© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Merchandising Activities Chapter 6.
©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Six Accounting for Merchandising...
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Transcript of ©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Six Accounting for Merchandising...
©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin
Chapter Six
Accounting for Merchandising Businesses—Advanced Topics
Inventory Cost Flow Methods
Four Common Inventory Cost Flow Methods
Specific Identificatio
n
First-in, First-Out
(FIFO)
Last-in, First-Out
(LIFO)
Weighted Average
Specific Identification
When a company’s inventory consists
of many high-priced, low-
turnover goods the record keeping
necessary to use specific
identification is more practical.
Specific Identification
Assume Baker Company purchased two identical inventory items: the first for $100 and the second
for $110.
Using specific identification, when the first item is sold, cost of
goods sold would be $100. When the second item is sold, cost of goods sold
would be $110.
First-in, First-out
The first-in, first-out cost flow
method requires that the cost of the
items purchased first be assigned to Cost of Goods Sold.
First-in, First-out
Assume Baker Company purchased two identical inventory items: the first for $100 and the second
for $110.
Using first-in, first-out, the cost assigned to the first item sold would be $100
(the first cost in). The cost of goods sold assigned to
the second item sold would be $110.
Last-in, First-out
The last-in, first-out cost flow
method requires that the cost of the
items purchased last be assigned to Cost of Goods Sold.
Last-in, First-out
Assume Baker Company purchased two identical inventory items: the first for $100 and the second
for $110.
Using last-in, first-out, the cost assigned to the first item sold would be $110
(the last cost in). The cost of goods sold assigned to
the second item sold would be $100.
Weighted Average
The weighted average cost flow
method assigns the average cost of the items available to
Cost of Goods Sold.
Weighted Average
Assume Baker Company purchased two identical inventory items: the first for $100 and the second
for $110.
Using weighted average, the cost assigned to the first item sold would be $105 (the average cost).
Total CostTotal
Number
=$210
2= $105
Physical Flow
Our discussions about inventory cost flow
methods pertain to the flow of costs through
the accounting records, not the actual physical flow of goods.
Cost flows can be done on a different basis than physical flow.
Effect of Cost Flow on Income Statement
FIFO LIFOWeighted Average
Sales 120$ 120$ 120$ Cost of Goods Sold 100 110 105 Gross Margin 20$ 10$ 15$
The cost flow method a company uses can significantly affect the gross margin reported in the income
statement.
Effect of Cost Flow on Balance Sheet
FIFO LIFOWeighted Average
Ending Inventory 110$ 100$ 105$
Since total product costs are allocated between costs of goods sold and
ending inventory, the cost flow method used affects its balance sheet as well.
Inventory Cost Flow Under a Perpetual System
Event 1 Paid cash to purchase 20 units of inventory that cost $220 per unit.
Event 2 Paid cash to purchase 25 units of inventory that cost $250 per unit.
Event 3a Recognized revenue on sales of 43 bikes at a price of $350 cash per bike.
Event 3b Recognized cost of goods sold for the 43 bikes. Event 4 Paid $2,600 cash for operating expenses. Event 5 Paid cash for income tax. Assume a tax rate of
30% of earnings before tax.
The Mountain Bike Company (TMBC) experienced the following events during 2006:
First-in, First-Out
(FIFO)
Last-in, First-Out
(LIFO)
Weighted Average
First-in, First-out Inventory Cost Flow
Jan. 1 Beginning inventory 10 units @ 200$ = 2,000$ Mar. 18 First purchase 20 units @ 220$ = 4,400 Aug. 21 Second purchase 13 units @ 250$ = 3,250 Total cost of the 43 bikes sold 9,650$
FIFO Cost of Goods Sold
Cost of goods sold is an expense and, thus, decreases
net income.
Last-in, First-out Inventory Cost Flow
Aug. 21 Second purchase 25 units @ 250$ = 6,250$ Mar. 18 First purchase 18 units @ 220$ = 3,960 Total cost of the 43 bikes sold 10,210$
LIFO Cost of Goods Sold
Weighted Average Inventory Cost Flow
Total cost of the 43 bikes sold 43 units @ 230$ = 9,890$ Weighted Average Cost of Goods Sold
Total CostTotal
Number
=$12,650
55= $230
Inventory Cost Flow When Sales and Purchases Occur Intermittently
In our previous examples, all
purchases were made before any goods were
sold. This section addresses more
realistic conditions when sales
transactions occur intermittently with
purchases.
Sharon Sales Company (SSC)
Date TransactionJan. 1 Beginning inventory 100 units @ 20.00$ = 2,000$ Feb. 14 Purchased 200 units @ 21.50$ = 4,300 Apr. 5 Sold 220 units @ 30.00$ = 6,600 June 21 Purchased 160 units @ 22.50$ = 3,600 Aug. 18 Sold 100 units @ 30.00$ = 3,000 Sept. 2 Purchased 280 units @ 23.50$ = 6,580 Nov. 10 Sold 330 units @ 30.00$ = 9,900
Sharon Sales CompanyDescription
Let’s use FIFO to determine the cost of goods sold and inventory for SSC at the end of 2008.
