ch 8 lecture notes

7/28/2019 Ch 8 Lecture Notes

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CHAPTER 8

INVENTORY

CICA HANDBOOK, Part II and IFRSInventory Section 3031 and IAS 2

Interest/Borrowing Costs Section 3850 and IAS 23Inventory Onerous contractual obligations PE GAAP N/A and IAS 11Inventory Biological assets/Agriculture PE GAAP N/A and IAS 41

LEARNING OBJECTIVES1. Define inventory and identify categories of inventory.

2. Identify the decisions that are needed to determine the inventory value to reporton the balance sheet under a lower of cost and net realizable value.

3. Identify the physical inventory items should be included in ending inventory.

4. Determine the components of inventory cost.

5. Distinguish between perpetual and periodic inventory systems and account forthem.

6. Identify and apply GAAP cost formula options and indicate when each costformula is appropriate.

7. Explain why inventory is measured at the lower of cost and market, and apply thelower of cost and net realizable value standard.

8. Explain the accounting issues for purchase commitments.

9. Identify inventories that are or may be valued at amounts other than the lower ofcost and net realizable value.

10. Identify the effects of inventory errors on the financial statements and adjust forthem.

11. Apply the gross profit method of estimating inventory.

12. Identify the type of inventory disclosures required by accounting standards forprivate enterprises (private entity GAAP) and IFRS.

13. Explain how inventory analysis provides useful information and apply ratioanalysis to inventory.

14. Identify differences in accounting between accounting standards for privateenterprises (private entity GAAP) and IFRS, and what changes are expected inthe near future.

15. Apply the retail method of estimating inventory (Appendix 8A)

16. Identify other primary sources of GAAP for inventory (Appendix 8B)

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Major Categories of Inventory

Inventories are defined in the CICA Handbook3031.06 and IAS 2.6 as assets:

(a) held for sale in the ordinary course of business;

(b) in the process of production for sale; or(c) in the form of materials or supplies to be consumed in the production process or

in rendering of services.

Inventories are asset that areheld for sale in the ordinary course of business orgoods that will be used or consumed in the production of goods to be sold.in the form of materials or supplies to be consumed in the production

process or in rendering of services.

Merchandise inventory refers to the goods held for resale by a merchandisingbusiness, which ordinarily purchases its inventory in a form ready for sale.

The inventory of a manufacturing firm is composed of three separate items:raw materials,work in process, andfinished goods.

Recognition and Measurement

Determining the value to report on the balance sheet requires answers to the followingquestions:

1. Which physical goods should be included as part of inventory?2. What costs should be included as part of inventory cost?

3. What cost formula should be used?4. Has there been any impairment in value of the inventory items?

Inventory is recognized and carried at cost. In situations where the net realizable value(the net amount of cash to be received from the sale of inventory) of inventory declinesbelow cost, the inventory should be written down to its net realizable value.

Goods Included in Ending Inventory

Normally, goods are included in inventory when they are received from the supplier.However, at the end of the period, appropriate accounting requires that all goods inwhich the company has the risks and rewards of ownership (i.e., legal title) be included

in ending inventory.

Goods in transit at the end of the period, shipped f.o.b. shipping point, shouldbe included in the buyer's ending inventory.If the goods are shipped f.o.b. destination, they belong to the seller untilreceived by the buyer.

Consigned Goods belongs to the consignor and should be excluded from theconsignee's inventory.

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Special sale agreements. Three of the more common special sale agreementsare a) sales with buybacks (product financing arrangements), b) sales with highrates of return, and c) sales with delayed payment terms. In the case of saleswith buybacks, the inventory is the sellers. In the other two cases, the inventoryis the buyers if returns or collectability can be measured.

What are the Costs to include in Inventory?Inventories are recorded at cost when acquired.

Both IFRS and private entity GAAP indicate that inventory cost includes allexpenditures that are reasonable and necessary in acquiring the goods and convertingthem to a saleable condition.Such charges would include freight charges on the goods purchased and labour andother production costs incurred in processing the goods up to the time of sale.

