BUAD 111 Financial Accounting I

1. MMeerrcchhaannddiissee
IInnvveennttoorryy aanndd
CCoosstt ooff SSaalleess
CHAPTER
6
PowerPoint Slides to accompany
Fundamental Accounting Principles, 14ce
Prepared by
Joe Pidutti, Durham College

2. LLeeaarrnniinngg OObbjjeeccttiivveess
1. Identify the components and costs included in
merchandise inventory. (LO1)
2. Calculate cost of goods sold and merchandise
inventory using specific identification, moving
weighted average, and FIFO-perpetual. (LO2)
3. Analyze the effects of the costing methods on
financial reporting. (LO3)
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3. LLeeaarrnniinngg OObbjjeeccttiivveess
4. Calculate the lower of cost and net realizable
value of inventory. (LO4)
5. Analyze the effects of merchandise inventory
errors on current and future financial
statements-perpetual. (LO5)
6. Apply both the gross profit and retail methods
to estimate inventory. (LO6)
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4. LLeeaarrnniinngg OObbjjeeccttiivveess
7. Calculate cost of goods sold and merchandise
inventory using FIFO –periodic, weighted
average , and specific identification (Appendix
6A). (LO7)
8. Analyze the effects of merchandise inventory
errors on current and future financial
statements-periodic. (Appendix 6A). (LO8)
9. Assess merchandise inventory management
using both merchandise turnover and days’
sales in inventory. (Appendix 6B) (LO9)
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5. Assigning CCoossttss ttoo MMeerrcchhaannddiissee
IInnvveennttoorryy
Accounting for merchandise inventory
requires several decisions which include:
• Items included and their costs.
• Costing Method. (specific identification, moving
weighted average or FIFO)
• Merchandise Inventory System. (perpetual or
periodic)
• Use of net realizable value or other estimates.
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6. IItteemmss iinn MMeerrcchhaannddiissee IInnvveennttoorryy
Merchandise inventory includes all goods
owned by a company and held for sale.
Items requiring special attention:
• Goods in Transit
• Goods on Consignment
• Goods Damaged or Obsolete
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7. CCoossttss ooff MMeerrcchhaannddiissee IInnvveennttoorryy
All expenditures necessary to bring an
item to a saleable condition and location.
This includes:
• Invoice price less discounts
• Import duties
• Transportation-in
• Storage
• Insurance
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8. AAssssiiggnniinngg CCoossttss ttoo MMeerrcchhaannddiissee
IInnvveennttoorryy
• Management must decide on method of
determining unit cost.
• This will affect both the income statement
and the balance sheet.
Methods:
1. First-in, first-out (FIFO)
2. Moving weighted average
3. Specific identification
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9. FFiirrsstt-IInn,, FFiirrsstt-OOuutt ((FFIIFFOO))
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 merchandise inventory.
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10. FIFO — Example
FIFO Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
The opening inventory consists of 10 units @ $91/unit.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost Total Cost
8/1 Beginning Inventory
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
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11. FIFO — Example
FIFO Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
This results in two layers of
merchandise inventory.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Additional units re
purchased @ $106/unit.
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost
Total
Cost
8/1 Beginning inventory
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
Additional units are
purchased @ $106/unit.
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12. FIFO — Example
FIFO Computations - Perpetual Inventory System
Purchases Sales (at cost) Inventory Balance
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.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost
Total
Cost
8/1 Beginning Inventory $ 910
10 $ 91 $ 910 10 $ 91
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
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13. FIFO — Example
FIFO Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
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.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost
Total
Cost
8/1 Beginning inventory
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
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14. FIFO — Example
FIFO Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
The ending inventory consists of the 5
remaining units from the August 3 purchase.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost
Total
Cost
8/1 Beginning Inventory
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
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15. MMiinnii--QQuuiizz
A company that uses a perpetual merchandise 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 FIFO
system is used.
Cash 640
Sales (40x $16)
640
Cost of goods sold 400
Merchandise Inventory (40x $10 )
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16. MMoovviinngg WWeeiigghhtteedd AAvveerraaggee
MMeetthhoodd
Under this method, the cost of all units are
averaged together.
