introduction to financial accounting

(c) 1999 Prentice Hall Business Publishing Introduction to Financial Accounting, 7th Edition Horngren, Sundem, and Elliot

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Introduction to Financial Accounting,

7th EditionPowerPoint Presentations

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Eddie Metrejean, MTAX, CPAUniversity of Mississippi

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Chapter 6

Inventories andCost of Goods Sold


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Learning Objectives

After studying this chapter, you should be able to: Link inventory valuation to gross profit. Use both perpetual and periodic inventory systems. Calculate the cost of merchandise acquired. Choose one of the four principle inventory valuation

methods. Calculate the impact on net income of LIFO liquidations.


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Learning Objectives

After studying this chapter, you should be able to: Use the lower-of-cost-or-market method to value

inventories. Show the effects of inventory errors on financial

statements. Evaluate the gross profit percentage and inventory

turnover.


5Gross Profit andCost of Goods Sold

An initial step in assessing profitability is gross profit (profit margin or gross margin), which is the difference between sales revenue and the costs of the goods sold.

Products being held for resale are reported as inventory, a current asset.• When the goods are sold, the costs of the inventory

become an expense, Cost of Goods Sold. This expense is deducted from sales to determine Gross Profit.


6Gross Profit andCost of Goods Sold

Sales

Cost ofGoods Sold(an expense)

Selling andAdministrative

Expenses

MerchandiseInventory

Balance Sheet Income Statement

Minus

Equals Gross ProfitMinus

Equals Net Income

MerchandisePurchases

MerchandiseSales


7The Basic Concept ofInventory Accounting

The key to calculating cost of goods sold is accounting for the remaining inventory.

Cost valuation - process of assigning specific historical costs to items counted in the physical inventory• Multiply the number of items in ending inventory

times the cost of each item.


8Perpetual and PeriodicInventory Systems

Two main systems for keeping merchandise inventory records:• Perpetual inventory system - a system that keeps a

running, continuous record that tracks inventories and the cost of goods sold on a day-to-day basis

• Periodic inventory system - the system by which the cost of good sold is computed periodically by relying solely on physical counts without keeping day-to-day records of units sold or on hand



A perpetual inventory system helps managers control inventory levels and prepare interim financial statements.• The inventory amount can be found at any given point

in time.

A physical count of inventory on hand must still be taken at least once a year. This is the process of counting all the items in inventory at a moment in time.



In a perpetual system, the journal entries are:

When inventory is purchased:

Merchandise inventory xxx

Accounts payable (or cash) xxx

When inventory is sold:

Accounts receivable (or cash) xxx

Sales revenue xxx

Cost of goods sold xxx

Merchandise inventory xxx



In a periodic system, no day-to-day inventory records are maintained.

The physical count allows management to delete damaged or obsolete items and helps to reveal inventory shrinkage - losses

from theft, breakage, or loss of inventory



Calculations for cost of goods sold start with cost of good available for sale, which is the sum of the beginning inventory plus current year purchases.

Computation for Cost of Goods Sold:

Beginning inventory xxx

Add: Purchases xxx

Cost of goods available for sale xxx

Less: Ending inventory xxx

Cost of goods sold xxx=======


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Physical Inventory

In both periodic and perpetual inventory systems, a physical

count of each item being held in inventory is required.

The physical count is extremely important in determining net income because inventory is included in the determination of cost of goods sold.


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Cost of Merchandise Acquired

Regardless of the inventory system used, the basis of inventory accounting is the cost of the merchandise a company purchases for resale.

What costs are included in the cost of the merchandise?• The cost of merchandise usually includes only the

invoice price plus any directly identifiable transportation charges less any offsetting discounts.


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Transportation Charges

The major cost of transporting merchandise is usually freight charges from the shipping point of the seller to the receiving point of the buyer.• If goods are shipped F.O.B. (free on board)

destination, the seller pays the costs from the shipping point of the seller to the receiving point of the buyer.

• If goods are shipped F.O.B. shipping point, the buyer pays the freight costs from the shipping point of the seller to the receiving point of the buyer.


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Any costs of transportation borne by the buyer should be

added to the cost of the inventory acquired. Usually, transportation costs are not easy to trace

to specific inventory items, so companies usually use a separate transportation cost account called, Freight In, Transportation In, Inbound Transportation, Inward Transportation, etc.


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Freight in is usually shown in the purchases section on the income statement as an additional cost of the goods acquired.

