Week 9/ 10, Chap7 Accounting 1A, Financial Accounting

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1 Week 9/ 10, Chap7 Accounting 1A, Financial Accounting Reporting and Interpreting Cost of Goods Sold and Inventory Instructor: Michael Booth

2 Understanding the Business Primary Goals of Inventory Management Provide sufficient quantities of highquality inventory. Minimize the costs of carrying inventory.

3 Apply the cost principle to identify the amounts included in inventory matching principle to determine cost of goods

4 Items Included in Inventory Inventory Work in Process or In-transit Held for Re-Sale Raw Material:Used to Produce Goods or Services Merchandise Inventory Raw Materials Inventory Work in Process Inventory Finished Goods Inventory

5 Costs Included in Inventory Purchases The cost principle requires that inventory be recorded at the price paid or the consideration given. Invoice Price Freight Inspection Costs Preparation Costs

6 Flow of Inventory Costs Merchandiser Merchandise Purchases Merchandise Inventory Cost of Goods Sold Manufacturer Raw Materials Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Direct Labor Factory Overhead Cost of Goods Sold

7 Nature of Cost of Goods Sold Beginning Inventory Purchases for the Period Goods available for Sale Ending Inventory (Balance Sheet) Cost of Goods Sold (Income Statement) Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale Ending inventory = Cost of goods sold

8 Report inventory and cost of goods sold using the four inventory costing methods. 1. LIFO 2. FIFO 3. Specific Identification 4. Weighted Average

9 Inventory Costing Methods Specific Identification FIFO LIFO Weighted Average

10 Inventory Costing Methods Total Dollar Amount of Goods Available for Sale Inventory Costing Method Ending Inventory Cost of Goods Sold

11 Specific Identification When units are sold, the specific Car Dealership cost of the unit sold is added to cost of goods sold. Custom homes

12 Cost Flow Assumptions The choice of an inventory costing method is not based on the physical flow of goods on and off the shelves.

13 First-In, First-Out Method (FIFO) Oldest Costs Cost of Goods Sold Prior price for material purchased Recent Costs Ending Inventory Most recent price for material purchased

14 Computers, Inc. First-In, Mouse First-Out Pad Inventory Date Units $/Unit Total Beginning Inventory 1,000 $ 5.25 $ 5, Purchases: Jan , June , Sept , Nov , Goods Available for Sale 2,250 $ 12, Ending Inventory 1,200? Cost of Goods Sold 1,050? Remember: The costs of most recent purchases are in ending inventory. Start with 11/29 and add units purchased until you reach the number in ending inventory.

15 First-In, First-Out Given Information Ending Inventory Cost of Goods Sold Beg. Inv. $ 5.25 Jan June Sept Nov $ Units Units

16 First-In, First-Out Cost of Goods Given Information Ending Inventory Sold Beg. Inv. $ 5.25 Jan $5.30 June $5.60 Sept $5.80 Nov $5.90 1,200 Units Units $ 6,695 Cost Now, we have allocated the cost to all 1,200 units in ending inventory.

17 First-In, First-Out Cost of Goods Given Information Ending Inventory Sold Beg. Inv. $ 5.25 $ 5.25 Jan $ June $5.60 Sept $5.80 Nov $5.90 1,200 Units 1,050 Units $ 6,695 Cost $ 5,515 Cost Now, we have allocated the cost to all 1,050 units sold.

18 Cost of Goods Sold 1,050 $ 5, First-In, Computers, First-Out Inc. Mouse Pad Inventory Date Units $/Unit Total Beginning Inventory 1,000 $ 5.25 $ 5, Purchases: Jan , June , Sept , Nov , Goods Available for Sale 2,250 $ 12, Ending Inventory 1,200 $ 6, Here is the cost of ending inventory and cost of goods sold using FIFO.

