Inventories and

1
Chapter 7

• Inventories and
• Cost of Goods Sold

Financial Accounting, Alternate 4e by Porter and
Norton
2
Inventory of Wholesalers and Retailers

• Purchased in finished form
• Resold without transformation

• Classified as Merchandise Inventory on
  balance sheet

3
CIRCUIT CITYConsolidated Balance Sheets
Partial
2003 2002
ASSETS (in thousands)

• CURRENT ASSETS
• Cash and cash equivalents 884,670 1,248,246
• Net accounts and notes receivable 775,339
  553,273
• Merchandise inventory 1,409,736 1,234,243
• Prepaid expenses and other current assets
  33,165 39,246
• Assets of discontinued operations
  --- 577,703
• TOTAL CURRENT ASSETS 3,102,910 3,652,711
• Property, plant and equipment, net 853,778
  988,947
• Deferred income taxes 22,362
  2,647
• Other assets 24,252 11,354
• Assets of discontinued operations
  --- 142,519
• TOTAL ASSETS
  3,799,117 4,542,033

More than 1/3 of current assets
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Inventory of Manufacturers
Costs Included in Inventory
Direct Materials
Direct Labor
Manufacturing Overhead
5
Inventory of Manufacturers
Balance Sheet Classifications
Costs Included in Inventory
Direct Materials
Raw Materials
Manufacture Products
Direct Labor
Work in Process
Manufacturing Overhead
Finished Goods
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NIKE, INC.Consolidated Balance Sheets Partial
May 31, 2002 2001
ASSETS (in millions)

• Current assets
• Cash and cash equivalents 575.5
  304.0
• Accounts receivable less allowance for
• doubtful accounts of 77.4 and 72.1
  1,807.1 1,621.4
• Inventories
• Finished goods 1,348.2 1,399.9
• Work in progress 13.0 15.1
• Raw materials 12.6 9.1
• 1,373.8 1,424.1
• Deferred income taxes 140.8 113.3
• Prepaid expenses 260.5 162.5
• Total current assets 4,157.7 3,625.3
• Property, plant and equipment, net
  1,614.5 1,618.8
• Identifiable intangible assets and goodwill
  437.8 397.3
• Deferred income taxes and other assets
  233.0 178.2
• TOTAL ASSETS 6,443.0 5,819.6

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Income Statement of a Merchandiser

• Cash sales 350,000
• Credit sales 124,000
• Total 474,000
• Less Sales returns
• allowances ( 12,400)
• Sales discounts ( 34,600)
• Net sales 427,000

Contra-accounts used for control and analysis
purposes
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Credit Terms and Sales Discounts

• n/30 Payment due 30 days from invoice
  date
• 1/10, n/30 Deduct 1 of invoice amount if paid
  within 10 days otherwise
• full invoice amount is due in 30 days
• 2/10, n/30 Deduct 2 of invoice amount if paid
  within 10 days otherwise full invoice amount is
  due in 30 days

9
The Cost of Goods Sold Model
New purchases
Beginning inventory
Inventory not sold - appears on balance sheet
Ending inventory
Inventory sold - appears on income statement
10
The Cost of Goods Sold Model

• Beginning inventory 15,000
• Plus Cost of goods purchased 63,000
• Cost of goods available for sale 78,000
• Less Ending inventory ( 18,000)
• Cost of goods sold 60,000

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Perpetual Inventory Systems
Inventory records are updated
after each purchase or sale

• Point of sale terminals have improved ability of
  mass merchandisers to maintain perpetual systems

12
Periodic Inventory Systems
Inventory records are updated periodically based
on physical inventory counts

• Reduces record-keeping but also decreases ability
  to track theft, breakage, etc. and prepare
  interim financial statements

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Cost of Goods Purchased

• Includes invoice price

Plus Transportation-in
Less Purchase returns and allowances Purchase
discounts
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Recording Purchase Discounts

• Assets Liab. O/E Rev.
  Exp.
• Cash (495) Accts Pay. 500 Purch.
  Discounts 5

To record payment within discount period to
supplier who offers 1 purchase discount.
( 500 x 1 5 discount)
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FOB Destination Point
Title Passes at Destination

• No sale or purchase until inventory reaches its
  destination
• Seller responsible for inventory while in transit

16
FOB Shipping Point
Title Passes when Shipped

• Both sale and purchase recorded upon shipment
• Buyer responsible for inventory while in transit

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Inventory Valuation and Income Measurement
Value Assigned to Inventory on Balance Sheet
Value Expensed as Cost of Goods Sold on
Income Statement
When Sold
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Calculating Cost of Goods Sold

• Internal calculation

• Beginning inventory 500
• Purchases 1,200
• Cost of goods available for sale 1,700

- Ending inventory (600) Cost of
goods sold 1,100
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Inventory costs include

