Reporting and Interpreting Cost of Goods Sold and Inventory

1. Reporting and Interpreting Cost of Goods Sold and Inventory Chapter 7

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

3. 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

4. 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

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. Merchandiser MerchandisePurchases MerchandiseInventory Cost ofGoods Sold Manufacturer RawMaterials Raw MaterialsInventory Work in ProcessInventory Finished GoodsInventory DirectLabor Cost ofGoods Sold FactoryOverhead Flow of Inventory Costs

7. 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

8. Learning Objectives Report inventory and cost of goods sold using the four inventory costing methods. LO2

9. Specific Identification FIFO Weighted Average LIFO Inventory Costing Methods

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

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

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. LIFO FIFO Weighted Average

13. First-In, First-Out Method Cost of Goods Sold Oldest Costs Ending Inventory Recent Costs

14. 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.

15. First-In, First-Out

16. First-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

17. First-In, First-Out Now, we have allocated the cost to all 1,050 units sold.

18. First-In, First-Out Here is the cost of ending inventory and cost of goods sold using FIFO.

19. Last-In, First-Out Method Ending Inventory Oldest Costs Cost of Goods Sold Recent Costs

20. 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.

21. Last-In, First-Out

22. Last-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

23. Last-In, First-Out Now, we have allocated the cost to all 1,050 units sold.

24. Last-In, First-Out Here is the cost of ending inventory and cost of goods sold using LIFO.

25. 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

26. Average Cost Method

27. Average Cost Method

28. Comparison of Methods

29. 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

30. Learning Objectives Decide when the use of different inventory costing methods is beneficial to a company. LO3

31. 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.

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

33. Learning Objectives Report inventory at the lower of cost or market (LCM). LO4

34. 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.

35. Valuation at Lower of Cost or Market

36. Learning Objectives Evaluate inventory management using the inventory turnover ratio and the effects of inventory on cash flows. LO5

37. 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.

38. 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

39. Learning Objectives Compare companies that use different inventory costing methods. LO6

40. 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.

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

42. Learning Objectives Understand methods for controlling and keeping track of inventory and analyze the effects of inventory errors on financial statements. LO7

43. 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.

44. 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.

45. Perpetual and Periodic Inventory Systems

46. Errors in Measuring Ending Inventory

47. Chapter Supplement A LIFO Liquidations

48. 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.

49. 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.

50. Chapter Supplement B Additional Issues in Measuring Purchases