Chapter 7 Reporting and Interpreting Cost of Goods Sold and Inventory

Chapter 7

Reporting and InterpretingCost of Goods Soldand Inventory

© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin

7-2

Business Background

Provides accurate Provides accurate information.information.

Provides accurate Provides accurate information.information.

Provides up-to-date Provides up-to-date information. information.

Provides up-to-date Provides up-to-date information. information.

Provides information Provides information to help protect assets. to help protect assets. Provides information Provides information

to help protect assets. to help protect assets.

Roles of the Accounting

System

Roles of the Accounting

System


7-3

Nature of Inventory and Cost of Goods Sold

BeginningBeginningInventoryInventory

BeginningBeginningInventoryInventory

PurchasesPurchasesfor the Periodfor the PeriodPurchasesPurchases

for the Periodfor the Period

Ending InventoryEnding Inventory(Balance Sheet)(Balance Sheet)

Ending InventoryEnding Inventory(Balance Sheet)(Balance Sheet)

Goods availableGoods availablefor Salefor Sale

Goods availableGoods availablefor Salefor Sale

Cost of Goods SoldCost of Goods Sold(Income Statement)(Income Statement)

Cost of Goods SoldCost of Goods Sold(Income Statement)(Income Statement)

Beginning inventory + Purchases – Ending inventory = Cost of goods soldBeginning inventory + Purchases – Ending inventory = Cost of goods soldBeginning inventory + Purchases – Ending inventory = Cost of goods soldBeginning inventory + Purchases – Ending inventory = Cost of goods sold


7-4

Flow of Inventory Costs

MerchandiseMerchandisePurchasesPurchases

MerchandiseMerchandisePurchasesPurchases

Cost ofCost ofGoods SoldGoods Sold


MerchandiseMerchandiseInventoryInventory

MerchandiseMerchandiseInventoryInventory

Merchandiser

RawRawMaterialsMaterials

RawRawMaterialsMaterials

Raw MaterialsRaw MaterialsInventoryInventory

Raw MaterialsRaw MaterialsInventoryInventory

Work in ProcessWork in ProcessInventoryInventory

Work in ProcessWork in ProcessInventoryInventory

Finished GoodsFinished GoodsInventoryInventory

Finished GoodsFinished GoodsInventoryInventory



Manufacturer

DirectDirectLaborLaborDirectDirectLaborLabor

FactoryFactoryOverheadOverheadFactoryFactory

OverheadOverhead


7-5

Inventory Cost

The cost cost principleprinciple

requires that inventory be

recorded at the price paid or the consideration

given up.


7-6

Inventory Costing Methods

FIFOFIFOFIFOFIFO LIFOLIFOLIFOLIFO

Weighted Weighted Average Average Weighted Weighted Average Average

Specific Specific IdentificationIdentification

Specific Specific IdentificationIdentification


7-7

Applying the Four Methods

Total Dollar Amount of Goods Total Dollar Amount of Goods Available for SaleAvailable for Sale

Total Dollar Amount of Goods Total Dollar Amount of Goods Available for SaleAvailable for Sale

Ending InventoryEnding InventoryEnding InventoryEnding Inventory Cost of Goods SoldCost of Goods SoldCost of Goods SoldCost of Goods Sold


7-8

Specific Identification

• Specific cost of Specific cost of each inventory each inventory item is known. item is known.

• Used with low Used with low volume, high dollar volume, high dollar cost inventory cost inventory items.items.

• Specific cost of Specific cost of each inventory each inventory item is known. item is known.

• Used with low Used with low volume, high dollar volume, high dollar cost inventory cost inventory items.items.


7-9

First-In, First-Out (FIFO)

Costs of Costs of Goods SoldGoods Sold

Costs of Costs of Goods SoldGoods SoldOldest CostsOldest CostsOldest CostsOldest Costs

Ending Ending InventoryInventoryEnding Ending

InventoryInventoryRecent CostsRecent CostsRecent CostsRecent Costs


7-10

First-In, First-Out

The schedule on the next screen shows the mouse pad inventory for Computers, Inc.

