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Chapter 6

Chapter 6 . Inventories & Cost of Goods Sold. Key Objectives & Concepts. Merchandise Inventories Inventory Valuation & Income Measurement Inventory Costing Assumptions (GAAP): Specific Identification Weighted Average First-In, First-Out (FIFO) Last-In, Last-Out (LIFO)

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Chapter 6

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  1. Chapter 6 Inventories & Cost of Goods Sold

  2. Key Objectives & Concepts • Merchandise Inventories • Inventory Valuation & Income Measurement • Inventory Costing Assumptions (GAAP): • Specific Identification • Weighted Average • First-In, First-Out (FIFO) • Last-In, Last-Out (LIFO) • Periodic vs. Perpetual Inventory Recording • Lower of Cost or Market (LCM) rule • Inventory Ratio Analysis

  3. Merchandise Inventory:Wholesale and Retail Companies • Goods are: • Purchased in finished form (“finished goods”) • Resold without further manufacturing • Classified as “Merchandise Inventory” on Balance Sheet

  4. Expense Inventory Inventory (A) Balance Sheet (Deferred Expense) Income Statement Cost of Goods Sold (E) Inventory Costing & Income Measurement When goods aresold, recordSalesand……. Follows the Matching Principle

  5. Relationships-Periodic InventoryInventory / CGS / Profit / Taxes /Cash Sales-COGS = GP - Op. Exp. =Inc.before Tax -Income Tax Exp.=NI • Higher Inventory Value (on B/S) => Lower CGS (on I/S) • Lower CGS (on I/S) => Higher Profits (on I/S) • Higher Profits (on I/S) => Higher Taxes (on I/S) • Higher Taxes (on I/S) => Lower Cash (on B/S) BEG INV. + PURCHASES = COGAS – ENDING INV. = COGS Summary: 2 general cases exist HIGHEREI => HIGHERPROFITS => LOWER CASH and conversely LOWER EI => LOWER PROFITS => HIGHERCASH

  6. Beginning Inventory * (A) $ 30,000 + Cost of Goods Purchased 100,000 Cost of Goods Available for Sale 130,000 -Ending Inventory * (A) 40,000 Cost of Goods Sold (E) $ 90,000 Calculating Cost of Goods Sold forPeriodic Inventory: A Review • An internal calculation needed for I/S * Must be determined by taking a physical inventory

  7. Internal calculation needed for I/S Beginning Inventory + Purchases = Cost of Goods Available for Sale -Ending Inventory Cost of Goods Sold (E) As presented on (multi-step) Income Statement Sales $200,000 Cost of goods sold 90,000 Gross margin 110,000 : : Net Income $ 30,000 Calculating Cost of Goods Sold forPeriodic Inventory:A Review

  8. Inventory Costing MethodsHow we determine key F/Samounts Cost of Goods Sold (E) Ending Inventory (A) Income Statement Balance Sheet COST OF GOODS AVAILABLE FOR SALE can only be accounted for in 1 of 2 accounts Cost of Goods Available for Sale $$$$$$ If goods were sold: If they’re still on hand:

  9. Inventory Costing MethodsObjective & Flows • Objective:We need $ amounts for COGS & EI on the financial statements (I/S and B/S) • ButPhysical Flows = Cost Flows(an assumption) – e.g., think of how goods flow in a grocery store. • How to proceed?We usecost flow assumptions(except for Specific Identification Method) to calculate COGS and EIwithout having to track physical flows. • Why?It is too costly to obtain exact information, which requires tracking exact physical flows.

