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CHAPTER 9 WHAT IS REPORTED AS INVENTORY? WHAT IS INVENTORY? COST OF GOODS SOLD AND INVENTORY

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CHAPTER 9

CHAPTER 9

COST OF GOODS SOLD COST OF GOODS SOLD AND INVENTORY AND INVENTORY

2

WHAT IS REPORTED AS

WHAT IS REPORTED AS

INVENTORY?

INVENTORY?

• Inventory represents goods that are either manufactured or purchased for resale in the normal course of business

• Inventory is classified as an asset on the balance sheet

WHAT IS INVENTORY?

WHAT IS INVENTORY?

• There are three types of inventory for a manufacturing firm:

– Raw materials

• Goods acquired in a raw state that will eventually be finished products – Work in process

• Partially finished products – Finished goods

• Completed products waiting for sale

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Raw Materials

Work in Process

Finished Goods

Cost of Goods Sold

INVENTORY COST FLOW FOR

INVENTORY COST FLOW FOR

A MANUFACTURING FIRM

A MANUFACTURING FIRM

Balance Sheet

Balance Sheet Income StatementIncome Statement

Manufacturing Overhead

Labor

5

INVENTORY OWNERSHIP

INVENTORY OWNERSHIP

• Legal title rule

– Goods should be reported in the balance sheet of the business holding legal title to the goods

• Goods in transit

– Legal title depends upon the shipping terms

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GOODS IN TRANSIT

GOODS IN TRANSIT

• Shipping terms:

– FOB (free-on-board) destination

• The seller is paying the shipping cost

• The seller owns the inventory until it is delivered

– FOB shipping point

• The buyer is paying the shipping cost

• The buyer owns the inventory during transit

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GOODS ON CONSIGNMENT

GOODS ON CONSIGNMENT

• The dealer does not pay for the inventory unless it is sold

• Although the dealer has

possession of the inventory, the supplier still owns the inventory at the balance sheet date

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THE COST OF INVENTORY

THE COST OF INVENTORY

• The cost of inventory includes all costs of acquisition and preparation for sale

– Purchase price – Freight

– Receiving and storage costs

THE COST OF INVENTORY

THE COST OF INVENTORY

• The cost of work in process and finished goods inventory includes

– Raw materials – Production labor

– Some allocation of factory overhead

• Activity-based cost (ABC) systems allocate overhead based on some clearly identified cost drivers

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Beginning Inventory Beginning Inventory Add: Inventory Purchases Add: Inventory Purchases

= Goods Available for Sale

= Goods Available for Sale Less: Ending Inventory Less: Ending Inventory

= Cost of Goods Sold

= Cost of Goods Sold

COST OF GOODS SOLD

COST OF GOODS SOLD

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OVERVIEW OF PERPETUAL

OVERVIEW OF PERPETUAL

AND PERIODIC SYSTEMS

AND PERIODIC SYSTEMS

• Perpetual system

– Inventory records are updated whenever a purchase or a sale is made – Advances in information technology

have made the cost of using this system practical

• Periodic system

– Inventory records are not updated when a sale is made

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TAKING A PHYSICAL

TAKING A PHYSICAL

COUNT OF INVENTORY

COUNT OF INVENTORY

• The actual quantity on hand is determined by taking a physical count

• A cost is attached to the quantity counted

• With a perpetual system, a physical count can reveal inventory shrinkage

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ENDING INVENTORY ERRORS

ENDING INVENTORY ERRORS

• When inventory is overstated

– Cost of good sold is understated – Net income is

overstated

• When inventory is understated

– Cost of good sold is overstated – Net income is understated

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INVENTORY VALUATION

INVENTORY VALUATION

METHODS

METHODS

• Where specific identification is not possible, an assumption must be made about which cost is associated with the units remaining

• Three assumptions are generally accepted:

– FIFO (first-in, first-out) – LIFO (last-in, first-out) – Average cost

SPECIFIC IDENTIFICATION

SPECIFIC IDENTIFICATION

• Requires no assumption about the flow of inventory units

• Inventory items are specifically identified and valued

• The actual cost of goods sold can be computed as inventory is sold

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INVENTORY VALUATION

INVENTORY VALUATION

METHODS

METHODS

Assume the following data:

Unit Total Units Cost Cost January 1 200 $10 $2,000

March 23 300 $12 3,600

July 15 500 $11 5,500

November 6 100 $13 1,300

1,100 $12,400

Sales: 700 units @ $15

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AVERAGE COST METHOD

AVERAGE COST METHOD

Cost of Goods Available for Sale Units Available for Sale

$12,400 1,100 units Ending Inventory = 400 Units x $11.27 Ending Inventory = 400 Units x $11.27 Cost of Goods Sold = 700 Units x $11.27 Cost of Goods Available for Sale

