Chapter 8: Reporting and Interpreting Cost of Goods Sold and Inventory October 22, 24, 2013

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1 Chapter 8: Reprting and Interpreting Cst f Gds Sld and Inventry Octber 22, 24, 2013 Merchandising and Manufacturing vs. Service Merchandising and Manufacturing (Merchandiser = Retailer) Sales revenue Cst f gd sld Grss prfit = Sales COGS Operating expenses Operating Incme = Grss Prfits Operating Expenses Different frm Net Incme incme tax and interest; NI is the bttm line (after tax figure) Operating incme = EBIT (earnings befre interest and taxes) Service Service revenue Operating expenses Inventry asset held fr resale r used t prduce services and gds fr sale Merchandising firms have nly merchandise inventry (buys inventry; sells inventry) Manufacturing firms have three types f inventry Raw materials put in labr and verhead (utilities, machines, factry, rent, hydr, security, insurance etc) t prduce gds Wrk in prcess r prgress unfinished items that have nt yet been finished; has cnversin csts (labr) Finished gds ready fr sale Relatinships between inventries Ending raw materials = beginning raw material inventry + raw materials purchases raw materials used Ending wrk in prcess = beginning wrk in prcess + (direct law + raw materials used + verhead) cst f gds manufactures Ending finished gds inventry = beginning finished gds inventry + cst f gds manufactured cst f gds sld Cst included in inventry purchases The cst principle requires that inventry be recrded at the price paid plus all csts incurred t bring the inventry t saleable cnditins Invice price Freight and insurance freight in (transprtatin paid t btain gds); freight ut (transprtatin paid t transprt gds t custmer) Inspectin csts Preparatin csts eg/ packaging cst, labeling cst etc prepare gds fr sale; cut ff pint (cut ff csts) is the pint in time when gd reaches psitin t be sld Inventry Systems Perpetual updating inventry, where inventry is a physical, permanent, tangible item n the balance sheet (asset) Detailed recrds f the cst f each inventry purchase and sales are maintained Cst f gds sld determined and inventry accunt updated each time a sale ccurs Prvides better cntrl ver inventry Elabrate system makes perpetual system easier eg/ everything yus can an item at checkut, it is accunted fr Peridic d nt update inventry when buy and sell; temprary purchases accunt t keep track f buying and selling; Detailed recrds are nt kept thrughut the perid Cst f gds sld determined and inventry accunt updated nly at the end f the accunting perid, when a physical inventry cunt is taken B. Inv + Net Purchases = COGAS Net Purchases = Purchases Purch. Disc. Purch R&A COGAS = cst f gds available fr sale COGAS E. Inv = COGS Small stres can use peridic system; perpetual system t difficult An adjusting entry is required Purchases temprary expense accunt; will nt see it in a financial statement; helps in calculatin f COGS Freight In pay t have gds delivered frm supplier; temprary asset (part f the cst f inventry) OR temprary expense depending n whether gds are sld; when gds are sld it is transferred t COGS affects grss prfit and net incme, and perating incme 1

2 Freight Out pay t deliver gds t custmers; perating expense affects perating incme, nt NI r grss prfit Purchases R&A cntra-expense; cntra t purchaes Eg/ Jan 3 rd, 2013 Seller Inc. sld merchandise t Buyer Inc. fr $10,000, received $3,000 cash and the balance t be paid in ne week; the cst f gds sld by Seller Inc, is 80% f the sales price Jan 7 th, Buyer Inc. returned $1,000 gds t seller Inc. and received credit fr the amunt Jurnal Entries fr Seller Inc. Jan 3 (1/3) sale f merchandise fr $10,000: $3,000 cash and balance n accunt; COGS is 80% f sales price Perpetual Cash 3,000 A/R 7,000 Sales 10,000 Cst f Gds Sld 8,000 update inventry Inventry 8,000 Peridic d nt calculate COGS Cash 3,000 A/R 7,000 Sales 10,000 Jan 7 (1/7) return f $1,000 f merchandise Perpetual Sales R&A 1,000 A/R 1,000 Inventry 800 Cst f Gds Sld 800 Peridic Sales R&A 1,000 A/R 1,000 Jurnal Entries fr Buyer Inc. Jan 3 (1/3) purchase f merchandise fr $10,000: $3,000 cash and the balance n accunt Perpetual Inventry 10,000 A/P 7,000 Cash 3,000 Peridic Purchases 10,000 A/R 7,000 Cash 3,000 Jan 7 (1/7) return f $1,000 merchandise Perpetual A/P 1,000 Inventry 1,000 2

