Inventories and

1
Chapter 5

• 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
4
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
5
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
6
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

7
The Cost of Goods Sold Model
New purchases
Beginning inventory
balance sheet
Ending inventory
income statement
8
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

9
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

10
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

11
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

12
Cost of Goods Purchased

• Includes invoice price

Plus Transportation-in
Less Purchase returns and allowances Purchase
discounts
13
Recording Inventory Purchases

• Assets Liab. O/E Rev. Exp.
• Inventory 500 Accts Pay. 500

To record purchase of 500 of inventory. Note
the method demonstrated above is different from
the textbooks treatment of inventory purchases
under the periodic method.
14
Recording End-of-Period Inventory

• Assets Liab. O/E Rev. Exp.
• Inventory (300) COGS (300)

At the end of the accounting period, a physical
inventory was performed and it was determined
that 200 of inventory was on hand (unsold). We
take the amount out of purchases and put on the
balance sheet.
15
Recording Purchase Discounts

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

To record payment within discount period to
supplier who offers 1 purchase discount.
( 500 x 1 5 discount)
Discounts reduce Inventory
16
FOB Destination Point
Title Passes at Destination

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

17
FOB Shipping Point
Title Passes when Shipped

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

18
Inventory Valuation and Income Measurement
Value Assigned to Inventory on Balance Sheet
Value Expensed as Cost of Goods Sold on
Income Statement
When Sold
19
Measuring Inventory Value
Hydro Company sells and services agricultural
irrigation equipment. On March 20, 2004, Hydro
purchased 20 pump motors at 200 each. Hydro
already had 8 identical motors on hand, for which
it had paid 175.
20
Measuring Inventory
On March 22, 2004, a customer purchased one
motor. Should the company record the cost of
goods sold for the motor as 175 or as 200?
21
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
(using periodic method)

• 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

Total Units Available 1,500 Cost of Goods
Available for Sale 17,100
22
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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 cost of goods sold.
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Specific Identification Method

• Cost of Goods Available for Sale 17,100
• Ending Inventory 7,300
• Cost of Goods Sold 9,800

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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 oldest
inventory to cost of goods sold first.
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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 first.
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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
17,100
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

44
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

46
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

• 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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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?

50
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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Key Points Summary for Ch. 5

• Inventory Types
• Merchandise Inventory (Retailer)
• Raw Materials (Manufacturer)
• Work in Process (Manufacturer)
• Finished Goods (Manufacturer)
• Net Sales Cash Sales Credit Sales Sales
  Returns Allowances Sales Discounts
• FOB Terms
• FOB Shipping Point Title transfers at ship
  point, buyer pays shipping (include in buyers
  inventory at ship point)
• FOB Destination Title transfers when goods
  arrive at buyers location, seller pays shipping
  (keep in sellers inventory during shipping)

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Key Points Summary for Ch. 5

• COGS Model
• Beg. Inventory xx
• Net Purchases xxx
• Cost of Goods
• Available for Sale xxx
• - Ending Inventory (xx)
• Cost of Goods Sold xx
• Perpetual vs. Periodic Inventory System
• Periodic COGS and End. Inventory updated at end
  of accounting period
• Perpetual COGS and Inventory updated after
  every purchase and sale

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Key Points Summary for Ch. 5

• Inventory Costs include invoice price, taxes,
  shipping costs, discounts, insurance, storage.
• Periodic System Inventory Purchases
• Purchases go to expense initially
• Purch. Discounts/RA decrease expense
• At end of period, physical inventory conducted
  and inventory and expense accounts adjusted.
• Inventory Errors
• See page 322 for summary of situations

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Key Points Summary for Ch. 5

• Inventory Costing Methods (Periodic Method)
• Specific Identification Costs for Ending
  Inventory and COGS specifically identified
• Weighted Average 1. Average cost per unit
  determined 2. COGS determined based on units
  sold average cost 3. Same idea for ending
  inventory
• FIFO Oldest costs assigned to COGS first
• LIFO Newest costs assigned to COGS first

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Key Points Summary for Ch. 5

• Lower-of-Cost-or-Market (LCM) If market value
  of inventory (replacement cost) dips below
  original cost of inventory, must write-off
  (expense) difference.
• Inventory Turnover COGS/Avg. Inventory
• Shows of times inventory balance sold during
  the year
• Days Sales in Inventory 365/Inv. Turnover
• Shows avg. of days to sell inventory
• Inventory Costing for Perpetual Method