©2009 The McGraw-Hill Companies, Inc.

Chapter 6

Inventory and Cost of Goods Sold

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Inventory

o Includes items a company intends for sale to customers clothes at The Limited, shoes at Payless ShoeSource, building supplies at Home Depot, and so on.

o Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers

o Includes items a company intends for sale to customers clothes at The Limited, shoes at Payless ShoeSource, building supplies at Home Depot, and so on.

o Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers

©2009 The McGraw-Hill Companies, Inc.

Part A

Understanding Inventory and Cost of Goods Sold

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LOB1 Trace the flow of inventory costs from manufacturing companies to merchandising companies

Inventory

Merchandise companyMerchandise company Manufacturing companyManufacturing company

WholesalerWholesaler Retailer Retailer Raw materialRaw material Work in progressWork in progress

Finished goods

Finished goods

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Merchandising Companies

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Manufacturing Companies

o Companies manufacture the inventories they sell, rather than buying them from suppliers in finished form.

o We classify inventory into three categories

o Raw materials inventory: Includes the cost of components that will become part of the finished product but have not yet been used in production.

o Work-in-process inventory: Refers to the products that have started the production process but are not yet complete at the end of the period.

o Finished goods inventory: Once the manufacturing process is complete, transfer these costs to finished goods inventory.

o Companies manufacture the inventories they sell, rather than buying them from suppliers in finished form.

o We classify inventory into three categories

o Raw materials inventory: Includes the cost of components that will become part of the finished product but have not yet been used in production.

o Work-in-process inventory: Refers to the products that have started the production process but are not yet complete at the end of the period.

o Finished goods inventory: Once the manufacturing process is complete, transfer these costs to finished goods inventory.

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Types of Companies and Flow of Inventory Costs

Raw material Flow of Inventory Costs

ManufacturingCompanies

Direct labor Overhead

Work in process

Products

MerchandisingCompanies

Finished goods

Service Companies ServicesEnd users

Raw material

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LO2 Calculate cost of goods sold

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Relationship between Inventory and Cost of Goods Sold

6-10LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods

Inventory cost method

Specific Identification

Specific Identification

First in,First out(FIFO)

First in,First out(FIFO)

Last in,First out(LIFO)

Last in,First out(LIFO)

Average Cost

Average Cost

Specific Identification Method Specific Identification Method

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o It has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19.

o There are 1,000 game cartridges available for sale.o During the year, it sells 800 video game cartridges for $10 each. This

means that 200 cartridges remain in ending inventory at the end of the year.

o It has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19.

o There are 1,000 game cartridges available for sale.o During the year, it sells 800 video game cartridges for $10 each. This

means that 200 cartridges remain in ending inventory at the end of the year.

Inventory Transactions for Mario’s Game Shop

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First-In, First-Out (FIFO)

o First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.

o Mario’s Game Shop, which 800 units were sold? o They were the first 800 units purchased, and that all other units

remain in ending inventory.

o First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.

o Mario’s Game Shop, which 800 units were sold? o They were the first 800 units purchased, and that all other units

remain in ending inventory.

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o Last units purchased are the first ones sold.o Mario’s, If 800 units were sold, all the 600 units purchased on

October 19 were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory .

o Last units purchased are the first ones sold.o Mario’s, If 800 units were sold, all the 600 units purchased on

October 19 were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory .

Last-In, First-Out (LIFO)

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Average Cost Method

o Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.

o Each unit of inventory has a cost equal to the weighted-average cost of all inventory items.

o Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.

o Each unit of inventory has a cost equal to the weighted-average cost of all inventory items.

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A company purchases three units of inventory and sells two. FIFO: Inventory is sold in the order purchased. LIFO: Inventory is sold in the opposite order that we purchased it. Weighted average cost: Inventory is sold using an average of all

inventory purchased.

A company purchases three units of inventory and sells two. FIFO: Inventory is sold in the order purchased. LIFO: Inventory is sold in the opposite order that we purchased it. Weighted average cost: Inventory is sold using an average of all

inventory purchased.

Comparison of Cost of Goods Sold Under The Three Inventory Cost Flow Assumptions

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LO4 Explain the financial statement effects and tax effects of inventory cost flow assumptions

Effects of Managers’ Choice of Inventory Reporting Methods

Effects of Managers’ Choice of Inventory Reporting Methods

Why Choose LIFO?

o Results in tax savings.o Has an income statement focus.

Why Choose LIFO?

o Results in tax savings.o Has an income statement focus.

