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Chapter 6 . Inventories & Cost of Goods Sold. Key Objectives & Concepts. Merchandise Inventories Inventory Valuation & Income Measurement Inventory Costing Assumptions (GAAP): Specific Identification Weighted Average First-In, First-Out (FIFO) Last-In, Last-Out (LIFO)

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slide1

Chapter 6

Inventories &

Cost of Goods Sold

key objectives concepts
Key Objectives & Concepts
  • Merchandise Inventories
  • Inventory Valuation & Income Measurement
  • Inventory Costing Assumptions (GAAP):
    • Specific Identification
    • Weighted Average
    • First-In, First-Out (FIFO)
    • Last-In, Last-Out (LIFO)
  • Periodic vs. Perpetual Inventory Recording
  • Lower of Cost or Market (LCM) rule
  • Inventory Ratio Analysis
merchandise inventory wholesale and retail companies
Merchandise Inventory:Wholesale and Retail Companies
  • Goods are:
    • Purchased in finished form (“finished goods”)
    • Resold without further manufacturing
  • Classified as “Merchandise Inventory” on Balance Sheet
inventory costing income measurement

Expense Inventory

Inventory (A)

Balance

Sheet

(Deferred Expense)

Income

Statement Cost of

Goods Sold (E)

Inventory Costing & Income Measurement

When goods aresold,

recordSalesand…….

Follows the Matching Principle

relationships periodic inventory inventory cgs profit taxes cash
Relationships-Periodic InventoryInventory / CGS / Profit / Taxes /Cash

Sales-COGS = GP - Op. Exp. =Inc.before Tax -Income Tax Exp.=NI

  • Higher Inventory Value (on B/S) => Lower CGS (on I/S)
  • Lower CGS (on I/S) => Higher Profits (on I/S)
  • Higher Profits (on I/S) => Higher Taxes (on I/S)
  • Higher Taxes (on I/S) => Lower Cash (on B/S)

BEG INV. + PURCHASES = COGAS – ENDING INV. = COGS

Summary: 2 general cases exist

HIGHEREI => HIGHERPROFITS => LOWER CASH

and conversely

LOWER EI => LOWER PROFITS => HIGHERCASH

calculating cost of goods sold for periodic inventory a review
Beginning Inventory * (A) $ 30,000

+ Cost of Goods Purchased 100,000

Cost of Goods Available for Sale 130,000

-Ending Inventory * (A) 40,000

Cost of Goods Sold (E) $ 90,000

Calculating Cost of Goods Sold forPeriodic Inventory: A Review
  • An internal calculation needed for I/S

* Must be determined by taking a physical inventory

calculating cost of goods sold for periodic inventory a review7
Internal calculation needed for I/S

Beginning Inventory

+ Purchases

= Cost of Goods Available for Sale

-Ending Inventory

Cost of Goods Sold (E)

As presented on (multi-step) Income Statement

Sales $200,000

Cost of goods sold 90,000

Gross margin 110,000

:

:

Net Income $ 30,000

Calculating Cost of Goods Sold forPeriodic Inventory:A Review
slide8

Inventory Costing MethodsHow we determine key F/Samounts

Cost of Goods Sold (E)

Ending Inventory (A)

Income Statement

Balance Sheet

COST OF GOODS AVAILABLE FOR SALE

can only be accounted for in 1 of 2 accounts

Cost of Goods Available for Sale

$$$$$$

If goods were sold:

If they’re still on hand:

slide9

Inventory Costing MethodsObjective & Flows

  • Objective:We need $ amounts for COGS & EI on the financial statements (I/S and B/S)
  • ButPhysical Flows = Cost Flows(an assumption) – e.g., think of how goods flow in a grocery store.
  • How to proceed?We usecost flow assumptions(except for Specific Identification Method) to calculate COGS and EIwithout having to track physical flows.
  • Why?It is too costly to obtain exact information, which requires tracking exact physical flows.
inventory costing methods alternates for determining the i s amounts
Inventory Costing MethodsAlternates for determining the I/S amounts

Four alternate costing methods are available:

Specific

Identification

Weighted

Average

First-in, First-out

(FIFO)

