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7 C H A P T E R Inventory Learning Objective 1 Identify what items and costs should be included in inventory and cost of goods sold. Define Inventory and COGS. What are some of their characteristics? Goods either manufactured or purchased for resale.

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slide1

7

C H A P T E R

Inventory

learning objective 1
Learning Objective 1

Identify what items and costs should be included in inventory and cost of goods sold.

define inventory and cogs what are some of their characteristics
Define Inventory and COGS. What are some of their characteristics?

Goods either manufactured or purchased for resale.

  • Inventory is reported on balance sheet as an asset.
  • When sold, inventory is reported on income statement as an expense (cost of goods sold).
  • COGS: the cost of inventory sold during the period.
describe the time line of business

BUY

raw materials or goods for resale

SELL

finished inventory

ADD

value

COMPUTE

ending inventory

cost of goods sold

Describe the Time Line of Business.
what is inventory
What is Inventory?

Defined according to type and nature of the company.

Merchandising:

Items to be resold.

For a supermarket, food is inventory, the shopping cart is not.

  • Manufacturing:
  • raw materials
  • work in process
  • finished goods
define each manufacturing inventory
Define Each Manufacturing Inventory
  • Raw materials
    • Goods acquired in a relatively undeveloped state.
    • Eventually will compose a major part of the finished product.
  • Work in process
    • Partly finished products.
    • Manufacturing plant contains work- in-process inventory.
  • Finished goods
    • Completed products waiting for sale.
what costs are included in inventory

Costs NOT included in inventory costs:

  • sales effort
  • general non-factory administrative costs
What Costs are Included in Inventory?
  • Costs incurred in buying inventory and preparing it for sale.
    • Cost of raw materials.
    • Cost of work-in-process inventory.
    • Cost of finished goods.
who owns the inventory
Who Owns the Inventory?

When goods are in transit?

Q: Who owns the inventory on a truck or railroad car?

A: The party who is paying the shipping costs.

When goods are on consignment?

Q: Who owns inventory stocked in a warehouse?

A: The supplier until the inventory is sold. The warehouse owner stocks and sells the inventory and receives a commission on sales as payment for services rendered.

ending inventory cogs
Ending Inventory & COGS

Cost of goods available for sale

Beginning inventory

Net purchases

At period’s end, is allocated between

  • inventory still remaining (an asset), and
  • inventory sold during the period (an expense, Cost of Goods Sold).

=

+

The question is where is the inventory that could have been sold this period? Only two choices:

learning objective 2
Learning Objective 2

Account for inventory purchases and sales using both a perpetual and a periodic inventory system.

what are the two methods for accounting for inventory
Perpetual

Records are updated when a purchase or sale is made.

Records reflect total items in inventory or sold at any given time.

Most often used when

each item has a relatively high value, or

the cost of running out of or overstocking an item is expensive.

Periodic

Records are not updated when a purchase or a sale is made.

Only the dollar amount of the sale is recorded.

Used when

inventory is composed of a large number of diverse items,

each with a relatively low value.

What are the Two Methods for Accounting for Inventory?
example accounting for inventory purchases and sales
Example: Accounting for Inventory Purchases and Sales

Harper’s Hats recorded the following transactions for 2001:

Beginning inventory 10 hats @ $10 each = $100

March 1 Purchase 15 hats @ $15 each = $225

March 1 Freight in $10

March 1 Purchase return 3 hats @ $15 each = $ 45

May 2 Purchase 10 hats @ $20 each = $200

May 2 Purchase discount 2/10, n/30

June 30 Sales 20 hats (10 @ $10, 10 @ $15)

July 3 Sales return 1 hat @ $15 = $ 15

Ending inventory 13 hats

example 2001 inventory
Example: 2001 Inventory

Purchase Sale Balance `

DateUnitsTotalUnitsTotalUnitsCostTotal

Jan. 1 10 $10 $100

Mar. 1 15 $225 10 $10 $100 15 $15 $225 (3) ($45) 12 $15 $180

May 2 10 $200 10 $10 $100 12 $15 $180 10 $20 $200

June 30 10 $100 10 $150 2 $15 $ 30 10 $20 $200

July 3 (1) ($15) 3 $15 $ 45 10 $20 $200

perpetual periodic journal entries

Perpetual

All purchases are added directly to the inventory account.