  10. Inventory Costing MethodsAlternates for determining the I/S amounts Four alternate costing methods are available: Specific Identification Weighted Average First-in, First-out (FIFO) Last-in, First-out (LIFO)

  11. PERIODIC INVENTORY SYSTEMA REVIEW • Is a type of recording system. • AssetaccountInventory is updated only when a physical inventory is taken – i.e., units are actually counted at the end of the period. • Expenseaccount Purchases is used during the period to record all purchases from the company’s vendors. • Cost of Goods Sold and update of Inventory cannot be recorded for individual sales since the information is unknown. (System doesn’t record cost of individual sales) • COGS and EI are both updated at the end of the period (periodic). • Example follows 

  12. May 1 May 12 May 20 Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea. Illustrated Example - Ken’s Camera Shop Inventory Data: COGAS 4 @ $10.00 = $40.00 5 @ $10.20 = $51.00 3 @ $10.50 = $31.50 Total COGAS (Entire Period) = $122.50

  13. Specific Identification Cost-Flow Approach Assume Ken can identify and track the cost of each camera sold Sell five cameras in May sold sold sold sold sold May 1 May 12 May 20 Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea. Total COGAS = $122.50

  14. Cost of Five Cameras Sold Using Specific Identification Method: May 1 May 12 May 20 Cost of Goods Sold $10.00 sold 10.00 sold sold 10.20 10.20 sold 10.50 $50.90 sold May 1 May 12 May 20 Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea. Total COGAS= $122.50

  15. Cost of Goods Sold $50.90 Seven Cameras Unsold Using Specific Identification Method: May 1 May 12 May 20 unsold unsold Ending Inv. $10.00 unsold 10.00 10.20 unsold unsold 10.20 10.20 unsold 10.50 unsold 10.50 $71.60 Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea.

  16. Specific Identification Cost-Flow Approach Specific Identification Cost-Flow Approach Cost of Goods Available for Sale = $122.50 Approach allocates COGAS between Cost of Goods Sold (E) Ending Inventory (A) $50.90 $71.60 Income Statement Balance Sheet

  17. = Per Unit Cost Cost of Goods Available for Sale $$ Units Available for Sale for Period Weighted Average Cost Flow Assumptionand Periodic Inventory Method May 1 May 12 May 20 Assigns same unit cost to all units of inventory available for sale during a period

  18. Weighted Average Cost Flow Assumptionand Periodic Inventory Method May 1 May 12 May 20 = Per Unit Cost = Per Unit Cost Cost of Goods Available for Sale $$ Units Available for Sale for Period Cost of Goods Available for Sale $$ Units Available for Sale for Period Assigns same unit cost to all units of inventory available for sale during a period $122.50 $10.21/camera 12

  19. Cost of Five Cameras Sold Using Weighted Average Cost Assumption & Periodic Inventory: COGS = # units sold x unit cost =5 cameras @ $10.21 = $51.05(rounded) sold sold sold sold sold Weighted Average Cost = $10.21/camera

  20. Seven Cameras Unsold Using Weighted Average Cost Method: unsold unsold EI = # units Unsold x unit cost =7 cameras @ $10.21 = $71.45(rounded) unsold unsold unsold unsold unsold Weighted Average Cost = $10.21/camera

  21. Weighted Average Cost Flow Assumptionand Periodic Inventory Method Cost of Goods Available for Sale = $122.50 Assumption allocates CGAS between Cost of Goods Sold (E) Ending Inventory (A) $51.05 $71.45 Income Statement Balance Sheet

  22. Comparison of Costing Assumptions Cost of Goods Sold Ending Inventory Goods Available for Sale Weighted Average $51.05 $71.45 $122.50 FIFO TBD $122.50 TBD LIFO $122.50 TBD TBD

  23. FIFO Cost-Flow Assumption& Periodic Inventory Method May 1 May 12 May 20 First cameras purchased are assumedfirst sold Sold Sold unsold Sold unsold unsold Sold unsold unsold Sold unsold unsold Sell five cameras in May; Which ones? Remaining 7 cameras are Ending Inventory

  24. Cost of Five Cameras Sold Using FIFO Method & Periodic Inventory May 1 May 12 May 20 Cost of Goods Sold Sold Sold $10.00 unsold 10.00 Sold unsold unsold 10.00 10.00 Sold unsold unsold 10.20 $50.20 Sold unsold unsold Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea.

  25. Cost of Seven Cameras Unsold Using FIFO Method & Periodic Inventory May 1 May 12 May 20 Ending Inventory $10.20 unsold 10.20 unsold unsold 10.20 10.20 unsold unsold 10.50 10.50 unsold unsold 10.50 $50.20 Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea.