Last-in, First-out

(LIFO)

periodic inventory system a review
PERIODIC INVENTORY SYSTEMA REVIEW
  • Is a type of recording system.
  • AssetaccountInventory is updated only when a physical inventory is taken – i.e., units are actually counted at the end of the period.
  • Expenseaccount Purchases is used during the period to record all purchases from the company’s vendors.
  • Cost of Goods Sold and update of Inventory cannot be recorded for individual sales since the information is unknown. (System doesn’t record cost of individual sales)
  • COGS and EI are both updated at the end of the period (periodic).
  • Example follows 
illustrated example ken s camera shop inventory data

May 1

May 12

May 20

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

Illustrated Example - Ken’s Camera Shop Inventory Data:

COGAS

4 @ $10.00 = $40.00

5 @ $10.20 = $51.00

3 @ $10.50 = $31.50

Total COGAS

(Entire Period) =

$122.50

specific identification cost flow approach
Specific Identification Cost-Flow Approach

Assume Ken can identify and track the cost of each camera sold

Sell five cameras in May

sold

sold

sold

sold

sold

May 1

May 12

May 20

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

Total COGAS =

$122.50

cost of five cameras sold using specific identification method
Cost of Five Cameras Sold Using Specific Identification Method:

May 1

May 12

May 20

Cost of

Goods Sold

$10.00

sold

10.00

sold

sold

10.20

10.20

sold

10.50

$50.90

sold

May 1

May 12

May 20

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

Total COGAS=

$122.50

slide15

Cost of

Goods Sold

$50.90

Seven Cameras Unsold Using Specific Identification Method:

May 1

May 12

May 20

unsold

unsold

Ending Inv.

$10.00

unsold

10.00

10.20

unsold

unsold

10.20

10.20

unsold

10.50

unsold

10.50 $71.60

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

slide16

Specific Identification Cost-Flow Approach

Specific Identification Cost-Flow Approach

Cost of Goods Available for Sale = $122.50

Approach allocates COGAS between

Cost of Goods Sold (E)

Ending Inventory (A)

$50.90

$71.60

Income Statement

Balance Sheet

weighted average cost flow assumption and periodic inventory method

= Per Unit

Cost

Cost of Goods Available for Sale $$

Units Available for Sale for Period

Weighted Average Cost Flow Assumptionand Periodic Inventory Method

May 1

May 12

May 20

Assigns same unit cost to all units of inventory available for sale during a period

slide18

Weighted Average Cost Flow Assumptionand Periodic Inventory Method

May 1

May 12

May 20

= Per Unit

Cost

= Per Unit

Cost

Cost of Goods Available for Sale $$

Units Available for Sale for Period

Cost of Goods Available for Sale $$

Units Available for Sale for Period

Assigns same unit cost to all units of inventory available for sale during a period

$122.50

$10.21/camera

12

cost of five cameras sold using weighted average cost assumption periodic inventory
Cost of Five Cameras Sold Using Weighted Average Cost Assumption & Periodic Inventory:

COGS = # units sold x unit cost

=5 cameras @ $10.21

= $51.05(rounded)

sold

sold

sold

sold

sold

Weighted Average Cost = $10.21/camera

slide20

Seven Cameras Unsold Using Weighted Average Cost Method:

unsold

unsold

EI = # units Unsold x unit cost

=7 cameras @ $10.21

= $71.45(rounded)

unsold

unsold

unsold

unsold

unsold

Weighted Average Cost = $10.21/camera

slide21

Weighted Average Cost Flow Assumptionand Periodic Inventory Method

Cost of Goods Available for Sale = $122.50

Assumption allocates CGAS between

Cost of Goods Sold (E)

Ending Inventory (A)

$51.05

$71.45

Income Statement

Balance Sheet

comparison of costing assumptions
Comparison of Costing Assumptions

Cost of

Goods

Sold

Ending

Inventory

Goods Available for Sale

Weighted

Average

$51.05

$71.45

$122.50

FIFO

TBD

$122.50

TBD

LIFO

$122.50

TBD

TBD

fifo cost flow assumption periodic inventory method
FIFO Cost-Flow Assumption& Periodic Inventory Method

May 1

May 12

May 20

First cameras purchased are assumedfirst sold

Sold

Sold

unsold

Sold

unsold

unsold

Sold

unsold

unsold

Sold

unsold

unsold

Sell five cameras in May;

Which ones?

