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Financial and Managerial Accounting John J. Wild Third Edition McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5 Inventories and Cost of Sales Conceptual Chapter Objectives C1: Identify the items making up merchandise inventory. C2: Identify the costs of merchandise inventory. 5-3 Analytical Chapter Objectives A1: Analyze the effects of inventory methods for both financial and tax reporting. A2: Analyze the effects of inventory errors on current and future financial statements. A3: Assess inventory management using both inventory turnover and days’ sales in inventory. 5-4 Procedural Chapter Objectives P1: Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted average. P2: Compute the lower of cost or market amount of inventory. P3: Appendix 5A: Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average. P4: Appendix 5B: Apply both the retail inventory and gross profit methods to estimate inventory. 5-5 C1 Determining Inventory Items Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Items requiring special attention include: Goods in Transit Goods on Consignment Goods Damaged or Obsolete 5-6 C1 Goods in Transit FOB Shipping Point Public Carrier Seller Buyer Ownership passes to the buyer here. Public Carrier Seller FOB Destination Point Buyer 5-7 C2 Determining Inventory Costs Include all expenditures necessary to bring an item to a salable condition and location. Minus Discounts and Allowances Plus Import Duties Invoice Cost Plus Freight Plus Insurance Plus Storage 5-8 C2 Internal Controls and Taking a Physical Count Most companies take a physical count of inventory at least once each year. When the physical count does not match the Merchandise Inventory account, an adjustment must be made. 5-9 P1 Inventory Costing Under a Perpetual System Accounting for inventory requires several decisions . . . Costing Method Specific Identification, FIFO, LIFO, or Weighted Average Inventory System Perpetual or Periodic 5-10 P1 Frequency in Use of Inventory Methods FIFO 46% LIFO 30% Weighted Average 20% Other* 4% 5-11 P1 Inventory Cost Flow Assumptions First-In, First-Out (FIFO) Assumes costs flow in the order incurred. Last-In, First-Out (LIFO) Assumes costs flow in the reverse order incurred. Weighted Average Assumes costs flow at an average of the costs available. 5-12 P1 Inventory Costing Illustration Cost of Goods Available Aug. 1 Beg. Inventory Aug. 3 Purchased Aug. 17 Purchased Aug. 28 Purchased for Sale 10 units 15 units 20 units 10 units = = = = $ 910 $ 1,590 $ 2,300 $ 1,190 Retail Sales of Goods Aug. 14 Sales Aug. 31 Sales 20 units @ $ 130 = 23 units @ $ 150 = $ 2,600 $ 3,450 @ @ @ @ $ $ $ $ 91 106 115 119 5-13 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Specific Identification Purchases 10 @ $ 91 = 15 @ $ 106 = Cost of Goods Sold $ 910 $ 1,590 8 @ 20 @ $ 115 = 10 @ $ 119 = Inventory Balance $ 910 $ 2,500 $ 91 = $ 728 12 @purchases $ 106 = $ were 1,272 $ 500 The above $ 2,300 $ 2,800 made in August. On August 14, $ 1,190 $ 3,990 a company eight 2 @ sold $ 91 = $bikes 182 @ $ 106 $91 = $and 31812 originally3 costing 14 @ $ 115 = $ 1,610 bikes originally costing $106. 4 @ $ 119 = $ 476 $ 1,404 5-14 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Specific Identification Purchases Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 8 @ $ 91 = $ Inventory Balance $ 910 $ 2,500 728 The Cost of Goods Sold12for@the$20 bikes on $ 106 = old $ 1,272 the August 14 sale is $2,000. 