4/10/2012. Inventories and Cost of Goods Sold. Learning Objectives (LO) Learning Objectives (LO) LO 1 Gross Profit and Cost of Goods Sold

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1 Learning Objectives (LO) Inventories and Cost of Goods Sold CHAPTER 7 After studying this chapter, you should be able to 1. Link inventory valuation to gross profit 2. Use both perpetual and periodic inventory systems 3. Calculate the cost of merchandise acquired 4. Compute income and inventory values using the three principal inventory valuation methods allowed under both U.S. GAAP and IFRS and the one method allowed only by U.S. GAAP 5. Use the lower-of-cost-or-market method to value inventories under U.S. GAAP and IRFS 2of 42 Learning Objectives (LO) LO 1 Gross Profit and Cost of Goods Sold After studying this chapter, you should be able to Balance Sheet Income Statement 6. Show the effects of inventory errors on financial statements 7. Evaluate the gross profit percentage and inventory turnover 8. Describe characteristics of LIFO and how they affect the measurement of income (App. 7A) Merchandise Purchases Merchandise Inventory Current Asset Merchandise Sales Sales Minus Cost of Goods Sold (an expense) Equals Gross Profit Minus Selling Expenses and Administrative Expenses 3of 42 Equals operating Income 4of 42 Purchase inventory (both systems) (LO 3) Merchandise Inventory 960 Accounts Payable 960 Record revenue en e (both systems) stems) when inventory is sold Accounts Receivable 1,740 Sales Revenue 1,740 Perpetual System at each sale Cost of Goods Sold (COGS) 870 Merchandise Inventory 870 Beginning balance 100 Purchases Available for sale 1,010 Cost of goods sold 870 Ending balance 140 (Derived) Ending inventory count identifies spoilage, theft, etc. 5of 42 6of 42 1

2 Periodic System at each sale No entry is made so at year-end, do not have an up to date inventory count or COGS. Must conduct an ending inventory count. Beginning balance 100 Purchases +910 Available for sale 1,010 Ending Balance 140 Cost of Goods Sold 870 (Derived) Spoilage/theft, etc. buried in COGS Ending inventory count Required under a periodic system A good control practice in a perpetual systems Firms often choose fiscal accounting periods so that the year ends when inventories are low External auditors usually observe a sample of the client s physical count to confirm its accuracy 7of 42 8of 42 Product Costs Easily associated with a specific product or inventory Product costs attach to COGS/Inventory, thus making those accounts larger and expenses smaller. Period Costs Easier to associate with the reporting period than with a specific product or inventory item Period costs do not get attached to COGS/Inventory. They become expenses on the income statement making them larger and COGS/Inventory smaller. Company policy determines which are which Possible costs added to the inventory costs besides the purchase price itself Transportation (freight) in Handling Insurance Discounts that reduce these costs Quantity Early/quick payment Vendor rebates Purchase returns and allowances 9of of 42 Transportation FOB (Free on Board) Destination - Seller pays for delivery to us, the buyer; title transfers on receipt No entry FOB (Free on Board) Shipping We pay for delivery from the seller; title transfers when goods leave buyer Freight in * 30 Freight Payable 30 *Adjunct account to COGS Returns, Allowances Merchandise Inventory (Purchases) 960 Accounts Payable 960 Accounts Payable 75 Purchase Returns/Allowances * 75 * Contra account to inventory or purchases Discounts Accounts Payable 885 Discounts on Purchases 5 Cash of of 42 2

3 If inventory prices were not changing, all methods would produce the same COGS and ending inventory amounts. Since prices do change, which are assigned to COGS and ending inventory? Four methods are generally accepted: Specific identification - U.S. and IFRS acceptable First-in, first-out (FIF0) - U.S. and IFRS acceptable Weighted-average - U.S. and IFRS acceptable Last-in, first out (LIFO) - U.S. only acceptable 13 of of 42 Specific Identification The cost of each inventory item is known When an inventory item is sold, its cost becomes part of COGS. Bar codes facilitate identifying units and costs. Physical flow matches the accounting flow Relatively easy to use, especially for expensive low-volume merchandise COGS/ending inventory easily manipulated if inventory prices are changing FIFO First In, First Out Oldest costs are assigned to the income statement (COGS) Latest costs are assigned to the balance sheet (Inventory), making ratios computed there from more reflective of current market value Perpetual and periodic systems produce the same COGS and ending inventory amounts COGS can not be manipulated In periods of rising prices, FIFO leads to higher taxes paid and net income (by placing the lower costs in COGS) 15 of of 42 LIFO Last In, First Out Weighted Average Oldest costs are assigned to the balance sheet (Inventory). Latest costs are matched to revenue on the income statement (COGS), making ratios computed there from more reflective of current market value Perpetual and periodic systems produce different COGS and ending inventory amounts COGS can be manipulated by buying inventory at year-end In periods of rising prices, LIFO leads to lower net income and lower taxes paid The Internal Revenue Code requires LIFO users for tax purposes to also use LIFO for financial reporting purposes Not permitted for IFRS users 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 Perpetual and periodic systems produce different COGS and ending inventory amounts 17 of of 42 3