  • Periodic
  • At end of period,
  • Inventory balance is updated using inventory count.
  • Temporary purchases account balance is closed to Inventory to compute COGS.
Perpetual & PeriodicJournal Entries
  • Purchases
  • Transportation costs
  • Purchase returns
  • Purchase discounts
  • Sales
  • Sales returns
  • Closing entries for COGS
example journal entries for purchases

Jan. 1 Inventory . . . . . . . . . . . . . . . . 100

Accounts Payable. . . . . . . 100

Purchased 10 hats @ $10.

Jan. 1 Purchases . . . . . . . . . . . . . . . 100

Accounts Payable. . . . . . . 100

Purchased 10 hats @ $10.

Example: Journal Entriesfor Purchases

Harper purchased 10 hats at $10 each on January 1. Record the entries for both the perpetual and the periodic systems.

PERPETUAL

PERIODIC

perpetual periodic journal entries16

Perpetual

All costs are added directly to the inventory balance.

Periodic

At end of period, temporary freight in account balance is closed to Inventory to compute COGS.

Perpetual & PeriodicJournal Entries
  • Purchases
  • Transportation costs
  • Purchase returns
  • Purchase discounts
  • Sales
  • Sales returns
  • Closing entries for COGS
example journal entries for transportation cost

Mar. 1 Inventory . . . . . . . . . . . . . . . . 10

Cash. . . . . . . . . . . . . . . . . . 10

Delivery charge on 15 hats.

Mar. 1 Freight In. . . . . . . . . . . . . . . . 10

Cash. . . . . . . . . . . . . . . . . . 10

Delivery charge on 15 hats.

Example: Journal Entriesfor Transportation Cost

Harper hired a trucking company to deliver its March 1 purchase of 15 hats. The trucking company charged $10. Record the entries for both the perpetual and the periodic systems.

PERPETUAL

PERIODIC

perpetual periodic journal entries18

Perpetual

Inventory is decreased.

Accounts Payable is decreased by same amount.

Periodic

If merchandise has been paid for, the supplier will reimburse (debit Cash).

At end of period, temporary purchase returns account balance is closed to Inventory to compute COGS.

Perpetual & PeriodicJournal Entries
  • Purchases
  • Transportation costs
  • Purchase returns
  • Purchase discounts
  • Sales
  • Sales returns
  • Closing entries for COGS
example journal entries for purchase returns

Mar. 1 Accounts Payable (or Cash) 45

Inventory . . . . . . . . . . . . . . 45

Returned 3 hats @ $15.

Mar. 1 Accounts Payable (or Cash) 45

Purchase Returns. . . . . . . 45

Returned 3 hats @ $15.

Example: Journal Entriesfor Purchase Returns

Of the 15 hats delivered on March 1, three were defective and Harper returned them the same day. Record the entries for both the perpetual and the periodic inventory systems.

PERPETUAL

PERIODIC

perpetual periodic journal entries20

Perpetual

Subtract the discount amount from the inventory account.

Periodic

At end of period, temporary purchase discounts account balance is closed to Inventory to compute COGS.

Perpetual & PeriodicJournal Entries
  • Purchases
  • Transportation costs
  • Purchase returns
  • Purchase discounts
  • Sales
  • Sales returns
  • Closing entries for COGS
example journal entries for purchase discounts

May 2 Accounts Payable (or Cash) 200

Inventory . . . . . . . . . . . . . . 4

Cash . . . . . . . . . . . . . . . . . . 196

Purchase discount on 10 hats.

May 2 Accounts Payable (or Cash) 200

Purchase Discounts . . . . . 4

Cash . . . . . . . . . . . . . . . . . . 196

Purchase discount on 10 hats.

Example: Journal Entriesfor Purchase Discounts

On May 2, Harper purchased 10 hats at $20 each. The supplier offered terms of 2/10, n/30. Record the entries for both the perpetual and the periodic inventory systems.

PERPETUAL

PERIODIC

perpetual periodic journal entries22

Perpetual

All adjustments are entered directly in the Inventory account.

Periodic

All adjustments are accumulated in an array of temporary holding accounts:

Purchases

Freight In

Purchase Returns

Purchase Discounts

The difference in terms of journal entries:

Perpetual & PeriodicJournal Entries
  • Purchases
  • Transportation costs
  • Purchase returns
  • Purchase discounts
perpetual periodic journal entries23

Perpetual

Recognize sales and COGS on a transaction-by-transaction basis.