Additional costs to include in inventory are:

Purchase discounts are treated as a reduction in the purchase price of inventory.

Either the gross or net method may be used in handling discounts.

Gross method: Purchases and accounts payable are recorded at the gross amount.Purchase discounts taken are credited to the Purchase Discounts account, which isreported in the income statement as a reduction of purchases.

Net method: Purchases and accounts payable are recorded at the net amount.Purchase discounts not taken are debited to the Purchase Discounts Lost account,which is reported in the other expense section of the income statement.

Vendor rebates can be recognized before they are received as a vendor receivable if

they meet both the definition of an asset and its recognition criteria, Otherwise they arenot recorded as the effect would be to overstate income.

Product costs are costs that attach to inventory and are recorded in the inventoryaccount (i.e. they are capitalized). For example, freight charges on goods purchased,other direct costs of acquisition, and non-recoverable taxes would all be recorded ininventory. Under IFRS, product costs also include any eventual decommissioning orrestoration costs incurred as a result of production, even though the relatedexpenditures may not be incurred until far into the future. Under private entity GAAP,such costs are generally added to the cost of the property, plant, and equipment.

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Borrowing costs. Capitalization of interest cost associated with the acquisition of anasset when a significant period of time will be required to get the asset ready for itsintended use may occur under IFRS, although interest cost can be expensed whenincurred if the inventories are manufactured or produced in large quantities and on arepetitive basis. Private entity GAAP requires that if interest is capitalized, it be

disclosed.

Standard Costs: Unit costs for material, labour, and manufacturing overhead arepredetermined. These costs are based on the costs that should be incurred per unit offinished goods when the plant is operating at normal capacity. Reporting inventory atcosts is acceptable when it is calculated using normal levels of materials and supplies,labour, efficiency, and capacity utilization. Unallocated overheads are expensed asthey are incurred.

Service Providers Work-in-Process: Work-in-process inventories comprised ofproduction costs that include service personnel and overhead costs associated withthe direct labour. Supervisory and other overhead costs are allocated using the same

principles as for manufactured products.

Costs EXCLUDED from inventory- storage costs (unless related to storage before next stage of production),- abnormal spoilage or wastage of materials, labour, or other production costs,- interest costs when inventories that are ready for use or sale are purchased ondelayed payment terms.

Basket purchases allocate the cost based on the relative sales value of the basket ofproducts purchased.

Perpetual Inventory System

A perpetual inventory system is a means for generating up-to-date records related toinventory quantities and, possibly, amounts. Under this inventory system, all purchasesand sales of goods are recorded directly in the inventory account as they occur.

Reconciliation between the recorded inventory amount and the actual amount ofinventory on hand is normally performed at least once a year. This is accomplished bytaking a physical inventory, and involves counting all inventory items and comparingthe amount counted with the amount shown in the detailed inventory records. Therecords are corrected to agree with the physical count.

Periodic Inventory System

A periodic inventory system does not maintain detailed records of inventoryacquisitions or dispositions during the period. Ending inventory is determined by aphysical count, which usually takes place once a year. Cost of goods sold is a residualamount, calculated by adding the beginning inventory to the net purchases during theperiod and then deducting the ending inventory. Therefore, emphasis is on the valuecalculated for ending inventory, either through an actual count or an estimation.

Supplementary System Quantities ONLY

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Most companies need more current information regarding their inventory levels toprotect against stock-outs or over-purchasing and to aid in the preparation of monthlyor quarterly financial statements. As a consequence, many companies use asupplementary system quantities only, which increases and decreases in quantitiesonly, not dollars.

Comparison of Journal Entries for Perpetual and Periodic Systems:

Cost Formulas

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Determining the cost of inventory items that have been sold as well as those remainingin ending inventory is sometimes a difficult process. Thus, the consistent use of a costformula is required in accounting for inventories. Choices include:

specific identification first-in, first-out (FIFO) weighted average cost

Regardless of the method chosen, the ending inventory in units is always the same,however the cost is different.

