Heintz & Parry. 20 th Edition. College Accounting

Heintz & Parry 20 th Edition College Accounting

Chapter 13 Accounting for Merchandise Inventory

1 Explain the impact of merchandise inventory on the financial statements.

Errors in inventory will cause errors on the: Income statement Statement of owner s equity Balance sheet o Since this year s ending inventory becomes next year s beginning inventory, financial statements for the following year will also contain errors

INCOME STATEMENT 20-1 20-2 Sales Cost of goods sold: 80 Beginning merch. inventory 20 Add purchases (net) 40 Cost of goods available for sale 60 Less ending merch. inventory (20) Let s first look at the income statement with the ending inventory correctly stated at $20.

INCOME STATEMENT 20-1 20-2 Sales 80 Cost of goods sold: Beginning merch. inventory 20 Add purchases (net) 40 Cost of goods available for 60 Less saleending merch. inventory (20) Cost of goods sold (40) Gross profit Now let s look at 40 Operating expenses the other financial (10) statements. Net income 30

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 30 Erv Bultman, capital, December 31 130 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital 20 130

INCOME STATEMENT 20-1 20-2 Sales 80 Cost of goods sold: Beginning merch. inventory 20 Add purchases (net) 40 Cost of goods available for sale 60 Less ending merch. inventory (20) Cost of goods sold (40) Gross profit 40 Operating expenses (10) 20-1 s ending inventory becomes 20-2 s beginning inventory. Net income 30 20 80

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 30 Erv Bultman, capital, December 31 130 30 130 160 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital 20 130 20 160

What would be the effect on the financial statements for 20-1 and 20-2 if the ending inventory was reported as $15 instead of $20?

INCOME STATEMENT 20-1 20-2 Sales 80 Cost of goods sold: Beginning merch. inventory 20 Add purchases (net) 40 Cost of goods available for sale 60 Less ending merch. inventory (15) Cost of goods sold (45) Gross profit 35 Operating expenses (10) Net income 25 Understated ending inventory results in understated net income.

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 25 Erv Bultman, capital, December 31 125 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital Understated net income results in understated owner s equity.

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 25 Erv Bultman, capital, December 31 125 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital 15 125 Current assets and owner s equity will be understated.

INCOME STATEMENT 20-1 20-2 Sales 80 Cost of goods sold: Beginning merch. inventory 20 Add purchases (net) 40 Cost of goods available for sale 60 Less ending merch. inventory (15) Cost of goods sold (45) Gross profit 35 Operating expenses Understated beginning (10) inventory results in Net income 25 overstated net income. 15 40 55 20 80 (35) 45 (10) 35

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 25 Erv Bultman, capital, December 31 125 35 125 160 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital 15 125 Owner s equity is correct by the end of 20-2.

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 25 Erv Bultman, capital, December 31 125 35 125 160 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital Current assets and owner s equity will be correct by the end of 20-2. 15 125 20 160

What would be the effect on the financial statements for 20-1 and 20-2 if the ending inventory was reported as $25 instead of $20?

INCOME STATEMENT 20-1 20-2 Sales 80 Cost of goods sold: Beginning merch. inventory 20 Add Purchases (net) 40 Cost of goods available for 60 Less saleending merch. inventory (25) Cost of goods sold (35) Gross profit 45 Operating expenses Overstated ending (10) inventory results in Net income 35 overstated net income.

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 35 Erv Bultman, capital, December 31 135 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital Overstated net income results in overstated owner s equity.

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 35 Erv Bultman, capital, December 31 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital Current assets and owner s equity will be overstated. 135 25 135

INCOME STATEMENT 20-1 20-2 Sales 80 Cost of goods sold: Beginning merch. inventory 20 Add purchases (net) 40 Cost of goods available for sale 60 Less ending merch. inventory (25) Cost of goods sold (35) Gross profit 45 Overstated beginning Operating expenses inventory results in (10) Net income understated net 35 income. 25 40 65 20 80 (45) 35 (10) 25

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 35 Erv Bultman, capital, December 31 135 25 135 160 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital 25 135 Owner s equity is correct by the end of 20-2.

