Chapter 5, Slide #1

Ch.5Accounting for Inventories

and Cost of Goods Sold

Prof. J. Wang

Chapter 5, Slide #2

Part I

Introduction

Chapter 5, Slide #3

• 1. merchandise inventory

• 2. I/S of a merchandise company

• 3. how companies keep track of their inventory: perpetual v. periodic systems

• 4. purchase of inventory on account

• 5. shipping cost

Chapter 5, Slide #4

1.1 Inventory of Wholesalers and Retailers

Purchased in finished form Resold without transformation Classified as “Merchandise Inventory”

on balance sheet

LO1

Chapter 5, Slide #5

1.2 Condensed Income Statement for a Merchandiser

Net sales $100,000Cost of goods sold 60,000Gross profit $ 40,000Selling and administrative expenses 29,300Net income before tax $ 10,700Income tax expense 4,280

Net income $ 6,420

Chapter 5, Slide #6

1.3 how companies keep track of their inventory

• Perpetual inventory system

• Periodic inventory system

Chapter 5, Slide #7

Perpetual Inventory Systems

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

Company knows the cost of sales and ending inventory figure from their books

Inventory records are updated after each purchase or sale

Chapter 5, Slide #8

Periodic Inventory Systems

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

Inventory records are updated periodically

based on physical inventory counts

Chapter 5, Slide #9

An increase in ending inventory means more was bought than sold

The Cost of Goods Sold Model

Beginning inventory $ 15,000

+ Cost of goods purchased 63,000

= Cost of goods available for sale 78,000

– Ending inventory (18,000)

= Cost of goods sold $ 60,000

“Pool” of goodsavailable to sell

during the period

Chapter 5, Slide #10

1.4 Purchase of inventory on account

• Cash discount

Chapter 5, Slide #11

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

Chapter 5, Slide #12

• On July 16, the company purchased merchandise inventory on account for $500. Term: 1/10, n/30.

Dr. Purchases 500Cr. A/P 500

Chapter 5, Slide #13

Recording Purchase DiscountsOn July 25, the company paid for the purchase, less

discount.Accounts Payable 500

Cash 495Purchase Discounts 5

To record payment within discount period to supplier who offers 1% purchase discount.

($ 500 × 1% = $5 discount)

Chapter 5, Slide #14

Cost of Goods Purchased Includes invoice price:

Less:

Purchase returns and allowances

Purchase discounts

Plus:

Transportation-in

Chapter 5, Slide #15

Inventory Costs Included

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

Chapter 5, Slide #16

1.5 Shipping cost:FOB Destination Point

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

Seller Buyer

Titlepasses at

destination

Chapter 5, Slide #17

1.5 Shipping cost:FOB Shipping Point

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

Seller Buyer

Titlepasses when

shipped

Chapter 5, Slide #18

Analysis of Profitability

Gross Profit %

Of particular

interest to current and

potentialinvestors

LO4

Chapter 5, Slide #19

Gross Profit Ratio = Gross Profit Net Sales

(How many cents on every $ of sales are leftover after covering the cost of the product)

Daisy’s Profitability

Net sales $100,000 Cost of goods sold 60,000 Gross profit $ 40,000

Gross profit ratio = 40%

Chapter 5, Slide #20

Part IIInventory Costing Method

How to determine the cost of inventory left on hand and cost of inventory sold in a period of inflation

Chapter 5, Slide #21

Inventory Valuation and Income Measurement

Value assigned toinventory on balance

sheet

Valueexpensedas cost of goods soldon incomestatement

When Sold =

LO5

Beginning inventory, Jan. 1: 500 units (unit cost $10)

Inventory purchases:Date Units Unit Cost1/20 300 $ 114/8 400 129/5 200 1312/12 100 14Total purchases 1,000 units

Ending inventory, Dec. 31: 600 units

Detailed Costing Method Example

What’re the cost of goods sold and ending inventory?

