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Chapter 7 Reporting and Interpreting Inventories and Cost of Goods Sold Power. Point Authors: Susan Coomer Galbreath, Ph. D. , CPA Charles W. Caldwell, D. B. A. , CMA Jon A. Booker, Ph. D. , CPA, CIA Fred Phillips, Ph. D. , CA

Learning Objective 1 Describe the issues in managing different types of inventory. 7 -3

Inventory Management Decisions The primary goals of inventory managers are to: 1. Maintain a sufficient quantity to meet customers’ needs 2. Ensure quality meets customers’ expectations and company standards 3. Minimize the costs of acquiring and carrying the inventory 7 -4

Types of Inventory Merchandisers. . . § Buy finished goods. § Sell finished goods. Merchandise inventory Manufacturers. . . § Buy raw materials. § Produce and sell finished goods. Raw Materials Work in Process Finished goods Completed products awaiting sale Materials waiting to be processed Partially complete products 7 -5

Learning Objective 2 Explain how to report inventory and cost of goods sold. 7 -6

Balance Sheet and Income Statement Reporting 7 -7

Cost of Goods Sold Equation BI + P – CGS = EI American Eagle Outfitters’ beginning inventory was $4, 800. During the period, the company purchased inventory for $10, 200. The cost of goods sold for the period is $9, 000. Compute the ending inventory. 7 -8

Cost of Goods Sold Equation Beginning Inventory $4, 800 + Purchases $10, 000 Goods Available for Sale $15, 000 Ending Inventory $6, 000 (Balance Sheet) 7 -9 Still Here Sold Cost of Goods Sold $9, 000 (Income Statement)

Learning Objective 3 Compute costs using four inventory costing methods. 7 -10

Inventory Costing Methods Specific identification First-in, first-out (FIFO) Last-in, first-out (LIFO) Weighted average 7 -11

Inventory Costing Methods Consider the following information May 6 $95 cost May 5 $75 cost May 3 $70 cost Specific Identification This method individually identifies and records the cost of each item sold as part of cost of goods sold. If the items sold were identified as the ones that cost $70 and $95, the total cost of those items ($70 + 95 = $165) would be reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance sheet at the end of the period. 7 -12

Inventory Costing Methods FIFO LIFO May 6 $95 cost May 5 $75 cost Sold Still there Sold May 6 $95 cost May 5 $75 cost May 3 $70 cost Still there May 6 $95 cost May 5 $75 cost May 3 $70 cost Weighted average $80 $240 = per unit 3 Sold Still there 7 -13

Inventory Costing Methods Summary Let’s consider a more complex example. 7 -14

Inventory Cost Flow Computations (10 units @ $10) + (5 units @ $8) 7 -15

Inventory Cost Flow Computations (10 units @ $10) + (25 units @ $8) 7 -16

Inventory Cost Flow Computations Weighted Average Weighted = Average Cost 7 -17 Cost of goods Available for Sale Number of Units Available for Sale $410 50 units = $8. 20 per unit

Inventory Cost Flow Computations 15 units @ $8. 20 35 units @ $8. 20 7 -18

Financial Statement Effects 7 -19

Financial Statement Effects 7 -20

Financial Statement Effects Advantages of Methods Weighted Average 7 -21 First-In, First-Out Last-In, First-Out

Tax Implications and Cash Flow Effects 7 -22

Learning Objective 4 Report inventory at the lower of cost or market. 7 -23

Lower of Cost or Market The value of inventory can fall below its recorded cost for two reasons: 1. it’s easily replaced by identical goods at a lower cost, or 2. it’s become outdated or damaged. When the value of inventory falls below its recorded cost, the amount recorded for inventory is written down to its lower market value. This is known as the lower of cost or market (LCM) rule. 7 -24

Lower of Cost or Market 1, 000 items @ $165 1 2 7 -25 Analyze Record 1, 000 items @ $150 400 items @ $20

Learning Objective 5 Analyze and record inventory purchases, transportation, returns and allowances, and discounts. 7 -26

Recording Inventory Transactions We will now look at the accounting for purchases, transportation costs, purchase returns and allowances, and purchase discounts. We will record all inventory-related transactions in the Inventory account. 7 -27

Inventory Purchases American Eagle Outfitters purchases $10, 500 of vintage jeans on credit. 1 Analyze 2 Record 7 -28

Transportation Cost American Eagle pays $400 cash to a trucker who delivers the $10, 500 of vintage jeans to one of its stores. 1 Analyze 2 Record 7 -29