Remaining 7 cameras are Ending Inventory

cost of five cameras sold using fifo method periodic inventory
Cost of Five Cameras Sold Using FIFO Method & Periodic Inventory

May 1

May 12

May 20

Cost of

Goods Sold

Sold

Sold

$10.00

unsold

10.00

Sold

unsold

unsold

10.00

10.00

Sold

unsold

unsold

10.20

$50.20

Sold

unsold

unsold

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

slide25

Cost of Seven Cameras Unsold Using FIFO Method & Periodic Inventory

May 1

May 12

May 20

Ending

Inventory

$10.20

unsold

10.20

unsold

unsold

10.20

10.20

unsold

unsold

10.50

10.50

unsold

unsold

10.50

$50.20

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

slide26

FIFO Cost-Flow Assumption& Periodic Inventory Method

Cost of Goods Available for Sale = $122.50

Assumption allocates CGAS between

Cost of Goods Sold (E)

Ending Inventory (A)

$50.20

$72.30

Income Statement

Balance Sheet

comparison of costing assumptions27
Comparison of Costing Assumptions

Cost of

Goods

Sold

Ending

Inventory

Goods Available for Sale

Weighted

Average

$51.05

$71.45

$122.50

FIFO

$72.30

$122.50

$ 50.20

LIFO

$122.50

TBD

TBD

lifo cost flow assumption periodic inventory method
LIFO Cost-Flow Assumption& Periodic Inventory Method

May 1

May 12

May 20

Last cameras purchased are assumedfirst sold

unsold

unsold

unsold

Sold

unsold

unsold

Sold

unsold

Sold

unsold

Sold

Sold

Sell five cameras in May;

Which ones?

Remaining 7 cameras are Ending Inventory

cost of five cameras sold using lifo assumption periodic inventory
Cost of Five Cameras Sold using LIFO Assumption & Periodic Inventory

May 1

May 12

May 20

Cost of

Goods Sold

unsold

unsold

unsold

10.50

Sold

unsold

10.50

unsold

10.50

unsold

Sold

10.20

Sold

10.20

$51.90

unsold

Sold

Sold

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

slide30

Cost of Seven Cameras Unsold using LIFO Assumption & Periodic Inventory

May 1

May 12

May 20

Ending

Inventory

$10.00

unsold

10.00

unsold

unsold

10.00

10.00

unsold

unsold

10.20

10.20

unsold

unsold

10.20

$70.60

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

slide31

LIFO Cost-Flow Assumptionand Periodic Inventory Method

Cost of Goods Available for Sale = $122.50

Assumption allocates CGAS between

Cost of Goods Sold (E)

Ending Inventory (A)

$51.90

$70.60

Income Statement

Balance Sheet

lifo issues
LIFO Issues
  • LIFO used on Tax Return
    • Then must be used for financial reporting purposes
  • LIFO Liquidation – Selling very old (low $ ) inventory out of Beginning Inventory
    • LIFO liquidation can result in high gross margin (and therefore large tax bill)
  • LIFO Reserve
    • DEFN: Difference between inventory value stated at FIFO and value stated at LIFO
      • Can be found in footnotes to Financial Statements
comparison of costing assumptions33
Comparison of Costing Assumptions

Cost of

Goods

Sold

Ending

Inventory

Goods Available for Sale

Weighted

Average

$71.45

$122.50

$51.05

FIFO

$72.30

$122.50

$50.20

LIFO

$122.50

$70.60

$51.90

slide34
Inventory Choice & Cash Flow Impact(Assumes:Periodic inventory, Cash sales = $100 & Inventory bought on credit)

Red = Lowest Black = Highest

slide35

LIFO Cost-Flow Assumption and Periodic Inventory – Some Questions

  • Which do you think is more important? Reporting higher EI and NIusing FIFO, or Saving taxes (and Cash) using LIFO? Why?
  • Why/when would a company use FIFO? LIFO?
  • If you are the CEO, whose bonus is based on net income, which method would you select? Why?
  • If you’re a stockholder, which method would you prefer? Why? How do you motivate the CEO?
perpetual inventory system a review
PERPETUAL INVENTORY SYSTEM: A REVIEW
  • Inventory is updated for every purchase and sale. The asset account Inventory is used.
  • Cost of Goods Soldexpense & update of asset Inventory is recorded for each individual sale at the time of the sale.
  • Inventory cost assumptionswork the same way as periodic except COGS & EI is updated for every purchase and sale (by date) instead of waiting until the end of the period (periodic).
  • Examples follow 
slide37

PERPETUAL INVENTORY SYSTEM

Accounts Payable

$3,000

Inventory

$3,000

Assume a purchase of $3,000 in inventory on account with payment terms of 2/10, net 30.

