Act 211, Chapter 6

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Chapter 06:

Chapter 06 Inventory and Cost of Goods Sold

Inventory:

Inventory Includes items a company intends for sale to customers. For example, clothes at The Limited , shoes at Payless ShoeSource , building supplies at Home Depot , and so on. Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer, and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers. 6- 2

Part A:

Part A Understanding Inventory and Cost of Goods Sold 6- 3

LO1 Trace the flow of inventory costs from manufacturing companies to merchandising companies:

LO1 Trace the flow of inventory costs from manufacturing companies to merchandising companies Inventory Merchandise company Manufacturing company Wholesaler Retailer Raw material Work in progress Finished goods 6- 4

Merchandising Companies :

Merchandising Companies 6- 5

Manufacturing Companies :

Manufacturing Companies These companies manufacture the inventories they sell, rather than buying them in finished form from suppliers. Manufacturers classify inventory into three categories: Raw materials inventory: Includes the cost of components that will become part of the finished product but have not yet been used in production. Work-in-process inventory: Refers to the products that have started the production process but are not yet complete at the end of the period. Finished goods inventory: It includes the cost of the units that have been completed by the end of the period but not yet sold. 6- 6

Types of Companies and Flow of Inventory Costs:

Types of Companies and Flow of Inventory Costs 6- 7

LO2 Calculate cost of goods sold:

LO2 Calculate cost of goods sold 6- 8

Relationship between Inventory and Cost of Goods Sold:

Relationship between Inventory and Cost of Goods Sold 6- 9

LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods:

LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods Inventory cost method Specific Identification First in, first out (FIFO) Last in, first out (LIFO) Average Cost Specific Identification Method 6- 10

Cost Flow Assumptions (LIFO, FIFO, Weighted Average):

11 Cost Flow Assumptions (LIFO, FIFO, Weighted Average) Assume all inventory dumped it at top Would this graphical analysis change if we assumed a perpetual “shop” If sold from bottom, then a FIFO flow! If sold from top, then a LIFO flow! If average unit assumed sold, we just sell average unit…(huh?) Specific Identification method simply IDs which units were sold vs. which are still left in inventory.

Inventory Costing – Cost Flow Assumptions:

Inventory Costing – Cost Flow Assumptions Use of cost flow methods in major U.S. companies Cost Flow Assumption does not need to equal Physical Movement of Goods 12

Inventory Transactions for Mario’s Game Shop:

It has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19. There are 1,000 game cartridges available for sale. During the year, it sells 800 video game cartridges for $15 each. This means that 200 cartridges remain in ending inventory at the end of the year. Inventory Transactions for Mario’s Game Shop 6- 13

First-In, First-Out (FIFO):

First-In, First-Out (FIFO) First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on. Mario’s Game Shop, which 800 units were sold? They were the first 800 units purchased, and that all other units remain in ending inventory. 6- 14

Last-In, First-Out (LIFO):

Last units purchased are the first ones sold. If Mario sold 800 units, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory. Last-In, First-Out (LIFO) 6- 15

Weighted-Average Cost:

Weighted-Average Cost Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale. Each unit of inventory has a cost equal to the weighted-average cost of all inventory items. 6- 16

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Comparison of Cost of Goods Sold Under the Three Inventory Cost Flow Assumptions:

A company begins the year with one unit, purchases three units and sells two units. FIFO: Inventory is sold in the order purchased. LIFO: Inventory is sold in the opposite order that we purchased it. Weighted-average cost: Inventory is sold using an average of all inventory purchased. Comparison of Cost of Goods Sold Under the Three Inventory Cost Flow Assumptions 6- 18

LO4 Explain the financial statement effects and tax effects of inventory cost flow assumptions:

LO4 Explain the financial statement effects and tax effects of inventory cost flow assumptions Effects of Managers’ Choice of Inventory Reporting Methods Why Choose LIFO? Results in tax savings when inventory costs are rising. Has an income statement focus. Why Choose FIFO? Matches physical flow for most companies. Results in higher assets and net income when inventory costs are rising. Has a balance sheet focus. 6- 19