Why Choose FIFO?

o Matches physical flow for most companies.o Results in higher assets and net income when inventory costs are rising.o Has a balance sheet focus.

Why Choose FIFO?

o Matches physical flow for most companies.o Results in higher assets and net income when inventory costs are rising.o Has a balance sheet focus.

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Comparison of Inventory Cost Flow Assumptions When Prices Are Rising

A comparison of FIFO, LIFO, and average cost for Mario’s Game Shop is provided below.

A comparison of FIFO, LIFO, and average cost for Mario’s Game Shop is provided below.

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LIFO Reserve

o Choice between FIFO and LIFO results in different amounts for ending inventory and cost of goods sold.

o It complicates the investment decisions of stockholders. o Due to financial statement effects of different inventory

methods, companies that choose LIFO must report what’s called their LIFO reserve.

o It is the additional amount of inventory a company would report if it used FIFO instead of LIFO.

o Companies that have been using LIFO for a long time or that have seen dramatic increases in inventory costs, the LIFO reserve can be substantial.

o The effect of the LIFO reserve for Lone Star Technologies, which uses LIFO to account for most of its inventory follows.

o Choice between FIFO and LIFO results in different amounts for ending inventory and cost of goods sold.

o It complicates the investment decisions of stockholders. o Due to financial statement effects of different inventory

methods, companies that choose LIFO must report what’s called their LIFO reserve.

o It is the additional amount of inventory a company would report if it used FIFO instead of LIFO.

o Companies that have been using LIFO for a long time or that have seen dramatic increases in inventory costs, the LIFO reserve can be substantial.

o The effect of the LIFO reserve for Lone Star Technologies, which uses LIFO to account for most of its inventory follows.

©2009 The McGraw-Hill Companies, Inc.

Part B

Recording Inventory Transactions

6-20LO5 Explain the differences between a perpetual inventory system and a periodic inventory system

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Inventory Information for Incredible Electronics for 2010

To record inventory transactions under the perpetual system and periodic system. We keep the amount of inventory small to make the calculations easy, but both systems can be applied to inventory of any size. Consider the given information below during 2010:

To record inventory transactions under the perpetual system and periodic system. We keep the amount of inventory small to make the calculations easy, but both systems can be applied to inventory of any size. Consider the given information below during 2010:

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FOB shipping pointo Title passes when the seller

ships the inventory, not when the buyer receives it.

FOB shipping pointo Title passes when the seller

ships the inventory, not when the buyer receives it.

FOB destinationo Title would not transfer to the

buyer and the purchase transaction would not be recorded until the shipped inventory reached its destination.

FOB destinationo Title would not transfer to the

buyer and the purchase transaction would not be recorded until the shipped inventory reached its destination.

Perpetual inventory system Debit inventory when we

purchase inventory . Credit cash if the purchase

was paid in cash or, credit accounts payable if the purchase was on account, increasing total liabilities.

Perpetual inventory system Debit inventory when we

purchase inventory . Credit cash if the purchase

was paid in cash or, credit accounts payable if the purchase was on account, increasing total liabilities.

Periodic Inventory system Debit purchases account

instead of inventory. We use the purchases account

to temporarily track increases in inventory. We close this account to cost of goods sold at the end of the period.

Periodic Inventory system Debit purchases account

instead of inventory. We use the purchases account

to temporarily track increases in inventory. We close this account to cost of goods sold at the end of the period.

Inventory Purchases

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o Under the perpetual system, we add the cost of freight-in to inventory.

o Under the perpetual system, we add the cost of freight-in to inventory.

o Under the periodic system, it also eventually becomes part of the cost of inventory, but we initially record it in a separate freight-in account. Like purchases, the freight-in account is closed to cost of goods sold at the end of the period.

o Under the periodic system, it also eventually becomes part of the cost of inventory, but we initially record it in a separate freight-in account. Like purchases, the freight-in account is closed to cost of goods sold at the end of the period.

Freight Charges

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o Under the perpetual system, the company records the purchase returns as a reduction in both inventory and accounts payable.

o Under the perpetual system, the company records the purchase returns as a reduction in both inventory and accounts payable.

o Under the periodic system, the company credits an account called purchase returns, a contra purchases account, instead of inventory. Purchase returns is a temporary account that will be closed to (and become part of) cost of goods sold at the end of the period.

o Under the periodic system, the company credits an account called purchase returns, a contra purchases account, instead of inventory. Purchase returns is a temporary account that will be closed to (and become part of) cost of goods sold at the end of the period.