Reflect effect on B/S Equation.

-----------Balance Sheet------------- --Income Statement--

Assets = Liabilities + OE+ Rev.- Expenses

Perpetual method uses Inventory(A) account; Periodic usedPurchases(E)

slide38

PERPETUAL INVENTORY SYSTEM(Reflects Matching Principle)

A/R

$1,600

Sales Revenue

$1,600

Inventory

($1,000)

COGS

($1,000)

Sold merchandise for $1,600 with payment terms of 2/10, net 30. Cost of merchandise is $1,000.

Record effect on B/S Equation.

-----------Balance Sheet------------- --Income Statement--

Assets = Liabilities + OE+ Rev.- Expenses

#1 Record the Sale

#2 Record the Cost of the Sale

slide39

PERPETUAL INVENTORY SYSTEM

A: Inventory

A/R

$1,600

Sales Revenue

$1,600

Inventory

($1,000)

COGS

($1,000)

E: Cost of Goods Sold

PURCHSES

$1,000

$3,000

$1,000

Inventory updated

$2,000

-----------Balance Sheet------------- --Income Statement--

Assets = Liabilities + OE+ Rev.- Expenses

Sales $1,600

- COGS 1,000

Gross

Profit $600

slide40

May 1

May 12

May 20

Cost =

$10.00 ea.

Cost =

$10.20 ea.

Cost =

$10.50 ea.

Ken’s Camera Shop - Perpetual InventoryInventory Purchases and Camera Sales

May 10

Sell

3

units

May 25

Sell

2

units

Total COGAS $

(Entire Period) =

$122.50

slide41

Example-Perpetual Inventory Weighted-Average:

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

COGS

EI

Unit

Cost

Unit

Cost

DATE

Purchase

Total $

Total $

5/1

$10.00

Average Unit Cost = $10.00

On May 1 purchase 4 cameras at $10.00 each

slide42

Example-Perpetual Inventory Weighted-Average:

COGS

EI

Unit

Cost

Unit

Cost

DATE

Purchase

Total $

Total $

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

sold

sold

5/1

$10.00

sold

$10.00

5/10

$10.00

COGS = $30.00

On May 10 Ken sells 3 cameras at $25.00 each.

What is the average unit cost?

What is COGS? What is EI?

slide43

Example-Perpetual Inventory Weighted-Average:

COGS

EI

Unit

Cost

Unit

Cost

DATE

Purchase

Total $

Total $

??????

$10.00

$10.20

$10.20

??????

??????

$10.20

$10.20

??????

??????

$10.20

5/12

??????

???

5/12

On May 12 purchase 5 cameras at $10.20 each

What is the average unit cost? Must be updated on a purchase.

slide44

Example-Perpetual Inventory Weighted-Average:

Weighted

Average

Cost

COGAS $

=

Units Available

for Sale

COGS

EI

Unit

Cost

Unit

Cost

DATE

Purchase

Total $

Total $

$10.17

???

5/12

$10.17

$10.17

$10.17

$10.17

$61.00

=

=

$10.17

$10.17

$10.17

6

$61.00

On May 12 purchase 5 cameras at $10.20 each

What is the average unit cost? Must be updated on a purchase.

slide45

Example-Perpetual Inventory Weighted-Average:

COGS

EI

Unit

Cost

Unit

Cost

DATE

Purchase

Total $

Total $

$10.50

$10.50

$10.50

Weighted

Average

Cost

COGAS $

=

Units Available

for Sale

$10.28

?????