Specific Identification

This method requires that each item sold needs to be identified and the original costassigned to it. It is most appropriate when the goods are not interchangeable and areeasily identifiable (e.g., by serial number or special markings). In manufacturing, itwould include special orders and products manufactured under a job cost system.Items sold are allocated to cost of goods sold, and items on hand to inventory.

FIFO

Use of the FIFO inventory method assumes that the oldest inventory costs are the firstcosts recorded for goods sold. Under this method, the cost flow formula mayapproximate the normal physical flow of goods. A major advantage of the FIFO methodis that the ending inventory is stated in terms of an approximate current cost figure.However, because FIFO tends to reflect more recent costs on the balance sheet, abasic disadvantage of this method is that recent costs are not matched against recentrevenues on the income statement. The FIFO inventory method will give the sameresult regardless of whether a periodic or perpetual inventory is used.

Weighted Average Cost

The average cost method prices items in inventory on the basis of the average cost ofthe goods available for sale during the period. The weighted average cost formulatakes into account that the volume of goods purchased at each price is different. Thismethod requires that a new average unit cost be calculated each time a purchase ismade because the cost of goods sold at average cost has to be recognized each time asale is made. Justification for use of the average cost is that the costs it assigns toinventory closely follows physical flow of an interchangeable inventory. It is also simpleto apply, objective, and not as subject to income manipulation as some of the otherinventory costing methods.

Selecting a Cost Formula

The new inventory standards limit the choice of cost formula between specificidentification required for inventory that is not interchangeable, weighted average, andFIFO. The requirement to use the same cost formula for all inventories having a similarnature further limits the choice. The primary objective of financial reporting ofinventories is to provide a value that is representationally faithful and to therebyincrease reliability. The inventory valuation method that leads to the accomplishment ofthis objective should be the one selected. Once selected, the inventory method shouldbe applied consistently.

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LIFOUntil recently, LIFO was an allowed alternative but it is no longer permitted underprivate entity GAAP and IFRS. This means that in the U.S., GAAP standard differs fromthe International and Canadian standards for private entities. Justification for theelimination of this method is that it does not reliably represent actual inventory flows.Use of the LIFO inventory method assumes that the most recent inventory costs arethe first costs recorded for goods sold. Therefore, the older inventory costs remain ininventory, and they likely do not fairly represent the recent cost of inventories if there

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have been price changes. The Canada Revenue Agency has never allowed thismethod for tax purposes and so the method has never been widely used in Canada.Nonetheless, the AcSB will permit Canadian public companies trading on U.S. as wellas on Canadian stock exchanges to use this method.

Lower of Cost and Net Realizable Value

Net realizable value (NRV) is the estimated selling price in the ordinary course ofbusiness less the estimated costs of completion and disposal is allowed in certaincircumstances even when NRV is above cost. When there is an active and controlledmarket with a quoted price that applies to all quantities and the costs of disposalare not significant, NRV valuation of inventory can be used. Examples includeinventories of farm crops and certain rare minerals.

Impairment in value

When the future revenue associated with inventory is below its original cost, theinventory should be written down to reflect this loss. Thus, the historical cost principle is

adjusted when the future utility (revenue-producing ability) of the asset is no longeras great as its original cost. This is known as the lower of cost and market. Use ofthis method is an example of proper asset valuation, the conservatism constraint, andmatching.

There are two methods are used to record inventory at market when market is belowcost. The two methods are:- direct method: substitutes the market value figure for cost when valuing the

inventory. Thus, the loss is buried in the cost of goods sold, and no individual lossaccount is reported in the income statement.

- indirect or allowance method: an entry is made debiting a loss and crediting anallowance account for the difference between cost and market. Separately

recording the loss and a contra account is preferable, as it does not distort thecost of goods sold and clearly displays the loss from market decline.

The cost and market rule may be applied on an:individual item basis (item-by-item)category basistotal of the inventory

The item-by-item approach is the most conservative of the three methods, becausemarket values above cost are never taken into account. This is the methodrecommended. The new accounting standards recognize, however, that it may be moreappropriate in some circumstances to group similar or related items and then compare

their cost and NRV as a group 1) if the items are closely related in terms of their use; 2)if they are produced and marketed in the same geographical area; and 3) the itemscannot be evaluated separately from other items in the product line in a practical andreasonable way.