20 @ $ 115 = $ 2,300 $ 10 @ $ 119 = $@1,190 $ 8 bikes 91 = $ 728 12 bikes @ 106 =2 @ $1,272 $ 91 = $ 182 3 @ $ 106 = $ 500 2,800 3,990 318 After this sale, there are five units in inventory 14 @ $ 115 = $ 1,610 at $500: 2 bikes @ $91 = $ 182 3 bikes @ $106 = $ 318 5-15 P1 Specific Identification Date Aug. 1 Aug. 3 Aug. 14 Purchases Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 8 @ $ 91 = $ 728 12 @ $ 106 = $ 1,272 Aug. 17 20 @ $ 115 = $ 2,300 Aug. 28 10 @ $ 119 = $ 1,190 Aug.Additional 31 $ 91 = $ 182 purchases were made2 on@August 17 and 28. 3 @ $ 106 = $ $ 500 $ 2,800 $ 3,990 318 The cost of the 23 items sold on August 14 @ 31 $ were 115 =as follows: $ 1,610 2 @ $91 4 @ $ 119 = $ 476 $ 1,404 3 @ $106 15 @ $115 3 @ $119 5-16 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Specific Identification Purchases Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 8 @ $ 91 = $ 728 12 @ $ 106 = $ 1,272 2 @ $ 91 = $ 182 3 @ $ 106 = $ 318 15 @ $ 115 = $ 1,725 3 @ $ 119 = $ 357 $ 500 $ 2,800 $ 3,990 $ 1,408 Cost of Goods Sold for August 31 = $2,582 5-17 P1 Specific Identification Here are the entries to record the purchases and sales. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 Aug. 3 Aug. 14 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Aug. 31 Merchandise inventory Accounts payable Accounts receivable Sales Cost of goods sold Merchandise inventory Merchandise inventory Accounts payable Merchandise inventory Accounts payable Accounts receivable Sales Cost of goods sold Merchandise inventory 1,590 1,590 2,600 2,600 2,000 2,000 2,300 2,300 1,190 1,190 3,450 3,450 2,582 2,582 5-18 P1 Date Aug. 1 Aug. 3 First-In, First-Out (FIFO) Purchases Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 Aug. 17 20 @ $ 115 = $ 2,300 The above purchases were Aug. 28 10 @ $ 119 = $ 1,190 made Aug. 31 in August. 5 @ 18 @ On August 14, the company sold 20 bikes. $ 2,300 $ 3,490 $ 106 = $ 530 $ 115 = $ 2,070 $ 890 5-19 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 First-In, First-Out (FIFO) Purchases Cost of Goods Sold 10 @ $ 91 = $ 15 @ $ 106 = $ 1,590 20 @ $ 115 = Inventory Balance $ 910 $ 2,500 910 10 @ $ 91 = $ 910 10 @ $ 106 = $ 1,060 $ 2,300 The Sold for the 10 @Cost $ 119 of = Goods $ 1,190 5 @ $ 106 = August 14 sale is $1,970. 18 @ $ 115 = $ $ 530 $ 2,830 $ 4,020 530 $ 2,070 $ 1,420 After this sale, there are five units in inventory at $530: 5 @ $106 5-20 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 First-In, First-Out (FIFO) Purchases Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 10 @ $ 91 = $ 910 10 @ $ 106 = $ 1,060 5 @ $ 106 = $ 18 @ $ 115 = $ 2,070 $ 530 $ 2,830 $ 4,020 530 $ 1,420 Cost of Goods Sold for August 31 = $2,600 5-21 P1 Date Aug. 1 Aug. 3 Aug. 14 First-In, First-Out (FIFO) Purchases Aug. 31 Cost of Goods Sold 10 @ $ 91 = $ 15 @ $ 106 = $ 1,590 Income Statement Aug. 17 20 @ $ 115 = Aug. 28 10 @ $ 119 = COGS = $4,570 Inventory Balance $ 910 $ 2,500 910 10 @ $ 91 = $ 910 10 @ $ 106 = $ 1,060 5 @ $ 106 = $ 18 @ $ 115 = $ 2,070 $ 2,300 $ 1,190 $ 530 $ 2,830 $ 4,020 530 $ 1,420 Balance Sheet Inventory = $1,420 5-22 P1 First-In, First-Out (FIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 Aug. 3 Aug. 14 