost)

Beg Bal (10 units @ $10) Purchases: 25 units @ $14 25 units @ $18 Ending Bal (20 units @ $18) 100 350 450 Cost of goods sold (40 units): (10 units @ $10 = 100) (25 units @ $14 = 350) ( 5 units @ $18 = 90) 540

360

LIFO
Last costs into inventory are first costs assigned to cost of goods sold.

Inventory (at LIFO cost)

Beg Bal (10 units @ $10) Purchases: 25 units @ $14 25 units @ $18 Ending Bal (10 units @ $10 = 100) (10 units @ $14 = 140) 100 350 450 Cost of goods sold (40 units): (25 units @ $18 = 450) (15 units @ $14 = 210) 660

240

Income Effects of Inventory Methods

Assumed Sales Revenue Cost of Goods Sold

Gross Profit

Specific unit cost Weighted-average FIFO LIFO

$1,000 $1,000 $1,000 $1,000

640 600 540 660

= = = =

$360 $400 $460 $340

2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Income Effects
When 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.

Other Issues
Tax advantages of LIFO in periods of rising prices
Higher Cost of Goods Sold = Lower Net Income = Lower Income Taxes

Inventory Method & managing income International issue LIFO not allowed in some countries

Inventory Errors
Each 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 Goods Sold and Net Income Goods Sold and Net Income Understated Overstated Overstated Understated

Inventory Error Period 1 Ending inventory overstated Period 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 Inventory Wrote inventory down to market value

1,000

1,000

Ratios
Gross Profit Percentage

Gross Profit Net Sales Revenue

Inventory Turnover

Cost of goods sold Average Inventory

Ratios
Gross Profit
Profit indicator

Inventory Turnover Liquidity ratio

How quickly is Inventory Sold?

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Gross Profit Method

Gross profit method is a way to estimate inventory based on the cost of goods sold model. Also called gross margin method.

Calculation
Cost of Beginning Inventory +Cost of Purchases ___________________ =Cost of Goods Available for Sale - Cost of Ending Inventory ___________________ =Cost of Goods Sold Cost of Beginning Inventory +Cost of Purchases ___________________ =Cost of Goods Available for Sale - Cost of Goods Sold ___________________ =Cost of Ending Inventory

Calculation Continued
Sales Cost of Goods Sold = Gross Profit Gross Profit% = Gross Profit / Sales Cost of Goods Sold = Sales x (1- Gross Profit%)

Estimate CGS using GP%

We know Beginning Inventory = 14,000 We know Purchases = 66,000 We know Sales = 100,000 We know Gross Profit % = 43% We Dont know Cost of Goods Sold We Dont know Ending Inventory

Gross Profit Method

Beginning inventory $14,000 Purchases 66,000 Goods available 80,000 Cost of goods sold: Net sales revenue $100,000 Less estimated gross profit 43% (43,000) Estimated cost of goods sold 57,000 Estimated cost of ending inventory $23,000

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