Purchase Commitments

Purchase commitments represent contracts for the purchase of inventory at aspecified price in a future period. If the contract price exceeds the market price and a

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loss is reasonably expected to occur, the loss should be recognized in the period duringwhich the market decline took place.

The loss is shown on the income statement under other expenses and losses. Theaccrued liability on purchase contracts is reported on the balance sheet.

Inventory Errors

Errors in recording inventory can affect the balance sheet, the income statement, orboth, because inventory is used in the preparation of both financial statements. Forexample, the failure to include certain inventory items in a year-end physical inventorycount would result in the following items being overstated (O) or understated (U):

ending inventory (U)

working capital (U)

cost of goods sold (O)

gross profit (U)

net income (U)

retained earnings (U)

Depending on the nature of errors, various ratios can be affected positively ornegatively (e.g., current ratio, inventory turnover ratio, debt to total assets ratio, rate ofreturn on total assets). Consequently, contracts related to management bonuses anddebt covenants can be affected.

The three most common types of inventory errors are:1. Correct recording of purchases but incorrect measurement and/or recording of

ending inventory count.

2. Recording purchase transactions in the wrong accounting period. However,

ending inventory is measured and recorded correctly.

3. Failure to include an item as a recorded purchase combined with failure to

include the item in the ending inventory count.

Corrections of inventory errors may involve the use of two procedures:1. Preparation of correcting journal entries. Generally, a purchase is recorded

when the invoice arrives. If this does not coincide with passage of legal title by

the end of the accounting period, correcting entries may be required to prevent

"cut-off errors."

2. Computation of the correct amounts of inventory and related items includingpurchases, cost of goods sold, net income, retained earnings, accounts

payable, working capital, and the current ratio.

Estimating Inventory - Gross Profit Method

Inventory must be counted, at least, annually. However, there are situations whenmanagement is in need of the value of inventory on a more frequent basis (e.g. interimreporting).

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The gross profit method can be used to estimate the amount of ending inventorywhen an approximation is needed. Such approximations are sometimes required byauditors (e.g., as a check on a physical count), or when inventory and inventory recordsare destroyed by fire or some other catastrophe, or when interim statements are beingprepared. The gross profit method should never be used as a substitute for a yearlyphysical inventory unless the inventory has been destroyed.

Disclosure, Presentation and Analysis

Disclosure and Presentation

Inventories often represent one of the most significant assets held by a business entity.Therefore, the accounting profession has mandated certain disclosure requirementsrelated to inventories. The following disclosures are required in the financial statementwith respect to inventories:

a. the choice of accounting policies adopted to measure the inventory;b. the carrying amount of the inventory in total and by classification (such as

supplies, material, work in process, and finished goods).c. The amount of inventories recognized as an expense in the period, including

unabsorbed and abnormal amounts of production overheads; andd. The carrying amount inventory pledged as collateral for loans

IFRS require additional disclosures, such as the carrying amount of inventorycarried at fair value less costs to sell, and details about inventory writedowns andreversals of write downs. Additional information is required for biological assetsand agricultural products.

Analysis of Inventories

Inventory planning and control is of vital importance to the success of amerchandising or manufacturing enterprise. If an excessive amount of inventory isaccumulated, there is the danger of loss due to obsolescence. If the supply ofinventory is inadequate, the potential for lost sales exists. This dilemma makesinventory an asset to which management must devote a great deal of attention.

There are two ratios that are most commonly used to analyse inventory:

Inventory Turnover RatioThe inventory turnover ratio measures the number of times inventory was sold duringthe period. Its purpose is to determine the liquidity of the investment in inventory.Seasonal factors should be considered when defining average inventory.

Inventory turnover = cost of goods soldaverage inventory on hand

Average Days to Sell Inventory RatioThis represents the average number of days to sell inventory, which in turn representsthe average age of inventory, or the number of days it takes to sell inventory once it ispurchased.