4 Example 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 19 of of 42 Miscellaneous LO 5 Lower of Cost or Market Accountants often refer to inventory methods as cost flow assumptions May choose any of the four flows. Over long run, all produce essentially the same end results Three out of the four flows are not linked to the physical flow of merchandise Consistency suggests the cost flow assumption cannot be changed unless a substantive reason surfaces (must be disclosed) Ending inventory should be valued at the lower of its cost ($45) or market value ($43) (Rarely record holding gains conservatism) Market value Input market replacement cost (i.e. LIFO cost) Output market net realizable value (NRV) or NRV less a normal profit margin Market value middle of those three numbers Loss on write-down of inventory 2 Merchandise Inventory 2 21 of of 42 Revenue recognized in the period when earned, realized, realizable Expenses recognized in the period when they helped to produce revenues Types of Errors Accidental (wrong amounts, accounts, GAAP, etc.) Intentional Profit pressures may cause managers to Delay the recording of purchases/expenses Accelerate incomplete sales orders 23 of of 42 4

5 An undiscovered inventory error usually affects All future periods if left undetected Two reporting periods if detected and correctly counted by the end of the second year 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 is understated If ending inventory is overstated, retained earnings is overstated 25 of of 42 Gross profit Sales Revenue less COGS Expressed in dollar or percentage terms Sales Revenue $100,000, % COGS $60,000,000, 60% Gross Profit Margin $40,000,000 40% Varies significantly by industry, wholesaler (lower due to volume) versus retailer (higher), presence of R&D, etc. Can also be used to save time counting ending inventory, assuming GPM is a constant 40% Sales Revenue $100 $100 Cost of Goods Sold? $60 Gross Profit Margin (40% x $100) $ Beginning Inventory $50 Purchases +$70 Ending Inventory?? = $60 Cost of Goods Sold $60 27 of of 42 Gross profit percentage can be used to check the accuracy of the accounting records Unusually lower 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 Inventory turnover Cost of goods sold 100,000 Average Inventory 20, ,000 = 4 On average inventory is being stocked/sold four times per year Higher turnover is associated with greater efficiency (lower costs associated with stocking/handling inventory) Effective in assessing companies in the same industry Days in inventory 365 days / 4 = On average inventory is held days before it is sold 29 of of 42 5

6 LO 7 Inventory Valuation Methods Miscellaneous LO 7 Inventory Valuation Methods Miscellaneous Inventory shrinkage can result from many factors, including 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 Shrinkage Example Cost of inventory from a physical count ($8,000) Inventory balance in the general ledger ($8,200) Periodic system Perpetual system Already included in COGS Inventory Shrinkage 200 Merchandise Inventory 200 Cost of Goods Sold 200 Inventory Shrinkage of of36 Inflation When low, no significant impact on financial accounting When high, companies using LIFO pass higher costs onto taxable income which reduces taxes paid (also reduces net income) Also presents net income at current prices Major shift in the late 1970s to LIFO Some with decreasing costs stayed with FIFO for the same reason, to have higher inventory costs reduce taxable income and thus taxes paid Holding Gains during periods of raising prices Under LIFO, the latest costs (e.g. $1) appear on the income statement so there are no holding gains Under FIFO, the lower/older inventory prices ($.60) are moving to the income statement If the product sold for $2, under: LIFO, profit margin is $2 $1 = $1 FIFO, profit margin is $2 $.60 = $1.40, i.e.: $1 gross profit margin on the sale itself $.40 holding gain ($1 $.60) Inventory Profits 33 of of 36 LIFO Layers As more inventory is bought than sold in a fiscal year Older inventory costs remain in ending inventory If inventory costs have generally been raising, lower costs remain in inventory LIFO Liquidations Later, when more inventory is sold than bought, those older layers (at lower than current costs) find their way into COGS. COGS, with lower than current costs, produces an artificial (misleading) higher net income LIFO Reserve - The difference between a company s LIFO and FIFO inventory level Begin End COGS LIFO $10,121 $8,618 $127,103 LIFO Reserve $1, FIFO $11,221 $9,509 $127,312 Reported in the notes to the financial statements At the end of the year, under FIFO ending inventory was $891 lower and COGS was $209 higher than it would have been under LIFO Facilitates comparing LIFO and FIFO companies 35 of of 36 6