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Financial Accounting

Financial Accounting

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Published by Neil Grigg
Financial Accounting
Financial Accounting

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Published by: Neil Grigg on Dec 21, 2012
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09/22/2013

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Chapter 7: Inventory and Cost of Goods Sold

Topics
•  Types of inventory •  Costs included in the acquisition cost of inventory (cost principle) •  Cost flow assumption used to trace movement of costs out of inventory (matching) •  Treatment of changes in market value of inventory subsequent to acquisition •  Effect of inventory errors

Types of Inventory
Merchandiser (retailer or wholesaler) – WalMart, Macy’s
•  Merchandise inventory »  goods held for sale in the normal course of business »  goods are normally acquired in a finished condition

Manufacturer – Alcoa, Boeing
•  Raw materials inventory »  Items acquired for future processing into finished goods •  Work in process »  goods in the process of being manufactured but not yet completed •  Finished goods »  manufactured goods that are ready for resale

Inventory Flows: Merchandiser
Balance Sheet Merchandise Purchases Merchandise Inventory Income Statement Cost of Goods Sold

Inventory Flows: Manufacturer
Raw Material Purchases Direct Labor Incurred Factory Overhead Incurred (utilities, depreciation, supervisors’ pay) Balance Sheet Raw Material Inventory Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Income Statement

Inventory Costs Inventory is originally recorded at the price paid or the consideration given up –  the cost principle The amount recorded for inventory should include the invoice price plus any other expenditures necessary to ready the inventory for sale: –  freight charges –  inspection costs –  preparation costs .

Cost of Goods Sold (Merchandiser) Beginning Inventory Purchases for the Period Cost of Goods Available for Sale Ending Inventory (Balance Sheet) Cost of Goods Sold (Income Statement) Beginning inventory + Purchases – Ending inventory = Cost of goods sold .

Tracking Inventory Quantities & Costs   Periodic Inventory System –  no up-to-date record of inventory is maintained –  Inventory must be physically counted at the end of the accounting period in order to value both ending inventory and cost of goods sold   Perpetual Inventory System –  up-to-date records of inventory quantities and costs are maintained on an ongoing basis –  Cost of goods sold is recorded at the time of sale (see Chapter Supplement C) .

Comparison of Perpetual and Periodic Systems Source of Information Periodic System Carried over Beginning Inventory from prior period Accumulated in Add: Purchases the Purchases account Measured at end of period by Less: Ending Inventory physical inventory count Computed as a residual amount Cost of Goods Sold at end of period Model Perpetual System Carried over from prior period Accumulated in the Inventory account Perpetual record updated at every sale Measured at every sale based on perpetual record .

different cost flow assumptions result in different amounts for cost of goods sold and net income .Inventory costing methods   Cost flow assumptions are used to assign unit costs to ending inventory and cost of goods sold   When inventory prices are changing.

First-Out (FIFO)  Last-In. First-Out (LIFO)  Weighted-average cost  Specific identification NOT physical flow concepts! .Inventory Costing Methods  First-In.

First-Out (FIFO) Oldest Costs earliest purchases Costs of Goods Sold Recent Costs most recent purchases (relatively current costs) Ending Inventory .First-In.

FIFO Beginning Inventory (most recent purchases from earlier periods) Purchases for the Period Cost of Goods Available for Sale Ending Inventory (most recently purchased) Cost of Goods Sold (oldest available for sale) .

200 mouse pads in ending inventory.FIFO Example The schedule on the next screen shows the mouse pad inventory for Computers. Inc. The physical inventory count shows 1. . (2) Cost of goods sold. Use the FIFO inventory method to determine: (1) Ending inventory cost.

250.00 840.30 5.FIFO Example Date Beginning Inventory Purchases: Jan.000 $ 300 150 200 150 5.25 5.00 1. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers. Inc.160.00 1.590.00 885. 3 June 20 Sept.800 1200 600 $ 9.00 1.90 Total $ 5.725.80 5. Mouse Pad Inventory Units $/Unit 1.60 5. 15 Nov.00 ? ? .