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Aug. 31 Merchandise inventory Accounts payable Accounts receivable Sales Cost of goods sold Merchandise inventory Merchandise inventory Accounts payable Merchandise inventory Accounts payable Accounts receivable Sales Cost of goods sold Merchandise inventory 1,590 1,590 2,600 2,600 1,970 1,970 2,300 2,300 1,190 1,190 3,450 3,450 2,600 2,600 5-23 P1 Date Aug. 1 Aug. 3 Aug. 14 Last-In, First-Out (LIFO) Purchases Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 15 @ $ 106 = $ 1,590 5 @ $ 91 = $ Aug. 20 @ $ 115 = $ 2,300 The17above purchases were Aug. 28 10 @ $ 119 = $ 1,190 made Aug. 31 in August. 10 @ $ 119 = $ 1,190 $ 115 = $ 1,495 13 @ On August 14, the company sold 20 bikes. 455 $ 455 $ 2,755 $ 3,945 $ 1,260 5-24 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Last-In, First-Out (LIFO) Purchases Cost of Goods Sold 10 @ $ 91 = $ 15 @ $ 106 = $ 1,590 20 @ 10 @ $ 115 = Inventory Balance $ 910 $ 2,500 910 15 @ $ 106 = $ 1,590 5 @ $ 91 = $ 455 $ 2,300 The Cost Goods Sold for the $ 119 = $of 1,190 10 @ 119 = $ 1,190 August 14 sale is $$2,045. 13 @ $ 115 = $ 1,495 $ 455 $ 2,755 $ 3,945 $ 1,260 After this sale, there are five units in inventory at $455: 5 @ $91 5-25 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Last-In, First-Out (LIFO) Purchases Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 15 @ $ 106 = $ 1,590 5 @ $ 91 = $ 10 @ $ 119 = $ 1,190 13 @ $ 115 = $ 1,495 455 $ 455 $ 2,755 $ 3,945 $ 1,260 Cost of Goods Sold for August 31 = $2,685 5-26 P1 Date Aug. 1 Aug. 3 Aug. 14 Last-In, First-Out (LIFO) Purchases Cost of Goods Sold 10 @ $ 91 = $ 15 @ $ 106 = $ 1,590 Aug. 17Income 20 @ $ 115 = Statement Aug. 28 10 @COGS $ 119 = = $4,730 Aug. 31 Inventory Balance $ 910 $ 2,500 910 15 @ $ 106 = $ 1,590 5 @ $ 91 = $ 10 @ $ 119 = $ 1,190 13 @ $ 115 = $ 1,495 455 $ 2,300 $ 1,190 $ 455 $ 2,755 $ 3,945 $ 1,260 Balance Sheet Inventory = $1,260 5-27 P1 Last-In, First-Out (LIFO) Here are the entries to record the purchases and sales entries. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 Aug. 3 Aug. 14 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Aug. 31 Merchandise inventory Accounts payable Accounts receivable Sales Cost of goods sold Merchandise inventory Merchandise inventory Accounts payable Merchandise inventory Accounts payable Accounts receivable Sales Cost of goods sold Merchandise inventory 1,590 1,590 2,600 2,600 2,045 2,045 2,300 2,300 1,190 1,190 3,450 3,450 2,685 2,685 5-28 P1 Weighted Average When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Cost of Goods Units on hand Available for ÷ on the date of Sale sale 5-29 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Weighted Average 10 15 20 10 Inventory Balance Purchases Cost of Goods Sold @ $ 91 = $ 910 $ 910 @ $ 106 = $ 1,590 $ 2,500 20 @ $ the 100 weighted = $ 2,000 $ 500 First, we need to compute @average $ 115 =cost $ 2,300 per unit of items in inventory. $ 2,800 @ $ 119 = $ 1,190 $ 3,990 Cost of goods available for sale $ 2,500 23 @ $ 114 = $ 2,622 $ 1,368 Total units in inventory 25 Weighted average cost per unit $ ÷ 100 The Cost of Goods Sold for the August 14 sale is $2,000. After this sale, there are five units in inventory at $500: 5-30 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Weighted Average Purchases Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 20 @ 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 $ 100 = $ 2,000 Inventory Balance $ 910 $ 2,500 $ 500 $ 2,800 $ 3,990 $ 1,368 23 @ $ 114 = $ 2,622 Additional purchases were made on August 17 and 28. Twenty-three bikes were sold on August 31. What is the weighted average cost per unit of items in inventory? 