Periodic

Only total sales are known.

Perpetual & PeriodicJournal Entries
  • Purchases
  • Transportation costs
  • Purchase returns
  • Purchase discounts
  • Sales
  • Sales returns
  • Closing entries for COGS
example journal entries for sales

Jun. 30 Accounts Receivable (or Cash) 500

Sales . . . . . . . . . . . . . . . . . . . . 500

Sold 20 hats @ $25.

Jun. 30 Cost of Goods Sold . . . . . . . . . . 250

Inventory (10 @ $10; 10 @ $15) 250

Record cost of goods sold.

Jun. 30 Accounts Receivable (or Cash) 500

Sales . . . . . . . . . . . . . . . . . . . . 500

Sold 20 hats @ $25.

No entry.

Example: Journal Entriesfor Sales

In June, Harper’s Hats sold 20 hats for $25 each (selling the old ones first). Record the entries for both the perpetual and the periodic systems.

PERPETUAL

PERIODIC

perpetual periodic journal entries25

Perpetual

Sales for returned items are canceled.

Cost of returned inventory is removed from COGS and restored to the inventory account.

Periodic

Sales for returned items are canceled.

No entry is made to adjust COGS.

Perpetual & PeriodicJournal Entries
  • Purchases
  • Transportation costs
  • Purchase returns
  • Purchase discounts
  • Sales
  • Sales returns
  • Closing entries for COGS
example journal entries for sales returns

Jul. 3 Sales Returns. . . . . . . . . . . . . . . 25

Accounts Receivable. . . . . . . 25

1 hat returned from June purchase.

Jul. 3 Inventory. . . . . . . . . . . . . . . . . . . 15

Cost of Goods sold . . . . . . . . 15

Placed returned hat back into inventory.

Jul. 3 Sales Returns. . . . . . . . . . . . . . . 25

Accounts Receivable. . . . . . . 25

1 hat returned from June purchase.

No entry.

Example: Journal Entriesfor Sales Returns

On July 3, one hat was returned from a late June purchase. Record the entries for both the perpetual and the periodic inventory systems.

PERPETUAL

PERIODIC

perpetual periodic journal entries27

Perpetual

All journal entries are posted to the ledger.

Results in new balances for Inventory and COGS.

Numbers are verified by physical count.

Periodic

Temporary holding accounts are accumulated and added to Inventory.

Inventory account balance is reduced by the amount of COGS.

Perpetual & PeriodicJournal Entries
  • Purchases
  • Transportation costs
  • Purchase returns
  • Purchase discounts
  • Sales
  • Sales returns
  • Closing entries for COGS
example accounting for inventory purchases and sales28
Example: Accounting for Inventory Purchases and Sales

Harper’s Hats recorded the following transactions for 2001:

Beginning inventory 10 hats @ $10 each = $100

March 1 Purchase 15 hats @ $15 each = $225

March 1 Freight in $10

March 1 Purchase return 3 hats @ $15 each = $ 45

May 2 Purchase 10 hats @ $20 each = $200

May 2 Purchase discount 2/10, n/30

June 30 Sales 20 hats (10 @ $10, 10 @ $15)

July 3 Sales return 1 hat @ $15 = $ 15

Ending inventory 13 hats

example closing entries for cost of goods sold
Example: Closing Entries for Cost of Goods Sold

Perpetual: the inventory account will have an ending balance of $255.

Inventory

COGS

6/30 250

7/3 15

Bal. 235

1/1 100

3/1 225 3/1 45

3/1 10

5/2 200

6/30 250

7/3 15

Bal. 255

example closing entries for cost of goods sold30
Example: Closing Entries for Cost of Goods Sold

Periodic: the inventory account will be debited by $386, which represents the net purchases for the year.