Comparison of Inventory Cost Flow Assumptions When Prices Are Rising:

Comparison of Inventory Cost Flow Assumptions When Prices Are Rising A comparison of FIFO, LIFO, and average cost for Mario’s Game Shop is provided below. 6- 20

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Reporting the LIFO Difference:

Reporting the LIFO Difference Choice between FIFO and LIFO results in different amounts for ending inventory and cost of goods sold. It complicates the investment decisions of stockholders. Due to financial statement effects of different inventory methods, companies that choose LIFO must report what’s called their LIFO difference. LIFO difference is the additional amount of inventory a company would report if it used FIFO instead of LIFO. Companies that have been using LIFO for a long time or that have seen dramatic increases in inventory costs, the LIFO difference can be substantial. LIFO difference reported by Rite Aid Corporation which uses LIFO to account for most of its inventory follows. 6- 22

Part B:

Part B Recording Inventory Transactions 6- 23

Perpetual inventory system and Periodic inventory system:

Perpetual inventory system and Periodic inventory system Perpetual Inventory System It maintains a continual—that is, perpetual—tracking of inventory. A continual tracking helps a company to better manage its inventory levels. Periodic Inventory System It does not continually modify inventory amounts, but instead periodically adjusts for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand. 6- 24

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LO5 Record inventory transactions using a perpetual inventory system.:

LO5 Record inventory transactions using a perpetual inventory system. To see how to record inventory transactions using a perpetual inventory system, we will look again at the inventory transactions for Mario’s Game Shop. 6- 26

Inventory Purchases:

Inventory Purchases To record the purchase of new inventory, we debit inventory (an asset) to show that the company’s balance of this asset account has increased. At the same time, if the purchase was paid in cash, we credit cash. Or more likely, if the company made the purchase on account, we credit accounts payable, increasing total liabilities. Thus, Mario records the first purchase of 300 units for $2,700 on April 25 as: 6- 27

Inventory Sales:

On July 17, Mario sold 300 units of inventory on account for $15 each, resulting in total sales of $4,500. We make two entries to record the sale: The first entry shows an increase to the asset account (in this case, Accounts Receivable) and an increase in sales revenue. The second entry adjusts the Inventory and Cost of Goods Sold accounts. Inventory Sales 6- 28

Other inventory transactions:

Other inventory transactions 6- 29

Simple Adjustment from FIFO to LIFO.:

Simple Adjustment from FIFO to LIFO. Mario’s ending balance of inventory using FIFO is $2,200. Under LIFO, it is only $1,600. As a result, if Mario wants to adjust its FIFO inventory records to LIFO for preparing financial statements, it needs to adjust inventory downward by $600 (decreasing the balance in ending inventory from $2,200 to $1,600). 6- 30

Additional Inventory Transactions – Freight Charges:

Additional Inventory Transactions – Freight Charges Mario pays $300 for freight charges associated with the purchase of inventory on April 25 6- 31

Determining Inventory Quantities:

Goods in Transit Purchased goods not yet received. Sold goods not yet delivered. Determining Ownership of Goods Determining Inventory Quantities Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of sale . 32

Determining Inventory Quantities:

Determining Inventory Quantities Illustration 6-1 Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. Ownership of the goods remains with the seller until the goods reach the buyer. Terms of Sale 33

PowerPoint Presentation:

Additional Inventory Transactions – Purchase Discounts. Mario on April 30, pays for the units purchased on April 25, less a 2% purchase discount. 6- 34

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Additional Inventory Transactions – Purchase Returns. Mario decides on October 22 to return 50 defective units from the 600 units purchased on October 19 for $11 each 6- 35

LO6 Prepare a multiple-step income statement:

For merchandising companies , sales and purchases of inventory are most important set of transactions , companies report revenues and expenses from these separately from other revenues and expenses. It makes easier for investors and other financial statement users to determine the profitability of a company’s inventory transactions. Use the information for Mario's Game Shop to calculate gross profit on the sale and purchase of inventory. LO6 Prepare a multiple-step income statement 6- 36

Part C:

Part C LOWER-OF-COST-OR-MARKET METHOD 6- 37

LO7 Apply the lower-of-cost-or-market method for inventories:

LO7 Apply the lower-of-cost-or-market method for inventories When the value of inventory falls below its cost, companies are required to report inventory at the lower market value. And it is considered to be the replacement cost. Once it has determined both the cost and market value of inventory, the company reports ending inventory in the balance sheet at the lower of the two amounts. 6- 38

Calculating the Lower of Cost or Market:

Calculating the Lower of Cost or Market 6- 39

LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio :

LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio Inventory turnover ratio = Cost of goods sold Average inventory Average days in inventory = 365 Inventory turnover ratio If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost. Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory. The average days in inventory then tells us how many days, on average, an inventory item remained on the shelf. Inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period. Average days in inventory indicates the approximate number of days the average inventory is held. 6- 40

Analyze the inventory of Best Buy and Radio Shack Corporation :

We can analyze the inventory of Best Buy and Radio Shack Corporation by calculating these ratios for both companies. Best Buy sells a large volume of commonly purchased products. Radio Shack sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers. Below are relevant amounts for each company. Analyze the inventory of Best Buy and Radio Shack Corporation 6- 41

Computation of the Inventory Turnover Ratio:

Computation of the Inventory Turnover Ratio The turnover ratio is more than twice as high for Best Buy. On average, it takes Radio Shack an additional 56 days to sell its inventory. 6- 42

Computation of Gross Profit Ratio:

Computation of Gross Profit Ratio Gross profit ratio : Important indicator of the company’s successful management of inventory. Gross profit ratio = Gross profit Net sales Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales. Higher the ratio, higher is the “markup” a company is able to achieve on its inventories. 6- 43

Calculation of Gross Profit Ratio for Best buy and Radio Shack :

Calculation of Gross Profit Ratio for Best buy and Radio Shack For Best Buy, this means that for every $1 of sales revenue, the company spends $0.76 on inventory, resulting in a gross profit of $ 0.24 per dollar (or 24%). In contrast , Radio Shack spends $0.54 on inventory, per $1 of sales, and the gross profit ratio is then 46 %. 6- 44

LO9 Record inventory transactions using a periodic inventory system.:

LO9 Record inventory transactions using a periodic inventory system. Recall that under a perpetual inventory system we maintain a continual—or perpetual —record of inventory purchased and sold. In contrast, using a periodic inventory system we do not continually modify inventory amounts. Instead, we periodically adjust for purchases and sales of inventory at the end of the reporting period, based on a physical count of inventory on hand. 6- 45

PowerPoint Presentation:

Comparing Perpetual and Periodic inventory system – Inventory Purchase and Sales 6- 46

PowerPoint Presentation:

Comparing Perpetual and Periodic inventory system – Freight charges, Purchase discounts and returns 6- 47

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Comparing Perpetual and Periodic inventory system – Period-End Adjustment A period-end adjustment is needed only under the periodic system . Adjusts the balance of inventory to its proper ending balance. Records the cost of goods sold for the period, to match inventory costs with the related revenues. Closes (or zeros out) the temporary purchases accounts (Purchases, Freight-in, Purchase Discounts, and Purchase Returns). 6- 48

LO10 Determine the financial statement effects of inventory errors :

Inventory Errors Errors can unknowingly occur in inventory amounts if there are mistakes in a physical count of inventory or in the pricing of inventory quantities. The formula for cost of goods sold, follows LO10 Determine the financial statement effects of inventory errors 6- 49

Determine the financial statement effects of inventory errors :

Summary of Effects of Inventory Error in the Current Year. Relationship between Cost of Goods Sold in the Current Year and the Following Year Determine the financial statement effects of inventory errors 6- 50

Inventory Errors:

Inventory Errors Common Cause: Failure to count or price inventory correctly. Not properly recognizing the transfer of legal title to goods in transit. Errors affect both the income statement and balance sheet. Appendix 6B 51

Inventory Amounts :

Inventory Amounts 6- 52

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End of Chapter 6:

3- 54 End of Chapter 6 Good Luck on the Chapter 6 Homework!!!

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