STMT. OF OWNER S EQUITY 20-1 20-2 Erv Bultman, capital, January 1 100 Net income 35 Erv Bultman, capital, December 31 135 25 135 160 BALANCE SHEET (Partial) Current assets: Merchandise inventory Owner s equity: Erv Bultman, capital Current assets and owner s equity will be correct by the end of 20-2. 25 135 20 160

2 Describe the two principal systems of accounting for merchandise inventory the periodic system and the perpetual system.

PERIODIC INVENTORY SYSTEM Merchandise inventory account balance = most recent physical inventory Purchases account used for all merchandise purchases Current inventory and cost of goods sold are only computed at the end of the period PERPETUAL INVENTORY SYSTEM Merchandise inventory account reflects current inventory Purchases are debited to Merchandise Inventory and cost of goods sold are credited to Merchandise Inventory Generally, there is no need for end-of-year adjustments

EXAMPLE: Purchased merchandise on account, $100.

11 1 2 3 DATE DESCRIPTION PR DEBIT CREDIT Purchases 100 00 Accounts Payable 100 00 4 5 6 7 The periodic system uses a purchases account. 8 9 10

1 2 3 4 5 6 7 8 9 DATE DESCRIPTION PR DEBIT CREDIT Merchandise Inventory Accounts Payable 100 00 The perpetual system records purchases directly in the merchandise inventory account. 100 00 10 11

EXAMPLE: Paid freight charge, $30.

11 1 2 3 DATE DESCRIPTION PR DEBIT CREDIT Freight-In 30 00 Cash 30 00 4 5 6 7 The periodic system separates freight charges into their own account. 8 9 10

1 2 3 4 5 6 7 8 9 DATE DESCRIPTION PR DEBIT CREDIT Merchandise Inventory 30 00 Cash 30 00 The perpetual system considers freight charges part of the cost of merchandise and includes them in the inventory account. 10 11

EXAMPLE: Sold merchandise on account, $80. The cost of the merchandise was $50.

11 1 2 3 DATE DESCRIPTION PR DEBIT CREDIT Accounts Receivable 80 00 Sales 80 00 4 5 6 7 8 9 The periodic system only records the selling price of merchandise sold. No attempt is made to reduce the inventory account for items sold. 10

11 1 2 3 DATE DESCRIPTION PR DEBIT CREDIT Accounts Receivable 80 00 Sales 80 00 4 5 6 7 The perpetual system also records the selling price of merchandise sold. 8 9 10

1 2 3 4 5 6 7 8 9 DATE DESCRIPTION PR DEBIT CREDIT Accounts Receivable 80 00 Sales 80 00 Cost of Goods Sold Merchandise Inventory In addition, the perpetual system removes the cost of merchandise sold from inventory. 50 00 50 00 10 11

EXAMPLE: Merchandise costing $10 was returned to the supplier.

1 2 3 4 DATE DESCRIPTION PR DEBIT CREDIT Accounts Payable 10 00 Purchases Ret. and Allow. 10 00 5 6 7 The periodic system maintains a separate account for returns. 8 9 10 11

11 1 2 3 DATE DESCRIPTION PR DEBIT CREDIT Accounts Payable 10 00 Merchandise Inventory 10 00 4 5 6 7 Since the merchandise was recorded in the inventory account when purchased, it is removed from the account when returned. 8 9 10

EXAMPLE: Customers returned merchandise sold for $20. The cost of the merchandise was $15.

11 1 2 3 DATE DESCRIPTION PR DEBIT CREDIT Sales Returns and Allowances 20 00 Accounts Receivable 20 00 4 5 6 7 The periodic system maintains a separate account for returns. 8 9 10

11 1 2 3 DATE DESCRIPTION PR DEBIT CREDIT Sales Returns and Allowances 20 00 Accounts Receivable 20 00 4 5 6 The perpetual system records the returned sale. 7 8 9 10

1 2 3 4 5 6 7 8 9 DATE DESCRIPTION PR DEBIT CREDIT Sales Returns and Allowances 20 00 Accounts Receivable 20 00 Merchandise Inventory 15 00 Cost of Goods Sold It also must adjust the cost of goods sold and merchandise inventory accounts. 15 00 10 11

EXAMPLE: Paid for merchandise costing $100. The supplier granted a 2% discount for prompt payment.