Purchase Returns

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o Incredible Electronics reduces its inventory balance by the amount of the discount. The true cash price for inventory is $49,000, not $50,000.

o Incredible Electronics reduces its inventory balance by the amount of the discount. The true cash price for inventory is $49,000, not $50,000.

o The company will record the discount in purchase discounts.

o Purchase discounts, like returns, is a temporary account that will be closed to cost of goods sold at the end of the period.

o The company will record the discount in purchase discounts.

o Purchase discounts, like returns, is a temporary account that will be closed to cost of goods sold at the end of the period.

Purchase Discounts

Digital Wholesale, offers terms 2/10, n/30 for purchases on account, and Incredible Electronics takes advantage of the discount. Incredibles’ purchases on account were $55,000, purchases returns were $5,000, the balance of account payable is $50,000. Subtracting the 2% purchase discount, Incredible owes only $49,000.

Digital Wholesale, offers terms 2/10, n/30 for purchases on account, and Incredible Electronics takes advantage of the discount. Incredibles’ purchases on account were $55,000, purchases returns were $5,000, the balance of account payable is $50,000. Subtracting the 2% purchase discount, Incredible owes only $49,000.

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Incredible sales $80,000. What is the cost of this inventory?o Cost of goods sold = $53,000 ($61,000 - $8000).o Record cost of goods sold of $53,000 only when using perpetual system.o Periodic system we record the reduction in inventory and increase in cost of

goods sold only periodically, as part of the period-end adjustment.

Incredible sales $80,000. What is the cost of this inventory?o Cost of goods sold = $53,000 ($61,000 - $8000).o Record cost of goods sold of $53,000 only when using perpetual system.o Periodic system we record the reduction in inventory and increase in cost of

goods sold only periodically, as part of the period-end adjustment.

Inventory Sales

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Period End Adjustment

o It is needed only under the periodic system.

o The entry serves the following purposes:o Adjusts the balance of inventory to its proper ending balance.o Records the cost of goods sold for the period to match

inventory costs with the related revenues.o Closes (or zeros out) the temporary purchases accounts

(purchases, freight-in, returns, and discounts).

o It is needed only under the periodic system.

o The entry serves the following purposes:o Adjusts the balance of inventory to its proper ending balance.o Records the cost of goods sold for the period to match

inventory costs with the related revenues.o Closes (or zeros out) the temporary purchases accounts

(purchases, freight-in, returns, and discounts).

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Sales and purchases of inventory are most important set of transactions , companies report revenues and expenses from these separately from other revenues and expenses.

It makes easier for investors and other financial statement users to determine the profitability of a company’s inventory transactions.

Use the information for Incredible to calculate gross profit on the sale and purchase of inventory.

Sales and purchases of inventory are most important set of transactions , companies report revenues and expenses from these separately from other revenues and expenses.

It makes easier for investors and other financial statement users to determine the profitability of a company’s inventory transactions.

Use the information for Incredible to calculate gross profit on the sale and purchase of inventory.

LO6 Prepare a multiple-step income statement

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Multiple-step Income Statement

©2009 The McGraw-Hill Companies, Inc.

Part C

Other Inventory Reporting Issues

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LO7 Apply the lower-of-cost-or-market rule for inventories

o When the value of inventory falls below its cost, companies are required to report inventory at the lower market value. And it is considered to be the replacement cost .

o Once it has determined both the cost and market value of inventory, Inventory is reported at the lower of the two amounts

o When the value of inventory falls below its cost, companies are required to report inventory at the lower market value. And it is considered to be the replacement cost .

o Once it has determined both the cost and market value of inventory, Inventory is reported at the lower of the two amounts

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Calculating the Lower of Cost or Market

1. Mario’s reports the FunStation 2 in ending inventory at market value. 2. The 15 FunStation 2s were originally reported in inventory at their cost of

$4,500.3. To reduce the inventory from that original cost of $4,500 to its lower

market value of $3,000, Mario records the following year-end adjustment.

1. Mario’s reports the FunStation 2 in ending inventory at market value. 2. The 15 FunStation 2s were originally reported in inventory at their cost of

$4,500.3. To reduce the inventory from that original cost of $4,500 to its lower

market value of $3,000, Mario records the following year-end adjustment.

6-33LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio

Inventory turnover ratio =Cost of goods sold

Average inventory

Average days in inventory =365

Inventory turnover ratio

o If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost.

o Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory.

o Investors often rely on the gross profit ratio to determine the core profitability of a company’s operations.

o If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost.

o Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory.

o Investors often rely on the gross profit ratio to determine the core profitability of a company’s operations.