$10.17

5/20

5/12

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

$92.50

$10.28

$10.28

$10.28

$10.28

=

=

$92.50

9

On May 20 purchase 3 cameras at $10.50 each

What is the average unit cost? Must be updated after every purchase.

slide46

Example-Perpetual Inventory Weighted-Average:

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

$10.28

X 2= $20.56

$10.28 x 7 = $71.94

7

COGS

EI

Unit

Cost

Unit

Cost

DATE

Purchase

Total $

Total $

sold

sold

$10.28

5/20

$92.50

5/25

On May 25 Sold 2 cameras at $22.00 each

What is the average unit cost ,COGS and EI?

slide47

Weighted Average Cost Flow Assumptionand Perpetual Inventory Method

Cost of Goods Available for Sale = $122.50

Assumption allocates COGAS between

Cost of Goods Sold (E)

Ending Inventory (A)

$30.00 + 20.56 = $50.56

$71.94

Income Statement

Balance Sheet

comparison of costing assumptions using perpetual inventory method
Comparison of Costing Assumptions using Perpetual Inventory Method

Cost of

Goods

Sold

Ending

Inventory

Goods Available for Sale

Weighted

Average

$50.56

$71.94

$122.50

FIFO

TBD

$122.50

TBD

LIFO

$122.50

TBD

TBD

slide49

Illustrated Example - Perpetual Inventory FIFO:

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

COGS

EI

DATE

Purchase

Total $

Total $

5/1

On May 1 purchase 4 cameras at $10.00 each

slide50

Illustrated Example - Perpetual Inventory FIFO:

COGS

EI

DATE

Purchase

Total $

Total $

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

sold

sold

5/1

sold

5/10

COGS = $30.00

On May 10 Sell 3 cameras at $25.00 each.

What is COGS $ ? Where did they come from?

What is EI $ ? Where did they come from?

slide51

Illustrated Example - Perpetual Inventory FIFO:

COGS

EI

DATE

Purchase

Total $

Total $

$10.20

$10.20

$10.00

$10.20

$10.20

$10.20

$10.20

$10.20

$10.20

$10.20

$10.20

5/12

5/12

On May 12 purchase 5 cameras at $10.20 each

Inventory needs to be updated. Must keep track of inventory layers at different dates and prices.

We’ll keep the oldest inventory layer on top.

slide52

Illustrated Example - Perpetual Inventory FIFO:

COGS

EI

DATE

Purchase

Total $

Total $

$10.50

$10.20

$10.00

$10.50

$10.20

$10.20

$10.50

$10.20

$10.20

$10.50

$10.50

$10.50

5/12

5/20

On May 20 purchase 3 cameras at $10.50 each

Inventory needs to be updated. Must keep track of inventory layers at different dates and prices.

We’ll keep the oldest inventory layer on top.

slide53

Illustrated Example - Perpetual Inventory FIFO:

COGS

EI

DATE

Purchase

Total $

Total $

$10.20

$10.00

$10.20

$10.20

$10.20

$10.20

$10.50

$10.50

$10.50

$10.00

$10.20

sold

sold

5/25

5/20

= $20.20 (CGS)

EI

$72.30

5/25

On May 25 Sold 2 cameras at $22.00 each

What is COGS $?

What is EI $?

slide54

FIFO Cost-Flow Assumption& Perpetual Inventory Method

Cost of Goods Available for Sale = $122.50

Assumption allocates COGAS between

Cost of Goods Sold (E)

Ending Inventory (A)

$30.00+$20.20=$50.20

$72.30

Income Statement

Balance Sheet

comparison of costing assumptions using perpetual inventory method55
Comparison of Costing Assumptions using Perpetual Inventory Method

Cost of

Goods

Sold

Ending

Inventory

Goods Available for Sale

Weighted

Average

$50.56

$71.94

$122.50

FIFO

$122.50

$72.30

$50.20

LIFO

$122.50

TBD

TBD

slide56

Illustrated Example - Perpetual Inventory LIFO:

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

COGS

EI

DATE

Purchase

Total $

Total $

5/1

On May 1 purchase 4 cameras at $10.00 each

slide57

Illustrated Example - Perpetual Inventory LIFO:

COGS

EI

DATE

Purchase

Total $

Total $

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

$10.00

sold

sold

5/1

sold

5/10

COGS = $30.00

On May 10 Sell 3 cameras at $25.00 each.

What is COGS $ ? Where did they come from?

