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Chap006
- 1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Chapter 6 INVENTORIES AND COST OF SALES
- 2. 6 - 2 DETERMINING INVENTORY ITEMS Merchandise inventory includes all goods that aMerchandise inventory includes all goods that a company owns and holds for sale, regardless of wherecompany owns and holds for sale, regardless of where the goods are located when inventory is counted.the goods are located when inventory is counted. Items requiring special attention include:Items requiring special attention include:Items requiring special attention include:Items requiring special attention include: Goods in Transit Goods Damaged or ObsoleteGoods on Consignment C1
- 3. 6 - 3 FOB Destination Point Public Carrier Seller Buyer GOODS IN TRANSIT Public Carrier Seller Buyer FOB Shipping Point Ownership passes to the buyer here. C1
- 4. 6 - 4 GOODS ON CONSIGNMENT Merchandise is included in the inventory of the consignor, the owner of the inventory. Consignor Consignee Thanks for selling my inventory in your store. C1
- 5. 6 - 5 GOODS DAMAGED OR OBSOLETE Damaged or obsolete goods are not counted in inventory if they cannot be sold. Cost should be reduced to net realizable value if they can be sold. C1
- 6. 6 - 6 DETERMINING INVENTORY COSTS Invoice Cost Invoice Cost Include all expenditures necessary to bring an item toInclude all expenditures necessary to bring an item to a salable condition and location.a salable condition and location. Minus Discounts and Allowances Minus Discounts and Allowances Plus Import Duties Plus Import Duties Plus Freight Plus Freight Plus Storage Plus Storage Plus Insurance Plus Insurance C2
- 7. 6 - 7 Most companies take a physical count of inventory at least once each year. INTERNAL CONTROLS AND TAKING A PHYSICAL COUNT When the physical count does not match the Merchandise Inventory account, an adjustment must be made. Good internal controls over count include: 1.Pre-numbered inventory tickets. 2.Counters have no inventory responsibility. 3.Counts confirm existence, amount, and quality of inventory item. 4.Second count is taken. 5.Manager confirms all items counted. Good internal controls over count include: 1.Pre-numbered inventory tickets. 2.Counters have no inventory responsibility. 3.Counts confirm existence, amount, and quality of inventory item. 4.Second count is taken. 5.Manager confirms all items counted. C2
- 8. 6 - 8 INVENTORY COST FLOW ASSUMPTIONS First-In, First-OutFirst-In, First-Out (FIFO)(FIFO) Assumes costs flow in the orderAssumes costs flow in the order incurred.incurred. Last-In, First-OutLast-In, First-Out (LIFO)(LIFO) Assumes costs flow in theAssumes costs flow in the reverse order incurred.reverse order incurred. WeightedWeighted AverageAverage Assumes costs flow at anAssumes costs flow at an average of the costs available.average of the costs available. P1
- 9. 6 - 9 FIRST-IN, FIRST-OUT (FIFO) Cost of Goods Sold Cost of Goods Sold Ending Inventory Ending Inventory Oldest Costs Oldest Costs Recent Costs Recent Costs P1
- 10. 6 - 10 LAST-IN, FIRST-OUT (LIFO) Cost of Goods Sold Cost of Goods Sold Recent Costs Recent Costs Oldest Costs Oldest Costs P1
- 11. 6 - 11 WEIGHTED AVERAGE When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Cost of Goods Available for Sale Units on hand on the date of sale ÷ P1
- 12. 6 - 12 FINANCIAL STATEMENT EFFECTS OF COSTING METHODS Because prices change, inventory methods nearly always assign different cost amounts. A1
- 13. 6 - 13 FINANCIAL STATEMENT EFFECTS OF COSTING METHODS Advantages of MethodsAdvantages of MethodsAdvantages of MethodsAdvantages of Methods Smoothes out price changes. Smoothes out price changes. Better matches current costs in cost of goods sold with revenues. Better matches current costs in cost of goods sold with revenues. Ending inventory approximates current replacement cost. Ending inventory approximates current replacement cost. First-In, First-Out First-In, First-Out Weighted Average Weighted Average Last-In, First-Out Last-In, First-Out A1
- 14. 6 - 14 TAX EFFECTS OF COSTING METHODS The Internal Revenue Service (IRS) identifies severalThe Internal Revenue Service (IRS) identifies several acceptable inventory costing methods for reportingacceptable inventory costing methods for reporting taxable income.taxable income. If LIFO is used for taxIf LIFO is used for tax purposes, the IRS requirespurposes, the IRS requires it be used in financialit be used in financial statements.statements. If LIFO is used for taxIf LIFO is used for tax purposes, the IRS requirespurposes, the IRS requires it be used in financialit be used in financial statements.statements. A1
- 15. 6 - 15 LOWER OF COST OR MARKET Inventory must be reported at market valueInventory must be reported at market value whenwhen marketmarket isis lowerlower than cost.than cost. Can be applied three ways: (1) separately to each individual item. (2) to major categories of assets. (3) to the whole inventory. Can be applied three ways: (1) separately to each individual item. (2) to major categories of assets. (3) to the whole inventory. P2
- 16. 6 - 16 FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS Income Statement EffectsIncome Statement Effects A2
- 17. 6 - 17 FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS Balance Sheet EffectsBalance Sheet Effects A2
- 18. 6 - 18 END OF CHAPTER 6
Hinweis der Redaktion
- Chapter 6: Inventories and Cost of Sales
- Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. We must pay special attention to include inventory that we own but that is in transit or on consignment. We should also consider the condition of inventory that is damaged or obsolete when determining a cost for the inventory.
