Inventories and Cost of Goods Sold

1. Inventories andCost of Goods Sold CHAPTER 7

2. 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 • Compute income and inventory values using the four principal inventory valuation methods • Calculate the impact on net income of LIFO liquidations • Use the lower-of-cost-or-market method to value inventories

3. Learning Objectives After studying this chapter, you should be able to • Show the effects of inventory errors on financial statements • Evaluate the gross profit percentage and inventory turnover

4. Gross Profit and Cost of Goods Sold • Companies report products being held prior to sale as inventory—a current asset on the balance sheet • When the products are sold, the cost of the inventory becomes Cost of Goods Sold in the income statement • Net Sales less Cost of Goods Sold equals Gross Profit • Gross Profit less additional expenses equals Net Income

5. Gross Profit and Cost of Goods Sold Balance Sheet Income Statement Sales Minus Merchandise Purchases Merchandise Sales Cost of Goods Sold (an expense) Merchandise Inventory Equals Gross Profit Minus Selling Expenses and Administrative Expenses Equals Net Income

6. Perpetual and Periodic Inventory Systems • There are two main systems for keeping inventory records: • Perpetual system • Periodic system • The perpetual inventory system keeps a continuous record of inventories and cost of goods sold • The periodic inventory system computes cost of goods sold and an updated inventory balance only at the end of the accounting period

7. Perpetual Inventory System • In the perpetual inventory system, the journal entries are: • When inventory is purchased: • When inventory is sold: Merchandise inventory xxx Accounts payable xxx Accounts receivable xxx Sales xxx Cost of goods sold xxx Inventory xxx

8. Periodic Inventory System • Under the periodic system, the calculation of cost of goods sold is delayed until there is a physical count:

9. Physical Inventory • Inventory control procedures require a physical count of items held in inventory at least annually in both periodic and perpetual inventory systems • Firms often choose fiscal accounting periods so that the year ends when inventories are low • External auditors usually observe the client’s physical count and confirm its accuracy

10. Cost of Merchandise Acquired • The cost of merchandise includes the invoice price plus the directly identifiable inbound transportation charges less any offsetting discounts • The costs of purchasing and receiving are period costs and are charged on the income statement as they occur

11. Transportation Charges • When the seller bears the transportation cost, the sales invoice reads free onboard or F.O.B. destination • When the buyer bears the transportation cost, it reads F.O.B. shipping point • In practice, accountants frequently use a separate transportation cost account, Freight-in • Freight-in appears in the purchases section of an income statement as an additional cost of the goods acquired during the period

12. Returns, Allowances, and Discounts • Using the periodic inventory system, suppose a company’s gross purchases are $960,000 and purchase returns and allowances are $75,000. The summary journal entries are: Purchases 960,000 Accounts payable 960,000 Accounts payable 75,000 Purchase returns and allowances 75,000

13. Returns, Allowances, and Discounts • Suppose also that the company takes cash discounts of $5,000 on payment of the remaining $960,000 - $75,000 = $885,000 of payables. The summary journal entry is: • To calculate cost of goods sold, Cash Discounts on Purchases and Purchase Returns and Allowances are subtracted from Purchases Accounts payable 885,000 Cash discounts on purchases 5,000 Cash 880,000

14. Detailed Gross Profit Calculation($ in thousands)

15. Principal Inventory Valuation Methods • In both systems, we must determine the costs of individual items by some inventory valuation method. • Four principal inventory valuation methods are generally accepted: • Specific identification • First-in, first-out (FIF0) • Last-in, first out (LIFO) • Weighted-average

16. Specific Identification • The specific identification method concentrates on physically linking the particular items sold with the cost of goods sold that is reported • This method is relatively easy to use for expensive low-volume merchandise • The use of bar cods and scanning equipment makes specific identification economically feasible for many companies

17. FIFO • FIFO assigns the cost of the earliest acquired units to cost of goods sold • The costs of the newer units is assigned to the units in ending inventory • FIFO provides inventory valuations that closely approximate the actual market value of the inventory at the balance sheet date • In periods of rising prices, FIFO leads to higher net income

18. LIFO • LIFO assigns the most recent cost to cost of goods sold • LIFO provides an income statement perspective in that net income measured using LIFO combines current sales prices and current acquisition costs • In a period of rising prices and constant or growing inventories, LIFO yields lower net income • The Internal Revenue Cods requires companies that use LIFO for tax purposes to also use it for financial reporting purposes

19. Weighted Average • The 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 • The weighted-average method produces gross profit somewhere between that obtained under FIFO and LIFO

20. Inventory Valuation Methods Example • Assume a vendor of soft drinks starts out the week with no inventory • He buys and sells cola as follows: • Buys one can on Monday for 30 cents • Buys one can on Tuesday for 40 cents • Buys one can on Wednesday for 56 cents • Sells one can on Thursday for 90 cents • The next slide shows the vendor’s cost of goods sold and ending inventory under the four methods

21. Inventory Valuation Methods Example

22. Cost Flow Assumptions • Companies may choose any of the four methods to record cost of goods sold • Three out of the four methods are not linked to the physical flow of merchandise • Accountants often refer to inventory methods as cost flow assumptions

23. Inventory Cost Relationships • The difference in the four methods centers on how inventory costs are allocated between inventory and cost of sales • The difference between FIFO and LIFO is:

24. The Consistency Convention • Companies can choose any inventory cost flow assumption, but they must be consistent over time with the method they choose • Consistency is defined as “conformity from period to period with unchanging policies and procedures” • A change in market conditions may justify a change in inventory method • The firm must note the change in its financial statements

25. Characteristics and Consequences of LIFO • LIFO • Is widely used in the United States • Has strong tax benefits for companies • Has some unusual features • Few companies outside the U. S. use LIFO

26. Holding Gains and Inventory Profits • LIFO matches the most recent acquisition cost with sales revenues • LIFO cost of goods sold typically offers a close approximation to the replacement cost • Reported net income rarely contains significant holding gains • FIFO reports a profit which includes an economic profit plus the holding gain because the value of the inventory rises over time

27. LIFO Layers • A LIFO layer is an addition to inventory at an identifiable cost level • As a company grows, the LIFO layers pile on top of one another over the years • LIFO inventory values may be far below market value or current replacement value of the inventory • While LIFO better presents the economic reality on the income statement, FIFO provides more current valuations on the balance sheet

28. LIFO Inventory Liquidations • A LIFO liquidation occurs when the physical amount of inventory decreases, and the cost of goods sold consists of old, low inventory acquisition costs associated with old LIFO layers • A LIFO liquidation means that the current year’s income includes the cumulative inventory profit from years of increasing prices

29. LIFO Inventory Liquidations • The difference between a company’s LIFO inventory level and what it would be under FIFO is called a LIFO reserve • Most companies that use LIFO explicitly measure and report their LIFO reserve on the balance sheet itself or in the footnotes

30. Lower-of-Cost-or-Market Method • The lower-of-cost-or-market method (LCM) requires a comparison of the current market price of inventory with historical cost derived under one of the four primary methods used • The lower of the two amounts is reported as the inventory value

31. Role of Replacement Cost • Market price is generally considered to be the replacement cost of the inventory item—what it would cost to buy the inventory item today • A write-down reduces the recorded historical cost of an item in response to a decline in value • The required journal entry for a write-down is: Loss on write-down of inventory (or cost of goods sold) XX Inventory XX

32. Effects of Inventory Errors • An undiscovered inventory error usually affects two reporting periods • The error will cause misstated amounts in the period in which the error occurred, but the effects will then be counterbalanced by identical offsetting amounts in the following period • If ending inventory is understated, retained earnings in understated • If ending inventory is overstated, retained earnings is overstated

33. Cutoff Errors and Inventory Valuation • Cutoff errors are failures to record transactions in the correct time period • Legal transfer of ownership controls the recording of purchases and sales near the year-end • The pressure for profits may cause managers to • Delay the recording of purchases • Include sales orders in revenues

34. The Importance of Gross Profits • Management and investors are interested in gross profit and how it changes over time • Gross profit is often expressed as a percentage of sales • Wholesalers have smaller gross profit percentages than retailers • R&D is treated as a period cost and not a product cost; thus, pharmaceutical companies have relatively high gross profit margins Gross profit % = Gross profit Sales

35. Estimating Intraperiod Gross Profit and Inventory • The gross profit percentage can be used to estimate ending inventory balances for monthly or quarterly reports • Suppose a Home Depot Store has quarterly sales of $10 million and usually has a gross profit percentage of 30%. Cost of goods sold can be estimated as: Sales – Cost of goods sold = Gross profit $10M – CGS = .30 x $10M CGS = $7M

36. Estimating Intraperiod Gross Profit and Inventory • Also assume the beginning inventory is $5 million and purchases are $7.1 million. Ending inventory can be estimated as: Beginning inventory + Purchases – Ending Inventory = CGS $5M + $7.1M – EI = $7.0M EI = $5.1M

37. Gross Profit Percentage and Turnover • Inventory turnover relates sales levels to inventory levels • Inventory turnover in the previous Home Depot example would be: Turnover = Cost of goods sold / Average inventory = $7M / $5.05M = 1.4

38. Gross Profit Percentage and Turnover • Industries with higher gross profit percentages tend to have lower inventory turnover • Example: lower turnover for jewelers and drug manufactures means that they need a higher gross profit margin to cover the high costs of selling or research • Inventory turnover is especially effective in assessing companies in the same industry • Higher turnover is associated with greater efficiency

39. Gross Profit Percentages and Accuracy of Records • The gross profit percentage can be used to prove the accuracy of the accounting records • An unusually low percentage may mean the company has tried to avoid taxes by failing to record all sales • Some other factors that may cause a decline in the percentage are • Price wars that reduce selling prices • Shifting of the product mix sold • Increase in shoplifting or embezzlement

40. Internal Control of Inventories • Inventory shrinkage can result from customer shoplifting or employee embezzlement • The best deterrent for shoplifting is an alert employee at the point of sale • Retail stores also use: • Sensitized tags on merchandise • Surveillance cameras

41. Shrinkage in Perpetual Inventory Systems • Shrinkage is the difference between the cost of inventory from a physical count and the inventory balance in the general ledger • The journal entries to record shrinkage under a perpetual inventory system would be: Inventory shrinkage XXX Inventory XXX To adjust inventory to its balance per physical count Cost of goods sold XXX Inventory shrinkage XXX To transfer inventory shrinkage to cost of goods sold

42. Shrinkage in Periodic Inventory Systems • A periodic inventory system has no running balance in the inventory account • Cost of goods sold automatically includes inventory shrinkage by virtue of the system • Shrinkage is much more difficult to isolate in the periodic system