5-31 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Weighted Average Purchases Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 Units Inventory 8/14 5 Purchase 8/17 20 Purchase 8/28 10 Units available for sale 35 20 @ $ 100 = $ 2,000 23 @ $ 114 = $ 2,622 Cost of goods available for sale Total units in inventory Weighted average cost per unit Inventory Balance $ 910 $ 2,500 $ 500 $ 2,800 $ 3,990 $ 1,368 $ 3,990 ÷ 35 $ 114 5-32 P1 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Weighted Average Purchases 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 Cost of Goods Sold for August 31 = $2,622 Inventory Balance Cost of Goods Sold $ 910 $ 2,500 20 @ $ 100 = $ 2,000 $ 500 $ 2,800 $ 3,990 23 @ $ 114 = $ 2,622 $ 1,368 Ending inventory is comprised of 12 units @ an average cost of $114 each or $1,368. 5-33 P1 Weighted Average Date Purchases Aug. 1 10 @ $ 91 = Aug. 3 15 @ $ 106 = Aug. 14 Aug. 17 Income 20 @ $ 115 = Aug.Statement 28 10 @ $COGS 119 = Aug. 31 = $4,622 $ 910 $ 1,590 $ 2,300 $ 1,190 Inventory Balance Cost of Goods Sold $ 910 $ 2,500 20 @ $ 100 = $ 2,000 $ 500 $ 2,800 $ 3,990 23 @ $ 114 = $ 2,622 $ 1,368 Balance Sheet Inventory = $1,368 5-34 P1 Weighted Average Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by the cost flow assumption used. All purchases and sales are made on credit. The selling price of inventory was as follows: 8/14 $130 8/31 150 Aug. 3 Aug. 14 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Aug. 31 Merchandise inventory Accounts payable Accounts receivable Sales Cost of goods sold Merchandise inventory Merchandise inventory Accounts payable Merchandise inventory Accounts payable Accounts receivable Sales Cost of goods sold Merchandise inventory 1,590 1,590 2,600 2,600 2,000 2,000 2,300 2,300 1,190 1,190 3,450 3,450 2,622 2,622 5-35 A1 Financial Statement Effects of Costing Methods Because prices change, inventory methods nearly always assign different cost amounts. Trekking Company For Month Ended August 31 Specific Identification Sales $ 6,050 Cost of goods sold 4,582 Gross profit $ 1,468 Operating expenses 450 Income before taxes $ 1,018 Income tax expense (30%) 305 Net income $ 713 Balance sheet inventory $ 1,408 $ FIFO 6,050 4,570 1,480 450 1,030 309 721 $ 1,420 $ $ $ $ LIFO 6,050 4,730 1,320 450 870 261 609 $ 1,260 $ $ $ Weighted Average $ 6,050 4,622 $ 1,428 450 $ 978 293 $ 685 $ 1,368 5-36 A1 Financial Statement Effects of Costing Methods Advantages of Methods Weighted Average First-In, First-Out Last-In, First-Out Smoothes out price changes. Ending inventory approximates current replacement cost. Better matches current costs in cost of goods sold with revenues. 5-37 A1 Tax Effects of Costing Methods The Internal Revenue Service (IRS) identifies several acceptable methods for inventory costing for reporting taxable income. If LIFO is used for tax purposes, the IRS requires it be used in financial statements. 5-38 A1 Consistency in Using Costing Methods The consistency concept requires a company to use the same accounting methods period after period so that financial statements are comparable across periods. 