3 Peridic A/P 1000 Purchases R&A 1,000 Accunting fr Purchase Discunt Just like accunting fr sales discunt, there are tw methds t accunt fr purchase discunts Grss Methd assumes that discunt will nt be taken; if discunt is taken, it will be given Purchases and A/P are recrded at the grss amunt Purchase discunts taken by custmers are credited t the Purchase Discunts accunt, nly when buyer pays within the discunt perid Purchase discunts cntra-expense; cntra t purchases (expense) Net Methd assumes that discunt will be taken; if time elapsed, the discunt lst Purchases and A/P are recrded at the net amunt Purchase discunts nt taken by buyers are credited t the Purchase Discunts Lst accunt Purchase Discunt Lst expense; purchases increase Eg/ On May 24 th, 2013, Seller Inc. sld t Buyer Inc. gds fr $20,000 n credit with the fllwing terms: (2/10, n/30) On June 2 nd, 2013, Buyer Inc. paid 60% f the invice t Seller Inc (within perid) On June 22 nd 2013, Buyer Inc. paid the balance f their accunt t Seller Inc. (nt within perid) Jurnal entries fr Buyer Inc. Peridic System May 24, 2013 the purchase f $20,000 merchandise Grss Methd Purchases 20,000 temprary expense A/P 20,000 Net Methd Ttal Discunt = 20,000 x 2% Net = 20, Purchases 19,600 A/P 19,600 June 2, 2013 the payment f 60% f the balance Grss Methd Discunt = 20,000 x 60% x 2% = $240 A/P 12,000 Cash 11,760 Purchase Discunt 240 cntra-expense Net Methd A/P 11,760 Cash 11,760 June 22, 2013 the payment f 40% f the balance Grss Methd Balance f A/P = 20,000 x 40% A/P 8,000 Cash 8,000 Net Methd reverse discunt given (2% discunt f 40% f the amunt) Balance f A/P = 19,600 x 40% = $7,840 Discunt lst = 8,000 x 2% A/P 7,840 P. Discunt Lst 160 temprary adjunct expense; cannt exist Cash 8,000 withut purchases Perpetual System May 24, 2013 the purchase f $20,000 merchandise Grss Methd Inventry 20,000 immediately; rather than purchases A/P 20,000 Net Methd Ttal Discunt = 20,000 x 2% Net = 20, Inventry 19,600 A/P 19,600 June 2, 2013 the payment f 60% f the balance Grss Methd 3

4 Discunt = 20,000 x 60% x 2% A/P 12,000 Cash 11,760 Inventry 240 Net Methd A/P 11,760 Cash 11,760 June 22, 2013 the payment f 40% f the balance Grss Methd Balance f A/P = 20,000 x 40% A/P 8,000 Cash 8,000 Net Methd Balance f A/P = 19,600 x 40% = $7,840 Discunt lst = 8,000 x 2% A/P 7,840 P. Discunt Lst 160 Cash 8,000 Cash flw issues if cmpany has purchase discunt lst i) d nt have cash ii) weak credit plicies, cannt cllect mney frm creditrs iii) weak management, cannt reach deadlines, pr centers f cntrl Peridic System Adjusting Entries 1. Physical cunt f ending inventry 2. Calculate cst f gds purchased as Purchases -- Purchase returns and allwances -- Purchase discunts + Freight in 3. Calculate cst f gds available fr sale as Beginning inventry + Cst f gds purchased 4. Calculate cst f gds sld as Cst f gds available fr sale (frm step 3) -- Ending inventry (frm step 1) 5. Prepare the fllwing entry Eg/ As f January 1, 2013, ABC Inc. had $65,000 (+) in merchandise inventry The fllwing transactins tk place in 2013: Sales R&A 5,000 Nt relevant fr adjusting entry (peridic) Purchases 40,000 + Purchase returns and allwances 10,000 - Purchase discunts 3,000 - Freight in 5,000 + Sales 30,000 Nt relevant fr adjusting entry (peridic) Freight Out 10,000 Nt relevant fr adjusting entry (peridic) Physical cunt f inventry n December 31, 2013, revealed that ABC Inc. had $75,000 f merchandise inventry 4