Average cost per unit
Cost of goods available for sale
Number of units available for sale
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17. Moving Weighted Average - Example
Moving Weighted Average Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
The opening inventory consists of 10 units @ $91/unit.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold
(b)
Units
(a)+(b)
Average
Cost/Unit
(a)
Total
Cost
8/1 Beginning inventory
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
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18. Moving Weighted Average- Example
Moving Weighted Average Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
This results in an average cost of
$100/unit.
(10 x $91) + (15 x $106)
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Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold
(b)
Units
(a)+(b)
Average
Cost/Unit
(a)
Total
Cost
8/1 Beginning inventory
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
15 additional units are
purchased @ $106/unit.
8/28 14 $ 112 $ 1,568 11 $ 112 $ 1,232
25 units
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19. Moving Weighted Average- Example
Moving Weighted Average Computations - Perpetual Merchandise Inventory System
Purchases Sales ( at cost) Inventory Balance
These 20 units are sold at the
average cost of $100/unit.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold
(b)
Units
(a)+(b)
Average
Cost /Unit
(a)
Total
Cost
8/1 Beginning inventory
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
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20. Moving Weighted Average- Example
Moving Weighted Average Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
This leaves 5 units remaining at
an average cost of $100/unit.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost Total Cost Units
Unit
Cost Total
(b)
Units
(a)+(b)
Average
Cost/Unit
(a)
Total
Cost
8/1 Beginning inventory
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
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21. MMiinnii--QQuuiizz
A company that uses a perpetual merchandise 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 (40x $16) 640
Cost of goods sold 430
Merchandise Inventory 430
(100x$10 + 60x$12)/160 x 40
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22. SSppeecciiffiicc IIddeennttiiffiiccaattiioonn
This method is used when items:
• Can be directly identified.
• Can be directly identified with a specific
purchase and its invoice.
Examples: Automobiles, art, custom furniture.
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23. Specific Identification - Example
Specific Identificaton Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
The opening inventory consists of 10 units @ $91/unit.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost
Total
Cost
8/1 Beginning inventory
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
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24. Specific Identification - Example
Specific Identificaton Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
This results in two layers of
merchandise inventory.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost
Total
Cost
8/1 Beginning inventory
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
15 additional units are
purchased @ $106/unit.
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25. Specific Identification - Example
Specific Identificaton Computations - Perpetual Merchandise Inventory System
Purchases Sales ( at cost) Inventory Balance
On August 14, 20 units are sold. Eight of these units
came from the opening merchandise inventory and the
remaining 12 units came from the August 3 purchase.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost
Total
Cost
8/1 Beginning inventory
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
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26. Specific Identification - Example
Specific Identificaton Computations - Perpetual Merchandise Inventory System
Purchases Sales (at cost) Inventory Balance
This leaves 2 units remaining from the
original mercandise inventory and 3 units
remaining from the August 3 purchase.
© 2013 McGraw-Hill Ryerson Limited.
Date Units
Unit
Cost
Total
Cost Units
Unit
Cost
Cost of
Goods Sold Units
Unit
Cost
Total
Cost
8/1 Beginning Inventory
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
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27. CCoommppaarriissoonn ooff MMeetthhooddss
Because prices change, the choice of an
merchandise inventory method is
important.
Units FIFO
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Moving
Weighted
Average
Specific
Identification
Cost of Goods Sold 34 $ 3,535 $ 3,568 $ 3,562
Ending Merchandise Inv. 11 $ 1,265 $ 1,232 $ 1,238
Goods Available for Sale 45 $ 4,800 $ 4,800 $ 4,800
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28. FFiinnaanncciiaall RReeppoorrttiinngg
Advantages of Each Method
First-In,
First-Out
First-In,
First-Out
First-In,
First-Out
Ending inventory
approximates
Ending inventory
approximates
Most current values
are on the balance
sheet as ending
current
current
inventory
replacement cost.
replacement cost.
Moving
Weighted
Average
Moving
Weighted
Average
Smoothes out
purchase price
Smoothes out
purchase price
changes
changes
Specific
Identification
Specific
Identification
Exactly matches costs
Exactly matches costs
and revenues
and revenues
First-In,
First-Out
Most current values
are on the balance
sheet as ending
inventory
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29. Disadvantages of Each Method
First-In,
First-Out
First-In,
First-Out
First-In,
First-Out
Ending inventory
approximates
Ending inventory
approximates
CGS does not reflect
current costs
current
current
replacement cost.
replacement cost.