19 First-In, First-Out Method (FIFO) Oldest Costs Cost of Goods Sold Prior price for material purchased Recent Costs Ending Inventory Most recent price for material purchased

20 In Class Exercise (AP7-1, page 374) Do one task at a time After the completion of Task 2 (FIFO), we will review how to calculate

21 In Class Exercise AP 7-1(FIFO) Transactions Units Unit Cost Total Cost Beginning Inventory Purchase, Feb 20 Purchase, June 30 Sale ($50 ea) 70 Sale ($50 ea) $32 $12, $23, $17,020

22 In Class Exercise AP 7-1 (FIFO) Transactions Units Unit Cost Total Cost Beginning Inventory Purchase, Feb 20 Purchase, June 30 Goods Available for Sale 390 $32 $12, $23, $17,020 1,550 $53,300

23 First-in, First out (FIFO) COGS 390 x $32 = $12, x $34 = $14,620 Total = $27,100 Ending Inventory 270 x $34 =$9, x $37 =$17,020 Total = $26,200

24 First-In, First-Out Method (FIFO) Oldest Costs Cost of Goods Sold Prior price for material purchased Recent Costs Ending Inventory Most recent price for material purchased

25 Last-In, First-Out Method (LIFO) Oldest Costs Ending Inventory Prior price for material purchased Recent Costs Cost of Goods Sold Most recent price for material purchased

26 Cost of Goods Sold 1,050? Last-In, Computers, First-Out Inc. Mouse Pad Inventory Date Units $/Unit Total Beginning Inventory 1,000 $ 5.25 $ 5, Purchases: Jan , June , Sept , Nov , Goods Available for Sale 2,250 $ 12, Ending Inventory 1,200? Remember: The costs of the oldest purchases are in ending inventory. Start with beginning inventory and add units purchased until you reach the number in ending inventory.

27 Last-In, First-Out(LIFO) Cost of Goods Given Information Ending Inventory Sold Beg. Inv. $ 5.25 Jan $ 5.30 June Sept Nov ,050 Units $ 5,900 Cost Now, we have allocated the cost to all 1,050 units sold.

28 Last-In, First-Out(LIFO) Cost of Goods Given Information Ending Inventory Sold Beg. Inv. $ 5.25 Jan $ 5.30 June Sept Nov ,200 Units 1,050 Units Now, allocate the cost to to remaining inventory units $ 5,900 Cost

29 Last-In, First-Out(LIFO) Cost of Goods Given Information Ending Inventory Sold Beg. Inv. $ 5.25 $5.25 Jan $ 5.30 June Sept Nov ,200 Units 1,050 Units $ 6,310 Cost $ 5,900 Cost Now, allocate the cost to to remaining 1,200 inventory units

30 Cost of Goods Sold 1,050 $ 5, Last-In, Computers, First-Out Inc. Mouse Pad Inventory Date Units $/Unit Total Beginning Inventory 1,000 $ 5.25 $ 5, Purchases: Jan , June , Sept , Nov , Goods Available for Sale 2,250 $ 12, Here is the cost of ending inventory and cost of goods sold using LIFO. Ending Inventory 1,200 $ 6,310.00

31 In Class Exercise (AP7-1, page 379) Do one task at a time After the completion of Task 3(LIFO), we will review how to calculate

32 In Class Exercise AP 7-1(LIFO) Transactions Units Unit Cost Total Cost Beginning Inventory Purchase, Feb 20 Purchase, June 30 Sale ($50 ea) 70 Sale ($50 ea) $32 $12, $23, $17,020

33 In Class Exercise AP 7-1(LIFO) Transactions Units Unit Cost Total Cost Beginning Inventory Purchase, Feb 20 Purchase, June 30 Goods Available for Sale 390 $32 $12, $23, $17,020 1,500 $53,300

34 Last-in, First out (LIFO) COGS 460 x $37 = $17, x $34 = $12,240 Total = $29,260 Ending Inventory 340 x $34 =$11, x $32 =$12,480 Total = $24,040

35 Inventory Costing Methods Specific Identification FIFO Matches Market cost for goods sold LIFO Matches market cost for Merchandise Inv. Weighted Average

36 Average Cost Method When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Cost of Goods Available for Sale Number of Units Available for Sale COGS

37 Cost of Goods Sold 1,050 Average Computers, Cost Inc. Method Mouse Pad Inventory Date Units $/Unit Total Beginning Inventory 1,000 $ 5.25 $ 5, Purchases: Jan , June , Sept , Nov , Goods Available for Sale 2,250 $ 12, Weighted Average Cost $ 12,210 2,250 = $ Ending Inventory 1,200

38 Average Computers, Cost Inc. Method Mouse Pad Inventory Date Units $/Unit Total Beginning Inventory 1,000 $ 5.25 $ 5, Purchases: Jan , June , Sept , Nov , Goods Available for Sale 2,250 $ 12, Ending Inventory 1,200 $ 6, Cost of Goods Sold 1,050 $ 5, Weighted Average Cost $ 12,210 2,250 = $ ,200 $ ,050 $

