Chapter 5 Notes: Inventories and Cost of Goods Sold

Inventories and Cost of Goods Sold

Inventory Types

• Finished Inventory: Held by retailers and wholesalers, also known as merchandise inventory.
• Materials Inventory: Held by manufacturers, including:
  • Raw materials
  • Work-in-progress
  • Finished goods

Types of Manufacturing Costs

• Direct Materials: Also called raw materials, are ingredients used in making a product.
• Direct Labor: Amounts paid to workers to manufacture the product.
• Manufacturing Overheads: All other costs related to the manufacturing process but cannot be directly matched to specific units of output.
  • Example: Depreciation of building and salary of supervisor.

Relationships Between Types of Businesses and Inventory Costs (Exhibit 5.1)

• Retailer/Wholesaler:
  • Activity: Buys finished products.
  • Asset on Balance Sheet: Merchandise inventory.
  • Income Statement When Inventory Is Sold: Cost of goods sold.
• Manufacturer:
  • Activity: Buys raw materials and then adds Direct labor and Overhead.
  • Assets on Balance Sheet: Raw materials, Work in process, Finished goods.
  • Income Statement When Inventory Is Sold: Cost of goods sold.

Account for Sales of Merchandise

• Sales Revenue: Represents the inflow of assets, either cash or accounts receivable, from the sale of a product during the period.
• Net Sales: Calculated as: $Net Sales = Sales - Sales Returns and Allowances - Sales Discount$
• Gross Profit: Calculated as: $Gross Profit = Net Sales - Cost of Goods Sold$

Net Sales Section of the Income Statement (Exhibit 5.3 - Example: Daisy's Running Depot)

• Sales revenue: 103,500
• Less: Sales returns and allowances: 2,000
• Sales discounts: 1,500
• Net sales: 100,000

Sales Returns and Allowances

• Sales Returns and Allowances: A contra-revenue account used to record refunds to customers and reductions of their accounts.
• Sales Discounts: A contra-revenue account used to record discounts given to customers for early payment of their accounts.

Credit Terms and Sales Discounts

• Credit Terms: A firm’s policy for granting credit.
  • Example: n/30; Net, 10 EOM; 1/10, n/30
    • n/30: The net amount of the selling price is due within 30 days of the date of the invoice.
    • Net, 10 EOM: The net amount is due anytime within ten days after the end of the month.
    • 1/10, n/30: The customer can deduct 1% from the selling price if the bill is paid within ten days.

Cost of Goods Sold Model

• Recognition of cost of goods sold as an expense is an excellent example of matching principle.
  • Sales Revenue: Inflow of assets, cash or accounts receivable.
  • Cost of Goods Sold: Outflow of asset, inventory.
• Cost of Goods Available for Sale: Beginning inventory + Cost of goods purchased.
• Cost of Goods Sold: Cost of goods available for sale − Ending inventory.

Cost of Goods Sold Section of the Income Statement (Exhibit 5.4 - Example: Daisy's Running Depot)

• Inventory, January 1, 2014: 15,000 (What is on hand to start the period)
• Purchases: 65,000
• Less: Purchase returns and allowances: 1,800
• Purchase discounts: 3,700
• Net purchases: 59,500
• Add: Transportation-in: 3,500
• Cost of goods purchased: 63,000 (What was acquired for resale during the period)
• Cost of goods available for sale: 78,000 (The "pool" of costs to be distributed)
• Less: Inventory, December 31, 2014: 18,000 (What was not sold during the period and therefore is on hand to start the next period)
• Cost of goods sold: 60,000 (What was sold during the period)

Inventory Systems: Perpetual and Periodic

• Perpetual:
  • The inventory account is increased at the time of each purchase and decreased at the time of each sale.
• Periodic:
  • The inventory account is updated only at the end of the period.

Recording Cost of Goods Sold in a Perpetual System (Example 5.3)

• Daisy’s sells a pair of running shoes that costs the company 70.

Cost of Goods Purchased (Exhibit 5.6 - Example: Daisy's Running Depot)

• Purchases: 65,000
• Less: Purchase returns and allowances: (1,800)
• Purchase discounts: (3,700)
• Net purchases: 59,500
• Add: Transportation-in: 3,500
• Cost of goods purchased: 63,000

Recording Purchase in a Periodic System (Example 5.4)

• Assume that Daisy’s buys shoes on account from Nike at a cost of 4,000.
• Purchases: Temporary account that is closed at the end of the period.
  • Not an asset account.
  • Included in income statement as an integral part of the calculation of cost of goods sold.