What is EI $ ? Where did they come from?

slide58

Illustrated Example - Perpetual Inventory LIFO:

COGS

EI

DATE

Purchase

Total $

Total $

$10.20

$10.20

$10.00

$10.20

$10.20

$10.20

$10.20

$10.20

$10.20

$10.20

$10.20

5/12

5/12

On May 12 purchase 5 cameras at $10.20 each

Inventory needs to be updated. Must keep track of inventory layers at different dates and prices.

We’ll keep the oldest inventory layer on top.

slide59

Illustrated Example - Perpetual Inventory LIFO:

COGS

EI

DATE

Purchase

Total $

Total $

$10.50

$10.20

$10.00

$10.20

$10.50

$10.20

$10.50

$10.20

$10.20

$10.50

$10.50

$10.50

5/12

5/20

On May 20 purchase 3 cameras at $10.50 each

Inventory needs to be updated. Must keep track of inventory layers at different dates and prices.

We’ll keep the oldest inventory layer on top.

slide60

Illustrated Example - Perpetual Inventory LIFO:

$10.00

$10.20

$10.20

$10.20

$10.20

$10.20

$10.50

$10.50

$10.50

$10.50

$10.50

COGS

EI

Total $

DATE

Purchase

Total $

5/25

5/20

sold

sold

= $21.00 CGS

EI

$71.50

5/25

On May 25 Sold 2 cameras at $22.00 each

What is COGS $?

What is EI $?

slide61

LIFO Cost-Flow Assumptionand Perpetual Inventory Method

Cost of Goods Available for Sale = $122.50

Assumption allocates CGAS between

Cost of Goods Sold (E)

Ending Inventory (A)

$30.00+$21.00=$51.00

$71.50

Income Statement

Balance Sheet

comparison of costing assumptions using perpetual inventory method62
Comparison of Costing Assumptions using Perpetual Inventory Method

Cost of

Goods

Sold

Ending

Inventory

Goods Available for Sale

Weighted

Average

$50.56

$71.94

$122.50

FIFO

$122.50

$72.30

$50.20

LIFO

$71.50

$51.00

$122.50

slide63
Inventory Choice & Cash Flow Impact(Assumes:Perpetual inventory, Cash sales = $100 & Inventory bought on credit)

Red = Lowest Black = Highest

inventory choice cash flow impact compares periodic vs perpetual inventory recording systems
Inventory Choice & Cash Flow Impact(Compares Periodic vs. Perpetual Inventory recording systems)

Can you draw conclusions?

lower of cost or market rule
LOWER OF COST OR MARKET RULE
  • Assets are originally recorded at their Historical Cost.
    • Why?
    • It is Objective & Verifiable
    • But it may not be the best possible information – e.g., market value would perhaps be better.
  • For a merchandising company remember that Inventoryis the mainrevenue producing stream.
  • Situation => Replacement cost of the inventory fallsbelowthe price of units we already purchased but have not yet sold (i.e., inventory).
    • What do you think that may indicate?
slide66

LOWER OF COST OR MARKET RULE

  • The sales price of the item is probably falling also!
  • So , when should this loss in revenue producing ability be recognized?
    • When we sell the item? or
    • Before we sell it?
  • Which do you think would be more relevant information for the financial statement user?
    • Historical cost or replacement cost of the item?
    • Why?(Matching & Conservatism!)
lower of cost or market rule67
LOWER OF COST OR MARKET RULE
  • Recognizeloss in value (remember it’s an asset) & reduce inventory now before it is sold.
  • This follows theconservatismprinciple =>
    • recognize the bad news now even though it may be an estimate,
    • don’t recognize the good news until it actually happens.
  • This follows the matching principle=>
    • recognizing the loss in value in the period it occurs
lower of cost or market example

Report loss in the

year that market falls below cost

Lower of Cost or Market - Example

Assume goods were purchased on May 1, 2002 at cost of $150 but RC is now $120

Before After

Adjustment Adjustment

12/30/0212/31/02

Inventory (A) $150 $120

Loss on Write Down (E) N/A $30

Adjustment applies LCM rule

lower of cost or market sale on 1 02 03
Lower of Cost or Market – Sale on 1/02/03

2002 2003 2003

Before prices fellAfter LCMIf NO Adjustment

Selling price $200 $160 $160

Cost 150 120 150

Gross margin $ 50 $ 40 $ 10

Gross margin % 25% 25% 7%

CONCLUSIONS: By applying LCM rule in 2002: (1) a normal profit margin is maintained in 2003-- when goods are finally sold! (2) Loss was recognized in 2002, when prices declined, and (3) Avoids “penalizing” 2003, as would happen if no LCM.