The physical inventory count shows 1,200 mouse pads in ending inventory.

Use the FIFO inventory method to determine:

(1) Ending inventory cost.

(2) Cost of goods sold.



Use the FIFO inventory method to determine:




7-11

First-In, First-OutComputers, Inc.Mouse Pad Inventory

Date Units $/Unit TotalBeginning Inventory 1,000 5.25$ 5,250.00$ Purchases:Jan. 3 300 5.30 1,590.00 June 20 150 5.60 840.00 Sept. 15 200 5.80 1,160.00 Nov. 29 150 5.90 885.00 Goods Available for Sale 1,800 9,725.00$

Ending Inventory 1200 ?

Cost of Goods Sold 600 ?

Remember: Remember: The costs of The costs of most most recent recent

purchasespurchases are are in ending in ending inventory. inventory. Start with Start with

11/29 and add 11/29 and add units units

purchased purchased until you reach until you reach the number in the number in

ending ending inventory.inventory.


7-12

First-In, First-Out

Date Beg. Inv. Purchases End. Inv.Cost of

Goods Sold

Nov. 29 150@$5.90 150@$5.90Units 150


7-13


Goods Sold

Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 350

First-In, First-Out


7-14


Goods Sold

June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 500

First-In, First-Out


7-15


Goods Sold

Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 800

First-In, First-Out


7-16


Goods Sold1,000@$5.25 600@$5.25

400@$5.25Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

First-In, First-Out

Now, we have allocated Now, we have allocated the cost to all the cost to all 1,2001,200 units units

in ending inventory.in ending inventory.

Now, we have allocated Now, we have allocated the cost to all the cost to all 1,2001,200 units units

in ending inventory.in ending inventory.


7-17


Goods Sold1,000@$5.25 600@$5.25

400@$5.25Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

Costs $6,575 $3,150

Cost of Goods Available for Sale $9,725

First-In, First-Out


7-18

ANY QUESTIONS BEFORE WE

DISCUSS LIFO?


7-19

Last-In, First-Out

????

????

Oldest CostsOldest CostsOldest CostsOldest Costs

Recent CostsRecent CostsRecent CostsRecent Costs


7-20

Last-In, First-Out

Ending Ending InventoryInventoryEnding Ending

InventoryInventory

Cost of Cost of Goods SoldGoods Sold

Cost of Cost of Goods SoldGoods Sold

Oldest CostsOldest CostsOldest CostsOldest Costs

Recent CostsRecent CostsRecent CostsRecent Costs


7-21

Last-In, First-Out



Use the LIFO inventory method to determine:





Use the LIFO inventory method to determine:




7-22

Last-In, First-OutComputers, Inc.Mouse Pad Inventory




Computers, Inc.Mouse Pad Inventory




Remember: Remember: The costs of the The costs of the

oldest oldest purchasespurchases are are

in ending in ending inventory. Start inventory. Start with beginning with beginning inventory and inventory and

add units add units purchased until purchased until you reach the you reach the

number in number in ending ending

inventory.inventory.

Remember: Remember: The costs of the The costs of the

oldest oldest purchasespurchases are are

in ending in ending inventory. Start inventory. Start with beginning with beginning inventory and inventory and

add units add units purchased until purchased until you reach the you reach the

number in number in ending ending

inventory.inventory.


7-23


Goods Sold1,000@$5.25 1,000@$5.25

Units 1,000

Last-In, First-Out


7-24


Goods Sold1,000@$5.25 1,000@$5.25

Jan. 3 300@$5.30 200@$5.30

Units 1,200

Last-In, First-Out

Now, we have allocated the cost to all 1,200 units

in ending inventory.

Now, we have allocated the cost to all 1,200 units

in ending inventory.


7-25


Goods Sold1,000@$5.25 1,000@$5.25

Jan. 3 300@$5.30 200@$5.30100@$5.30

Units 1,200 100

Last-In, First-Out


7-26


Goods Sold1,000@$5.25 1,000@$5.25

Jan. 3 300@$5.30 200@$5.30100@$5.30

June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

Costs $6,310 $3,415

Cost of Goods Available for Sale $9,725

Last-In, First-Out


7-27

Now let’s move on to the average cost inventory method.