Recording Purchase Returns in a Periodic System (Example 5.5)

• Daisy’s returns 850 of merchandise to Nike for credit on Daisy’s account.
• Purchase Returns and Allowances: Contra-purchases account.
  • Used when a refund is received from a supplier, or a reduction is given in the balance owed to a supplier.

Purchase Discounts

• A contra-purchases account used to record reductions in purchase price for early payment to a supplier.

Recording Purchase Discounts in a Periodic System (Example 5.6)

• Assume a purchase of merchandise on March 13 for 500, with credit terms of 1/10, n/30.
• Company pays its account on March 23, within the discount period.

Shipping Terms and Transportation Costs

• Cost Principle: All costs necessary to prepare an asset for its intended use should be included in its cost.
• FOB Destination Point: Seller incurs the transportation costs.
• FOB Shipping Point: Buyer incurs the transportation costs.
• FOB: Stands for ‘‘free on board’’.

Recording Transportation-In in a Periodic System (Example 5.7)

• Assume that on delivery of a shipment of goods, Daisy’s pays an invoice for 300 from Rocky Mountain Railroad. The terms of shipment are FOB shipping point.

The Gross Profit Ratio

• Important measure of profitability.
• Indicates a company’s ability to cover operating expenses and earn a profit.

Valuation of Inventory and the Measurement of Income

• Value assigned to inventory on balance sheet determines the amount eventually recognized as an expense on income statement.
• Incorrect ending inventory will affect cost of goods sold and net income.
• Example:
  • Beginning inventory: 500
  • Add: Purchases: 1,200
  • Cost of goods available for sale: 1,700
  • Less: Ending inventory: (600)
  • Costs of goods sold: 1,100

Inventory Costs

• Cost: Price paid or consideration given to acquire an asset.
  • Includes expenditures directly or indirectly incurred in bringing to its existing condition and location.
• Examples:
  • Freight costs incurred to bring inventory to the place of business.
  • Cost of insurance when inventory is in transit.
  • Cost of storing inventory before it is ready to be sold.
  • Taxes paid—excise and sales taxes.

Inventory Costing Methods with a Periodic System

• Specific Identification
• Weighted Average
• First-in, First-out (FIFO)
• Last-in, First-out (LIFO)

Specific Identification Method

• Relies on matching unit costs with the actual units sold.

Determining Ending Inventory and Cost of Goods Sold Using Specific Identification (Example 5.10)

• Ending Inventory Calculation:
  • January 20: 100 units @ $11 =$1,100
  • April 8: 300 units @ $12 =$3,600
  • September 5: 200 units @ $13 =$2,600
  • Ending inventory: 600 units, Total Cost: 7,300
• Cost of Goods Sold Calculation:
  • Costs of goods available for sale: 17,100
  • Less: Ending inventory: 7,300
  • Equals: Costs of goods sold: 9,800
• Units Sold Calculation:
  • Beginning inventory: 500 units @ $10 =$5,000
  • January 20: 200 units @ $11 =$2,200
  • April 8: 100 units @ $12 =$1,200
  • December 12: 100 units @ $14 =$1,400
  • Costs of goods sold: 900 units, Total Cost: 9,800

Weighted Average Cost Method

• Assigns the same unit cost to all units available for sale during the period.
• Ending inventory = Weighted Average Cost × Number of Units in Ending Inventory

Determining Ending Inventory and Cost of Goods Sold Using Weighted Average (Example 5.11)

• Weighted Average Cost 11.40 × Number of Units in Ending Inventory 600 = Ending Inventory 6,840
• Cost of goods sold can be calculated in one of two ways:
  • Cost of goods available for sale: 17,100
  • Less: Ending inventory: 6,840
  • Equals: Costs of goods sold: 10,260
  • OR
  • Weighted Average Cost $11.40 × Number of Units Sold 900 = Costs of Goods Sold$10,260

First-In, First-Out Method (FIFO)

• Assigns the most recent costs to ending inventory.

Determining Ending Inventory and Cost of Goods Sold Using FIFO (Example 5.12)

• Ending Inventory Calculation:
  • December 12: 100 units @ $14 =$1,400
  • September 5: 200 units @ $13 =$2,600
  • April 8: 300 units @ $12 =$3,600
  • Ending inventory: 600 units, Total Cost: 7,600
• Cost of Goods Sold Calculation:
  • Costs of goods available for sale: 17,100
  • Less: Ending inventory: 7,600
  • Equals: Costs of goods sold: 9,500
• Units Sold Calculation:
  • Beginning inventory: 500 units @ $10 =$5,000
  • January 20: 300 units @ $11 =$3,300
  • April 8: 100 units @ $12 =$1,200
  • Units sold: 900, Costs of goods sold: 9,500

Last-In, First-Out Method (LIFO)

• Assigns the most recent costs to cost of goods sold.

