merchandise inventory and cost of sales c h a p t e r 7 © 2007 mcgraw-hill ryerson ltd. electronic...

Merchandise Inventory and Cost of Sales

C H A P T E R 7C H A P T E R 7

© 2007 McGraw-Hill Ryerson Ltd.

Electronic Presentations in Microsoft® PowerPoint®

1. Identify the components and costs included in merchandise inventory.

2. Calculate the cost of goods sold and merchandise inventory using specific identification, moving weighted average, FIFO, and LIFO-perpetual.

3. Analyze the effects of the costing methods on financial reporting.

Learning ObjectivesLearning Objectives


4. Calculate the lower of cost or market value of inventory.

5. Analyze the effects of inventory errors on current and future financial statements-perpetual.

6. Apply both the gross profit and retail methods to estimate inventory.



7. Calculate cost of goods sold and merchandise inventory using specific identification, weighted average, FIFO, and LIFO-periodic. (Appendix 7A).

8. Analyze the effects of inventory errors on current and future financial statements-periodic. (Appendix 7A).

9. Assess inventory management using both merchandise turnover and days’ sales in inventory. (Appendix 7B)



Accounting for inventory requires several decisions which include: Items to include in cost. Inventory System.

Perpetual or Periodic Costing Method.

FIFO, LIFO, Moving Weighted Average, Specific ID Use of estimates.

Gross profit method, Retail inventory method

Assigning Costs to InventoryAssigning Costs to Inventory


Inventory includes all goods owned by a company and held for sale.

Items requiring special attention: Goods in Transit Goods on consignment Obsolete or damaged goods

Items in Merchandise InventoryItems in Merchandise Inventory


All expenditures necessary to bring an item to a saleable condition and location. This includes:

Invoice price less discounts Import dutiesTransportation-inStorage Insurance

Costs of Merchandise InventoryCosts of Merchandise Inventory


Management must decide on method of determining unit cost.

This will affect both the income statement and the balance sheet.

Methods:1. Specific Identification2. FIFO3. LIFO4. Average Cost

Assigning Costs to InventoryAssigning Costs to Inventory


MerchandiseAvailable

for Sale

Net Costof Purchases

Cost ofGoods Sold

BeginningInventory

EndingInventory

Balance SheetBalance Sheet Income StatementIncome Statement

Merchandising Cost Flows


FIFO47%

Other4%

Average Cost45%

LIFO4%

Use of Inventory Methods in Use of Inventory Methods in PracticePractice


This method is used when items: Are unique. Can be directly identified with a specific

purchase and its invoice.

Examples: Automobiles, art custom furniture.

Specific IdentificationSpecific Identification


Specific Identification — Example

Purchases Sales BalanceDate Units Cost Total Units Cost Total Units Cost Total

8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 8 91$ 728$ 2 91$ 182$

12 106$ 1,272$ 3 106$ 318$

5 500$ 2 91$ 182$ 3 106$ 318$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,800$ 8/28 2 91$ 182$ 3 106$ 318$

12 115$ 1,380$ 8 115$ 920$ Totals 45 4,800$ 34 3,562$ 11 1,238$

Specific Identificaton Computations - Perpetual Inventory System

The opening inventory consists of 10 units @ $91/unit.




8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 8 91$ 728$ 2 91$ 182$

12 106$ 1,272$ 3 106$ 318$

5 500$ 2 91$ 182$ 3 106$ 318$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,800$ 8/28 2 91$ 182$ 3 106$ 318$

12 115$ 1,380$ 8 115$ 920$ Totals 45 4,800$ 34 3,562$ 11 1,238$


This results in two layers of inventory.

Additional units are purchased @ $106/unit.




8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 8 91$ 728$ 2 91$ 182$

12 106$ 1,272$ 3 106$ 318$

5 500$ 2 91$ 182$ 3 106$ 318$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,800$ 8/28 2 91$ 182$ 3 106$ 318$

12 115$ 1,380$ 8 115$ 920$ Totals 45 4,800$ 34 3,562$ 11 1,238$


On August 14, 20 units are sold. Eight of these units came from the opening inventory and the remaining 12

units came from the August 3 purchase.