Average Cost Method


7-28

Average Cost Method

Average cost per unitCost of goods available for sale Number of units available for sale

Ending InventoryUnits in Ending Inventory Average cost per Unit

Cost of Good SoldUnits Sold Average cost per Unit

Average cost per unitCost of goods available for sale Number of units available for sale

Ending InventoryUnits in Ending Inventory Average cost per Unit

Cost of Good SoldUnits Sold Average cost per Unit


7-29

Average Cost Method



Use the average cost inventory method to determine:





Use the average cost inventory method to determine:




7-30

Average Cost MethodComputers, Inc.Mouse Pad Inventory





7-31

Weighted-Average

Weighted-Average Cost per Unit: $9,725 1,800

Ending Inventory:

1,200 Units × $5.40278 = $6,483*

Cost of Goods Sold:

600 Units × $5.40278 = $3,242*

* Rounded

Weighted-Average Cost per Unit: $9,725 1,800

Ending Inventory:

1,200 Units × $5.40278 = $6,483*

Cost of Goods Sold:

600 Units × $5.40278 = $3,242*

* Rounded

= $5.40278


7-32

Comparison of MethodsComputers, Inc.

Income StatementFor Year Ended December 31, 2003

Average FIFO LIFONet sales 25,000$ 25,000$ 25,000$ Cost of goods sold:Merchandise inventory, 12/31/02 5,250$ 5,250$ 5,250$ Net purchases 4,475 4,475 4,475 Goods available for sale 9,725$ 9,725$ 9,725$ Merchandise inventory, 12/31/03 6,483 6,575 6,310 Cost of goods sold 3,242$ 3,150$ 3,415$ Gross profit from sales 21,758$ 21,850$ 21,585$ Operating expenses: 750 750 750 Income before taxes 21,008$ 21,100$ 20,835$ Income taxes expense (30%)* 6,302 6,330 6,251 Net income 14,706$ 14,770$ 14,584$

* Tax expense amounts were rounded.


7-33

Computers, Inc.Income Statement

For Year Ended December 31, 2003 Average FIFO LIFO

Net sales 25,000$ 25,000$ 25,000$ Cost of goods sold:Merchandise inventory, 12/31/02 5,250$ 5,250$ 5,250$ Net purchases 4,475 4,475 4,475 Goods available for sale 9,725$ 9,725$ 9,725$ Merchandise inventory, 12/31/03 6,483 6,575 6,310 Cost of goods sold 3,242$ 3,150$ 3,415$ Gross profit from sales 21,758$ 21,850$ 21,585$ Operating expenses: 750 750 750 Income before taxes 21,008$ 21,100$ 20,835$ Income taxes expense (30%)* 6,302 6,330 6,251 Net income 14,706$ 14,770$ 14,584$


Comparison of MethodsIn periods of rising prices, In periods of rising prices, FIFOFIFO

results in the results in the highest ending highest ending inventoryinventory, gross profit, tax expense, , gross profit, tax expense, and net income, and the and net income, and the lowest cost lowest cost

of goods soldof goods sold. .

In periods of rising prices, In periods of rising prices, FIFOFIFO results in the results in the highest ending highest ending

inventoryinventory, gross profit, tax expense, , gross profit, tax expense, and net income, and the and net income, and the lowest cost lowest cost

of goods soldof goods sold. .