Inventory turnover ratio is cost of goods sold divided by average inventory. It shows the number of times the firm sells its average inventory balance during a reporting period.

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1. We can analyze the inventory of Best Buy and Sharper Image Corporation by calculating these ratios for both companies.

2. Best Buy sells a large volume of commonly purchased products.

3. Sharper Image sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers.

4. Below are relevant amounts for each company.

1. We can analyze the inventory of Best Buy and Sharper Image Corporation by calculating these ratios for both companies.

2. Best Buy sells a large volume of commonly purchased products.

3. Sharper Image sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers.

4. Below are relevant amounts for each company.

Analyze the inventory of Best Buy and Sharper Image Corporation

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Computation of the Inventory Turnover Ratio

The turnover ratio is more than twice as high for Best Buy. On average, it takes Sharper Image an additional 73 days to sell its inventory.

6-36LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio

Gross profit ratio: Important indicator of the company’s successful management of inventory.

Gross profit ratio =Gross profit

Net sales

1. Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales.

2. Higher the ratio, higher is the “markup” a company is able to achieve on its inventories.

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Calculation of Gross Profit Ratio for Best buy and Sharper Image

For Best Buy, the gross profit ratio is 25% This meansthat for every $1 of sales revenue, the company spends$0.75 on inventory, resulting in a gross profit of $0.25.

For Best Buy, the gross profit ratio is 25% This meansthat for every $1 of sales revenue, the company spends$0.75 on inventory, resulting in a gross profit of $0.25.

For Sharper Image gross profit ratio is 49%For Sharper Image gross profit ratio is 49%

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LO9 Calculate inventory amounts using FIFO and LIFO under a perpetual inventory system We can calculate the amount of ending inventory by one of

several methods. We saw in Part B, the periodic and perpetual inventory

systems determine when to report inventory transactions Mario’s Game Shop. It sold 800 games to customers. Modify

it by giving exact dates for the sale of the 800 games—250 on July 17 and 550 on December 15. The chronological order of inventory transactions follows.

We can calculate the amount of ending inventory by one of several methods.

We saw in Part B, the periodic and perpetual inventory systems determine when to report inventory transactions

Mario’s Game Shop. It sold 800 games to customers. Modify it by giving exact dates for the sale of the 800 games—250 on July 17 and 550 on December 15. The chronological order of inventory transactions follows.

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FIFO with Perpetual System

FIFO AND LIFO WITH PERIODIC SYSTEMFIFO, the first 800 units purchased for the period are those we assume were sold first. LIFO the last 800 units purchased for the period are those we assume were sold first.

FIFO WITH PERPETUAL SYSTEMFirst units sold at the time of the sale, consistent with the perpetual systems approach to continually recording transactions.

FIFO AND LIFO WITH PERIODIC SYSTEMFIFO, the first 800 units purchased for the period are those we assume were sold first. LIFO the last 800 units purchased for the period are those we assume were sold first.

FIFO WITH PERPETUAL SYSTEMFirst units sold at the time of the sale, consistent with the perpetual systems approach to continually recording transactions.

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LIFO with Perpetual System

Last units purchased at the time of the sale are the ones were sold first.

What are the last 250 units purchased at the time of the July 17 sale?

What are the last 550 units purchased at the time of the December 15 sale?

Last units purchased at the time of the sale are the ones were sold first.

What are the last 250 units purchased at the time of the July 17 sale?

What are the last 550 units purchased at the time of the December 15 sale?

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Inventory Errorso Errors can unknowingly occur in inventory amounts if

there are mistakes in a physical count of inventory or in the pricing of inventory quantities.

o The formula for cost of goods sold, follows

Inventory Errorso Errors can unknowingly occur in inventory amounts if

there are mistakes in a physical count of inventory or in the pricing of inventory quantities.

o The formula for cost of goods sold, follows

LO10 Determine the financial statement effects of inventory errors

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Summary of Effects of Inventory Error in the Current Year.

Relationship between Cost of Goods Sold in the Current Year

and the Following Year

Summary of Effects of Inventory Error in the Current Year.

Relationship between Cost of Goods Sold in the Current Year

and the Following Year

Determine the financial statement effects of inventory errors

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Inventory Amounts

Incorrect Inventory Amounts

Correct Inventory Amounts

©2009 The McGraw-Hill Companies, Inc.

End of chapter 6