39 In Class Exercise (AP7-1, page 379) Do one task at a time After the completion of Task 1(Weighted Average), we will review how to calculate

40 In Class Exercise AP 7-1(Weighted Average) Transactions Units Unit Cost Total Cost Beginning Inventory Purchase, Feb 20 Purchase, June 30 Sale ($50 ea) 70 Sale ($50 ea) $32 $12, $23, $17,020

41 In Class Exercise AP 7-1 (Weighted Average) Transactions Units Unit Cost Total Cost Beginning Inventory Purchase, Feb 20 Purchase, June 30 Goods Available for Sale 390 $32 $12, $23, $17,020 1,550 $53,300

42 Weighted Average Goods Available Sale/ Total Units $53,300/1,550 = $34.39 per unit Ending inventory $53,300 (820 * $34.39) = $25,100 COGS (820 * $34.39) = $28,200

43 Comparison of Methods Computers, Inc. Income Statement For Year Ended December 31, 2006 FIFO LIFO Weighted Average Net sales $ 25,000 $ 25,000 $ 25,000 Cost of goods sold: Merchandise inventory, beginning $ 5,250 $ 5,250 $ 5,250 Net purchases 6,960 6,960 6,960 Goods available for sale $ 12,210 $ 12,210 $ 12,210 Merchandise inventory, ending 6,695 6,310 6,512 Cost of goods sold $ 5,515 $ 5,900 $ 5,698 Gross profit $ 19,485 $ 19,100 $ 19,302 Operating expenses Income before taxes $ 18,735 $ 18,350 $ 18,552 Income taxes expense (30%)* 5,621 5,505 5,566 Net income $ 13,114 $ 12,845 $ 12,986 For period of rising prices

44 In Class Exercise AP 7-1(Specific Identification) Transactions Units Unit Cost Total Cost Beginning Inventory Purchase, Feb 20 Purchase, June 30 Sale ($50 ea) 70 Sale ($50 ea) $32 $12, $23, $17,020

45 In Class Exercise AP 7-1(Specific Identification) Transactions Units Unit Cost Total Cost Beginning Inventory Purchase, Feb 20 Purchase, June 30 Goods Available for Sale 390 $32 $12, $23, $17,020 1,500 $53,300

46 Specific Identification COGS 70 * 2/5 = 28 units Beginning Inv = = 362 units 42 units Feb 20 Purchase = = 658 units units (remaining beginning) = 388 units 388 units from June 30 Purchase COGS = 390 *$32 = $12, * $34 = $ 1, * $37 = $14,356 Total = $28,264 Ending Inventory $53,300 - $28,264 = $25,036

47 Financial Statement Effects of Costing Methods Advantages of Methods First-In, First-Out Last-In, First-Out Weighted Average Ending inventory approximates current replacement cost. Better matches current costs in cost of goods sold with revenues. Smoothes out price changes.

48 When the use of different inventory costing methods is beneficial to a company.

49 Managers Choice of Inventory Methods Net Income Effects Managers prefer to report higher earnings for their companies. Income Tax Effects Managers prefer to pay the least amount of taxes allowed by law as late as possible.

50 Choosing Inventory Costing Methods If... Then... LIFO Conformity LIFO for taxes Rule LIFO for books

51 Report inventory at the lower of cost or market (LCM).

52 Valuation at Lower of Cost or Market Ending inventory is reported at the lower of cost or market (LCM). Replacement Cost The current purchase price for identical goods. The company will recognize a holding loss in the current period rather than the period in which the item is sold. This practice is conservative.

53 Valuation at Lower of Cost or Market Item Quantity Cost Replacement Cost LCM Total LCM Intel 9 Series Chips 1,000 $ 250 $ 200 $ 200 $ 200,000 1 TB Disk drives ,000 GENERAL JOURNAL Date Description Debit Credit Cost of goods sold 50,000 Inventory 50,000 Inventory cost= 1,000 x $250 = $250,000 LCM Adjustment = $250,000 - $200,000 = $50,000

54 Inventory management: The inventory turnover ratio Effects of inventory on cash flows.

55 Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory Average Inventory is... (Beginning Inventory + Ending Inventory) 2 This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly thus reducing storage and obsolescence costs.