Purchase Returns and Allowances American Eagle returned some of the vintage jeans to the supplier and received a $500 reduction in the balance owed. 1 Analyze 2 Record 7 -30

Purchase Discounts American Eagle’s vintage jeans purchase for $10, 500 had terms of 2/10, n/30. Recall that American Eagle returned inventory costing $500 and received a $500 reduction in its Accounts Payable. American Eagle paid within the discount period. 1 Analyze 2 Record 7 -31

Summary of Inventory Transactions 7 -32

Learning Objective 6 Evaluate inventory management by computing and interpreting the inventory turnover ratio. 7 -33

Inventory Turnover Analysis 7 -34

Comparison to Benchmarks 7 -35

Supplement 7 A FIFO, LIFO, and Weighted Average in a Perpetual Inventory System

Perpetual Inventory System This is the same information that we used earlier in the chapter to illustrate a periodic inventory system. The only difference is that we have assumed the sales occurred on October 4, prior to the final inventory purchase. 7 -37

FIFO (First-in, First-Out) 7 -38

LIFO (Last-in, First-Out) 7 -39

Weighted Average Cost $310 ÷ 40 units = $7. 75 per unit 7 -40

Financial Statement Effects Summary of Perpetual Inventory System Cost Flow Assumptions on Financial Statements 7 -41

Supplement 7 B The Effects of Errors in Ending Inventory

The Effects of Errors in Ending Inventory Cost of Goods Sold Equation BI + P – CGS = EI Errors in Ending Inventory will affect the Balance Sheet and the Income Statement. Assume that Ending Inventory was overstated in 2009 by $10, 000 due to an error that was not discovered until 2010. 7 -43

The Effects of Errors in Ending Inventory Now let’s examine the effects of the 2009 Ending Inventory Error on 2010. Assume that Ending Inventory was overstated in 2009 by $10, 000 due to an error that was not discovered until 2010. 7 -44

Supplement 7 C Recording Inventory Transactions in a Periodic System

Recording Inventory Transactions in a Periodic System A local cell phone dealer stocks and sells one item, the MOTORAZR phone. The following events occurred in the past year: We will record these events assuming the company uses a periodic inventory system and then compare the periodic inventory system to a perpetual inventory system. 7 -46

Recording Inventory Transactions in a Periodic System Periodic Inventory System 7 -47 Perpetual Inventory System

Recording Inventory Transactions in a Periodic System Periodic Inventory System BI + P – CGS = EI End-of-year adjustment entries are not required using a perpetual inventory system. 7 -48

Recording Inventory Transactions in a Periodic System Summary of the Effects on the Accounting Equation Periodic Inventory System 7 -49 Perpetual Inventory System

Chapter 7 Solved Exercises M 7 -6, M 7 -7, E 7 -3, E 7 -5, E 7 -10, E 7 -17

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost Given the following information, calculate cost of goods available for sale and ending inventory, then sales, cost of goods sold, and gross profit, under (a) FIFO, (b) LIFO, and (c) weighted average. Assume a periodic inventory system is used. 7 -51

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost 7 -52

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost 7 -53

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost 7 -54 = $7, 500 600 units = $12. 50 per unit

M 7 -6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost 7 -55

M 7 -7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) Given the following information, calculate the cost of goods available for sale, ending inventory, and cost of goods sold, assuming a periodic inventory system is used in combination with (a) FIFO, (b) LIFO, and (c) Weighted Average Cost. 7 -56

M 7 -7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) 7 -57

M 7 -7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) a. FIFO: Ending Inventory (7, 000 units x $25) $175, 000 Cost of Goods Sold (2, 000 units x $20) (6, 000 units x $22) (1, 000 units x $25) $197, 000 b. LIFO: Ending Inventory Cost of Goods Sold 7 -58 (2, 000 units x $20) (5, 000 units x $22) (8, 000 units x $25) (1, 000 units x $22) $150, 000 $222, 000

M 7 -7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) c. Weighted average : Average unit cost Ending Inventory Cost of Goods Sold 7 -59 $372, 000 ÷ 16, 000 = $23. 25 per unit (7, 000 units × $23. 25) = $162, 750 (9, 000 units × $23. 25) = $209, 250

E 7 -3 Inferring Missing Amounts Based on Income Statement Relationships Supply the missing dollar amounts for the 2010 income statement of Lewis Retailers for each of the following independent cases. 7 -60

E 7 -3 Inferring Missing Amounts Based on Income Statement Relationships Supply the missing dollar amounts for the 2010 income statement of Lewis Retailers for each of the following independent cases. 7 -61