Moving
Weighted
Average
Moving
Weighted
Average
Does not
Does not
accurately match
revenues to
accurately match
revenues to
expenses
expenses
Specific
Identification
Specific
Identification
Relatively more costly
to implement and
Relatively more costly
to implement and
maintain
maintain
FFiinnaanncciiaall RReeppoorrttiinngg
First-In,
First-Out
CGS does not reflect
current costs
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30. FFiinnaanncciiaall RReeppoorrttiinngg
• 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).
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31. LLoowweerr ooff CCoosstt aanndd NNeett RReeaalliizzaabbllee
VVaalluuee ((LLCCNNRRVV))
Merchandise Inventory must be reported at
net realizable value (NRV) when NRV is
lower than cost (principle of faithful
representation).
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32. LLoowweerr ooff CCoosstt aanndd NNeett RReeaalliizzaabbllee
VVaalluuee ((LLCCNNRRVV))
May be applied in one of two ways:
1. Separately to each item.
2. To groups of similar or related items.
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33. MMeerrcchhaannddiissee IInnvveennttoorryy EErrrroorrss
Errors in the computation of or physical
count of merchandise inventory will cause a
misstatement of:
• Cost of goods sold
• Gross profit
• Net income
• Current assets
• Equity
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34. Inventory EErrrroorrss-- EEffffeecctt oonn TThhiiss PPeerriioodd’’ss
IInnccoommee SSttaatteemmeenntt
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35. Inventory EErrrroorrss-- EEffffeecctt oonn TThhiiss PPeerriioodd’’ss
BBaallaannccee SShheeeett
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36. GGrroossss PPrrooffiitt MMeetthhoodd
Ending merchandise inventory is estimated
by applying the gross profit ratio to net
sales.
It is used:
• When merchandise inventory has been
destroyed, lost, or stolen.
• For testing the reasonableness of the physical
merchandise inventory count.
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37. RReettaaiill IInnvveennttoorryy MMeetthhoodd
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.
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38. RReevviieeww
Q Describe how management’s decisions can
affect the determination of the cost of
merchandise inventory.
A Choice of method –FIFO, moving weighted
average, specific identification.
Choice of application of LCNRV -separate item or
categories.
Choice of periodic or perpetual system.
Items to include in cost.
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39. EEnndd ooff CChhaapptteerr
47 © 2013 McGraw-Hill Ryerson Limited.

40. PPeerriiooddiicc SSyysstteemm--AAppppeennddiixx 66AA
• The periodic system also uses FIFO,
specific identification, and weighted
average methods to assign costs to
merchandise inventory and cost of goods
sold.
• The results may be the same or different
under both systems.
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41. FFIIFFOO--AAppppeennddiixx 66AA
Yields same results as perpetual system
since most recent purchases are in ending
merchandise inventory under both systems.
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42. WWeeiigghhtteedd AAvveerraaggee--AAppppeennddiixx 66AA
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
merchandise inventory.
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43. SSppeecciiffiicc IIddeennttiiffiiccaattiioonn--
AAppppeennddiixx 66AA
• Applied in same manner as periodic
system.
• Yields same results as perpetual system
since units are specifically identified.
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44. MMeerrcchhaannddiissee IInnvveennttoorryy EErrrroorrss iinn
aa PPeerriiooddiicc SSyysstteemm--AAppppeennddiixx 66AA
• An error in the ending merchandise
inventory affects the assets, net income,
and equity of that period.
• The ending merchandise inventory of one
period becomes the opening merchandise
inventory of the next period. The cost of
goods sold and net income of the next
period are affected as well.
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45. RRaattiiooss--AAppppeennddiixx 66BB
Merchandise Inventory ratios may be used
to assess:
1. Short-term liquidity.
2. Merchandise Inventory management.
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46. RRaattiiooss--AAppppeennddiixx 66BB
Merchandise Turnover Ratio
• Measures how many times a company
turns its merchandise inventory over each
period.
• The ratio will vary from industry to industry.
Merchandise turnover Cost of goods sold
Average merchandise inventory
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47. RRaattiiooss--AAppppeennddiixx 66BB
Days’ Sales in Inventory
• Used to estimate how many days it will take to
convert merchandise inventory to cash or
receivables.
• Used to assess if merchandise inventory levels
can meet sales demand.
Days’ sales in inventory Ending inventory x 365
Cost of goods sold
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=