8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 8 91$ 728$ 2 91$ 182$

12 106$ 1,272$ 3 106$ 318$

5 500$ 2 91$ 182$ 3 106$ 318$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,800$ 8/28 2 91$ 182$ 3 106$ 318$

12 115$ 1,380$ 8 115$ 920$ Totals 45 4,800$ 34 3,562$ 11 1,238$


This leaves 2 units remaining from the original inventory and 3 units remaining

from the August 3 purchase.


Under this method, the cost of all units are averaged together.

Cost of goods available for sale

Number of units available for sale

Average cost per unit

=

Moving Weighted Average MethodMoving Weighted Average Method


Moving Weighted Average - Example


8/1 10 91$ 910$ 10 91$ 910$ 8/3 15 106$ 1,590$ 25 100$ 2,500$

8/14 20 100$ 2,000$ 5 100$ 500$

8/17 20 115$ 2,300$ 25 112$ 2,800$

8/28 14 112$ 1,568$ 11 112$ 1,232$

Totals 45 4,800$ 34 3,568$ 11 1,232$

Moving Weighted Average Computations - Perpetual Inventory System



Moving Weighted Average- Example


8/1 10 91$ 910$ 10 91$ 910$ 8/3 15 106$ 1,590$ 25 100$ 2,500$

8/14 20 100$ 2,000$ 5 100$ 500$

8/17 20 115$ 2,300$ 25 112$ 2,800$

8/28 14 112$ 1,568$ 11 112$ 1,232$

Totals 45 4,800$ 34 3,568$ 11 1,232$


Additional units are purchased @ $106/unit. This results in an average cost of

$100/unit.

(10 x $91) + (15 x $106) 25 units




8/1 10 91$ 910$ 10 91$ 910$ 8/3 15 106$ 1,590$ 25 100$ 2,500$

8/14 20 100$ 2,000$ 5 100$ 500$

8/17 20 115$ 2,300$ 25 112$ 2,800$

8/28 14 112$ 1,568$ 11 112$ 1,232$

Totals 45 4,800$ 34 3,568$ 11 1,232$


These 20 units are sold at the average cost of $100/unit.




8/1 10 91$ 910$ 10 91$ 910$ 8/3 15 106$ 1,590$ 25 100$ 2,500$

8/14 20 100$ 2,000$ 5 100$ 500$

8/17 20 115$ 2,300$ 25 112$ 2,800$

8/28 14 112$ 1,568$ 11 112$ 1,232$

Totals 45 4,800$ 34 3,568$ 11 1,232$


This leaves 5 units remaining at an average cost of $100/unit.


Mini-QuizMini-QuizA company that uses a perpetual inventory system made the following cash purchases and sales:

Jan. 1-Purchased 100 units at $10 per unit.

Feb. 5-Purchased 60 units at $12 per unit.

Mar.16-Sold for cash 40 units for $16 per unit.

Prepare journal entries to record the sale assuming a Moving Weighted Average system is used.

Cash 640 Sales (40x16) 640

Cost of goods sold 430 Inventory 430(100x10 + 60x12)/160 x 40 © 2007 McGraw-Hill Ryerson Ltd.

Based on the assumption that the items are sold in the order acquired.

When a sale occurs: The earliest units purchased are

charged to Cost of Goods Sold. The cost of the most recent purchases

remain in inventory.

First-In, First-Out (FIFO)First-In, First-Out (FIFO)


FIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 10 91$ 910$

10 106$ 1,060$ 5 106$ 530$ 5 106$ 530$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,830$ 8/28 5 106$ 530$

9 115$ 1,035$ 11 115$ 1,265$ Totals 45 4,800$ 34 3,535$ 11 1,265$

FIFO Computations - Perpetual Inventory System



FIFO — Example

Additional units re purchased @ $106/unit.