5 Adjusting Entry Classified Incme Statement (step-by-step) line items classified as perating r nn-perating Clumns and tabbing d nt matter; headings matter Perpetual System Net sales COGS = Grss Prfit COGS already determined (thrughut perid) Grss Prfits Operating expenses = Earnings frm peratins Earnings frm perating s nt accunting terminlgy Operating Incme r EBIT (earnings befre interest and tax) Earnings befre incme tax (NOT EBIT) Incme tax expense Net Incme Freight In affects grss prfit, net incme and perating incme Freight Out affects perating incme and net incme Interest affects net incme Inventry Methds fr Estimating Inventry Under the peridic system, the balance f inventry (and COGS) is nt available until the accunting perid end Smetimes cmpanies wuld like t have an estimate f inventry balance Grss Prfit methd is used t estimate inventry balance using available infrmatin: sales, beginning inventry, purchases, histrical grss prfit percentage Histrical grss prfit percent Previus Year Sales Prev. Year COGS = GP COGS = Sales (1-GP%) Illustratin f Grss Prfit Methd Estimate the cst f gds sld using histrical grss prfit percentage Use the estimated cst f gds sld t calculate the cst f inventry Inventry = Beg. Inv. + Purch Estimated COGS Eg/ ABC Inc. has a fiscal end n Dec 31; n May 16, 2008, a fld damaged the entire inventry. Since ABC uses the peridic system, they need t estimate the cst f damaged inventry The fllwing infrmatin was available: 5

6 Step 1 estimate cst f gds sld using histrical grss prfit percentage Estimates COGS = Sales x (1- GP%) = 200,000 x (1 0.30) = $140,000 Step 2 Estimate cst f inventry = B. Inv + Purch Est COGS = 4, , ,000 = $14,500 Inventry Errrs Errrs can be made in taking physical cunt f ending inventry Since ending inventry in ne perid is the beginning inventry f the fllwing perid inventry errrs affect the financial statements f tw cnsecutive years Analyzing Inventry Errrs Examine the inventry equatin t analyze inventry errrs Ending Inv = Beg. Inv. + Purchases COGS COGS = Beg. Inv. + Purchases Ending Inv. Beg Inv + COGP = COGAS COGAS End Inv = COGS COGAS = Purchases Purchase Discunts Purchase R&A + Freight In At the end f 2007, ending inventry was verstated as a result, COGS will be understated, net incme will be verstated, assets will be verstated, and equity will be verstated Fr 2008, beginning inventry is verstated as a result, COGS will be verstated, net incme will be understated, and assets and equity nt be misstated Summary EI (U) CGS (O) NI (U) RE (U), Assets (U) BI (U) CGS (U) NI (O) Assets (NE), RE (NE) Purchases (U) CGS (U) NI (O) RE (O) A/P (U) Slved after tw years (because Assets are cunted at the end f year 2) Inventry Quantities Take physical cunt As f the end f the accunting perid, determine what s included in inventry Ownership f gds in transit F.O.B Shipping Pint F.O.B Destinatin Cnsigned gds nt wned by hlder Eg/ Magazines; wned by publisher; cnvenience stre that sells magazines cnvenience stre wuld nt cunt magazines in inventry Eg/ Buyers Inc. inventry physical cunts shws inventry f $600,000. Upn examinatin f recrds, the accuntants discvered the fllwing Buyer shipped $30,000 f gds n Dec 23 t a custmer. Shipping terms are FOB destinatin. Expected delivery date is Jan 4. Buyer shuld include $30,000 in inventry cunt because they wn it until it is delivered Buyer purchased $20,000 f gds frm Seller. Seller shipped these gds n Dec 28, FOB shipping pint. Expected delivery sate is Jan 7. Buyer shuld include these in inventry cunt because they wned them n December 28 Cash Flw Assumptins The cst f gds available fr sale is split between the cst f gds sld and the cst f ending inventry When pssible, specific identificatin shuld be applied ther wise, make ne f the fllwing assumptins First-in First-ut (FIFO) The ldest units are sld first Cst f inventry cnsists f the newest units Weighted Average Cst The cst per unit is the same fr all units in inventry Last in First-ut (LIFO) 6