1 2 3 4 5 6 7 8 9 10 11 DATE DESCRIPTION PR DEBIT CREDIT Accounts Payable 100 00 Purchases Discounts 2 00 Cash 98 00 Discounts are recorded in a separate account.

1 2 3 4 5 6 7 8 9 10 11 DATE DESCRIPTION PR DEBIT CREDIT Accounts Payable 100 00 Merchandise Inventory Cash The perpetual system does not record discounts in a separate account. It reduces Merchandise Inventory directly for the discount amount. 2 00 98 00

3 Compute the costs allocated to the ending inventory and cost of goods sold using different inventory methods.

Counting the goods on hand at the end of the period Used in the PERIODIC system to allocate merchandise costs between sold and unsold goods In the PERPETUAL system, it is compared to the accounting records to determine if what is actually held agrees with what is reported in the accounting records Done after regular business hours The ideal time to count the goods is when the quantity on hand is at its lowest levels o A fiscal year that starts and ends when inventory is at its lowest level is known as natural business year

Two special situations: Goods held for sale on CONSIGNMENT o Goods held on consignment remain the property of the shipper (consignor) Goods IN TRANSIT o o If goods are shipped FOB shipping point, the BUYER pays for shipping and goods belong to the buyer as soon as they are shipped If goods are shipped FOB destination, the seller pays for shipping and the goods belong to the seller until they are received by the buyer

EXAMPLE: A physical inventory found 50 bicycles (Model ZX007) on hand. All of this particular model were purchased for $60 each. Number of bikes on hand Cost per unit = Ending inventory 50 $60 = $3,000 Computing ending inventory is simple if all purchases were made at the same price.

What if each time we restocked this bicycle the price had changed? Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 Cost of these 200 sold? 3,900 5,360 4,760 $16,500

Method #1 Specific Identification Method Used when each unit of inventory can be specifically identified Examples: cars, motorcycles, furniture, appliances, and fine jewelry Practical only for businesses in which sales volume is relatively low and inventory unit value is relatively high Let s apply this method to the bicycle example.

Inventory was maintained using the specific identification method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 30 of the beginning inventory were sold 3,900 5,360 4,760 $16,500

Inventory was maintained using the specific identification method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 50 from the 1 st purchase were sold 3,900 5,360 4,760 $16,500

Inventory was maintained using the specific identification method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 60 from the 2 nd purchase were sold 3,900 5,360 4,760 $16,500

Inventory was maintained using the specific identification method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 60 from the 3 rd purchase were sold 3,900 5,360 4,760 $16,500

Units Unit Price Total Beginning inventory 30 $62 $ 1,860 1st purchase 50 65 3,250 2nd purchase 60 67 4,020 3rd purchase 60 68 4,080 Total 200 $13,210 Cost of goods (the 200 bicycles) sold

Units Unit Price Total Beginning inventory 10 $62 $ 620 1st purchase 10 65 650 2nd purchase 20 67 1,340 3rd purchase 10 68 680 Total 50 $3,290 This ending inventory will be reported on the income statement and the balance sheet.

Method #2 First-In, First-Out (FIFO) Method Assumes that the first goods purchased were the first goods sold Therefore, the latest goods purchased remain in inventory Follows the natural flow of goods Especially true of grocery stores, fresh fruit stands, and computer software businesses Let s apply this method to the bicycle example.

Inventory was maintained using the FIFO method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 All of these were 65 67 68 assumed sold 3,900 5,360 4,760 $16,500

Inventory was maintained using the FIFO method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 3,900 All of these were 5,360 assumed sold 4,760 $16,500

Inventory was maintained using the FIFO method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 3,900 5,360 All of these were 4,760 $16,500 assumed sold

Inventory was maintained using the FIFO method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 40 3,900 60 67 5,360 80 68 4,760 180 considered sold $16,500 so far

Inventory was maintained using the FIFO method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 3,900 5,360 4,760 $16,500 20 of these were assumed sold

Units Unit Price Total Beginning inventory 40 $62 $2,480 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 20 68 1,360 The remaining units from the 3 rd purchase are the 50 units in ending inventory.