  26. FIFO Cost-Flow Assumption& Periodic Inventory Method Cost of Goods Available for Sale = $122.50 Assumption allocates CGAS between Cost of Goods Sold (E) Ending Inventory (A) $50.20 $72.30 Income Statement Balance Sheet

  27. Comparison of Costing Assumptions Cost of Goods Sold Ending Inventory Goods Available for Sale Weighted Average $51.05 $71.45 $122.50 FIFO $72.30 $122.50 $ 50.20 LIFO $122.50 TBD TBD

  28. LIFO Cost-Flow Assumption& Periodic Inventory Method May 1 May 12 May 20 Last cameras purchased are assumedfirst sold unsold unsold unsold Sold unsold unsold Sold unsold Sold unsold Sold Sold Sell five cameras in May; Which ones? Remaining 7 cameras are Ending Inventory

  29. Cost of Five Cameras Sold using LIFO Assumption & Periodic Inventory May 1 May 12 May 20 Cost of Goods Sold unsold unsold unsold 10.50 Sold unsold 10.50 unsold 10.50 unsold Sold 10.20 Sold 10.20 $51.90 unsold Sold Sold Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea.

  30. Cost of Seven Cameras Unsold using LIFO Assumption & Periodic Inventory May 1 May 12 May 20 Ending Inventory $10.00 unsold 10.00 unsold unsold 10.00 10.00 unsold unsold 10.20 10.20 unsold unsold 10.20 $70.60 Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea.

  31. LIFO Cost-Flow Assumptionand Periodic Inventory Method Cost of Goods Available for Sale = $122.50 Assumption allocates CGAS between Cost of Goods Sold (E) Ending Inventory (A) $51.90 $70.60 Income Statement Balance Sheet

  32. LIFO Issues • LIFO used on Tax Return • Then must be used for financial reporting purposes • LIFO Liquidation – Selling very old (low $ ) inventory out of Beginning Inventory • LIFO liquidation can result in high gross margin (and therefore large tax bill) • LIFO Reserve • DEFN: Difference between inventory value stated at FIFO and value stated at LIFO • Can be found in footnotes to Financial Statements

  33. Comparison of Costing Assumptions Cost of Goods Sold Ending Inventory Goods Available for Sale Weighted Average $71.45 $122.50 $51.05 FIFO $72.30 $122.50 $50.20 LIFO $122.50 $70.60 $51.90

  34. Inventory Choice & Cash Flow Impact(Assumes:Periodic inventory, Cash sales = $100 & Inventory bought on credit) Red = Lowest Black = Highest

  35. LIFO Cost-Flow Assumption and Periodic Inventory – Some Questions • Which do you think is more important? Reporting higher EI and NIusing FIFO, or Saving taxes (and Cash) using LIFO? Why? • Why/when would a company use FIFO? LIFO? • If you are the CEO, whose bonus is based on net income, which method would you select? Why? • If you’re a stockholder, which method would you prefer? Why? How do you motivate the CEO?

  36. PERPETUAL INVENTORY SYSTEM: A REVIEW • Inventory is updated for every purchase and sale. The asset account Inventory is used. • Cost of Goods Soldexpense & update of asset Inventory is recorded for each individual sale at the time of the sale. • Inventory cost assumptionswork the same way as periodic except COGS & EI is updated for every purchase and sale (by date) instead of waiting until the end of the period (periodic). • Examples follow 

  37. PERPETUAL INVENTORY SYSTEM Accounts Payable $3,000 Inventory $3,000 Assume a purchase of $3,000 in inventory on account with payment terms of 2/10, net 30. Reflect effect on B/S Equation. -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE+ Rev.- Expenses Perpetual method uses Inventory(A) account; Periodic usedPurchases(E)

  38. PERPETUAL INVENTORY SYSTEM(Reflects Matching Principle) A/R $1,600 Sales Revenue $1,600 Inventory ($1,000) COGS ($1,000) Sold merchandise for $1,600 with payment terms of 2/10, net 30. Cost of merchandise is $1,000. Record effect on B/S Equation. -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE+ Rev.- Expenses #1 Record the Sale #2 Record the Cost of the Sale

