Chapter 7

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Chapter 7 Inventories and

Cost of Goods Sold

Financial Accounting, Alternate 4e by Porter and Norton

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Inventory of Wholesalers and Retailers

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

on balance sheet

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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

CIRCUIT CITYConsolidated Balance Sheets [Partial]

2003 2002ASSETS (in thousands)

More than 1/3 of

currentassets

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Inventory of Manufacturers

ManufacturingOverhead

Direct Materials

Direct Labor

Costs Included in Inventory

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Inventory of Manufacturers

ManufacturingOverhead

Direct Materials

Direct Labor Manufacture

Products

Work in Process

FinishedGoods

Raw Materials

Costs Includedin Inventory

Balance SheetClassifications

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Current assets:Cash and cash equivalents $ 575.5 $ 304.0Accounts receivable less allowance for

doubtful accounts of $77.4 and $72.1 1,807.1 1,621.4Inventories:

Finished goods 1,348.2 1,399.9Work in progress 13.0 15.1Raw materials 12.6 9.1

1,373.8 1,424.1Deferred income taxes 140.8 113.3Prepaid expenses 260.5 162.5

Total current assets 4,157.7 3,625.3

Property, plant and equipment, net 1,614.5 1,618.8Identifiable intangible assets and goodwill 437.8 397.3Deferred income taxes and other assets 233.0 178.2TOTAL ASSETS $ 6,443.0 $ 5,819.6

NIKE, INC.Consolidated Balance Sheets [Partial]

May 31,2002 2001ASSETS (in millions)

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Income Statement of a Merchandiser

Cash sales $ 350,000Credit sales 124,000

Total 474,000Less: 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

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Newpurchases

Beginninginventory

The Cost of Goods Sold Model

Cost of goods

sold

Inventory not sold - appears on

balancesheet Inventory sold -

appears onincome statement

Ending inventory

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An increase in ending inventory means more was bought than sold

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

“Pool” of goodsavailable to sell

during the period

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Perpetual Inventory Systems

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

Inventory records are updated after each purchase or sale

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Periodic Inventory Systems

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

Inventory records are updated periodically

based on physical inventory counts

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Cost of Goods Purchased

Includes invoice price:

Less:

Purchase returns and allowances

Purchase discounts

Plus:

Transportation-in

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Recording Purchase Discounts

Assets = Liab. + O/E + Rev. – Exp.

Cash (495) Accts Pay. 500 Purch. Discounts 5

($ 500 x 1% = $5 discount)

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

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FOB Destination Point

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

Seller Buyer

TitlePasses at

Destination

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FOB Shipping Point

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

Seller Buyer

TitlePasses when

Shipped

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Inventory Valuation and Income Measurement

Value Assigned toInventory

on BalanceSheet

ValueExpensedas Cost of Goods Soldon IncomeStatement

When Sold =

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Beginning inventory $ 500

+ Purchases 1,200


Calculating Cost of Goods Sold

Internal calculation

- 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 MethodsFour costing methods available:

SpecificIdentification

WeightedAverage

First-in, First-out(FIFO)

Last-in, First-out(LIFO)

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

Ending inventory, Dec. 31: 600 units

Detailed Costing Method Example

Calculate the cost of goods sold and ending inventory under each method using the data below:

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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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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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Step 2: Identify the units sold and calculate the cost of goods sold.

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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


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

:

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Cost of Goods Available Units Available

$17,100 1,500

= $ 11.40/unit

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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.

XAvg.Cost

# Units

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ALLOCATE TO Ending Cost of Inventory Goods

SoldUnits on hand 600 Units sold 900Weighted 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.

1stin

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ALLOCATE TOEnding 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

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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.

2nd3rd etc.

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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.

1stin

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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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1stin

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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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 GoodsSold

Ending Inventory

11,000

6,840

7,600

10,260

9,500

17,100

17,000

17,100

WeightedAverage

FIFO

LIFO

Goods Available for Sale

6,100

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

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Comparison of Costing Methods

X XX

XX

Weighted Avg. FIFO LIFO

In periods of rising prices:

highest COGS? lowest COGS?highest gross margin?lowest net income?lowest income taxes?

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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 EffectSales $1,000 $1,000Beginning inventory $ 200 200 Add: Purchases 700 700 Goods available for sale $ 900 $ 900 Less: Ending inventory 300 250 $50 OSCost of goods sold $ 600 $ 650 50 USGross margin $ 400 $ 350 50 OSOperating expenses 150 150Net 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 EffectSales $1,500 $1,500Beginning 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 350Cost of goods sold $1,050 $1,000 50 OSGross margin $ 450 $ 500 50 USOperating expenses 120 120Net 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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2004 ending inventory becomes 2005 beginning inventory:

2004 2005Beginning inventory $ xxx,xxx + 50,000Add: Purchases xxx,xxx = Goods available for sale xxx,xxx Less: Ending inventory +50,000 = Cost of goods sold - 50,000

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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

Lower of Cost or Market

Before After

Price PriceChange Change

Cost 150 120

Report loss in year

market falls below cost…

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Before After

Price PriceChange Change

Selling price $200 $160

Cost 150 120

Gross margin $ 50 $ 40


Gross margin % 25% 25%

…to maintain

normal G.M.%

when sold

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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 butreverse steps 4 and 5

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Gross Profit Method

Beginning inventory $ 100,000

+ Purchases 30,000


- 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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Cost of Goods SoldAverage Inventory

Inventory Turnover Ratio

The number of times per period inventory is turned over (i.e., sold)

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Circuit City 5.8 times per yearSafeway 9.2 times per year

Inventory Turnover Ratios

Example:

Can you compare the two ratios?

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Number of Days’ Sales in Inventory

The average # of days inventory is on handbefore it is sold.

# of Days in PeriodInventory Turnover

Ratio

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

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Days’ Sales in Inventory

Circuit City 365 = 62 days5.8

Safeway 365 = 39 days9.2

Do these averages seem reasonable?

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Statement of Cash FlowsCash 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 –

IndirectMethod

DirectMethod

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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

Different inventory total under weighted average (periodic) and moving average (perpetual)

New weighted average

cost is computed for

each purchase

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End of Chapter 7

Chapter 7

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