Units Unit Price Total Beginning inventory 40 $62 $ 2,480 1st purchase 60 65 3,900 2nd purchase 80 67 5,360 3rd purchase 20 68 1,360 Total 200 $13,100 Cost of goods (the 200 bicycles) sold

Units Unit Price Total Beginning inventory 0 $62 $ 0 1st purchase 0 65 0 2nd purchase 0 67 0 3rd purchase 50 68 3,400 Total 50 $3,400 This ending inventory will be reported on the income statement and the balance sheet.

Method #3 Weighted-Average Method Computes an average cost per unit using the following formula: Total cost of units available for sale divided by the units available for sale Let s apply this method to the bicycle example.

Inventory was maintained using the weightedaverage method. Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 $16,500 250 3,900 5,360 4,760 $16,500 = $66/unit

Cost of goods sold 200 units @ $66 = $13,200 Ending inventory 50 units @ $66 = 3,300 One of the advantages of the weighted-average method is its simplicity.

Method #4 Last-In, First-Out (LIFO) Method Assumes that the sales in the period were made from the most recently purchased goods Therefore, the earliest goods purchased remain in inventory The use of this method is justified because: The actual physical flow of goods in some businesses is actually last-in, first-out It matches the most current costs of items purchased against the current sales revenue

Inventory was maintained using the LIFO method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 68 All of these were assumed sold 3,900 5,360 4,760 $16,500

Inventory was maintained using the LIFO method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 70 65 3,900 80 67 5,360 150 68considered 4,760 sold so $16,500 far

Inventory was maintained using the LIFO method. The identity of the 200 bicycles sold is as follows: Units Unit Price Total Cost On hand at start of period 40 $62 $ 2,480 Purchased during period: 1st purchase 60 2nd purchase 80 3rd purchase 70 No. of units available for sale 250 On hand at end of period 50 No. of units sold during period 200 65 67 50 of these were 68assumed sold 3,900 5,360 4,760 $16,500

Units Unit Price Total Beginning inventory 0 $62 $ 0 1st purchase 50 65 3,250 2nd purchase 80 67 5,360 3rd purchase 70 68 4,760 200 $13,370

Units Unit Price Total Beginning inventory 40 $62 $2,480 1st purchase 10 65 650 2nd purchase 0 67 0 3rd purchase 0 68 0 Total 50 $3,130 This ending inventory will be reported on the income statement and the balance sheet.

The assumed cost flows (FIFO, weighted-average, and LIFO) do not have to match the actual physical movement of goods Any one of the methods may be used under any set of physical flow conditions

Sales Cost of goods sold: Beg. inventory Purchases Goods avail. for sale Specific Identification $18,000 $ 2,480 14,020 $16,500 FIFO $ 2,480 14,020 $16,500 $18,000 Goods available for sale is the same for all four methods!

FIFO $18,000 $ 2,480 14,020 $16,500 Weighted-Average $18,000 $ 2,480 14,020 $16,500 LIFO $18,000 $ 2,480 14,020 $16,500

Sales Cost of goods sold: Beg. inventory Purchases Goods avail. for sale Less ending inventory Specific Identification $18,000 $ 2,480 $ 2,480 14,020 14,020 $16,500 $16,500 3,290 3,400 FIFO $18,000 Cost of goods sold 13,210 13,100 Ending inventory and cost of goods sold differ with each method.

FIFO $18,000 Weighted-Average $18,000 LIFO $18,000 $ 2,480 14,020 $16,500 3,400 13,100 $ 2,480 $ 2,480 14,020 14,020 $16,500 $16,500 3,300 3,130 13,200 13,370

Sales Cost of goods sold: Beg. inventory Purchases Goods avail. for sale Less ending inventory Specific Identification $18,000 FIFO $ 2,480 $ 2,480 14,020 14,020 $16,500 $16,500 3,290 3,400 $18,000 Cost of goods sold 13,210 13,100 Gross profit $ 4,790 $ 4,900

FIFO $18,000 Weighted-Average $18,000 LIFO $18,000 $ 2,480 14,020 $16,500 3,400 13,100 $ 4,900 $ 2,480 $ 2,480 14,020 14,020 $16,500 $16,500 3,300 3,130 13,200 13,370 $ 4,800 $ 4,630 When prices are rising (as with the bicycles), FIFO results in the largest gross profit.