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# days required = 365to sell inventory inventory turnover

Appendix 8ARetail Inventory Method

The retail inventory method is an inventory estimation technique based upon anobservable pattern between cost and sales price that exists in most retail concerns.This method requires that a record be kept of:a) the total cost of goods available for sale,b) the total retail value of the goods available for salec) the sales for the period.

Basically, the retail method requires the determination of the cost to retail ratio ofinventory available for sale. This ratio is calculated by dividing the cost of the goods

available for sale by the retail value of goods available for sale. Once the ratio isdetermined, total sales for the period are deducted from the retail value of inventoryavailable for sale. The resulting amount represents ending inventory priced at retail.When this amount is multiplied by the cost to retail ratio, an approximation of the cost ofending inventory results.

Use of this method eliminates the need for a physical count of inventory each time anincome statement is prepared. However, a physical count is made at least yearly todetermine the accuracy of the records and to avoid overstatements due to theft, loss,and breakage.When a physical count is taken at the retail amount, this is converted to the chosenbasis by multiplying it by the appropriate cost to retail ratio.

An understanding of the terminology common to the retail method is necessary forappropriate application. The terms and their definitions are:a. Original Retail Price

The price at which the item was originally marked for sale.This price consists of the item's cost plus an original mark-up ormark on.

b. Mark-upAn increase above the original retail price.

c. Mark-up CancellationA decrease in the selling price of an item that had been previously marked up abovethe original price. A mark-up cancellation will never reduce the selling price belowthe original retail price.

d. MarkdownsA decrease below the original retail price.

e. Markdown CancellationAn increase in the selling price that follows a markdown.

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A markdown cancellation cannot exceed the original markdown.

When the cost to retail ratio is calculated by including net mark-ups (mark-ups lessmark-up cancellations) but excluding net markdowns, the retail inventory methodapproximates lower of average cost and market, with market being net realizable valueless normal profit margin.

This is known as the conventional retail inventory method. If both net mark-ups andnet markdowns are included before the cost to retail ratio is calculated, the retailinventory method approximates average cost.

The retail inventory method becomes more complicated when such items as freight-in,purchase returns and allowances, and purchase discounts are involved. Inessence, the treatment of the items affecting the cost column of the retail inventoryapproach follows the calculation of cost of goods available for sale.Other items that require careful consideration include transfers-in, normal shortages,abnormal shortages, and employee discounts.

Conventional retail (average LCM):

PurchaseAt Beginning Returns Freight- AbnormalCost Inventory + Purchases - Allowances, + in - Spoilage

Discounts

PurchaseAt Beginning Returns, Abnormal NetRetail Inventory + Purchases - Allowances, - Spoilage + Mark-ups

Discounts

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ILLUSTRATION 8-1

INVENTORY RECORD SYSTEMS: JOURNAL ENTRIES

Assumptions: Beginning inventory 100 units at $6 = $ 600Purchases 900 units at $6 = $5,400Sales 600 units at $12 = $7,200Ending inventory 400 units at $6 = $2,400

To recordpurchases


Inventory 5,400Accounts Payable 5,400

Supplementary System - quantitiesonly.

Inventory 5,400Accounts Payable 5,400


Purchases 5,400Accounts Payable 5,400

To record sales Accounts Receivable 7,200Sales 7,200

Accounts Receivable 7,200Sales 7,200

Accounts Receivable 7,200Sales 7,200

Cost of Goods Sold 3,600Inventory 3,600(600 x $6)

Post this entry to the perpetual

inventory records.

A record is kept of the fact that 600units were sold, but their cost is notcomputed. Therefore no journalentry is made to record the cost ofgoods sold at this time.

No record is kept of the number ofunits sold or their cost. Thereforeno journal entry is made to recordthe cost of goods sold at this time.

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At the end ofthe period


Because inventory costs werecomputed and journal entries weremade whenever units were sold,the records show that:(1) 900 units costing $5,400 werepurchased.(2) 600 units costing $3,600 weresold.

(3) 400 units costing $2,400remain on hand.

The balance in the inventoryaccount is correctly stated at$2,400.

No entry is required to adjust theInventory account.