56 Inventory and Cash Flows Subtract Increase in Inventory Decrease in Accounts Payable Cost of Goods Sold Cash Payment to Suppliers Add Decrease in Inventory Increase in Accounts Payable

57 Compare companies that use different inventory costing methods.

58 Inventory Methods and Financial Statement Analysis U.S. public companies using LIFO also report beginning and ending inventory on a FIFO basis if the FIFO values are materially different. Beginning inventory FIFO - Beginning inventory LIFO Beginning LIFO Reserve (Excess of FIFO over LIFO) Ending inventory FIFO - Ending inventory LIFO Ending LIFO Reserve (Excess of FIFO over LIFO) Beginning LIFO Reserve - Ending LIFO Reserve Difference in COGS Under FIFO

59 LIFO and International Comparisons No LIFO Permitted? Yes Singapore China Canada Australia Great Britain

60 Understand methods for controlling and keeping track of inventory and analyze the effects of inventory errors on financial statements.

61 Internal Control of Inventory Separation of inventory accounting and physical handling of inventory. Storage in a manner that protects from theft and damage. Limiting access to authorized employees. Maintaining perpetual inventory records. Comparing perpetual records to periodic physical counts.

62 Perpetual and Periodic Inventory Systems Perpetual System Provides up-to-date inventory records. Detailed inventory record Purchase transctions are direct to Inv Each sales is matched directly with COGS; decressing inventory and posting COGS Provides up-to-date cost of sales records. In a periodic inventory system, ending inventory and cost of goods sold are determined at the end of the accounting period based on a physical count.

63 Perpetual and Periodic Inventory Systems Inventory System Item Beginning Inventory Add: Purchases Less: Ending Inventory Cost of Goods Sold Periodic System Perpetual System Carried over from prior period Accumulated in the Purchases account Measured at end of period by physical inventory count Computed as a residual amount at end of period Carried over from prior period Accumulated in the Inventory account Perpetual record updated at every sale Measured at every sale based on perpetual record

64 Errors in Measuring Ending Inventory Errors in Measuring Inventory Ending Inventory Beginning Inventory Effect on Current Period's Balance Sheet Overstated Understated Overstated Understated Ending Inventory + - N/A N/A Retained Earnings Effect on n Current Period's Income Statement Goods Available for Sale N/A N/A + - Cost of Goods Sold Gross Profit Net Income

65 Additional Issues in Measuring Purchases

66 Purchase Returns and Allowances Purchase returns and allowances are a reduction in the cost of purchases associated with unsatisfactory goods. Returned goods require a reduction in the cost of inventory purchases and the recording of a cash refund or a reduction in the liability to the vendor.

67 Purchase Discounts A purchase discount is a cash discount received for prompt payment of an account. Terms Time Due Discount Period Full amount less discount Credit Period Full amount due Purchase or Sale

68 Purchase Discounts 2/10,n/30 Discount Percent Number of Days Discount Is Available Otherwise, Net (or All) Is Due Credit Period

69 Purchase Discounts Purchases paid for within the discount period reduce the Inventory account for the amount of the cash discount received.

70 Comparison of Perpetual and Periodic Inventory Systems

71 Perpetual Inventory System Jan. 1 Had beginning inventory of 800 units at a unit cost of $50. Apr. 14 Purchased 1,100 units at a unit cost of $50. Inventory 55,000 Accounts payable 55,000 Nov. 30 Sold 1,300 units at a sales price of $83. Accounts receivable 107,900 Sales revenue 107,900 Cost of goods sold 65,000 Inventory 65,000 Dec. 31 Use cost of goods sold and inventory amounts.

72 Periodic Inventory System Jan. 1 Had beginning inventory of 800 units at a unit cost of $50. Apr. 14 Purchased 1,100 units at a unit cost of $50. Purchases 55,000 Accounts payable 55,000 Nov. 30 Sold 1,300 units at a sales price of $83. Accounts receivable 107,900 Sales revenue 107,900 Dec. 31 Count the number of units on hand. Compute the dollar valuation of the ending inventory. Compute and record the cost of goods sold. Inventory (beginning) 40,000 Purchases 55,000 Total Inventory Available for Sale 95,000 Inventory (ending) (30,000) Cost of goods sold 65,000

73 Assignments: See web: http//cabrillo.blackboard.edu This will be updated weekly as required Update your weekly journal for the Final Journal Work weekly on your final project, do the analysis with information learned during the week

74 Weighted Average Goods Available Sale/ Total Units $53,300/1,550 = $34.39 per unit Ending inventory $53,300 (820 * $34.39) = $25,100 COGS (820 * $34.39) = $28,200