Freight out represents the costs borne by the seller and is shown as an expense of selling the merchandise.• It is included with other selling expenses on the

income statement.


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Purchases and Purchase Returns

The accounting for purchases, purchase returns, purchase allowances, and cash discounts on purchases is just the opposite of the accounting for sales.

To record the purchase of merchandise:

Purchases 900,000

Accounts payable 900,000

To record the return of merchandise:


Purchase returns and allowances 80,000


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Gross ProfitGross sales $175,000

Deduct: Sales returns and allowances $ 2,000

Cash discounts on sales 1,500 3,500

Net sales $171,500

Deduct: Cost of goods sold:

Merchandise inventory, 1/1/97 $ 7,500

Purchases $120,000

Deduct: Purchase returns and allowances $3,000

Cash discounts on purchase 1,000 4,000

Net purchases $116,000

Add: Freight in 10,000

Total cost of merchandise acquired 126,000

Cost of good available for sale $133,500

Deduct: Merchandise inventory, 12/31/97 9,000

Cost of good sold 124,500

Gross profit $ 47,000 =============


20Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems

In the perpetual system, purchases of merchandise directly increase the Inventory account, and purchase returns and allowances and sales directly decrease the Inventory account.

As we have seen, in the periodic system, purchases of merchandise increase a Purchases account, and purchase returns and allowances are placed in separate accounts that are deducted from Purchases. Sales have no effect on the Purchases account.



Journal entries under the perpetual system:To record the purchase of merchandise:

Inventory 900,000

Accounts payable900,000

To record the return of merchandise:


Inventory 80,000



Under the perpetual system, inventory amounts are updated each time an inventory transaction is processed.

Under a periodic system, the inventory account does not change until the end of the accounting period.• At that time, a physical inventory is taken to

determine the amount of inventory on hand, and an adjusting entry is made to inventory.


23Principal InventoryValuation Methods

Four inventory valuation systems have been generally accepted.• Specific identification• First in, first out (FIFO)• Last in, first out (LIFO)• Weighted average


24Principal InventoryValuation Methods

If unit prices and costs did not change, all four inventory valuation methods would show identical results.

Because prices change, cost of goods sold and inventories are affected which in turn affect income measurement and asset measurement.• The choice of the inventory valuation method can

significantly affect the amount reported as ending inventory.


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Specific Identification

Specific identification method - concentrates on the physical tracing of the particular items sold• Used mostly when the physical flow of goods is easy

to track• Relatively easy to use• Works best for relatively

expensive low-volume merchandise, such as automobiles or jewelry


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FIFO

FIFO (first in, first out) method - assumes that the units acquired earliest are used or sold first• This might not actually be the actual physical flow of

goods within the company.• Under FIFO, the oldest unit is deemed to be sold,

regardless of which unit is actually given to the customer.

• The costs of the newer units in stock are included in ending inventory.


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FIFO

FIFO uses the most recent cost in ending inventory, so the inventory tends to closely approximate that actual market value of the inventory at the balance sheet date.

Also, in periods when prices are rising, FIFO leads to higher net income because

the costs of the older, lower costing items are included in cost of goods

sold.


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LIFO

LIFO (last in, first out) - assumes that the units acquired most recently are used or sold first• This might not actually be the actual physical flow of

goods within the company.• Under LIFO, the newest unit is deemed to be sold,

regardless of which unit is actually given to the customer.

• The costs of the older units in stock are included in ending inventory.


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LIFO

LIFO uses the oldest costs to value ending inventory, so that value may be significantly different from the actual market value of the inventory at the balance sheet date.

In periods when prices are rising, LIFO yields lower net income because the higher costs of more recent purchases are put into cost of goods sold first.


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LIFO

Because LIFO results in reduced net income, it also results in lower income taxes. • The Internal Revenue Code requires that if a company

uses LIFO to compute its taxable income, the company must also use LIFO to compute its financial net income.

• The result is lower income taxes and lower reported earnings figures to investors.


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LIFO

If LIFO is such a good deal, why do some companies still use FIFO?

For several reasons:• Costs of changing methods can be significant.• Management may be reluctant to decrease earnings

and possibly salaries and bonuses.• Management might fear that lower income would hurt

in loan negotiations with banks.• Lower earnings will often lower stock prices.


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Weighted Average

Weighted average method - computes a unit cost by dividing the total acquisition cost of all items available for sale by the number of units available for sale

salefor available Units

salefor available goods ofCost average Weighted


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Weighted Average

The averaging in the weighted average must consider not only the price paid, but also the number of units purchased at each price.