Jul. 31 Inventory. . . . . . . . . . . . . . . . . . . 386

Purchase Returns. . . . . . . . . . . . 45

Purchase Discounts. . . . . . . . . . 4

Freight In. . . . . . . . . . . . . . . . . 10

Purchases. . . . . . . . . . . . . . . . 425

periodic inventory
Periodic Inventory

With a periodic system, a physical count is the only way to get the information necessary to compute COGS:

Beginning Inventory, January 1, 2001

+ Purchases for the year

= Cost of goods available for sale during 2001

– Ending Inventory, December 31, 2001

= Cost of Goods Sold for 2001

learning objective 3
Learning Objective 3

Calculate cost of goods sold using the results of an inventory count and understand the impact of errors in ending inventory on reported cost of goods sold.

physical count of inventory
Physical Count of Inventory

Essential to maintaining reliable inventory accounting records.

Perpetual

Physical count either confirms records are accurate or highlights shortages and clerical errors.

Periodic

The only way to get information necessary to compute COGS:

  • Quantity count.
  • Inventory costing (assigning a unit cost to each type of merchandise).
  • Ending inventory = quantity of each type x its unit cost.
cogs computation
COGS Computation
  • Periodic
  • Company does not know what ending inventory should be.
  • Assumes physical count is the difference between cost of goods available for sale and ending inventory.
  • Cannot tell whether goods were sold, lost, stolen, or spoiled.

Perpetual

  • The accounting records yield the COGS for the period as well as the amount of inventory that should be found with a physical count.
  • The difference between the records and actual count = inventory lost, stolen, or spoiled.
what is the income effect of an error in ending inventory
What is the Income Effect of an Error in Ending Inventory?

Any uncorrected error will affect the financial statements for two years.

An error in inventory results in COGS being overstated or understated.

The inventory error has the opposite effect on gross margin and net income.

slide36

Understate

Beginning

Inventory

UnderstateEnding Inventory

Sales OK

Beginning inventory OK

Net purchases OK

Goods available OK

Ending inventory LOW

Cost of goods sold HIGH

Gross margin LOW

Expenses OK

Net income LOW

Understate

Purchases

Understate Sales

Effects of Inventory Errors

OK

OK

LOW

LOW

OK

LOW

HIGH

OK

HIGH

OK

LOW

OK

LOW

OK

LOW

HIGH

OK

HIGH

LOW

OK

OK

OK

OK

OK

LOW

OK

LOW

learning objective 4
Learning Objective 4

Apply the four inventory cost flow alternatives: specific identification, FIFO, LIFO, and average cost.

inventory cost flow
Inventory Cost Flow
  • Kernel King buys and sells corn and had the following transactions for 2002:
    • June 10 Purchased 10 tons at $6 per ton.
    • July 28 Purchased 10 tons at $9 per ton.
    • October 10 Sold 10 tons at $11 per ton.
  • How much did Kernel King make in 2002?

Case #1Case #2Case #3

Sold Sold Sold

Old CornNew CornMixed Corn

Sales ($11 x 10 tons) $110 $110 $110

COGS (10 tons) 60 90 75

Gross margin$ 50 $ 20 $ 35

specific identification cost flow
Specific Identification Cost Flow
  • Specifically identify the cost of each unit sold.
  • The individual cost of each unit is charged against revenue as COGS.
  • To compute COGS and ending inventory, a firm must know each unit sold and its cost.
inventory cost flow methods
Inventory Cost Flow Methods
  • LIFO
    • The newest units are sold and the oldest units remain in inventory.
    • The cost of the most recent units purchased is transferred to COGS.
  • Average Cost
    • An average cost is computed for all inventory available for sale during the period.
    • COGS is computed by multiplying the number of units sold by the average cost per unit.

FIFO

  • The oldest units are sold and the newest units remain in inventory.
  • The cost of the oldest units purchased is transferred to COGS.
comparison of inventory methods
Comparison ofInventory Methods
  • LIFO gives a better reflection of COGS in the income statement.
  • Therefore, LIFO is a better measure of income.
  • FIFO gives a better measure of inventory on the balance sheet.
  • Therefore, FIFO is a better measure of inventory value.
learning objective 5
Learning Objective 5

Use financial ratios to evaluate a company’s inventory level.

why use jit inventory management
Why Use JIT Inventory Management?
  • Money tied up in inventory cannot be used for other purposes.
  • JIT attempts to have exactly enough inventory arrive “just in time” for sale.
  • Its purpose is to minimize investment in inventories while at the same time having enough inventory on hand to meet customer demand.
evaluating inventory levels

Cost of goods sold

Average inventory

365 days

Inventory turnover

Evaluating Inventory Levels
  • Inventory Turnover
  • Measures how many times a company turns over (or replenishes) its inventory.
  • Average inventory = average of the beginning and ending inventory balances.
  • Number of Days’ Sales in Inventory
example evaluating inventory management

Cost of goods sold

Average inventory

$60,000

$4,500

=

=

13.33

365 days

Inventory turnover

365

13.33

=

=

27.38

Example: Evaluating Inventory Management

Buster Boots had cost of goods sold of $60,000 during 2002. The inventory account decreased by $1,000 to $4,000 during the same time. Calculate the inventory turnover ratio and number of days’ sales in inventory.