• Any freight costs incurred by buyer
• Cost of insurance for inventory in transit
• Cost of storing inventory before selling
• Excise and sales taxes

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Inventory Costing Methods

• Four costing methods available

Specific Identification
Weighted Average
First-in, First-out (FIFO)
Last-in, First-out (LIFO)
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Detailed Costing Method Example
Calculate the cost of goods sold and ending
inventory under each method using the data below

• Beginning inventory, Jan. 1 500 units (unit cost
  10)
• Inventory purchases
• Date Units Unit Cost
• 1/20 300 11
• 4/8 400 12
• 9/5 200 13
• 12/12 100 14
• Total purchases 1,000
• Ending inventory, Dec. 31 600 units

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Specific Identification Method
Step 1 Identify the specific units in
inventory at the end of the year and their
costs.
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Specific Identification Method
Units in ending inventory Date purchased Units
Cost Total cost 1/20 100
11 1,100 4/8 300 12 3,600
9/5 200 13 2,600 Ending
inventory 600 7,300
Units x Cost Total cost
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Specific Identification Method
Step 2 Identify the units sold and
calculate the cost of goods sold.
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Specific Identification Method
Date purchased Units Cost Total cost Beg.
Inventory 500 10 5,000 1/20 200
11 2,200 4/8 100 12 1,200
12/12 100 14 1,400 Cost of goods
sold 900 9,800
Units x Cost Total cost
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Weighted Average Method
Step 1 Calculate the cost of goods
available for sale.
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Weighted Average Cost Method
Date purchased Units Cost Total cost Beg.
inventory 500 10 5,000 1/20
300 11 3,300 4/8 400 12
4,800 9/5 200 13 2,600 12/12
100 14 1,400 Cost of goods
available for sale 1,500 17,100
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Weighted Average Method
Step 2 Divide the cost of goods
available for sale by the total units
to determine the weighted average cost per
unit.
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Weighted Average Method
Cost of Goods Available Units Available
17,100 1,500
11.40/unit
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Weighted Average Method
Step 3 Calculate ending inventory and COGS
by multiplying the weighted average cost per
unit by the of units in ending inventory
and the of units sold.
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Weighted Average Method
ALLOCATE TO Ending Cost
of Inventory Goods Sold Units on
hand 600 Units sold
900 Weighted average cost X 11.40
11.40 Total cost of goods available of
17,100 allocated 6,840 10,260
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First-in, First-out (FIFO) Method
Step 1 Assign the cost of the beginning
inventory to cost of goods sold.
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First-in, First-out (FIFO) Method

• ALLOCATE TO
• Ending Cost of
• Units Cost Inventory Goods Sold
• 1/1 500 10 5,000
• 1/20 300 11
• 4/8 400 12
• 9/5 200 13
• 12/12 100 14

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First-in, First-out (FIFO) Method
Step 2 Continue to work forward until you
assign the total of units sold during the
period to cost of goods sold. Allocate the
remaining units to ending inventory.
etc.
3rd
2nd
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First-in, First-out (FIFO) Method
ALLOCATE TO Ending Cost
of Units Cost Inventory Goods Sold 1/1
500 10 5,000 1/20 300
11 3,300 4/8 300 / 100
12 3,600 1,200 9/5 200 13
2,600 12/12 100 14 1,400
TOTALS 7,600 9,500

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Last-in, First-out (LIFO) Method
Step 1 Assign the cost of the last units
purchased to cost of goods sold.
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Last-in, First-out (LIFO) Method

ALLOCATE TO Ending Cost
of Units Cost Inventory Goods Sold 1/1
500 10 1/20 300 11 4/8
400 12 9/5 200
13 12/12 100 14 1,400
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Last-in, First-out (LIFO) Method
Step 2 Work backward until you assign the
total of units sold during the period to
cost of goods sold (allocate the remaining
units to ending inventory).
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Last-in, First-out (LIFO) Method
ALLOCATE TO Ending Cost
of Units Cost Inventory Goods Sold 1/1
500 10 5,000 1/20 100 / 200
11 1,100 2,200 4/8 400 12
4,800 9/5 200 13
2,600 12/12 100 14 1,400
TOTALS 6,100 11,000

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Comparison of Costing Methods
Cost of Goods Sold
Goods Available for Sale
Ending Inventory
Specific Identification
7,300
9,800
17,100
Weighted Average
10,260
6,840
17,100
7,600
9,500
17,000
FIFO
11,000
LIFO
6,100
17,100
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Comparison of Costing Methods
Weighted Avg. FIFO LIFO
In periods of rising prices
highest COGS? lowest COGS? highest gross
margin? lowest net income? lowest income taxes?