200] Cost of goods sold = 600 @ $5.725 .150 .FIFO Example continued Ending Inventory = (150 @ 5.25 = $3.Cost of goods sold $6.$3.575 = $9.90) + (200 @ $5.575 [Units in ending inventory total 1.25) = $6.150 Note that Ending Inventory = Cost of goods available for sale .80) + (150 @ $5.30) + (400 @ $5.60) + (300 @ $5.

Last-In. First-Out (LIFO) Oldest Costs earliest purchases Ending Inventory Recent Costs most recent purchases (relatively current costs) Cost of Goods Sold .

Last-In. First-Out (LIFO) Beginning Inventory (oldest available from earlier period) Purchases for the Period Cost of Goods Available for Sale Ending Inventory (oldest available) Cost of Goods Sold (most recently purchased) .

Use the LIFO inventory method to determine: (1) Ending inventory cost.Last-In. . (2) Cost of goods sold. First-Out Use the same information of Computers. Inc.

00 885. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers.250.590. Mouse Pad Inventory Units $/Unit 1. 3 June 20 Sept.000 $ 300 150 200 150 5. 15 Nov.00 1.25 5.00 840.90 Total $ 5.00 1.30 5.80 5. Inc.160.800 1200 600 $ 9.LIFO Example Date Beginning Inventory Purchases: Jan.725.00 1.00 ? ? .60 5.

LIFO Example continued Ending Inventory = (1.310 Cost of goods sold = (150 @ 5.725 .310 = $9.415 .80) + (150 @ $5.415 Ending Inventory = Cost of goods available for sale .90) + (200 @ $5.30) = $6.30) = $3.Cost of goods sold $6.25) + (200 @ $5.000 @ $5.$3.60) + (100 @ $5.

LIFO LIFO is not permitted under international accounting standards. what are the consequences of this ban? . If U. converges to international standards.S.

WAC = COG Available / Units Available Ending Inventory Ending Inv.Weighted-Average Weighted-average cost (WAC) per unit = Beginning inventory cost + Current purchase cost Beginning inventory units + Current purchase units Or. × WAC per Unit Cost of Good Sold COGS = Units Sold × WAC per Unit . = Units in Ending Inv.

Inc.Example Use the same information of Computers. Use the weighted-average inventory method to determine: (1) Ending inventory cost.Weighted-Average . (2) Cost of goods sold. .

800 = $5.403 = $6.483 Cost of Goods Sold: 600 @ $5.725 / 1.242 Note that EI = COGA .Example Weighted-Average Cost per Unit: $9.200 @ $5.COGS .403 = $3.403 Ending Inventory: 1.Weighted-Average .

000 $ 25.250 4. 20B Weighted Average FIFO $ 25.758 750 21.835 6.770 Net sales Cost of goods sold: Merchandise inventory.475 9.330 14.251 14.475 9.150 21.584 * Tax expense amounts were rounded.725 6.250 4.483 3.250 4.000 $ $ $ $ $ $ 5.12/31/20A Net purchases Goods available for sale Merchandise inventory.585 750 20.100 6.475 9.575 3.Comparison of Methods Computers.706 $ $ $ $ $ $ 5.310 3.242 21.850 750 21.725 6.415 21.725 6.008 6. .12/31/20B Cost of goods sold Gross profit from sales Operating expenses: Income before taxes Income taxes expense (30%) Net income LIFO $ 25. Income Statement For Year Ended December 31.000 $ $ $ $ $ $ 5. Inc.302 14.

high dollar inventory. .   Used with small volume.Specific Identification   Specific cost of each inventory item is known.

a company can use any of the inventory costing methods   However.Important To Remember   Regardless of the actual physical flow of goods. it must disclose the reason for the change and the accounting effects of the change . accounting rules require companies to apply their accounting methods on a consistent basis –  when a company changes methods.

Analyzing Financial Statements That Have Different Costing Methods The ability of companies to choose different inventory costing methods makes comparison of financial results across companies difficult   The effect on cost of goods sold and inventory of using LIFO can be calculated from information in the notes to the financial statements   LIFO Reserve is the difference in inventory balances (in dollars) between LIFO and FIFO   »  Only firms who report inventory under LIFO have a LIFO reserve to show what the inventory balance would be if the firm had used the FIFO method .