inventory turnover ratio

Defn: The number of times per period (i.e., year) inventory is turned over (i.e., sold)

Inventory Turnover Ratio

Cost of Goods Sold

Average Inventory *

*Average Inventory = (Beginning Inv. + Ending Inv.) / 2

What’s better – a larger or smaller ratio? Why?

inventory turnover ratios
Inventory Turnover Ratios

Examples:

Circuit City 4.3 times per year

Safeway 10.1 times per year

Can you compare the two ratios?

days sales in inventory

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

Days’ Sales in Inventory

# of Days in Period

Inventory Turnover Ratio

Defn:The average # of

days inventory is on

hand before its sold.

days sales in inventory73
Days’ Sales in Inventory

Circuit City 360 = 84 days 4.3

Safeway 360 = 36 days 10.1

Do these averages seem reasonable?

statement of cash flows
Statement of Cash Flows

Cash Flows from Operating Activities:

Net income $ xxx

Add (deduct) noncash items:

:

(Increase) decrease in inventories $ xx or (xx)

Increase (decrease) in accts. payable $ xx or (xx)

- OR -

Cash paid for inventory purchases $ ( xx)

Indirect

Method

Direct

Method

summary key objectives concepts
Summary: Key Objectives & Concepts
  • Merchandise Inventories
  • Inventory Valuation & Income Measurement
  • Inventory Costing Assumptions (GAAP):
    • Specific Identification
    • Weighted Average
    • First-In, First-Out (FIFO)
    • Last-In, Last-Out (LIFO)
  • Periodic vs. Perpetual Inventory Recording
  • Lower of Cost or Market (LCM) rule
  • Inventory Ratio Analysis
reasons for inventory errors
Reasons for Inventory Errors
  • Mathematical mistakes
  • Physical inventory counting errors
  • Cut-off problems - in-transit
  • Goods on consignment
effect of inventory errors
Effect of Inventory Errors

Example: 2002

Assume ending inventory is Overstated by $10,000 :

Correct Incorrect

Beginning inventory $ 30,000 $ 30,000

Add: purchases100,000 100,000

Goods available for sale 130,000 130,000

Less: ending inventory (40,000) (50,000)

Cost of goods sold $ 90,000$ 80,000

Cost of goods sold is understated by same amount. $10,000

effect of inventory errors79

Example:2003

Effect of Inventory Errors

The ending inventory of one period becomes the beginning inventory of the next period…so assume now…. beginning inventory is Overstated by $10,000:

Correct Incorrect

Beginning inventory $ 40,000 $50,000

Add: purchases 100,000 100,000

= Goods available for sale 140,000 150,000

Less: ending inventory(40,000) (40,000)

= Cost of goods sold $ 100,000 $ 110,000

Cost of Goods Sold & COGAS is Overstated by same amount. $10,000

reversal of inventory errors error may be self correcting
Reversal of Inventory Errors (Error may be self-correcting)
  • 2002 ending inventoryoverstated by $10,000.
  • COGS is correct in total after 2 years but incorrect in individual years.
  • The 2002 error (COGS understated $10,000) reverses in 2003 (COGS overstated $10,000).

2002 2003 Total

Beginning inventory $ 30,000 $ 50,000 $ 80,000

Add: purchases100,000100,000200,000

Goods available for sale 130,000 150,000 280,000

Less: ending inventory(50,000) (40,000) (90,000)

Cost of goods sold $ 80,000 $ 110,000 $ 190,000

Correct90,000 100,000 $ 190,000

slide81

Reversal of Inventory Errors (Error may be self-correcting)

  • Both 2002 and 2003 profits are misstated by $10,000
  • But in Total 2 years combined is correct.
  • Therefore, Total Ending Retained earnings would be correct.

Income Statement w/errors:

2002 2003 2 years

Sales $200,000 $200,000 $400,000

COGS 80,000110,000 $190,000

GM 120,000 90,000 210,000

S&A exp 80,00080,000 160,000

NI $ 40,000 $ 10,000 $50,000

It all comes out in the WASH!

Over

$10,000

Under

$10,000

Total

$0