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 10 91$ 910$

10 106$ 1,060$ 5 106$ 530$ 5 106$ 530$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,830$ 8/28 5 106$ 530$

9 115$ 1,035$ 11 115$ 1,265$ Totals 45 4,800$ 34 3,535$ 11 1,265$





FIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 10 91$ 910$

10 106$ 1,060$ 5 106$ 530$ 5 106$ 530$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,830$ 8/28 5 106$ 530$

9 115$ 1,035$ 11 115$ 1,265$ Totals 45 4,800$ 34 3,535$ 11 1,265$


Under FIFO, units are assumed to be sold in the order acquired. Therefore, of the 20 units sold on August 14, the first 10 units come

from beginning inventory. Therefore, those 10 units are removed from the inventory record based on the cost of those units of $91.


FIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 10 91$ 910$

10 106$ 1,060$ 5 106$ 530$ 5 106$ 530$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,830$ 8/28 5 106$ 530$

9 115$ 1,035$ 11 115$ 1,265$ Totals 45 4,800$ 34 3,535$ 11 1,265$


The remaining 10 units sold on August 14th come from the next purchase, made on August 3rd. Therefore, these units are removed

from the inventory record based on their cost of $106.


FIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 10 91$ 910$

10 106$ 1,060$ 5 106$ 530$ 5 106$ 530$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,830$ 8/28 5 106$ 530$

9 115$ 1,035$ 11 115$ 1,265$ Totals 45 4,800$ 34 3,535$ 11 1,265$


The ending inventory consists of the 5 remaining units from the August 3 purchase.


Mini-QuizMini-Quiz

A company that uses a perpetual inventory system made the following cash purchases and sales:




Prepare journal entries to record the sale assuming a FIFO system is used.

Cash 640 Sales (40x16) 640

Cost of goods sold 400 Inventory (40x10) 400


Based on the assumption that the most recently purchased items are sold first.

When a sale occurs: The latest units purchased are charged to

Cost of Goods Sold. The cost of the earliest purchases remain

in inventory.

Last-In, First-Out (LIFO)Last-In, First-Out (LIFO)


LIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 15 106$ 1,590$

5 91$ 455$ 5 91$ 455$ 5 91$ 455$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,755$ 8/28 14 115$ 1,610$ 5 91$

Totals 45 4,800$ 34 3,655$ 11 1,145$

LIFO Computations - Perpetual Inventory System



LIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 15 106$ 1,590$

5 91$ 455$ 5 91$ 455$ 5 91$ 455$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,755$ 8/28 14 115$ 1,610$ 5 91$

Totals 45 4,800$ 34 3,655$ 11 1,145$





LIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 15 106$ 1,590$

5 91$ 455$ 5 91$ 455$ 5 91$ 455$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,755$ 8/28 14 115$ 1,610$ 5 91$

Totals 45 4,800$ 34 3,655$ 11 1,145$


Of the 20 units sold, these units are assumed to be sold

first.


LIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 15 106$ 1,590$

5 91$ 455$ 5 91$ 455$ 5 91$ 455$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,755$ 8/28 14 115$ 1,610$ 5 91$

Totals 45 4,800$ 34 3,655$ 11 1,145$


Once the latest units purchased are sold, units are sold from the

previous purchase.


LIFO — Example


8/1 10 91$ 910$ 10 91$ 910$ 10 91$ 910$

8/3 15 106$ 1,590$ 15 106$ 1,590$

25 2,500$ 8/14 15 106$ 1,590$

5 91$ 455$ 5 91$ 455$ 5 91$ 455$

8/17 20 115$ 2,300$ 20 115$ 2,300$

25 2,755$ 8/28 14 115$ 1,610$ 5 91$

Totals 45 4,800$ 34 3,655$ 11 1,145$


This leaves 5 units remaining from the first purchase.


Mini-QuizMini-Quiz

A company that uses a perpetual inventory system made the following cash purchases and sales:




Prepare journal entries to record the sale assuming a LIFO system is used.

Cash 640 Sales (40x16) 640

Cost of goods sold 480 Inventory (40x12) 480


Because prices change, the choice of an inventory method is important.

Units Specific

Identification

Moving Weighted Average FIFO LIFO

Cost of Goods Sold 34 3,562$ 3,568$ 3,535$ 3,655$

Ending Inventory 11 1,238$ 1,232$ 1,265$ 1,145$

Goods Available for Sale 45 4,800$ 4,800$ 4,800$ 4,800$

Financial ReportingFinancial Reporting


Advantages of Each Method

First-In, First-Out

First-In, First-Out

Ending inventory approximates

current replacement cost.