Determining Ending Inventory and Cost of Goods Sold Using LIFO (Example 5.13)

• Ending Inventory Calculation:
  • Beginning inventory: 500 units @ 10 = 5,000
  • January 20: 100 units @ 11 = 1,100
  • Ending inventory: 600 units, Total Cost: 6,100
• Cost of Goods Sold Calculation:
  • Costs of goods available for sale: 17,100
  • Less: Ending inventory: 6,100
  • Equals: Costs of goods sold: 11,000
• Units Sold Calculation:
  • December 12: 100 units @ 14 = 1,400
  • September 5: 200 units @ 13 = 2,600
  • April 8: 400 units @ 12 = 4,800
  • January 20: 200 units @ 11 = 2,200
  • Units sold: 900, Costs of goods sold: 11,000

Selecting an Inventory Costing Method

• The choice of an inventory method will impact cost of goods sold and thus net income.
• A company should choose the method that results in the most accurate measure of net income for the period.

Computing Taxes Saved by Using LIFO Instead of FIFO (Example 5.14)

• Assume a 40% tax rate, income tax expense under LIFO is only $2,000, compared with$2,600 under FIFO, a savings of 600 in taxes.
• LIFO \space cost \space of \space goods \space sold \space $11,000$ – FIFO \space cost \space of \space goods \space sold \space 9,500
• Additional \space expense \space from \space use \space of \space LIFO \space $1,500$
• $× Tax \space rate \space 0.40$
• $Tax \space savings \space from \space the \space use \space of \space LIFO \space$600$$

Result of FIFO and LIFO during a Period of Raising Prices

LIFO Issues

• LIFO Liquidation: Negative tax consequences.
• LIFO Conformity Rule: If LIFO is used on a tax return, it must also be used in reporting income to stockholders.
• LIFO Reserve: The excess of the value of a company’s inventory stated at FIFO over the value stated at LIFO.

Costing Methods and Inventory Profits

• Replacement Cost: The current cost of a unit of inventory.
• Inventory Profit: The portion of the gross profit that results from holding inventory during a period of rising prices.

Inventory Valuation in Other Countries

• Valuing inventory differ around the world
  • GAAP in the United States allows LIFO
  • IASB strictly prohibits the use of LIFO
• Survival of LIFO is not only a matter of convergence with international standards
  • LIFO allows companies with rising inventory costs to report lower income

Inventory Errors

• Mathematical errors
• Physical count of inventory at year-end
• Cutoff problems—in-transit—at year-end

Analyzing the Effect of an Inventory Error on Net Income (Example 5.17)

• An overstatement or understatement of ending inventory affects the cost of goods sold and net income in the current and subsequent periods.

Lower-of-Cost-or Market Rule

• A conservative inventory valuation approach
• Require that inventory be written down at the end of the period if the market value of the inventory is less than its cost
• Can be applied to:
  • Entire inventory
  • Individual items
  • Groups of items

Lower-of-Cost-or-Market under International Standards

• Required under both U.S. GAAP and IFRS
• Difference:
  • U.S.GAAP
    • Define market value as replacement cost, subject to a maximum and a minimum amount
    • New amount becomes basis for future adjustments
  • IFRS
    • Uses net realizable value with no upper or lower limits
    • Write-downs of inventory can be reversed in later periods

Inventory Turnover Ratio

• Measures company’s ability to sell its inventory quickly
• Number of times inventory is sold during a period

Number of Days’ Sales in Inventory

• Measures of how long it takes to sell inventory

Inventory Costing Methods with the Use of a Perpetual Inventory System

• Demonstrates the use of FIFO and LIFO using a perpetual inventory system given various purchases and sales during a period.

Determining Ending Inventory Using FIFO with a Perpetual System (Example 5.20)

• Details how to track inventory balances, unit costs, and total costs after each purchase and sale using the FIFO method.

Determining Ending Inventory Using LIFO with a Perpetual System (Example 5.21)

• Details how to track inventory balances, unit costs, and total costs after each purchase and sale using the LIFO method.

Moving Average

• An average cost method when a weighted average cost assumption is used with a perpetual inventory system.

Determining Ending Inventory Using Moving Average with a Perpetual System (Example 5.22)

• Illustrates the calculation of the weighted average cost after each purchase.