  39. PERPETUAL INVENTORY SYSTEM A: Inventory A/R $1,600 Sales Revenue $1,600 Inventory ($1,000) COGS ($1,000) E: Cost of Goods Sold PURCHSES $1,000 $3,000 $1,000 Inventory updated $2,000 -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE+ Rev.- Expenses Sales $1,600 - COGS 1,000 Gross Profit $600

  40. May 1 May 12 May 20 Cost = $10.00 ea. Cost = $10.20 ea. Cost = $10.50 ea. Ken’s Camera Shop - Perpetual InventoryInventory Purchases and Camera Sales May 10 Sell 3 units May 25 Sell 2 units Total COGAS $ (Entire Period) = $122.50

  41. Example-Perpetual Inventory Weighted-Average: $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 COGS EI Unit Cost Unit Cost DATE Purchase Total $ Total $ 5/1 $10.00 Average Unit Cost = $10.00 On May 1 purchase 4 cameras at $10.00 each

  42. Example-Perpetual Inventory Weighted-Average: COGS EI Unit Cost Unit Cost DATE Purchase Total $ Total $ $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 sold sold 5/1 $10.00 sold $10.00 5/10 $10.00 COGS = $30.00 On May 10 Ken sells 3 cameras at $25.00 each. What is the average unit cost? What is COGS? What is EI?

  43. Example-Perpetual Inventory Weighted-Average: COGS EI Unit Cost Unit Cost DATE Purchase Total $ Total $ ?????? $10.00 $10.20 $10.20 ?????? ?????? $10.20 $10.20 ?????? ?????? $10.20 5/12 ?????? ??? 5/12 On May 12 purchase 5 cameras at $10.20 each What is the average unit cost? Must be updated on a purchase.

  44. Example-Perpetual Inventory Weighted-Average: Weighted Average Cost COGAS $ = Units Available for Sale COGS EI Unit Cost Unit Cost DATE Purchase Total $ Total $ $10.17 ??? 5/12 $10.17 $10.17 $10.17 $10.17 $61.00 = = $10.17 $10.17 $10.17 6 $61.00 On May 12 purchase 5 cameras at $10.20 each What is the average unit cost? Must be updated on a purchase.

  45. Example-Perpetual Inventory Weighted-Average: COGS EI Unit Cost Unit Cost DATE Purchase Total $ Total $ $10.50 $10.50 $10.50 Weighted Average Cost COGAS $ = Units Available for Sale $10.28 ????? $10.17 5/20 5/12 $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 $92.50 $10.28 $10.28 $10.28 $10.28 = = $92.50 9 On May 20 purchase 3 cameras at $10.50 each What is the average unit cost? Must be updated after every purchase.

  46. Example-Perpetual Inventory Weighted-Average: $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 $10.28 X 2= $20.56 $10.28 x 7 = $71.94 7 COGS EI Unit Cost Unit Cost DATE Purchase Total $ Total $ sold sold $10.28 5/20 $92.50 5/25 On May 25 Sold 2 cameras at $22.00 each What is the average unit cost ,COGS and EI?

  47. Weighted Average Cost Flow Assumptionand Perpetual Inventory Method Cost of Goods Available for Sale = $122.50 Assumption allocates COGAS between Cost of Goods Sold (E) Ending Inventory (A) $30.00 + 20.56 = $50.56 $71.94 Income Statement Balance Sheet

  48. Comparison of Costing Assumptions using Perpetual Inventory Method Cost of Goods Sold Ending Inventory Goods Available for Sale Weighted Average $50.56 $71.94 $122.50 FIFO TBD $122.50 TBD LIFO $122.50 TBD TBD

  49. Illustrated Example - Perpetual Inventory FIFO: $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 COGS EI DATE Purchase Total $ Total $ 5/1 On May 1 purchase 4 cameras at $10.00 each

  50. Illustrated Example - Perpetual Inventory FIFO: COGS EI DATE Purchase Total $ Total $ $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 sold sold 5/1 sold 5/10 COGS = $30.00 On May 10 Sell 3 cameras at $25.00 each. What is COGS $ ? Where did they come from? What is EI $ ? Where did they come from?

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