The weighted average method produces a gross profit somewhere between gross profit under FIFO and LIFO.


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Weighted Average

Smith Corporation purchased 5 units of Product X for $4.00 on Monday and 7 units of Product X for $4.25 on Friday. What is the weighted average cost per unit?

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$4.25) x (7 $4.00) x (5 average Weighted

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75.49$

= $4.15


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Cost Flow Assumptions

The accounting profession has determined that companies may choose any of the four methods for valuing inventory.

The units are all the same, but their costs are different, so tracing the flow or assignment of those costs is more important than tracing where each specific unit actually goes.


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Cost Flow Assumptions Because three out of the four methods are not

linked to the physical flow of the goods, inventory valuation methods are often called cost flow assumptions.• No matter which cost flow assumption is picked, the

cumulative gross profit over the life of a company remains the same.

• The need to match particular costs to particular revenues makes the choice of cost flow assumptions important.


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Inventory Cost Relationships The four cost flow assumptions affect inventory

only. They do not affect purchases and liabilities for those purchases.

Note that in the detailed computation of gross profit, ending inventory affects cost of goods sold.• The lower the ending inventory, the higher the cost of

goods sold.• The higher the ending inventory, the lower the cost of

goods sold.


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The Consistency Convention

Although companies can choose any cost flow assumption, they have to be consistent over time.

Consistency - conformity from period to period with unchanging policies and procedures• Consistency makes year-to-year comparisons of

financial information useful.• Companies can change inventory methods for

justifiable reasons, such as changes in market conditions.


39Characteristics and Consequences of LIFO

LIFO is widely used in the U.S. for reasons stated earlier; however, LIFO is a fairly uncommon inventory method.• Many countries do not allow its use.

The most popular method worldwide is weighted average, followed by FIFO.


40Holding Gains andInventory Profits

LIFO approximates a replacement cost view of transactions, and measures profit relative to newer costs. • replacement cost - the cost at which an inventory item

could be acquired today In contrast, FIFO measures profit relative to older

costs.


41Holding Gains andInventory Profits

The difference between profit measured under FIFO and LIFO is called a holding gain or inventory profit.• The holding gain is also the difference between the

historical cost under FIFO (older costs) and the historical cost under LIFO (newer costs).

• LIFO ending inventory rarely has holding gains.• FIFO ending inventory often has holding gains.


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LIFO Layers

LIFO layer - a separately identifiable additional segment of LIFO inventory• Ending inventory under LIFO will have one total

value, but it may contain prices from many different points in time.

• As a company continues in business, the LIFO layers tend to pile on top of one another over the years.


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LIFO Layers

Many companies show inventories that have LIFO layers dating as far back as 1940. These inventories are probably far below the true market value or replacement cost of the inventory.

LIFO presents an economic reality on the Income Statement, but FIFO presents a more up-to-date valuation on the Balance Sheet.


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LIFO Inventory Liquidations

As stated before, in periods of rising prices, LIFO will produce a higher cost of goods sold and lower gross profit than FIFO.

Sometimes companies must “liquidate” some of their LIFO layers.• In such a case, cost of goods sold decreases because

very old costs are now included in cost of goods sold. When cost of goods sold decreases, gross profit increases.


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LIFO Inventory Liquidations

Security analysts often like to keep track of the effect of choosing LIFO over FIFO because the effect on net income can be significant.

LIFO reserve - the difference between a company’s inventory valued at LIFO and what it would be under FIFO• The balance in the LIFO reserve indicates the

cumulative affect on gross profit over all prior years due to LIFO.


46Lower-of-Cost-or-Market Method (LCM)

Lower-of-cost-or-market (LCM) method - the imposition of a market-price test on an inventory cost method• The current market price is compared with historical

cost of inventory under one of the valuation methods.• The lower of the two values is selected as the basis for

the valuation of goods at a specific inventory date.– When the market value is lower and is used for valuing

ending inventory, cost of goods sold is effectively increased.


47Lower-of-Cost-or-Market Method (LCM)

LCM is an example of conservatism, which means selecting the methods of measurement that yield lower net income, lower assets, and lower stockholders’ equity.• Erring in the direction of conservatism

is better than erring in the direction of overstating assets and net income.