• X
• X
• X
• X
• X

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LIFO Issues

• LIFO Liquidation
• liquidation can result in high gross margin (and
  large tax bill)
• LIFO Conformity Rule
• if used for tax, LIFO must
  also be used for books
• LIFO Reserve
• difference between inventory value stated at FIFO
  and value stated at LIFO

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Reasons for Inventory Errors

• Mathematical mistakes
• Physical inventory counting errors
• Cut-off problems - in-transit
• Goods on consignment

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Effect of Inventory Errors on the Income Statement

• (In 000s) Reported Corrected
  Effect
• Sales 1,000 1,000
• Beginning inventory 200 200
• Add Purchases 700 700
• Goods available for sale 900 900
• Less Ending inventory 300 250
  50 OS
• Cost of goods sold 600 650
  50 US
• Gross margin 400 350 50 OS
• Operating expenses 150 150
• Net income 250 200 50 OS

OS overstatement US understatement
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Effect of Inventory Errors on the Income Statement

• (in 000s) Reported Corrected
  Effect
• Sales 1,500 1,500
• Beginning inventory 300 250
  50 OS
• Add Purchases 1,100 1,100
• Goods available for sale 1,400 1,350
  50 OS
• Less Ending inventory 350 350
• Cost of goods sold 1,050 1,000
  50 OS
• Gross margin 450 500 50 US
• Operating expenses 120 120
• Net income 330 380 50 US

OS overstatement US understatement
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Counterbalancing Errors

• Assume ending inventory is overstated () by
  50,000 in 2004
• 2004
• Beginning inventory xxx,xxx
• Add Purchases xxx,xxx
• Goods available for sale xxx,xxx
• Less Ending inventory 50,000
• Cost of goods sold - 50,000

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Counterbalancing Errors

• 2004 ending inventory becomes 2005 beginning
  inventory
• 2004 2005
• Beginning inventory xxx,xxx 50,000
• Add Purchases xxx,xxx
• Goods available for sale xxx,xxx
• Less Ending inventory 50,000
• Cost of goods sold - 50,000

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Counterbalancing Errors

• The 2004 error reverses in 2005 (but 2004
  inventory and both 2004 and 2005 profits are
  misstated by 50,000)
• 2004 2005
• Beginning inventory xxx,xxx 50,000
• Add Purchases xxx,xxx xxx,xxx
• Goods available for sale xxx,xxx 50,000
• Less Ending inventory 50,000 xxx,xxx
• Cost of goods sold

- 50,000 50,000
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Lower of Cost or Market

• Before After
• Price Price Change Change
• Cost 150 120

Report loss in year market falls below cost
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50
Lower of Cost or Market

• Before After
• Price Price Change Change
• Selling price 200 160
• Cost 150 120
• Gross margin 50 40

to maintain normal G.M. when sold
Gross margin 25 25
50
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Lower of Cost or Market

• Market replacement cost (not retail value)
• Cost determined under one of four methods
• Justified on basis of conservatism
• Can be applied to
• entire inventory
• individual items
• groups of items

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Estimating Inventory Values

• Sometimes impossible or impractical to measure
  inventory at cost
• Estimation is necessary
• Two methods used to estimate ending inventory
  values
• gross profit method
• retail inventory method

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Gross Profit Method

• 1 Beginning inventory
• 2 Purchases
• 3 Cost of goods available for sale
• 4 - Ending inventory
• 5 Cost of goods sold

Use income statement model but reverse steps 4
and 5
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Gross Profit Method

• Beginning inventory 100,000
• Purchases 30,000
• Cost of goods available for sale 130,000
• - Cost of goods sold (estimated) 90,000
• Ending inventory (estimated) 40,000

Cost of goods sold is estimated as a
percentage of sales
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Inventory Turnover Ratio
Cost of Goods Sold Average Inventory

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Inventory Turnover Ratios
Example

• Circuit City 5.8 times per year
• Safeway 9.2 times per year

Can you compare the two ratios?

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Number of Days Sales in Inventory
of Days in Period Inventory Turnover Ratio
The average of days inventory is on
hand before it is sold.
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Days Sales in Inventory

• Circuit City 365 62 days 5.8
• Safeway 365 39 days 9.2

Do these averages seem reasonable?
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Statement of Cash Flows

• Cash Flows from Operating Activities
• Net income xxx
• Increase in inventory
• Decrease in inventory
• Increase in accts. payable
• Decrease in accts. payable
• - OR -
• Cash paid for inventory purchases

Indirect Method
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Appendix

• Accounting Tools
• Inventory Costing Methods with the Use of a
  Perpetual Inventory System

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FIFO Costing With a Perpetual System

FIFO applied at time of sale
Same FIFO inventory total under periodic and
perpetual systems
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LIFO Costing With a Perpetual System

LIFO applied at time of sale
Different LIFO inventory total under periodic and
perpetual systems because of pricing gap
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Moving Average With a Perpetual System

New weighted average cost is computed for each
purchase
Different inventory total under weighted average
(periodic) and moving average (perpetual)
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End of Chapter 7