Inventory turnover ratio

Number of days’ sales in inventory

expanded material learning objective 6
Expanded MaterialLearning Objective 6

Analyze the impact of inventory errors on reported cost of goods sold.

what is the effect of these inventory errors
What Is the Effect of These Inventory Errors?

If a sale is recorded but the merchandise remains in inventory and is counted in ending inventory,

> COGS Ô understated

> gross margin Ô overstated

> net income Ô overstated

If a sale is not recorded, but inventory is shipped and not counted in ending inventory,

> COGS Ô overstated

> gross margin Ô understated

> net income Ô understated

expanded material learning objective 7
Expanded MaterialLearning Objective 7

Describe the complications that arise when LIFO or average cost is used with a perpetual inventory system.

using average cost or lifo with a perpetual system
Using Average Cost or LIFO with a Perpetual System
  • Using average cost or LIFO with perpetual leads to complications.
    • The average cost of units available for sale changes every time a purchase is made.
    • The identification of the “last in” units also changes with every purchase.
  • With periodic,
    • One overall average cost is used for all goods available for sale during the period.
    • The “last in” units are identified at the end of the period.
describe the similarities of using fifo for perpetual and periodic systems
Describe the Similarities of Using FIFO for Perpetual and Periodic Systems.
  • No complications arise as no matter when sales occur, the “first in” units are always the same in both systems.
  • FIFO periodic and FIFO perpetual yield the same numbers for COGS and ending inventory.
expanded material learning objective 8
Expanded MaterialLearning Objective 8

Apply the lower-of-cost-or-market method of accounting for inventory.

when do you report inventory below cost
When Do You Report Inventory Below Cost?
  • All inventory costing alternatives report inventory at cost.
  • Inventory is reported at less than cost when:
    • the future value of the inventory is in doubt (damaged, used, or obsolete), or
    • it can be replaced new at a price less than the original cost.
when do you report inventory at net realizable value nrv
When Do You Report Inventory at Net Realizable Value (NRV)?
  • When inventory is damaged, used, or obsolete, it should be reported at no more than its net realizable value (the amount it can be sold for, less any selling costs).
  • NRV should be recognized as soon as a firm determines that an economic loss has occurred.
  • Loss is recognized when inventory is written down, not when inventory is finally sold.
  • Therefore, assets are not being reported at more than their future economic benefit.
lower of cost or market lcm

Ceiling:the maximum market amount at which inventory can be carried on the books; equal to net realizable value (selling price less estimated selling costs).

Floor: the minimum market amount at which inventory can be carried on the books; equal to net realizable value less a normal profit.

Lower of Cost or Market (LCM)

LCM: A basis for valuing inventory at the lower of original cost or current market value.

example lcm
Example: LCM

Market

Inventory Replacement NRV

Item CostFloor Cost Ceiling

A 34 20 32 30

B 42 32 36 46

C 52 44 42 62

D 38 50 32 68

  • Define market value as:
  • replacement cost, if it falls between the ceiling and the floor.
  • the floor, if the replacement cost is less than the floor.
  • the ceiling, if the replacement cost is higher than the ceiling.
  • When replacement cost, ceiling, and floor are compared, market is always the middle value.

Compare the defined market value with the original cost and choose the lower amount.

expanded material learning objective 9
Expanded MaterialLearning Objective 9

Explain the gross margin method of estimating inventories.

gross margin method
Gross Margin Method
  • There are times when a physical count of inventory is either impossible or impractical.
    • If perpetual is used, the inventory account balance is assumed to be correct.
    • If periodic is used, an estimate of the inventory balance must be made.
  • Gross margin method.
    • COGS and ending inventory are estimated using available information:
      • beginning inventory
      • purchases
      • historical gross margin percentage