Merchandise Inventory

1. Merchandise Inventory Chapter 6

2. Objective 1 Account for inventory by the FIFO, LIFO, and average cost methods.

3. Inventory Costing Methods • Specific Unit Cost • FIFO • LIFO • Average Cost

4. Specific Unit Cost • When units are sold, the specific cost of the unit sold is added to cost of goods sold

5. Cost of Goods Sold Ending Inventory First-In, First-Out (FIFO) Oldest Costs Recent Costs

6. $10 $10 $10 $12 $12 $12 $12 $12 First-In, First-Out (FIFO) Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold? Beginning Inventory First-In, First-Out Purchase 5 shirts Inventory = $48 Cost of good sold = $42

7. First-In, First-Out (FIFO) Accounts Receivable ($20 x 4) 80 Sales Revenue 80 To record sales on account Cost of Goods Sold 42 Inventory 42 To record cost of sales

8. First-In, First-Out (FIFO) Sales $80 Cost of Goods Sold 42 Gross Profit $38

9. Cost of Goods Sold Ending Inventory Last-In, First-Out (LIFO) Recent Costs Oldest Costs

10. $10 $10 $10 $12 $12 $12 $12 $12 Last-In, First-Out (LIFO) Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold? Beginning Inventory Last-In, First-Out Purchase 5 shirts Inventory = $42 Cost of good sold = $48

11. Last-In, First-Out (LIFO) Accounts Receivable ($20 x 4) 80 Sales Revenue 80 To record sales on account Cost of Goods Sold 48 Inventory 48 To record cost of sales

12. Last-In, First-Out (LIFO) Sales $80 Cost of Goods Sold 48 Gross Profit $32

13. The average cost of each unit in inventory is assigned to cost of goods sold Cost of Inventory on Hand Number of Units on Hand ÷ = Average Cost Average Cost

14. $10 $10 $10 $12 $12 $12 $12 $12 Average Cost Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold? Beginning Inventory Compute the Average Cost Units Cost Beginning inventory 3 $30 Purchases 560 Total 8 $90 Average = $90/8 = $11.25 Purchase 5 shirts Inventory = $11.25 x 4 = $45 Cost of good sold = $11.25 x 4 = $45

15. Average Cost Accounts Receivable ($20 x 4) 80 Sales Revenue 80 To record sales on account Cost of Goods Sold 45 Inventory 45 To record cost of sales

16. Average Cost Sales $80 Cost of Goods Sold 45 Gross Profit $35

17. Objective 2 Compare the effects of FIFO, LIFO, and average cost

18. Comparison

19. Smoothes out price changes Ending inventory approximates current replacement cost Better matching of current costs in cost of goods sold with revenues Advantage of Each Method First-In, First-Out Last-In, First-Out Weighted Average

20. Use of Inventory Methods in Practice

21. Notice: We keep separate cost layers as inventory is acquired E6-13 Notice: This is not the selling price, but the cost of goods sold Nov 1 Bal. 5 $70 $350 6 3 $70 $210 2 70 140 8 10 $79 $790 2 70 140 10 79 790 17 2 $70 140 2 79 158 8 79 632 30 5 79 395 3 79 237 Total cost of goods sold for November = $903 Cost of ending inventory for November = $237

22. E6-14 Nov 8 Inventory 790 Accounts Payable 790 Purchased inventory on account Nov 17 Cash 480 Sales Revenue 480 To record sales for cash 17 Cost of Goods Sold 298 Inventory 298 To record cost of sales

23. The last inventory costs incurred are the first inventory costs to be assigned to cost of goods sold E6-15 Nov 1 Bal. 5 $70 $350 6 3 $70 $210 2 70 140 8 10 $79 $790 2 70 140 10 79 790 17 4 79 316 2 70 140 6 79 474 30 5 79 395 2 70 140 1 79 79 Total cost of goods sold for November = $921 Cost of ending inventory for November = $219

24. Every time the company purchases inventory, a new average price per unit is computed: Total cost of goods available for sale Total number of units available for sale $140 + $790 / 12 units = $77.50 E6-16 Nov 1 Bal. 5 $70.00 $350.00 6 3 $70.00 $210.00 2 70.00 140.00 8 10 $79 $790 12 77.50 930.00 17 4 77.50 310.00 8 77.50 620.00 30 5 77.50 387.50 3 77.50 232.50 Total cost of goods sold for November = $907.50 Cost of ending inventory for November = $232.50