Inventory Disclosure Example   Coca In NOTE 1: Cola Inventory Note .

inventories subsequently are required to be valued at the lower of cost or market (LCM) –  this requires companies to mark down the value of inventories that have declined in value Why not let companies write up inventory to market if it s above cost? .Valuation (measurement) – Lower of Cost or Market   The cost principle requires that companies initially value inventory at historical cost   Due to conservatism.

the expected sales price less selling costs. then an adjusting entry must be recorded to reduce the book value of the inventory –  Replacement cost . .Lower of Cost or Market   When either replacement cost or net realizable value of inventory drops below the historical cost.the current purchase price –  Net realizable value .

. the loss is immediately recorded. Cost of inventory = $55. Example: At 12/31/07.Lower of Cost or Market When the market value (replacement cost or net realizable value) of the inventory is less than the historical cost at the end of an accounting period.000 Give the required adjusting entry.000 Market value of inventory = $50.

Lower of Cost or Market Example: At 12/31/07.000 Market value of inventory = $50. . Cost of inventory = $55.000 Inventory 5.000 12/31/07 Holding Loss 5.000 Holding loss is sometimes called unrealized loss.

000 12/31/07 COGS Inventory 5. . Cost of inventory = $55.000 5.000 Holding loss is included with this year s COGS. Note that while this increases COGS in 2007. it will decrease COGS in 2008.Lower of Cost or Market – an alternative treatment of loss Example: At 12/31/07.000 Market value of inventory = $50.

000 12.000 How much cash was paid to suppliers in 2007? .Focus on Cash Flows Statement of Cash Flows – Convert COGS to Cash Paid to Suppliers Example: 2007 COGS $100.000 12/31/06 Inventory $8.000 12/31/07 $10.000 Accounts payable 7.

000 100.000 End Purchases End 10.000 COGS Accounts payable 7.Focus on Cash Flows Beg Inventory 8.000 Beg Purchases Payments 12.000 1st Plug: Purchases 2nd Plug: Payments to suppliers .

000 End 10.000 .000 12.000 1st Plug: Purchases 2nd Plug: Payments to suppliers = $97.000 COGS Accounts payable 7.000 100.Focus on Cash Flows Beg Inventory 8.000 Beg 102.000 End Purchases 102.000 Purchases Payments 97.

with the offset recorded to Cost of Goods Sold   So errors in the measurement of ending inventory will affect the balance sheet and the income statement .Inventory Errors   Most businesses validate their ending inventory by taking physical counts at the end of the accounting period –  any difference between the book balance and the physical count is recorded to the Inventory account.

what is the effect on: 2007 Cost of Goods Sold? 2007 Gross Profit? 2007 Net Income? 12/31/2007 Retained Earnings? Remember: COGS = BI + Purchases − EI .Question If the 2007 ending inventory is understated by $3.000.

000 2007 Net Income? Understated by $3.000 Remember – if ending assets (inventories) are understated by $3. then (assuming liabilities are not misstated) ending stockholders equity must be understated by $3.000 2007 Gross Profit? Understated by $3.000. what is the effect on: 2007 Cost of Goods Sold? Overstated by $3.000. .000.Question If the 2007 ending inventory is understated by $3.000 12/31/2007 Retained Earnings? Understated by $3.

000. what is the effect on: 2008 Beginning Inventory? 2008 Cost of Goods Sold? 2008 Gross Profit? 2008 Net Income? 12/31/08 Retained Earnings? 2008 ending inventory is correctly counted and recorded.Question If the 2007 ending inventory is understated by $3. .

000.000 2008 Cost of Goods Sold? Understated by $3.000 12/31/08 Retained Earnings? Correctly stated* *Net income was understated in 2007 and overstated in 2008.000 2008 Net Income? Overstated by $3.Question If the 2007 ending inventory is understated by $3. what is the effect on: [Note – 2008 ending inventory is correctly counted and recorded] 2008 Beginning Inventory? Understated by $3. .000 2008 Gross Profit? Overstated by $3.

4 (inventory = content library ) Blockbuster inventory turnover = 3. Inventory = Turnover Cost of Goods Sold Average Inventory Netflix inventory turnover = 7.3 (inventory = merchandise & rental library) .Inventory Turnover Ratio Inventory turnover reflects the efficiency of inventory management – a higher ratio => more turnover.

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