Supplementary System - quantitiesonly.The records show that:(1) 900 units costing $5,400 werepurchased.(2) 600 units were sold.(3) 400 units remain on hand.

Periodic inventory procedures must

be used to determine that the costof the 400 units in ending inventoryis $2,400.

The balance in inventory account is$6,000 (beginning inventory pluspurchases).

The following entries are required toadjust the inventory account (seeIllustration 8-2):

Cost of Goods Sold 6,000Inventory 6,000

(Beginning & Purchases)

Inventory (Ending) 2,400Cost of Goods Sold 2,400


The records show only that 900units costing $5,400 werepurchased.

A physical count must be taken todetermine that 400 units remain onhand.

Periodic inventory procedures mustbe used to determine that the costof the 400 units in ending inventoryis $2,400.

The balance in the inventoryaccount is $600 from the beginningof the period.)

The following entries are requiredto adjust the inventory account(see Illustration 8-2):

Cost of Goods Sold 600Inventory 600(Beginning)

Inventory (Ending) 2,400Cost of Goods Sold 2,400

Cost of Goods Sold 5,400Purchases 5,400

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ILLUSTRATION 8-2

INVENTORY RECORDING SYSTEMS: T-ACCOUNTS

Transaction A: Beginning Inventory 100 units at $6 = $ 600B: Purchases 900 units at $6 = $5,400

C: Sales 600 units at $12 = $7,200D: Ending inventory 400 units at $6 = $2,400

SALES ACCOUNTS RECEIVABLE INVENTORY

7,200 C C 7,200 A 600600 D

D 2,400

COST OFGOODS SOLD ACCOUNTS PAYABLE PURCHASES

B 5,400D 3,600 5,400 B 5,400 D

SALES ACCOUNTS RECEIVABLE INVENTORYA 600

7,200 C C 7,200 B 5,400 3,600 CD 2,400

COST OFGOODS SOLD ACCOUNTS PAYABLE

C 3,600 5,400 B

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PERIODIC

PERPETUAL

NO CLOSINGENTRY REQUIRED


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ILLUSTRATION 8-3

ADJUSTING AND CLOSING THE INVENTORY ACCOUNTSAdjusting thePermanentInventory

Account Adjust for beginning Adjust for endingInventory by crediting inventory by debitingInventory and debiting Inventory and creditingCost of Goods Sold Cost of Goods Sold

Close these accounts by Close these accounts bycrediting the account debiting the accountand Crediting Cost of

Goods Sold

Beginning Inventory and Ending Inventory and

Temporary Accounts with Temporary Accounts with

Normal Debit Balances: Normal Credit Balances:1. An overstatement of these 1. An overstatement ofitems results in an overstatement these items results in anof Cost of Goods Sold and an understatement of Costsunderstatement of net income. of Goods Sold and an

overstatement of net income.

2. An understatement of these 2. An understatement ofitems results in an understatement these items results in anof Costs of Goods Sold and an overstatement of Costsoverstatement of net income. of Goods Sold and an

understatement of net income.

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Beginning Inventory Ending Inventory

Cost of Goods Sold

Accounts with NormalDebit balances:

Purchases

Transportation-in

Accounts with NormalCredit Balances:

Purchase Discounts

PurchaseAllowances

Returned Purchases

(Purchases Returns)


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ILLUSTRATION 8-4

EFFECT OF INVENTORY ERRORS

Error Effect on Income

Statement

Effect on Balance Sheet

Beginning Inventoryis understated.

Cost of Goods Sold isunderstated.

Retained Earnings iscorrect, assuming thatEnding Inventory for thepreceding period wasunderstated.*

Beginning Inventoryis overstated.

Cost of Goods Sold isoverstated.Gross Profit and NetIncome are understated.

Retained Earnings iscorrect, assuming thatEnding Inventory for thepreceding period wasoverstated.

Purchasesare understated


Gross Profit and NetIncome are overstated.

Accounts Payable isunderstated.

Retained Earnings isoverstated.

Purchasesare overstated.

Cost of Goods Sold isoverstated.

Gross Profit and NetIncome are understated.

Accounts Payable isoverstated.