= Average Cost/Unit

= $11.27 Average Cost/Unit

= $4,510

= $4,510

= 7,890

$12,400

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Goods Available Goods Available

for Sale for Sale 1,100 units

1,100 units == Ending InventoryEnding Inventory 400 units

400 units ++ Goods SoldGoods Sold700 units700 units

$12,400

$12,400 =

$2,000

$2,000 20

0 units

@ $10/unit

$3,600

$3,600 30

0 units

@ $12/unit

$2,200

$2,200

SOLD 200 units

@ $11/unit

$4,600

$4,600 $7,800$7,800

SOLD

SOLD

$3,300

$3,300 30

0units

@ $11/unit 100 units

@ $13/unit

$1,300

$1,300

+

Purchase Purchase Jan. 1

200 units

@ $10/unit

Purchase Purchase March 23

300 units

@ $12/unit

Purchase Purchase July 15

500 units

@ $11/unit

Purchase Purchase Nov. 6

100 units

@ $13/unit

FIFO FIFO

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$12,400

$12,400 =

$1,200

$1,200 10

0 units

@ $12/unit

$5,500

$5,500 50

0 units

@ $11/unit

$1,300

$1,300

SOLD 100 units

@ $13/unit

$4,400

$4,400 $8,000$8,000

SOLD

SOLD

$2,000

$2,000 20

0units

@ $10/unit 200 units

@ $12/unit

$2,400

$2,400

+

Purchase Purchase Jan. 1

200 units

@ $10/unit

Purchase Purchase March 23

300 units

@ $12/unit

Purchase Purchase July 15

500 units

@ $11/unit

Purchase Purchase Nov. 6

100 units

@ $13/unit

Goods Available Goods Available

for Sale for Sale 1,100 units

1,100 units == Ending InventoryEnding Inventory 400 units

400 units ++ Goods SoldGoods Sold700 units700 units

LIFO

LIFO

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• FIFO

– Advantages:

• Inventories are reported on the balance sheet near current costs

• Cost flow often matches the physical flow of goods in a business

– Disadvantages:

• Current costs are not matched with current revenues

• Choosing FIFO for financial reporting prohibits the use of LIFO on the tax return (LIFO conformity rule)

COMPARISON OF METHODS

COMPARISON OF METHODS

• LIFO

– Advantages:

• Current costs are matched with current revenues (matching principle)

• Income taxes are minimized during periods of rising prices

– Disadvantages:

• Inventory is valued at old prices

• Cost flow may not match the physical flow of goods in the business

COMPARISON OF METHODS

COMPARISON OF METHODS

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MORE LIFO ISSUES

MORE LIFO ISSUES

• Any year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending

inventory

• The creation of LIFO layers results in ending inventory at very old prices

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INVENTORY ESTIMATION

INVENTORY ESTIMATION

AND VALUATION

AND VALUATION

• The gross profit method is used to estimate inventory without actually taking a physical count

• The gross profit percentage is applied to estimate cost of goods sold, and ultimately gross profit

24

GROSS PROFIT METHOD

GROSS PROFIT METHOD

Gross Profit % = (Sales - Cost of Goods Sold) / Sales

Assume the following data:

Beginning inventory, January 1 $25,000 Purchases, January 1 through January 31 40,000 Sales, January 1 through January 31 50,000 Historical gross profit percentage 40%

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GROSS PROFIT METHOD

GROSS PROFIT METHOD

Sales (actual) $50,000 100%

Gross profit (estimate) 20,000 40%

Cost of goods sold (estimate) $30,000 60%

Beginning inventory (actual) $25,000

+ Purchases (actual) 40,000

= Cost of goods available for sale (actual) $65,000 - Cost of goods sold (estimate) $30,000

= Ending inventory (estimate) $35,000

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INVENTORY ESTIMATION

INVENTORY ESTIMATION

AND VALUATION

AND VALUATION

• The lower of cost or market

method recognizes inventory price declines, but not price increases until the inventory is sold

• Market value is defined as – Replacement cost or – Net realizable value

INVENTORY ESTIMATION

INVENTORY ESTIMATION

AND VALUATION

AND VALUATION

• Replacement cost is the cost to buy equivalent new inventory items

• Net realizable value is the amount expected to be received when the inventory is sold

• Rule of thumb: Inventory is valued on the balance sheet at the lowest of (1) historical cost, (2) replacement cost, or (3) net realizable value

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INVENTORY ESTIMATION

INVENTORY ESTIMATION

AND VALUATION

AND VALUATION

• An inventory write-down when market value is lower than cost recognizes the economic loss when it happens rather than when the inventory is sold

• This is another example of the principle of conservatism

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EVALUATING THE LEVEL

EVALUATING THE LEVEL

OF INVENTORY

OF INVENTORY

• Two widely used measurements:

– Inventory turnover

• Measures how many times a company turns over its inventory during the year

– Number of days’ sales in inventory

• Measures the number of days’ sales represented in the inventory value

30

EVALUATING THE LEVEL

EVALUATING THE LEVEL

OF INVENTORY

OF INVENTORY

Inventory Turnover =

Inventory Turnover = Cost of Goods SoldCost of Goods Sold Average Inventory Average Inventory Number of Days

Number of Days’Sales = 365 / Inventory TurnoverSales = 365 / Inventory Turnover in Inventory

in Inventory

These ratios are compared with those of other firms in the same industry and with comparable ratios for the same firm in previous years.

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EVALUATING THE LEVEL

EVALUATING THE LEVEL

OF INVENTORY

OF INVENTORY

• The number of days’ purchases in accounts payable indicates how long it takes for a company to pay its suppliers

365 days 365 days

_______________________________

_______________________________

Purchases/Average Accounts Payable Purchases/Average Accounts Payable Number of Days

Number of Days’ Purchases in Purchases in Accounts Payable Accounts Payable==

References

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