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Role of Replacement Cost

The concept of replacement cost assumes that as replacement costs decline, selling prices also decline.• If this is the case, the inventory must be written down

to the replacement cost (market value), and the replacement cost is regarded as the “new historical cost.”

Loss on write-down (or cost of goods sold) xxx

Inventory xxx


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Conservatism in Action

Cumulative net income is never lower and is usually higher under the strict cost method than under the LCM method.• The LCM method affects

how much income is reported in each year, but not the total income over the company’s life.


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Effects of Inventory Errors

An undiscovered inventory error usually affects two accounting periods.

• Amounts are affected in the period in which the error occurred, but the effects will be counterbalanced by identical offsetting amounts in the following period.

• The net effect on retained income is zero.


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Effects of Inventory Errors

A handy rule of thumb:• If ending inventory is understated,

retained income is understated because cost of good sold will be overstated.

• If ending inventory is overstated, retained income is overstated because cost of goods sold will be understated.


52Cutoff Errors andInventory Valuation

Cutoff errors - failure to record transactions in the correct time period

The general approach to recording purchases and sales is keyed to the legal transfer of ownership.• Inventory is counted only if it is owned by the

company.


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The Importance of Gross Profit

Gross profit percentage - gross profit as a percentage of sales

Sales

Profit Gross %Profit Gross


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Gross Profit Percentage

Often the nature of the business of the firm affects the gross profit as compared to other types of firms.• Wholesaler - an intermediary that sells inventory

items to retailers - incur few selling costs• Retailer - a company that sells items to the final users,

individuals


55Estimating IntraperiodGross Profit and Inventory

The gross profit percentage is very useful in estimating inventory amounts when related information is unavailable.• Companies that prepare interim financial statements

cannot take physical inventories each period.• They must rely on gross profit percentage or ratios to

estimate inventory amounts.


56Gross Profit Percentageand Turnover

Retailers often lower gross profit margins and selling prices and hope that the lower selling prices will increase sales volume enough to compensate for the lower gross profit.

One measure of sales level is inventory turnover - cost of goods sold divided by the average inventory held during the period.• It tells how fast inventory is sold.


57Gross Profit Percentageand Turnover

Industries with higher gross profit percentages tend to have the lowest inventory turnover.• Inventory turnover is especially effective for

assessing companies in the same industry.• A higher inventory turnover indicates an ability to use

smaller inventory levels to attain a high sales level.


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Adjusting from LIFO to FIFO

The LIFO reserve can answer two questions:• The change in the LIFO reserve from one year to

another answers the question “How much did this year’s LIFO cost of goods sold differ from the FIFO cost of goods sold?”

• The end of year level of the LIFO reserve answers the question “What has the total cumulative effect been on cost of goods sold over the years that LIFO has been used?”


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Internal Control of Inventories

Inventories are more easily accessible than cash in many instances, so internal controls must be in place to protect inventory. Retail merchants must contend with shoplifting and theft.

Internal controls over inventory:• Alert employees at the point of sale• Sensitized tags on merchandise that set off an alarm

as the item leaves the store• Surveillance cameras


60Shrinkage in Perpetual and Periodic Inventory Systems

In perpetual systems, shrinkage is simply the difference between the cost of inventory identified by a physical count and the clerical inventory balance.

The entries to record the shrinkage:Inventory shrinkage xxx

Inventory xxx

Cost of goods sold xxx

Inventory shrinkage xxx


61Shrinkage in Perpetual and Periodic Inventory Systems

In periodic systems, no clerical balance of inventory exists.

Inventory shrinkage is automatically included in cost of goods sold.• Beginning inventory plus purchases less ending

inventory measures all inventory that has flowed out, whether it was sold, stolen, or damaged.


62Inventory in a Manufacturing Environment

When a company manufactures products, the cost of inventory is a combination of the cost of raw materials, the wages paid to workers who make the product, and an allocation of costs of space, energy, and equipment used by the workers to make the product.


63Inventory in a Manufacturing Environment

Manufacturing firms have three types of inventory, each of which is in a different stage of completion.

Raw materials inventory - includes the cost of materials held for use in the manufacturing of a product

Work in process inventory - includes the cost incurred for partially completed items, including costs of raw materials, labor, and other costs

Finished goods inventory - the accumulated costs of manufacturing for goods that are complete and ready for sale

introduction to financial accounting

Business

physical inventory

beginning inventory

inventory levels

inventory times

lossof inventory

inventory turnover

heldin inventory

remaining inventory