5-39 P2 Lower of Cost or Market Inventory must be reported at market value when market is lower than cost. Defined as current replacement cost (not sales price). Consistent with the conservatism principle. Can be applied three ways: (1) (2) (3) separately to each individual item. to major categories of assets. to the whole inventory. 5-40 P2 Lower of Cost or Market A motorsports retailer has the following items in inventory: Per Unit Inventory Items Cycles: Roadster Sprint Category subtotal Off-Road Trax-4 Blazer Category subtotal Total Units on Hand Cost 20 $ 8,000 10 5,000 8 5 5,000 9,000 Market Total Cost Total Market $ 7,000 6,000 $160,000 50,000 210,000 $ 140,000 60,000 200,000 6,500 7,000 40,000 45,000 85,000 $295,000 52,000 35,000 87,000 $ 287,000 5-41 P2 Lower of Cost or Market Here is how to compute lower of cost or market for individual inventory items. LCM Applied to Units on Inventory Items Hand Total Cost Cycles: Roadster 20 $ 160,000 Sprint 10 50,000 Category subtotal $ 210,000 $ 140,000 $ 140,000 60,000 50,000 $ 200,000 Off-Road Trax-4 Blazer Category subtotal Total $ 52,000 40,000 35,000 35,000 $ 87,000 $ 287,000 $ 265,000 8 5 $ 40,000 45,000 $ 85,000 $ 295,000 Total Market Items Categories Whole 5-42 P2 Lower of Cost or Market Here is how to compute lower of cost or market for the two groups of inventory items. LCM Applied to Units on Inventory Items Hand Total Cost Cycles: Roadster 20 $ 160,000 Sprint 10 50,000 Category subtotal $ 210,000 $ 140,000 $ 140,000 60,000 50,000 $ 200,000 $ 200,000 Off-Road Trax-4 Blazer Category subtotal Total $ 52,000 40,000 35,000 35,000 $ 87,000 $ 287,000 $ 265,000 85,000 $ 285,000 8 5 $ 40,000 45,000 $ 85,000 $ 295,000 Total Market Items Categories Whole 5-43 P2 Lower of Cost or Market Here is how to compute lower of cost or market for the entire inventory. LCM Applied to Units on Inventory Items Hand Total Cost Cycles: Roadster 20 $ 160,000 Sprint 10 50,000 Category subtotal $ 210,000 $ 140,000 $ 140,000 60,000 50,000 $ 200,000 $ 200,000 Off-Road Trax-4 Blazer Category subtotal Total $ 52,000 40,000 35,000 35,000 $ 87,000 $ 287,000 $ 265,000 85,000 $ 285,000 8 5 $ 40,000 45,000 $ 85,000 $ 295,000 Total Market Items Categories Whole $ 287,000 5-44 A2 Financial Statement Effects of Inventory Errors Income Statement Effects Inventory Error Understate ending inventory Understate beginning inventory Overstate ending inventory Overstate beginning inventory Cost of Goods Sold Net Income Overstated Understated Understated Overstated Understated Overstated Overstated Understated 5-45 A2 Financial Statement Effects of Inventory Errors Balance Sheet Effects Inventory Error Understate ending inventory Overstate ending inventory Assets Equity Understated Understated Overstated Overstated 5-46 A3 Inventory Turnover Shows how many times a company turns over its inventory during a period. Indicator of how well management is controlling the amount of inventory available. Inventory Turnover Average Inventory = = Cost of goods sold Avg. inventory (Beg. Inv. + End Inv.) ÷ 2 5-47 A3 Days’ Sales in Inventory Reveals how much inventory is available in terms of the number of days’ sales. Days' Sales in Inventory = Ending Inventory Cost of goods sold × 365 5-48 End of Chapter 5 5-49