FIFO $18,000 Weighted-Average $18,000 LIFO $18,000 $ 2,480 14,020 $16,500 3,400 13,100 $ 4,900 $ 2,480 $ 2,480 14,020 14,020 $16,500 $16,500 3,300 3,130 13,200 13,370 $ 4,800 $ 4,630 LIFO results in the smallest gross profit, therefore creating the smallest tax liability.

Merchandise Inventory is a controlling account A subsidiary ledger is maintained with an account for each type of merchandise Goods sold are usually assigned cost on either a FIFO, moving-average, or LIFO basis

Date Jan. 1 (BI) Let s return to the example of the 200 bicycles sold. Units Purchases Cost/ Unit Total Units Cost of Goods Sold Cost/ Unit CGS Cumulative CGS There were 40 bicycles in inventory at the beginning of the year.

Units Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Unit CGS Cumulative CGS Inventory on Hand Cost/ Layer Units Unit Layer Cost Total (1) 40 $62 $2,480 $2,480 Each of the 40 units were purchased at $62.

Date Jan. 1 (BI) Let s return to the example of the 200 bicycles sold. Units Purchases Cost/ Unit Total Units Cost of Goods Sold Cost/ Unit CGS Cumulative CGS Feb. 15 30 $62 The 30 bicycles sold came from the $62 bicycles in beginning inventory.

Date Jan. 1 (BI) Let s return to the example of the 200 bicycles sold. Units Purchases Cost/ Unit Total Units Cost of Goods Sold Cost/ Unit CGS Cumulative CGS Feb. 15 30 $62 $1,860 $ 1,860

Date Jan. 1 (BI) Let s return to the example of the 200 bicycles sold. Units Purchases Cost/ Unit Total Units Cost of Goods Sold Cost/ Unit CGS Cumulative CGS Feb. 15 30 $62 $1,860 $ 1,860 Mar. 1 60 $65 $3,900

Units Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Unit CGS Cumulative CGS Inventory on Hand Cost/ Layer Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620 (1) 10 $62 $ 620 (2) 60 65 3,900 $4,520 Now there are two layers in inventory 10 bicycles from the beginning inventory and the 60 bicycles just purchased.

Date Jan. 1 (BI) Let s return to the example of the 200 bicycles sold. Units Purchases Cost/ Unit Total Units Cost of Goods Sold Cost/ Cumulative Unit CGS CGS Feb. 15 30 $62 $1,860 $ 1,860 Mar. 1 60 $65 $3,900 April 1 On April 1, 40 units were sold.

Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Units Unit CGS Cumulative CGS Inventory on Hand Cost/ Layer Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620 (1) 10 $62 $ 620 (2) 60 65 3,900 $4,520 FIFO assumes the first-in are the first sold.40 sold = 10 from the beginning inventory and the 30 from the 3/1 purchase.

Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Units Unit CGS Cumulative CGS Inventory on Hand Cost/ Layer Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620 (1) 10 $62 $ 620 (2) 60 65 3,900 $4,520 10 $62 $ 620 (2) 30 $65 $1,950 30 65 1,950 $ 4,430 $1,950

Units Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Unit CGS Cumulative CGS Inventory on Hand Cost/ Layer Layer Units Unit Cost Total (1) 40 $62 $2,480 $2,480 30 $62 $1,860 $ 1,860 (1) 10 $62 $ 620 $ 620 (1) 10 $62 $ 620 (2) 60 65 3,900 $4,520 10 $62 $ 620 (2) 30 $65 $1,950 30 65 1,950 $ 4,430 $1,950 (2) 30 $65 $1,950 (3) 80 67 $5,360 $7,310

Date May 15 June 30 Let s return to the example of the 200 bicycles sold. Units Purchases Cost/ Unit Total 80 $67 $5,360 Units Cost of Goods Sold Cost/ Unit CGS Cumulative CGS On June 30, 90 units were sold.