7-34

Computers, Inc.Income Statement

For Year Ended December 31, 2003 Average FIFO LIFO

Net sales 25,000$ 25,000$ 25,000$ Cost of goods sold:Merchandise inventory, 12/31/02 5,250$ 5,250$ 5,250$ Net purchases 4,475 4,475 4,475 Goods available for sale 9,725$ 9,725$ 9,725$ Merchandise inventory, 12/31/03 6,483 6,575 6,310 Cost of goods sold 3,242$ 3,150$ 3,415$ Gross profit from sales 21,758$ 21,850$ 21,585$ Operating expenses: 750 750 750 Income before taxes 21,008$ 21,100$ 20,835$ Income taxes expense (30%)* 6,302 6,330 6,251 Net income 14,706$ 14,770$ 14,584$


Comparison of MethodsIn periods of rising prices, In periods of rising prices, LIFOLIFO results results in the in the lowest ending inventorylowest ending inventory, gross , gross profit, tax expense, and net income, profit, tax expense, and net income, and the and the highest cost of goods soldhighest cost of goods sold. .

In periods of rising prices, In periods of rising prices, LIFOLIFO results results in the in the lowest ending inventorylowest ending inventory, gross , gross profit, tax expense, and net income, profit, tax expense, and net income, and the and the highest cost of goods soldhighest cost of goods sold. .


7-35

Choosing Inventory Costing Methods

Net Income Effects.Net Income Effects.Managers prefer to report Managers prefer to report

higher earning for their higher earning for their companies.companies.

Net Income Effects.Net Income Effects.Managers prefer to report Managers prefer to report

higher earning for their higher earning for their companies.companies.

Income Tax Effects.Income Tax Effects.Managers prefer to pay Managers prefer to pay

the least amount of taxes the least amount of taxes allowed by law as late as allowed by law as late as

possible.possible.

Income Tax Effects.Income Tax Effects.Managers prefer to pay Managers prefer to pay

the least amount of taxes the least amount of taxes allowed by law as late as allowed by law as late as

possible.possible.


7-36

Choosing Inventory Costing Methods

LIFO for books

LIFO for books

LIFO for LIFO for taxestaxes

LIFO for LIFO for taxestaxes

If . . . Then . . .LIFO Conformity

Rule


7-37

Inventory Costing Methods and Financial Statement Analysis

Beginning inventory LIFO- Beginning inventory FIFO

Difference in beginning inventory(LIFO to FIFO)

Beginning inventory LIFO- Beginning inventory FIFO

Difference in beginning inventory(LIFO to FIFO)

Ending inventory LIFO- Ending inventory FIFO

Difference in ending inventory(LIFO to FIFO)

Ending inventory LIFO- Ending inventory FIFO

Difference in ending inventory(LIFO to FIFO)


7-38

LIFO and International Comparisons

LIFO Permitted?LIFO Permitted?

YesYesNoNo

ChinaSingapore

Canada

Great Britain

Australia


7-39

Lower of Cost or Market

Ending inventory is reported at the Ending inventory is reported at the lower of cost or market (LCM)lower of cost or market (LCM). .

Ending inventory is reported at the Ending inventory is reported at the lower of cost or market (LCM)lower of cost or market (LCM). .

Net Realizable ValueNet Realizable ValueThe expected sales priceThe expected sales price

less selling costs.less selling costs.

Net Realizable ValueNet Realizable ValueThe expected sales priceThe expected sales price

less selling costs.less selling costs.

Replacement CostReplacement CostThe current purchase price The current purchase price

of identical goods.of identical goods.

Replacement CostReplacement CostThe current purchase price The current purchase price

of identical goods.of identical goods.

Market is either . . .Market is either . . .

oror


7-40

Lower of Cost or Market

Mouse pads Cost

Total Cost

Replacement Cost

Total Market LCM

1,600 5.20$ 8,320$ 4.15$ 6,640$ 6,640$

Mouse pads Cost

Total Cost

Replacement Cost

Total Market LCM

1,600 5.20$ 8,320$ 4.15$ 6,640$ 6,640$

The mouse pads will be shown on the balance sheetThe mouse pads will be shown on the balance sheetat $6,640 (LCM). The company will recognize aat $6,640 (LCM). The company will recognize a““holding” loss in the current period rather thanholding” loss in the current period rather than

the period in which the item is sold.the period in which the item is sold.This practice is This practice is conservativeconservative..