E 7 -3 Inferring Missing Amounts Based on Income Statement Relationships Supply the missing dollar amounts for the 2010 income statement of Lewis Retailers for each of the following independent cases. 7 -62

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 1. Calculate the number and cost of goods available for sale. Beginning Inventory + Purchase Goods Available for Sale 7 -63 120 units x $ 8 380 units x $ 9 200 units x $11 700 units $ 960 3, 420 2, 200 $ 6, 580

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 2. Calculate the number of units in ending inventory. Units in Ending Inventory = Units Available – Units Sold Units in Ending Inventory = 700 – 240 = 460 Units 7 -64

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. (a) FIFO Goods Available for Sale – Ending Inventory (LIST) (200 × $11) + (260 x $9) 4, 540 Cost of Goods Sold (FIFO) (120 x $8) + (120 × $9) 7 -65 $ 6, 580 $ 2, 040

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. (b) LIFO Goods Available for Sale – Ending Inventory (FIST) (120 × $8) + (340 x $9) 4, 020 Cost of Goods Sold (LIFO) (200 × $11) + (40 x $9) 7 -66 $ 6, 580 $ 2, 560

E 7 -5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted Average Assume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units. Required: 3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods. Weighted average cost = $6, 580 ÷ 700 units = $9. 40 per unit (c) Weighted Average Goods Available for Sale – Ending Inventory (460 × $9. 40) 4, 324 Cost of Goods Sold (240 × $9. 40) 7 -67 $ 6, 580 $ 2, 256

E 7 -10 Reporting Inventory at Lower of Cost or Market Peterson Furniture Designs is preparing the annual financial statements dated December 31, 2009. Ending inventory information about the five major items stocked for regular sale follows: Required: 1. Complete the final two columns of the table and then compute the amount that should be reported for the 2009 ending inventory using the LCM rule applied to each item. $1, 750 7 -68

E 7 -10 Reporting Inventory at Lower of Cost or Market Peterson Furniture Designs is preparing the annual financial statements dated December 31, 2009. Ending inventory information about the five major items stocked for regular sale follows: Required: 2. Prepare the journal entry that Peterson Furniture Designs would record on December 31, 2009. dr Cost of Goods Sold (+E, SE) cr Inventory (-A) 7 -69 1, 750

E 7 -10 Reporting Inventory at Lower of Cost or Market Peterson Furniture Designs is preparing the annual financial statements dated December 31, 2009. Ending inventory information about the five major items stocked for regular sale follows: Required: 3. If the market values recovered by June 30, 2010, to greater than original cost, would the journal entry in requirement 2 be reversed under GAAP? Under IFRS? GAAP does not allow inventory to be written up, even when the circumstances that necessitated the write-down no longer exist. IFRS, on the other hand, does require that a company record a recovery in the inventory’s market value back to its original cost. That is, the previous write-down may be reversed, but only to the point where the ending inventory is reported at the lower of cost or market. 7 -70

E 7 -17 Analyzing and Interpreting the Inventory Turnover Ratio Polaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the following amounts in its financial statements (in millions): Required: 1. Calculate to one decimal place the inventory turnover ratio and average days to sell inventory for 2008, 2007, and 2006. 2008 Inventory Turnover = Ratio Days to Sell = Cost of Goods Sold Average Inventory = 365 Days Inventory Turnover = Ratio 2007 2006 6. 8* 6. 2** 6. 0*** times per year 53. 7 58. 9 days 60. 8 *6. 8 = $1, 502 ÷ $220 **6. 2 = $1, 387 ÷ $224 ***6. 0 = $1, 297 ÷ $216 7 -71

E 7 -17 Analyzing and Interpreting the Inventory Turnover Ratio Polaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the following amounts in its financial statements (in millions): Required: 2. Comment on any trends, and compare the effectiveness of inventory managers at Polaris to inventory managers at its main competitor, Arctic Cat, where inventory turns over 4. 5 times per year (81. 1 days to sell). Both companies use the same inventory costing method (FIFO). The inventory turnover ratio reflects how many times average inventory was made and sold during the year. The inventory turnover ratio for Polaris Industries has increased each year since 2006, leading to a decrease in the average days to sell. This trend suggests that Polaris is selling its inventory more quickly. This is generally considered to be a positive performance. Polaris is performing better than Arctic Cat, where the inventory turnover is 4. 5 times per year or every 81. 1 days. 7 -72

End of Chapter 7