Reporting and interpreting cost of goods sold and inventory
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Reporting and Interpreting Cost of Goods Sold and Inventory. Chapter 7. Understanding the Business. Provide sufficient quantities of high-quality inventory. Primary Goals of Inventory Management. Minimize the costs of carrying inventory. Learning Objectives.

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Reporting and Interpreting Cost of Goods Sold and Inventory

Chapter 7


Understanding the Business

Provide sufficient quantities of high-quality inventory.

Primary Goals of Inventory Management

Minimize the costs of carrying inventory.


Learning Objectives

Apply the cost principle to identify the amounts that should be included in inventory and the matching principle to determine cost of goods sold for typical retailers, wholesalers, and manufacturers.

LO1


Items Included in Inventory

Inventory

Tangible

Held for Sale

Used to Produce Goods or Services

Merchandise Inventory

Raw Materials Inventory

Work in Process Inventory

Finished Goods Inventory


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


Merchandiser

MerchandisePurchases

MerchandiseInventory

Cost ofGoods Sold

Manufacturer

RawMaterials

Raw MaterialsInventory

Work in ProcessInventory

Finished GoodsInventory

DirectLabor

Cost ofGoods Sold

FactoryOverhead

Flow of Inventory Costs


Nature of Cost of Goods Sold

BeginningInventory

Purchasesfor the Period

Goods availablefor 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


Learning Objectives

Report inventory and cost of goods sold using the four inventory costing methods.

LO2


Specific Identification

FIFO

Weighted Average

LIFO

Inventory Costing Methods


Inventory Costing Methods

Total Dollar Amount of Goods Available for Sale

Inventory Costing Method

Ending Inventory

Cost of Goods Sold


When units are sold, the specific cost of the unit sold is added to cost of goods sold.

Specific Identification


Cost Flow Assumptions

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

LIFO

FIFO

Weighted

Average


First-In, First-Out Method

Cost of Goods Sold

Oldest Costs

Ending Inventory

Recent Costs


First-In, First-Out

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.


First-In, First-Out


First-In, First-Out

Now, we have allocated the cost to all 1,200 units in ending inventory.


First-In, First-Out

Now, we have allocated the cost to all 1,050 units sold.


First-In, First-Out

Here is the cost of ending inventory and cost of goods sold using FIFO.


Last-In, First-Out Method

Ending Inventory

Oldest Costs

Cost of Goods Sold

Recent Costs


Last-In, First-Out

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.


Last-In, First-Out


Last-In, First-Out

Now, we have allocated the cost to all 1,200 units in ending inventory.


Last-In, First-Out

Now, we have allocated the cost to all 1,050 units sold.


Last-In, First-Out

Here is the cost of ending inventory and cost of goods sold using LIFO.


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

Average Cost Method


Average Cost Method


Average Cost Method


Comparison of Methods


Smoothes out price changes.

Ending inventory approximates current replacement cost.

Better matches current costs in cost of goods sold with revenues.

Financial Statement Effects of Costing Methods

Advantages of Methods

First-In, First-Out

Last-In, First-Out

Weighted Average


Learning Objectives

Decide when the use of different inventory costing methods is beneficial to a company.

LO3


Managers Choice of Inventory Methods

Net Income EffectsManagers prefer to report higher earnings for their companies.

Income Tax EffectsManagers prefer to pay the least amount of taxes allowed by law as late as possible.


Choosing Inventory Costing Methods

If . . .

Then . . .

LIFO Conformity Rule

LIFO for taxes

LIFO for books


Learning Objectives

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

LO4


Valuation at Lower of Cost or Market

Ending inventory is reported at the lower of cost or market (LCM).

Replacement CostThe 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.


Valuation at Lower of Cost or Market


Learning Objectives

Evaluate inventory management using the inventory turnover ratio and the effects of inventory on cash flows.

LO5


Inventory Turnover

Cost of Goods Sold

=

Average Inventory

Inventory Turnover

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.


Inventory and Cash Flows

Increase in Inventory

Decrease in Accounts Payable

Add

Cost of Goods Sold

Cash Payment to Suppliers

Decrease in Inventory

Increase in Accounts Payable

Subtract


Learning Objectives

Compare companies that use different inventory costing methods.

LO6


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.


No

Yes

LIFO and International Comparisons

LIFO Permitted?

Singapore

China

Canada

Australia

Great Britain


Learning Objectives

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

LO7


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.


Perpetual and Periodic Inventory Systems

Provides up-to-date inventory records.

Perpetual

System

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.


Perpetual and Periodic Inventory Systems


Errors in Measuring Ending Inventory


Chapter Supplement A

LIFO Liquidations


LIFO Liquidations

When a LIFO company sells more inventory than it purchases or manufactures, items from beginning inventory become part of cost of goods sold. This is called a LIFO liquidation.

When inventory costs are rising, these lower cost items in beginning inventory produce a higher gross profit, higher taxable income, and higher taxes when they are sold.


LIFO Liquidations

Companies must disclose the effects of LIFO liquidations in the notes when they are material.

Many companies avoid LIFO liquidations and the accompanying increase in tax expense by purchasing sufficient quantities of inventory at year-end to ensure that ending inventory quantities are greater than or equal to beginning inventory quantities.


Chapter Supplement B

Additional Issues in Measuring Purchases


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.


Purchase Discounts

A purchase discount is a cash discount received for prompt payment of an account.

Terms

Time

Due

Discount Period

Credit Period

Full amount

less discount

Full amount due

Purchase or Sale


Number of Days Discount Is Available

Otherwise, Net (or All) Is Due

Discount Percent

CreditPeriod

Purchase Discounts

2/10,n/30


Purchase Discounts

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


Chapter Supplement C

Comparison of Perpetual and Periodic Inventory Systems


Perpetual Inventory System


Periodic Inventory System


End of Chapter 7


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