The mouse pads will be shown on the balance sheetThe mouse pads will be shown on the balance sheetat $6,640 (LCM). The company will recognize aat $6,640 (LCM). The company will recognize a““holding” loss in the current period rather thanholding” loss in the current period rather than

the period in which the item is sold.the period in which the item is sold.This practice is This practice is conservativeconservative..


7-41Measuring Efficiency in Inventory Management

Inventory Turnover Cost of Goods Sold

= Average Inventory

Inventory Turnover

Average Inventory is . . .Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2(Beginning Inventory + Ending Inventory) ÷ 2

Average Inventory is . . .Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2(Beginning Inventory + Ending Inventory) ÷ 2

This ratio is often used to measure the This ratio is often used to measure the liquidity (nearness to cash) of the inventory. liquidity (nearness to cash) of the inventory.

This ratio is often used to measure the This ratio is often used to measure the liquidity (nearness to cash) of the inventory. liquidity (nearness to cash) of the inventory.


7-42Measuring Efficiency in Inventory Management

$1,915,547$1,915,547

($191,931 + $168,616) ($191,931 + $168,616) ÷ 2÷ 2 = 10.6= 10.6

The 2000 inventory turnover ratio The 2000 inventory turnover ratio for Harley-Davidson:for Harley-Davidson:

Inventory Turnover Cost of Goods Sold

= Average Inventory

Inventory Turnover


7-43

Focus on Cash Flows

Add

Subtract

Cash Cash Payment to Payment to SuppliersSuppliers

Cash Cash Payment to Payment to SuppliersSuppliers

Cost of Cost of Goods Goods SoldSold

Cost of Cost of Goods Goods SoldSold

Increase in InventoryIncrease in InventoryDecrease in Accounts Decrease in Accounts

PayablePayable

Increase in InventoryIncrease in InventoryDecrease in Accounts Decrease in Accounts

PayablePayable

Decrease in Inventory Decrease in Inventory Increase in Accounts Increase in Accounts

PayablePayable

Decrease in Inventory Decrease in Inventory Increase in Accounts Increase in Accounts

PayablePayable


7-44

Errors in Measuring InventoryErrors in Measuring Inventory

Beginning Inventory Ending Inventory

Overstated Understated Overstated Understated

Effect on Income Statement

Goods Available for Sale + - N/A N/A

Cost of Goods Sold + - - +Gross Profit - + + -Net Income - + + -Effect on Balance Sheet

Inventory (12/31) N/A N/A + -Retained Earnings - + + -


7-45

Question

If the 2002 ending inventory is understated by $3,000, which of the

following is true for 2002?

a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. Net Income will be understated.





7-46







Question

Errors in Measuring InventoryEnding Inventory

Overstated Understated

Effect on Income Statement

Goods Available for Sale N/A N/A

Cost of Goods Sold - +Gross Profit + -Net Income + -Effect on Balance Sheet

Inventory (12/31) + -Retained Earnings + -


7-47

Question



a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. All of the above.





7-48







Question

Remember:Remember: The ending inventory for 2002 becomes the The ending inventory for 2002 becomes the beginning inventory for 2003.beginning inventory for 2003.


7-49Perpetual and Periodic Inventory Systems

Provides Provides up-to-dateup-to-date inventory records.inventory records.

Provides Provides up-to-dateup-to-date inventory records.inventory records.

Provides Provides up-to-date up-to-date cost of sales records. cost of sales records. Provides Provides up-to-date up-to-date

cost of sales records. cost of sales records.

Perpetual Perpetual SystemSystem

Perpetual Perpetual SystemSystem


7-50Comparison of Perpetual and Periodic Systems

Source of InformationModel Periodic System Perpetual System

Beginning InventoryCarried over

from prior periodCarried over from

prior period

Add: PurchasesAccumulated in the Purchases

account

Accumulated in the Inventory

account

Less: Ending Inventory

Measured at end of period by

physical inventory count

Perpetual record updated at every

sale

Cost of Goods Sold

Computed as a residual amount at end of period

Measured at every sale based

on perpetual record


7-51

The End of Chapter 7

Documents

Chapter 7 Reporting and Interpreting Cost of Goods Sold and Inventory