Weighted Average

Weighted Average

Smoothes out purchase price

changes.

Smoothes out purchase price

changes.

Last-In, First-Out

Last-In, First-Out

Better matches current costs in

cost of goods sold with revenues.

Better matches current costs in

cost of goods sold with revenues.


First-In, First-Out

First-In, First-Out






A company is required to use the same accounting methods from period to period (consistency principle).

A change is only acceptable when it improves financial reporting.

The costing method used must be disclosed in the notes to the financial statements (full-disclosure principle).



Inventory must be reported at market value when market is lower than cost (conservatism principle).

Market may be defined as: Net realizable value Current replacement cost

Lower of Cost or MarketLower of Cost or Market


May be applied in one of three ways:

1. Separately to each item.

2. To major categories of items.

3. To the inventory as a whole.

Lower of Cost or MarketLower of Cost or Market


Errors in the computation of or physical count of inventory will cause a misstatement of:

Cost of goods sold Gross profit Net income Current assets Owner’s equity

Inventory ErrorsInventory Errors


Inventory Errors- Effects on the Inventory Errors- Effects on the Income StatementIncome Statement


Inventory Errors- Effects on the Inventory Errors- Effects on the Balance SheetBalance Sheet


Ending inventory is estimated by applying gross profit ratio to net sales.

It is used: when inventory has been destroyed, lost, or

stolen. for testing the reasonableness of the

physical inventory count.

Gross Profit MethodGross Profit Method


Occasionally used for interim period reporting.

Information required:1. Beginning inventory at cost and retail.

2. Net purchases at cost and retail.

3. Net sales.

Retail Inventory MethodRetail Inventory Method


Q Describe how management’s decisions can affect the determination of the cost of inventory.

A Choice of method –FIFO,LIFO, Moving weighted average, Specific item.

Choice of application of LCM -separate item, categories, whole inventory. Definition of market.

Choice of periodic or perpetual system.

Items to include in cost. Other.

ReviewReview


The periodic system also uses FIFO, LIFO, specific identification, and weighted average methods to assign costs to inventory and cost of goods sold.

The results may be the same or different under both systems.

Periodic System-Appendix 7APeriodic System-Appendix 7A


Applied in same manner as periodic system.

Yields same results as perpetual system since units are specifically identified.

Specific Identification- Appendix 7ASpecific Identification- Appendix 7A


Steps:

1. Calculate weighted average unit cost.

(# units beg. Inv. X unit cost) + (#units purchased x unit cost) # units available for sale

= weighted average unit cost

2. Use weighted average unit cost to assign costs to cost of goods sold and ending inventory.

Weighted Average-Appendix 7AWeighted Average-Appendix 7A


Yields same results as perpetual system since most recent purchases are in ending inventory under both systems.

FIFO-Appendix 7AFIFO-Appendix 7A


Yields different results than perpetual system since:

LIFO periodic assigns costs at the end of period.

LIFO perpetual assigns most recent costs to cost of goods sold.

LIFO-Appendix 7ALIFO-Appendix 7A


An error in the ending inventory affects the assets, net income, and owner’s equity of that period.

The ending inventory of one period becomes the opening inventory of the next period. The cost of goods sold and net income of the next period are affected as well.

Inventory Errors in a Periodic Inventory Errors in a Periodic System-Appendix 7ASystem-Appendix 7A


Inventory ratios may be used to assess:

1. Short-term liquidity.

2. Inventory management.

Ratios-Appendix 7BRatios-Appendix 7B


Merchandise Turnover Ratio Measures how many times a company

turns its inventory over each period. The ratio will vary from industry to

industry. Merchandise turnover cost of goods sold

average inventory



Days’ Sales in Inventory Used to estimate how many days it will take to

convert inventory to cash or receivables. Used to assess if inventory levels can meet sales

demand.

Days’ sales in inventory = Ending inventory x 365

Cost of goods sold



End of ChapterEnd of Chapter


merchandise inventory and cost of sales c h a p t e r 7 © 2007 mcgraw-hill ryerson ltd. electronic...

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