Chapter 6 Financial 3 Ed

Spiceland | Thomas | Herrmann

Financial Accounting

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Inventory and Costof Goods

Sold

Chapter 6

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Learning Objectives

• Trace the flow of inventory costs from manufacturing companies to merchandising companies

• Understand how cost of goods sold is reported in a multiple-step income statement

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

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

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Learning Objectives

• Record inventory transactions using a perpetual inventory system

• Apply the lower-of-cost-or-market method for inventories

• Analyze management of inventory using the inventory turnover ratio and gross profit ratio

• Record inventory transactions using a periodic inventory system

• Determine the financial statement effects of inventory errors

Part A

Understanding Inventory and Cost

of Goods Sold

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Learning Objective 1

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

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Inventory

• Includes items a company intends for sale to customers• Also includes items that are not yet finished

products

• Reported as a current asset• Cost of goods sold: Cost of the inventory that is

sold during the period

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Manufacturing and Merchandising Companies

Inventory

Merchandisecompany

Merchandisecompany

Manufacturingcompany

Manufacturingcompany

Wholesaler Retailer Raw

materialWork in Progress

Finished goods

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Illustration 6.2—Types of Companies and Flow of Inventory Costs


Understand how cost of goods sold is reported in a multiple-step income statement

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Illustration 6.3—Relationship between Inventory and Cost of Goods Sold

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Illustration 6.4—Multiple-Step Income Statement


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

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Inventory Cost Methods

• Specific identification• First-in, first-out (FIFO)• Last-in, first-out (LIFO)• Weighted-average cost

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Illustration 6.5—Inventory Transactions

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Illustration 6.6—FIFO Method

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Illustration 6.7—LIFO Method

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Weighted-Average Cost

• Under this method, we assume:• 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 unit cost of all inventory items

• Calculated as:

Cost of goods available for sale

Number of units available for sale

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Illustration 6.8—Weighted Average Cost Method

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Illustration 6.9—Comparison of the Three Inventory Cost Flow Assumptions


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

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Choice of Inventory Reporting Methods

• FIFO method• Matches physical flow for most companies• Ending inventory reflects today’s costs• Balance-sheet approach

• LIFO method• Cost of goods sold reflects today’s costs• Income-statement approach

• LIFO conformity rule: requires companies that use LIFO for tax reporting to also use LIFO for financial reporting

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Illustration 6.10—Comparison of Inventory Cost Flow Assumptions, When Costs Are

Rising

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Reporting the LIFO Difference

• LIFO Difference• Companies that choose LIFO must report the difference

if it used FIFO instead of LIFO• Example—Impact of the LIFO Difference on Reported

Inventory

Part B

Recording Inventory Transactions

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Perpetual Inventory System and Periodic Inventory System

Perpetual Inventory

System

• Maintains a continual track of inventory

• Helps a company better manage inventory levels

Periodic Inventory

System

• Does not maintain a continual track of inventory

• Periodically adjusts for purchase and sale of inventory

• Reports inventory based on a physical count


Record inventory transactions using a perpetual inventory system

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Perpetual Inventory System—Example

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Inventory Purchases—Example

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Inventory Sales—Example

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Illustration 6.13—Inventory Account

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LIFO Adjustment

• Used to convert a company’s own inventory records maintained on a FIFO basis to LIFO basis for preparing financial statements

• The difference in reported inventory when using LIFO instead of FIFO is commonly referred to as the LIFO reserve

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Recording the LIFO Adjustment

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Additional Inventory Transactions

• Freight charges• Freight-in• Freight-out

• Purchase discounts• Purchase returns

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Illustration 6.15—Shipping Terms

Part C

Lower-of-Cost-or-Market Method

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

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Lower-of-Cost-or-Market Method

• Reports inventory in the balance sheet at the lower of cost or market value

• Replacement cost• Cost to replace an inventory item in its identical

form

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Illustration 6.20—Calculating the Lower-of-Cost-or-Market


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

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Inventory Turnover Ratio

• Shows the number of times the firm sells its average inventory balance during a reporting period

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Average Days in Inventory

• Indicates the approximate number of days the average inventory is held

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Gross Profit Ratio

• Indicator of the company’s successful management of inventory

• Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales


Record inventory transactions using a periodic inventory system

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Periodic Inventory System

• Does not continually modify inventory amounts• Periodically adjust for purchases and sales of

inventory• At the end of the reporting period• Based on a physical count of inventory on hand

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Illustration 6.23—Inventory Transactions

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Inventory Purchases and Sales Side-by-Side Comparisons Between the Perpetual System and Periodic System

• Purchase inventory on account

• Sell inventory on account

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Freight Charges, Purchase Discounts and Returns side-by-side Comparisons Between

the Perpetual System and Periodic System

• Pay freight-in charges

• Pay on account with a 2% purchase discount of $54; Return inventory previously purchased on account

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Period-End Adjustment

• Needed only under the periodic system


Determine the financial statement effects of inventory errors

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Illustration 6.26—Effects in the Current Year

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Illustration 6.28 and 6.29—Effects in the Following Year

End of Chapter 6

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Business

Chapter 6 Financial 3 Ed