25. In this illustration, prices are rising. What impact do these different methods have on the income statement? Lets assume that all items were sold for $100 each Analysis of E6-13, 15, 16 During rising prices FIFO gives you the highest net income, LIFO the lowest. Average will always be in between * Rounded

26. How about the balance sheet? Analysis of E6-13, 15, 16 During rising prices FIFO gives you the highest inventory valuation, LIFO the lowest Average will always be in between * Rounded

27. Accounting Principles • Consistency Principle • Disclosure Principle • Materiality Concept • Accounting Conservatism

28. Consistency in Reporting • A company should use the same accounting methods from period to period so that financial statements are comparable across periods

29. Disclosure Principle • Report enough information for outsiders to make wise decisions about the company

30. Materiality Concept • A company must perform strictly proper accounting only for significant items

31. Accounting Conservatism • Exercise caution in reporting items in the financial statements • Report realistic figures

32. Objective 3 Apply the lower-of-cost-or market rule to inventory

33. Lower-or-Cost-or-Market Rule • Example of Accounting Conservatism • Inventory is reported at whichever is lower – historical cost or market value (current replacement cost) • If market is lower than cost – write inventory down • Debit Cost of Goods Sold • Credit Inventory

34. Lower-or-Cost-or-Market Rule • Must disclose method of valuation in financial statements • As parenthetical in statements or • In notes to financial statements

35. When market value of inventory is below cost, you must decrease the inventory account. The corresponding debit increases cost of goods sold E6-22 Dec 31 Cost of Goods Sold 1,000 Inventory 1,000 LCM adjustment Inventory Cost of Goods Sold 14,000 72,000 1,000 1,000 Bal 13,000 Bal 73,000

36. E6-22 Eagle Resources Income Statement (partial) For the Year Ended December 31, 2006 Sales revenue $118,000 Cost of goods sold 73,000 Gross profit $45,000

37. Objective 4 Measure the effects of inventory errors.

38. Inventory Errors • Ending inventory becomes next year’s beginning inventory • Results in misstatement of income statement over two years • Misstatement of balance sheet in first year and then error counterbalances itself

39. Inventory Errors Hint: Remember, the two I’s are affected the same way I – Inventory I – Income • If ending inventory is overstated, so is net income and gross profit. Cost of Goods sold is understated • If ending inventory is understated, so is net income and gross profit. Cost of Goods sold is overstated • In year two, the effects of year one are reversed

40. E6-25 Sales revenue $137,000 $120,000 Cost of Goods Sold Beginning inventory $14,000 $12,000 Net purchases 72,00066,000 Cost of goods available $86,000 $78,000 Ending inventory (16,000)(14,000) Cost of goods sold 70,00064,000 Gross profit $67,000 $56,000 Operating expenses 25,00020,000 Net income $42,000 $36,000 $11,000 $83,000 (11,000) 67,000 67,000 $70,000 $53,000 $45,000 $33,000 Notice: Net income for the two years combined is the same in both cases. The error in 2006 counterbalances the error in 2005

41. Objective 5 Estimate ending inventory by the gross profit method

42. Gross Profit Method • Estimate ending inventory by applying the gross profit ratio to net sales • Useful when inventory has been destroyed, lost, or stolen

43. Things to Remember Compute Gross Profit: Sales - Cost of Goods Sold Gross Profit Compute Gross Profit Percent: Gross Profit / Net Sales

44. Things to Remember Compute Cost of Goods Sold Beginning inventory + Purchases - Purchases returns + Freight-in Goods available for sale - Ending inventory Cost of goods sold

45. Sales - Cost of Goods Sold Gross Profit Sales - Cost of Goods Sold Gross Profit 100% 60% 40% $1,000,000 400,000 E6-26 ???? 600,000

46. Beginning inventory $150,000 + Purchases 800,000 Goods available for sale $950,000 - Ending inventory Cost of goods sold $400,000 E6-25 550,000 ????

47. End of Chapter 6