Chapter 6

1. Chapter 6 Inventories and Cost of Goods Sold

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. • Choose one of the four principal inventory valuation methods. • Calculate the impact on net income of LIFO liquidations.

3. 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.

4. Gross 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 revenues 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 Net Sales to determine Gross Profit.

5. Gross Profit andCost 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 and Administrative Expenses Equals Net Income

6. The Basic Concept ofInventory Accounting • The key to calculating cost of goods sold is accounting for the remaining inventory at the end of the year. • 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.

7. Perpetual 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 - a system in 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

8. Perpetual and PeriodicInventory Systems • 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. • Inventory items must be counted at least once a year to ensure correct valuation. • Physical count - the process of counting all the items in inventory at a moment in time

9. Perpetual and PeriodicInventory Systems • 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

10. Perpetual and PeriodicInventory Systems • In a periodic system, no day-to-day inventory records are maintained. • The physical count allows management to delete damaged or obsolete items and thus helps to reveal inventory shrinkage - inventory reductions from theft, breakage, or losses of inventory.

11. Perpetual and PeriodicInventory Systems • Under the periodic system, calculations for cost of goods sold start with cost of goods available for sale, which is the sum of the beginning inventory plus current year purchases. • Under the perpetual system, cost of goods sold is kept on a day-to-day basis.

12. Perpetual and PeriodicInventory Systems • Calculation of Cost of Goods Sold: Beginning inventory (by physical count) $ 25,000 Add: Purchases 90,000 Cost of goods available for sale $115,000 Less: Ending inventory (by physical count) 33,000 Cost of goods sold $ 82,000 ====================

13. Perpetual and PeriodicInventory Systems • Both methods produce the same cost of goods sold figure. • The perpetual system is more timely, but it is more costly to administer. • The perpetual system is less costly to administer because there is no day-to-day processing regarding inventory costs or cost of goods sold.

14. 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.

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

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

17. Transportation Charges • In theory, any costs of transportation borne by the buyer should be added to the cost of the inventory acquired. • However, 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.

18. Transportation Charges • 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.

19. 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: Accounts payable 80,000 Purchase returns and allowances 80,000

20. Detailed Gross Profit Calculation Gross 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, 1/1/2002 $ 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, 12/31/2002 9,000 Cost of good sold 124,500 Gross profit $ 47,000 =============

21. Comparing 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. • In the periodic system, purchases of merchandise increase the Purchases account, and purchase returns and allowances are placed in separate accounts that are deducted from Purchases. • Sales of merchandise have no effect on the Purchases account.

22. Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems • 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 entry is made to adjust the Inventory account to that amount.

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

24. Principal 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 (income measurement) and inventories (asset measurement) are affected. • The choice of the inventory valuation method can significantly affect the amount reported as net income and ending inventory.

25. 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 • Works best for relatively expensive low-volume merchandise, such as automobiles or jewelry

26. FIFO • FIFO (first in, first out) method - assigns the cost of the earliest acquired units to cost of goods sold • This might not be the actual physical flow of goods within the company. • Under FIFO, the oldest units are deemed to be sold, regardless of which units are actually given to the customer. • The costs of the newer units in stock are included in ending inventory.

27. FIFO • FIFO includes the most recent costs 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.

28. LIFO • LIFO (last in, first out) method - assigns the most recent costs to cost of goods sold • This might not be the actual physical flow of goods within the company. • Under LIFO, the newest units are deemed to be sold, regardless of which units are actually given to the customer. • The costs of the older units in stock are included in ending inventory.

29. 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.

30. 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.

31. LIFO • If LIFO is such a good deal, why do some companies still use FIFO? • For several reasons: • The 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.

32. 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

33. 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.

34. 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? = $4.15

35. 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.

36. 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.

37. 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.

38. 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 may change inventory methods for justifiable reasons, such as changes in market conditions.

39. Characteristics 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.

40. Holding 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.

41. Holding Gains andInventory Profits • The difference between profit measured under FIFO and LIFO is called a holding gain or an 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.

42. 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.

43. LIFO Layers • Many companies show inventories that have LIFO layers dating as far back as 1940, when LIFO was first used. • 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.

44. 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, that is, units in the older LIFO layers are sold. • 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.

45. 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 effect on gross profit over all prior years due to LIFO.

46. Adjusting from LIFO to FIFO • When lower costs are used to calculate cost of goods sold under LIFO, cost of goods sold will be lower and net income will be higher. • 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?”

47. Lower-of-Cost-or-Market Method (LCM) • Lower-of-cost-or-market (LCM) method - the superimposition 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.

48. Lower-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.

49. 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 Merchandise inventory xxx

50. Conservatism in Action • The LCM method reports less net income in the period of decline in market value and more net income in the period of sale. • The LCM method affects how much income is reported in each year, but not the total income over the company’s life.