- Transportation costs are sometimes included in the cost of Merchandise Inventory. The FOB terms designate when title passes and who pays the transportation costs. FOB stands for “Free On Board.” So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means the buyer will pay all transportation costs. In this case, the transportation costs will be added to the merchandise inventory account. On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means the seller will pay the transportation costs.
- Goods on consignment are goods that we own, but that are on display for sale at another place of business. Even though these goods are not in our physical possession, we still have ownership of them and should include them in our inventory count.
- Damaged and obsolete goods are not counted in inventory if they cannot be sold. If these goods can be sold at a reduced price, they are included in inventory at a conservative estimate of their net realizable value. Net realizable value is sales price minus the cost of making the sale.
- The cost of inventory includes any cost that is necessary and reasonable to get the inventory to your place of business and to get it in a salable condition. We already know that the invoice price and transportation costs are included in the total cost of inventory. Other costs to include are insurance, storage and import duties. Any purchase discounts or allowances received reduce the cost of the inventory purchased.
- Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in our inventory records. In reality, this is not the case. The physical count may not match our records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps us get our records up to date to reflect what we actually have on hand. A company has adequate internal controls over the inventory count if, (1) it uses pre-numbered inventory tags, (2) inventory counters have no responsibility for inventory, (3) the count confirms the existence, amount, and quality of inventory items counted, (4) a second count of the inventory is made, and (5) a count supervisor confirms that all items in inventory have been counted.
- We must make assumptions about the inventory cost flow. First-in, first-out assumes costs flow in the order incurred. Last-in, first-out assumes costs flow in the reverse order incurred. Weighted average assumes costs flow at an average of the costs available.
- The first-in, first-out method is abbreviated as FIFO, and pronounced as Fifo. When using FIFO, we assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory.
- The last-in, first-out method is abbreviated as LIFO, and pronounced as Lifo. When using LIFO, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory.
- When using weighted average, we assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand.
- This slide presents a comparison of the impact on the income statement of using the different inventory costing methods. Everything is the same in each example, except the amount of Cost of Goods Sold, and its flow through effects on Income Before Taxes, Income Tax Expense, and Net Income. Specific identification provides the most accurate cost of goods sold amount. But, this method is very costly to use. In periods of rising prices, of the other three methods, FIFO will provide the lowest Cost of Goods Sold amount. This is because it uses the older costs which tend to be lower to arrive at this amount. LIFO will provide the highest Cost of Goods Sold amount. This is because it uses the most recent costs which tend to be higher to arrive at this amount. Weighted average will provide a Cost of Goods Sold amount that falls between FIFO and LIFO. As you can see, the impact on net income is that FIFO results in the highest net income, LIFO results in the lowest net income, and weighted average results in net income that falls in the middle of these two.
- An advantage of weighted average is that it smoothes out peaks and valleys in price changes that may occur during the period. FIFO does a great job of valuing Ending Inventory at an approximate replacement cost. This is because FIFO uses the most recent costs to value Ending Inventory. LIFO does a great job of matching current costs in Cost of Goods Sold with current revenues. This is because LIFO uses the most recent costs to determine Cost of Goods Sold.
- Using LIFO for tax reporting purposes makes sense because it provides the lowest net income figure, and, therefore, the lowest tax expense of the three methods. However, the Internal Revenue Service requires that if a company uses LIFO for tax reporting purposes, it must also use LIFO for financial reporting.
- When we report inventory on the balance sheet, we report it at the lower of cost or market value. Cost is determined using one of the methods we just discussed: Specific identification, FIFO, LIFO or weighted average. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market value follows the conservatism principle by not overstating the value of assets. We can apply the lower of cost or market concept on an individual item basis, for similar categories of inventory, or for the inventory as a whole.
- Take a few minutes and review this chart. It shows the impact of inventory errors on the income statement. For example, if Ending Inventory is understated, that will result in an overstatement of Cost of Goods Sold which will result in an understatement of Net Income.
- Take a few minutes and review this chart. It shows the impact of inventory errors on the balance sheet. As we just noted on the previous slide, if Ending Inventory is understated, Cost of Goods Sold will be overstated, which will result in an understatement of net income. An understatement of net income will result in an understatement of equity. Also, if Ending Inventory is understated, then assets on the balance sheet will be understated.
- End of Chapter 6.