Learning Objectives (LO)

After studying this chapter, you should be able to

Inventories and Cost of Goods Sold

CHAPTER

1. 2. 3. 4.

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 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 IFRS

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Learning Objectives (LO)

After studying this chapter, you should be able to
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)

LO 1 Link Inventory Valuation to Gross Profit

The initial step in assessing profitability is examining gross profit. Gross Profit = Sales Cost of Goods Sold. Inventory products being held by the company prior to sale; a current asset on the balance sheet. The value of each item in the inventory affects the cost of goods sold and therefore the gross profit. Cost Valuation is the process of assigning a specific value from the historical cost records to each item in ending inventory.

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LO 2 Perpetual and Periodic Systems

Perpetual Inventory System keeps a continuous record of inventories and cost of goods sold that helps managers control inventory levels and prepare interim financial statements.
A a. Purchase b. Sale c. Cost of Goods Sold + + Inventory Accounts Receivable Inventory = = + = = Accounts Payable + Sales Revenue COGS + SE

LO 2 Perpetual and Periodic Systems

Journal entries for the perpetual system
Merchandise Inventory 870 Accounts Payable To record the purchase of the inventory Accounts Receivable (or cash) Sales Revenue To record the sale of the inventory 870 870 870

Cost of Goods Sold 870 Merchandise Inventory To record the reduction in the inventory
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LO 2 Perpetual and Periodic Systems

Periodic Inventory System cost of goods sold is computed only at the end of an accounting period, when a physical count of an inventory is taken.
Beginning + Purchases Ending = Cost of Goods Inventory Inventory Sold

LO 2 Perpetual and Periodic Systems

Physical 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 clients physical count to confirm its accuracy Perpetual system provide continues assessments of inventory levels, but may be costly to implement Implementation costs have fallen with the computerized systems
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Periodic Inventory System cost of goods sold is computed only at the end of an accounting period, when a physical count of an inventory is taken.
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LO 3 - Cost of Merchandise Acquired

Cost of merchandize
Invoice price Inbound transportation costs (freight-in) Discounts Handling Insurance Other costs related to the purchasing and receiving departments (treated as period costs by most of the companies)

LO 3 - Cost of Merchandise Acquired

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 Point We pay for delivery from the seller; title transfers when goods leave buyer Freight in * Freight Payable *Adjunct account to COGS
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LO 3 - Cost of Merchandise Acquired

Returns, Allowances
Merchandise Inventory (Purchases) 960 Accounts Payable 960 Accounts Payable 75 Purchase Returns/Allowances* 75 * Contra account to inventory or purchases

LO 3 - Cost of Merchandise Acquired

Discounts
Accounts Payable Discounts on Purchases Cash
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885 5 880
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LO 4 Inventory Valuation Methods

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
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LO 4 Inventory Valuation Methods 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
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LO 4 Inventory Valuation Methods 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 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)

LO 4 Inventory Valuation Methods LIFO Last In, First Out

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 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

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LO 4 Inventory Valuation Methods Weighted Average

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

LO 5 Lower of Cost or Market

LCM method requires companies to compare the current market price of inventory with historical cost and report the lower of the two as inventory value. Write-down reduces the recorded historical cost of an item in response to a decline in market value. Net Realizable Value the net amount the company expects to receive for the inventory (used under IFRS) Current Replacement Cost the cost to buy the inventory today (used under US GAAP) No reversal of the inventory write-down under US GAAP, Reversal possible under IFRS.

Loss on write-down of inventory Merchandise Inventory

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LO 6 Inventory Errors
Types of Errors
Accidental (wrong amounts, accounts, etc.) Intentional Profit pressures may cause managers to Delay the recording of purchases/expenses Accelerate incomplete sales orders Impact of the Errors If ending inventory is understated, retained earnings is understated If ending inventory is overstated, retained earnings is overstated

LO 7- Gross Profit Percentage and Inventory Turnover

Gross profit Sales Revenue less COGS
Expressed in dollar or percentage terms Sales Revenue $100,000,000 100% 60% COGS $60,000,000 Gross Profit Margin $40,000,000 40% Varies significantly by industry, wholesaler (lower due to volume) versus retailer (higher), presence of R&D, etc.

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LO 7- Gross Profit Percentage and Inventory Turnover

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) $40 -------------------------------------------------------- Beginning Inventory $50 Purchases +$70 Ending Inventory ?? = $60 Cost of Goods Sold $60
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LO 7- Inventory Gross Profit and Turnover

Inventory Turnover cost of goods sold divided by the average inventory held during a given period.
Cost of goods sold Average Inventory 100,000 20,000 + 30,000 = 4 2 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
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365 days / 4 = 91.25

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On average inventory is held 91.25 days before it is sold

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LO 8 LIFO Characteristics/Consequences
Inflation is a key factor driving companies to use LIFO:
Low inflation small tax and income differences High inflation companies using LIFO pass higher costs onto taxable income which reduces taxes and net income

LO 8 LIFO Characteristics/Consequences
Holding Gains (Inventory Profits) increase in the replacement cost of the inventory held during the current period. LIFO Reserve The difference between a companys LIFO and FIFO inventory level; facilitates comparing LIFO and FIFO; is reported in the notes to the financial statements. LIFO Liquidation a decrease in the physical amount in inventory, causing old, low LIFO inventory acquisition costs to become the cost of goods sold, resulting in a high gross profit.
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Possible drawback with the switch

Change is costy Management compensation linked to the bottomline Red flag to the creditors and investors

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