7 The newest units are sld first Cst f inventry cnsists f the ldest units Keep in mind that physical and cst is separate LIFO Liquidatin calculatin; knw COGS in given year (refer t example belw) Nt permitted fr IFRS r tax purpses When prices are rising, which methd will match current inventry gds t current csts FIFO LIFO best fllws matching principle under GAAP and IFRS Latest mney spent, selling items, generating revenue matching current cst with current revenue Eg/ Using LIFO 2010; Purchased 10,000 items at $10, sld 8000 items at $ at $ ; Purchased 10,000 at $12; sld 7,000 items at $ at $ ; Purchased 10,000 at $14; sld 9000 items at $ at $ ; Purchased 10,000 items at $17; sld 15, 000 items at $ at $10 Sld items fr $20, value at $10 results in NI is large; taxes sht up If drp price t less than previus year (eg/$15) LIFO liquidatin sale (still higher than price purchased technically) t reduce taxes, but still make prfit Specific Identificatin With large and expensive inventry items, it is easy t track the cst f each individual item When a unit is sld, its cst is included in the cst f gds sld The cst f ending inventry is the sum f the cst f the individual units left in the inventry Eg/ a car dealership had a Hnda that cst $15,000 and a Tyta that cst $17,000 as f January 1, 2008 During 2008, the dealership bught a Ddge fr $12,000, a Buick fr $20,000 and a Chevy fr $16,000; and sld the Tyta and the Buick The cst f gds available fr sale = 15, , , , ,000 = $80,000 The cst f gds sld = the cst f the Tyta + the cst f the Buick = 17, ,000 = $37,000 The cst f ending inventry = the cst f the Hnda + the Ddge + the Chevy = 15, , ,000 = $43,000 The cst f ending inventry = cst f gds available fr sale cst f gds sld = 80,000 37,000 = $43,000 Eg/ stre that sells HtWheels First batch f 10,000 HtWheels cst $3,000; secnd batch f 20,000 cst $6,200; the stre sld 14,000 T cstly t track the cst f each HtWheels sld, must make assumptins as t where the units came frm Cst Flw Assumptins and Inventry Systems Peridic System Assumes all sales are made after all the purchases With average cst, the cst per unit equals the cst f gds available fr sale divided by ttal units available fr sale Perpetual System Apply the cst flw assumptin after each sale The weighted average cst changes after each purchase Apprach Always calculate the fllwing regardless f the inventry system Ttal units available fr sale Cst f gds available fr sale Under peridic system Ttal units sld Units in ending inventry Eg/ ABC Inc. began 2006 with $44,000 f inventry. The cst f beginning inventry (BI) is cmpsed f 8,000 units purchased fr $5.5 each. Merchandise transactins during 2006 were as fllws Observatins 7

8 FIFO will result in the same cst f gds sld and cst f ending inventry under bth the peridic and the perpetual inventry systems Cst f gds sld under FIFO is lwer than under LIFO because it is priced at the lder csts, which are the lwest Ending inventry is higher under FIFO than under LIFO because it is priced at the mst recent csts, which are the highest LIFO best matches the current value f cst f gds sld with current revenue by assigning t this expense the mst recent inventry csts Cst allcated t ending inventry using FIFO will apprximate current csts Lwer Cst f Net Realizable Value (LCNRV) A direct applicatin f cnservatism Inventry be reprted in the financial statements at whichever is lwer its cst f its NRC Cst is determined by ne f the cst flw assumptins Net realizable value is amunt at which the cmpany expects t sell its inventry Eg/ Hawkeye Vide Center Ltd. Accumulates the fllwing cst and NRV data at December 31 LCM applied t: Ttal Inventry = $33,500 Individual Items = $33,000 Inventry Turnver Inventry Turnver = COGS/Average Inventry Average Inventry = (beginning inventry + ending inventry)/2 This rati reflects hw many times average inventry was prduced and sld during the perid A higher rati indicates that inventry mves mre quickly thus reducing strage and bslescence csts This rati ften used t measure the liquidity (nearness t cash) f the inventry 8