Chapter 7 Condensed (Day 1)

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1 Chapter 7 Condensed (Day 1) I. Valuing and Cost of Goods Sold (COGS) II. Costing Methods: Specific Identification, FIFO, LIFO, and Average Cost III. When managers use FIFO, LIFO, and Average Cost IV. Lower-of-Cost-or-Market (LCM) V. Turnover Ratio VI. Perpetual and Periodic Systems VII. Errors in valuing inventory I. Valuing and Cost of Goods Sold (COGS) A. tangible property that is (1) held for sale in the normal course of business or (2) used to produce goods or services for sale. is an asset. Paper is inventory for Dunder Mifflin, but supplies for Northeastern. Cars are inventory for Ford, but equipment for Northeastern. B. Types of : Merchandise and Manufacturing R4 i. Merchandise inventory Costs include the sum of costs incurred in bringing an article to usable or salable condition and location i. Invoice Price ii. Freight In (NOT freight out, which is a shipping expense) iii. Import Taxes and duties iv. Inspection Costs v. Preparation Costs assembly, etc. Include everything it takes to get the merchandise to its salable condition. Buy inventory entry Dr. Cr. Cash Freight in entry Dr. Cr. Cash E.g. Based on its physical count of inventory in its warehouse at year-end, Dec 31, 2011, Madison Company planned to report inventory of $34,500. During the audit, the independent CPA uncovered the following additional information: Supplier Madison Company Customers $700 -> 1

2 -> $650 -> $1,500 a. Goods from a supplier costing $700 are in transit with UPS on December 31, The terms are FOB shipping point. Because these goods had not yet arrived, they were excluded from the physical inventory count b. Madison delivered samples costing $1,800 to a customer on December 27, 2011, with the understanding that they would be returned to Madison on January 15, Because these goods were not on hand, they were excluded from the inventory count. Counts as inventory, because it will be returned +1,800 Your inventory doesn t have to be on hand at a company for it to be inventory (ex. consignment store) c. On December 31, 2011, goods in transit to customers, with terms FOB shipping point, amounted to $6,500 (expected delivery date January 10, 2012). Because the goods had been shipped, they were excluded from the inventory count. It should have been excluded from the inventory count do nothing. +0 d. On December 31, 2011, goods in transit to customers, with terms FOB destination, amounted to $1,500 (expected delivery date January 10, 2012). Because the goods had been shipped, they were excluded from the inventory count. +1,500 e. Madison only includes the invoice price in the value of their inventory. The auditor uncovered these additional costs: i. Freight on goods purchased from vendors = $ ii. Freight on goods sold to customers = $ (freight out) iii. Inspection Costs = $ iv. Interest (6.0%) on $2,250 borrowed to finance the purchase of inventory +0 You have to finance everything, this is not really part of getting items into their salable condition. Compute the correct amount for ending inventory $39,125 ii. Manufacturing i. Raw Materials ii. Work in Process iii. Finished Goods iv. Direct labor cost v. Factory Overhead Costs (eg. Heat, light, and power to operate the factory) C. Cost of Goods Sold (COGS) directly related to Sales revenue Dr. A/R or Cash 2

3 Cr. Sales Revenue = number of units sold multiplied by the sales price Dr. COGS = number of units multiplied by their unit costs Cr. How do we get the unit costs? Cost of goods sold equation: Beginning inventory + Purchases of merchandise Cost of Goods available for sale (COGAS) Ending inventory Cost of goods sold (COGS) Merchandise (A) Beginning inventory Add: Purchases of inventory Ending inventory Deduct: Cost of goods sold II. Costing Methods: Specific Identification, FIFO, LIFO, and Average Cost Specific identification: used by some industries, such as antique dealers Four alternative methods used costing differs because the price of inventory and raw materials fluctuates throughout time. A. Specific Identification Method identifies the cost of the specific item sold. Eg. Retailer Inc. provides the following information related to its merchandise inventory for 2007: Purchases: January ,800 1,800 $23,900 (COGAS) We have a generally inflationary economy, so most will be rising costs. Specific Identification Retailer sold 50 units from the beginning inventory, 400 units from the January purchase, 450 units from the May purchase, 450 units from the July purchase, and 150 units from the November purchase. COGS Ending 3

4 Beg Inv = $1,000 Purchases = $22,900 (COGAS BI) COGS = The specific identification method is impractical when large quantities of similar items are stocked (Gas); appropriate when dealing with expensive unique items (Airplanes) B. First-In, First-Out (FIFO) Method: FIFO assumes that the first goods purchased (the first in) are the first goods sold (the first out) for accounting purposes only. FIFO allocates the oldest unit costs to cost of goods sold and the newest unit costs to ending inventory. You want to be consistent, based on accounting principles. Eg. Retailer Inc. provides the following information related to its merchandise inventory for 2007: Purchases: January ,800 1,800 23,900 First In - First Out (FIFO) COGS Ending Beg Inv = Purchases = COGS = C. Last-In, First-Out (LIFO) Method - LIFO assumes that the last goods purchased (the last in) are the first goods sold (the first out). LIFO allocates the newest unit costs to cost of goods sold and the oldest unit costs to ending inventory. 4

5 Eg. Retailer Inc. provides the following information related to its merchandise inventory for 2007: Purchases: January ,800 1,800 23,900 Last In - First Out (LIFO) COGS Ending Beg Inv = Purchases = COGS = D. Average Cost Method (Weighted Average Cost Method) - Average cost uses the weighted average unit cost of the goods available for sale for both cost of goods sold and ending inventory Average Cost = Cost of Goods Available for Sale Number of Available for Sale Eg. Retailer Inc. provides the following information related to its merchandise inventory for 2007: Purchases: January ,800 Average Cost = 23,900 / 1,800 = $13.28 COGS = * 1,500 units = 19, Ending = * 300 units = 3, Beg Inv = Purchases = COGS = III. When managers use FIFO, LIFO, and Average Cost 5

6 A. The reasons companies adopt different inventory cost flow methods are varied, but usually involve one of the three following factors: i. Income statement effects ii. Balance sheet effects iii. Tax Effects Beg Inv = 1,000 FIFO Purchases = 22,900 COGS = 19,300 4,600 Beg Inv = 1,000 LIFO Purchases = 22,900 COGS = 20,500 3,400 Beg Inv = 1,000 Weighted Average Purchases = 22,900 COGS = 19, , MC Example B. If costs are rising: i. FIFO has the highest inventory ii. FIFO has the lowest cost of goods sold (therefore highest Net Income) iii. FIFO has the highest taxable income C. If costs are rising: i. LIFO has the lowest inventory ii. LIFO has the highest cost of goods sold (therefore lowest Net Income) iii. LIFO has the lowest taxable income. D. Average cost always falls between FIFO and LIFO In a period of increasing prices, the inventory system that will yield the highest net income is: a. specific identification. b. FIFO. c. LIFO. d. weighted average. Consistency - Companies must consistently use one cost flow method. They can change but they must do significant disclosures so comparison to prior years may be made. 6

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