This table describes the beginning inventory, purchases, and sales transactions for SSC during
2008.
SSC: First-in, First-out
FIFOSales (650 @ $30) 19,500$ Cost of Goods Sold 14,365 Gross Margin 5,135$
Jan. 1 Beginning inventory 100 units @ 20.00$ = 2,000$ Feb. 14 Purchased 120 units @ 21.50$ = 2,580 Total cost of goods sold for April 5 sale 4,580$
FIFO Cost of Goods Sold for April 5
Weighted Average and LIFO Cost FlowsWhen
maintaining perpetual inventory
records, using the weighted
average or LIFO cost flow
methods leads to timing
difficulties.
Further discussion of these methods
is beyond the scope of this text.
Lower of Cost or Market (LCM)
Inventory must be reported at Inventory must be reported at lowerlower of cost or market.of cost or market.
Inventory must be reported at Inventory must be reported at lowerlower of cost or market.of cost or market.
Applied three ways:Applied three ways:(1)(1) separately to each separately to each individual item.individual item.(2)(2) to major classes or to major classes or categories of assets.categories of assets.(3)(3) to the whole inventory.to the whole inventory.
Applied three ways:Applied three ways:(1)(1) separately to each separately to each individual item.individual item.(2)(2) to major classes or to major classes or categories of assets.categories of assets.(3)(3) to the whole inventory.to the whole inventory.
Market is defined as Market is defined as current current replacement replacement
costcost (not sales (not sales price).price).
Consistent withConsistent withthe conservatismthe conservatism
principle.principle.
Market is defined as Market is defined as current current replacement replacement
costcost (not sales (not sales price).price).
Consistent withConsistent withthe conservatismthe conservatism
principle.principle.
Lower of Cost or Market (LCM)
To illustrate lower of cost or market, To illustrate lower of cost or market, assume Wilson Office Supply Company assume Wilson Office Supply Company has in ending inventory 100 calculators has in ending inventory 100 calculators
purchased at a cost of $14 each. purchased at a cost of $14 each.
To illustrate lower of cost or market, To illustrate lower of cost or market, assume Wilson Office Supply Company assume Wilson Office Supply Company has in ending inventory 100 calculators has in ending inventory 100 calculators
purchased at a cost of $14 each. purchased at a cost of $14 each.
Cost Market LCMSituation 1 14$ 18$ 14$ Situation 2 14$ 11$ 11$
Fraud Avoidance in Merchandising Businesses
Because inventory and cost of goods sold accounts are so significant, they are
attractive targets for concealing fraud.
Because of this, auditors and financial analysts carefully examine them for signs of
fraud.
Fraud Avoidance in Merchandising Businesses
Ending Inventory is
Accurate
Ending Inventory is Overstated
Beginning Inventory 4,000$ 4,000$ Purchases 6,000 6,000 Cost of Goods Aval. for Sale 10,000 10,000 Ending Inventory (3,000) (4,000) Cost of Goods Sold 7,000$ 6,000$
Sales 11,000$ 11,000$ Cost of Goods Sold (7,000) (6,000) Gross Margin 4,000$ 5,000$
Ending Inventory is
Accurate
Ending Inventory is Overstated
Assets Cash 1,000$ 1,000$ Inventory 3,000 4,000 Other Assets 5,000 5,000 Total Assets 9,000$ 10,000$
Stockholders' EquityCommon Stock 5,000$ 5,000$ Retained Earnings 4,000 5,000 Total Stockholders' Equity 9,000$ 10,000$
Estimating the Ending Inventory Balance
Many companies
use the gross margin
method to estimate the
current period’s ending
inventory.
Calculate the expected gross margin ratio using prior period’s financials.
Multiply the expected gross margin ratio by the current period’s sales to estimate the amount of gross margin.
Subtract the estimated gross margin from sales to estimate cost of goods sold.
Subtract the estimated cost of goods sold from the amount of goods available for sale to estimate the ending inventory.
Calculate the expected gross margin ratio using prior period’s financials.
Multiply the expected gross margin ratio by the current period’s sales to estimate the amount of gross margin.
Subtract the estimated gross margin from sales to estimate cost of goods sold.
Subtract the estimated cost of goods sold from the amount of goods available for sale to estimate the ending inventory.
The Gross Profit Method
Inventory Turnover
Cost of Goods SoldInventory
This measures how quickly a company
sells its merchandise inventory.
This is the first step in calculating the average number of days to sell
inventory.
Average Number of Days to Sell Inventory
365Inventory Turnover
This measures how many days, on average, it takes to sell inventory.
Other things being equal, the company with the lower average
number of days to sell inventory is doing better.