Retained Earnings isunderstated.

Ending InventoryIs understated

Cost of Goods Sold isoverstated.Gross profit and NetIncome are understated.

Inventory is understated.

Retained Earnings isunderstated.

Ending Inventory

Is overstated.


Gross Profit and NetIncome are overstated.

Inventory is overstated.

Retained Earnings isoverstated.

* If beginning inventory for the current period is understated, then ending inventory forthe preceding period must also have been understated. Retained Earnings at the endof the preceding period was therefore understated. Retained Earnings will be correct atthe end of the current period after the current periods overstated Net Income is closedinto the Retained Earnings account.

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ILLUSTRATION 8-5

CALCULATION OF ENDING INVENTORY

Inventory Data

1/1 Begin with 1,000 units @ $51/10 Purchase 200 units @ $81/15 Sell 400 units1/20 Purchase 300 units @ $61/31 Ending inventory is 1,100 units (1,000 + 200 - 400 + 300)

Ending inventory calculations for 1,100 units

FIFO (periodic or perpetual) = (300 @ $6) + (200 @ 8) + (600 @ $5) = $6,400

Weighted average (periodic) =

160,6$units100,160.5$500,1

)3006($)2008($)000,15($ ==++

Weighted average (perpetual) =

[ ] [ ] 200,63006$units80050.5$200,1

)2008($)000,15($=+=

+

SUMMARYPERIODIC PERPETUAL

Average AverageFIFO Cost FIFO Cost

Goods available for sale $8,400 $8,400 $8,400 $8,400($51,000) + ($8200)

+ ($6300)Ending inventory 6,400 6,160 6,400 6,200Cost of goods sold $2,000 $2,240 $2,400 $2,200

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ILLUSTRATION 8-6

THE GROSS PROFIT METHOD

There is one general approach to estimating the cost of ending inventory using thegross profit method. It makes use of the percent of gross profit on sales. If given thepercent mark-up on cost, calculate the percent of gross profit on sales.

Assume that the following information is given:

Beginning inventory $ 60,000Purchases 90,000Sales 100,000Percent of mark-up on cost 25%

You are to use the gross profit method to solve for the cost of ending inventory.

1. Calculate percent of gross profit on sales (if not given):

Gross profit on Salescostonup-markof%100

costonup-markof%=

%20%125

%25

%25%100

%25==

+

=

2. Calculate cost of goods sold:

Cost of Goods Sold = Sales (100% - % Gross profit on Sales)

= $100,000 (100% - 20%)

= $100,000 80%

= $80,000

3. Calculate estimated cost of ending inventory:

Cost of beginning inventory $ 60,000+ Cost of purchases + 90,000

Cost of goods available for sale 150,000

- Cost of goods sold - 80,000

= Estimated cost of ending inventory $ 70,000

ILLUSTRATION 8-7

NUMERICAL EXAMPLE OF THE GROSS PROFIT AND CONVENTIONAL RETAILINVENTORY METHODS

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Assume that the following information is given:

Beginning InventoryAt Cost $100,000At Retail 125,000

Net Purchases

At Cost $300,000At Retail 360,000

Net Mark-ups 15,000Net Markdowns 10,000

Net Sales at Retail $280,000

Average Cost per Unit $ 8.00Average Selling Price per Unit $10.00

GROSS PROFIT METHOD

% Gross profit on sales = Avg. Selling Price - Avg. Cost = $2/$10 = 20%Avg. Selling Price

Cost of goods sold = $280,000 (100% - 20%) = $280,000 80%= $224,000 (using gross profit on sales)

Ending inventory = $100,000 + $300,000 - $224,000 = $176,000

CONVENTIONAL RETAIL METHOD

Ending inventory at retail = $125,000 + $360,000 + $15,000 - $10,000 - $280,000= $210,000

Cost-to-retail ratio = $100,000 + $300,000 = $400,000$125,000 + $360,000 + $15,000 $500,000

= 80%

Ending inventory atlower of average costand market (netrealizable value less normal profit) = 80% $210,000 = $168,000

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ch 8 lecture notes

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