Chapter 5, Slide #23

Inventory Costing Methods(in a period of inflation)

Four costing methods available:

SpecificIdentification

WeightedAverage

First-in, First-out(FIFO)

Last-in, First-out(LIFO)

LO6

Chapter 5, Slide #24

Specific Identification Method

Step 1: Identify the specific units in inventory at the end of the year and their costs.

Chapter 5, Slide #25

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 × Cost = Total cost

Chapter 5, Slide #26

Specific Identification Method

Step 2: cost of goods sold = cost of goods available for sale – ending inventory = 17,100 – 7,300 = 9,800

* Few companies use this method

Chapter 5, Slide #27

Weighted Average Method

Step 1: Calculate the cost of goods available for sale.

Chapter 5, Slide #28

Weighted Average 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

Chapter 5, Slide #29

Weighted Average Method

Step 2: Divide the cost of goods availablefor sale by the total units todetermine the weighted averagecost per unit.

:

Chapter 5, Slide #30

Weighted Average Method

Cost of Goods Available for SaleUnits Available for Sale

$17,100 1,500

= $11.40/unit

Chapter 5, Slide #31

Weighted Average Method

Step 3: Calculate ending inventory and cost of goods sold by multiplying the weighted average cost per unit by the number of units in ending inventory and the number of units sold.

×Avg.Cost

# ofUnits

Chapter 5, Slide #32

Weighted Average Method

ALLOCATE TO Ending Cost of Inventory Goods

SoldUnits on hand 600 Units sold 900Weighted average cost × $11.40 $ 11.40

Total cost of goods available of $17,100 allocated: $6,840 $10,260

Chapter 5, Slide #33

First-in, First-out (FIFO) Method

Step 1: Assign the cost of the beginning inventory to cost of goods sold.

1stin

Chapter 5, Slide #34

First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost ofUnits 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

Chapter 5, Slide #35

First-in, First-out (FIFO) Method

Step 2: Continue to work forward until you assign the total number of units sold during the period to cost of goods sold. Allocate the remaining costs to ending inventory.

2nd3rd etc.

Chapter 5, Slide #36

First-in, First-out (FIFO) Method

ALLOCATE TO Ending Cost ofUnits 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

Chapter 5, Slide #37

Last-in, First-out (LIFO) Method

Step 1: Assign the cost of the last units purchased to cost of goods sold.

1stin

Chapter 5, Slide #38

Last-in, First-out (LIFO) Method ALLOCATE TO

Ending Cost ofUnits 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

Chapter 5, Slide #39

1stin

Step 2: Work backwards until you assign the total number of units sold during the period to cost of goods sold (allocate the remaining costs to ending inventory).

Last-in, First-out (LIFO) Method

Chapter 5, Slide #40

Last-in, First-out (LIFO) Method

ALLOCATE TO Ending Cost ofUnits 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

Chapter 5, Slide #41

Comparison of Costing Methods

Cost of GoodsSold

Ending Inventory

11,000

6,840

7,600

10,260

9,500

17,100

17,000

17,100

WeightedAverageFIFO

LIFO

Goods Available for Sale

6,100

Specific Identification $7,300 $ 9,800 $17,100

Chapter 5, Slide #42

Chapter 5, Slide #43

Comparison of Costing Methods

X X X

X X

Weighted Average FIFO LIFO

In periods of rising prices: Highest cost of goods sold? Lowest cost of goods sold?Highest gross profit?Lowest net income?Lowest income taxes?

LO7

Chapter 5, Slide #44

LIFO Conformity Rule LIFO conformity rule

• If used for tax, LIFO must also be used for books

• In general, companies can use one accounting method for financial reporting purpose and use a different method for tax purpose. Accounting choice should be made based on which method produces most useful information.

Chapter 5, Slide #45

Lower of Cost or Market(for your information only)

• If inventory’s market value has fallen below the cost, the inventory must be reported at the lower market value, and a loss must be recorded.