Units Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Unit CGS Cumulative CGS Inventory on Hand Cost/ Layer Layer Units Unit Cost (2) 30 $65 $1,950 Total (3) 80 67 5,360 $7,310 90 bicycles sold = 30 (layer 2) + 60 (layer 3)

Date May 15 Let s return to the example of the 200 bicycles sold. Units Purchases Cost/ Unit Total Units Cost of Goods Sold Cost/ Cumulative Unit CGS CGS 80 $67 $5,360 une 30 30 $65 $1,950 60 67 4,020 $10,400

Units Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Unit CGS Cumulative CGS 30 $65 $1,950 60 67 4,020 $10,400 Inventory on Hand Cost/ Layer Layer Units Unit Cost (2) 30 $65 $1,950 Total (3) 80 67 5,360 $7,310 (3) 20 $67 $1,340 $1,340

Date May 15 Let s return to the example of the 200 bicycles sold. Units Purchases Cost/ Unit Total Units Cost of Goods Sold Cost/ Cumulative Unit CGS CGS 80 $67 $5,360 June 30 30 $65 $1,950 Aug. 28 70 $68 $4,760 60 67 4,020 $10,400

Let s return to the example of the 200 bicycles sold. Units Cost of Goods Sold Cost/ Unit CGS Cumulative CGS 30 $65 $1,950 60 67 4,020 $10,400 Inventory on Hand Cost/ Layer Layer Units Unit Cost (2) 30 $65 $1,950 Total (3) 80 67 5,360 $7,310 (3) 20 $67 $1,340 $1,340 (3) 20 $67 $1,340 (4) 70 68 4,760 $6,100 40 units sold = 20 (layer 3) + 20 (layer 4)

Units Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Unit CGS 30 $65 $1,950 Cumulative CGS 60 67 4,020 $10,400 20 $67 $1,340 20 68 1,360 $13,100 Inventory on Hand Cost/ Layer Layer Units Unit Cost (2) 30 $65 $1,950 Cost of goods sold for the year Total (3) 80 67 5,360 $7,310 (3) 20 $67 $1,340 $1,340 (3) 20 $67 $1,340 (4) 70 68 4,760 $6,100 (4) 50 $68 $3,400 $3,400

Units Let s return to the example of the 200 bicycles sold. Cost of Goods Sold Cost/ Unit CGS Cumulative CGS 30 $65 $1,950 60 67 4,020 $10,400 20 $67 $1,340 20 68 1,360 $13,100 Inventory on Hand Cost/ Layer Layer Units Unit Cost (2) 30 $65 $1,950 Total (3) 80 67 5,360 $7,310 (3) 20 $67 $1,340 $1,340 (3) 20 $67 $1,340 (4) 70 68 4,760 $6,100 (4) 50 $68 $3,400 Ending inventory $3,400

An asset that increases in value while being held No formal entry of the gain is made on the books until asset is sold An asset that decreases in value while being held An entry is made to recognize the loss We should never anticipate gains, but we should always anticipate and account for losses

Conservatism means that if the value of inventory declines while it is being held, the loss should be recognized in the period of the decline The purpose of the lower-of-cost-or-market method is to recognize such losses on the income statement and to report the lower inventory valuation on the balance sheet Cost The dollar amount calculated using one of the four inventory costing methods Market The cost to replace the inventory

Item Recorded Purchase Cost End-of-Period Market Value Lower-of-Costor-Market 1 2 3 This company sells three products.

Item Recorded Purchase Cost 1 $ 8,000 2 3 End-of-Period Market Value Lower-of-Costor-Market The inventory of product #1 cost $8,000.

Item Recorded Purchase Cost End-of-Period Market Value 1 $ 8,000 $ 7,000 Lower-of-Costor-Market 2 3 But the price has fallen; it now could be replaced for $7,000.

Item Recorded Purchase Cost End-of-Period Market Value 1 $ 8,000 $ 7,000 Lower-of-Costor-Market $ 7,000 2 3 Market is the lowest.

Item Recorded Purchase Cost End-of-Period Market Value 1 $ 8,000 $ 7,000 Lower-of-Costor-Market $ 7,000 2 9,000 10,000 9,000 3 7,000 6,500 6,500 $24,000 $23,500 $22,500 There are two ways to calculate the lower-of-cost-or-market.

Item Recorded Purchase Cost End-of-Period Market Value 1 $ 8,000 $ 7,000 Lower-of-Costor-Market $ 7,000 2 9,000 10,000 9,000 3 7,000 6,500 6,500 $24,000 $23,500 $22,500 #1 Applied to Total Inventory The lower of all items at their cost or all items at their market value

Item Recorded Purchase Cost End-of-Period Market Value 1 $ 8,000 $ 7,000 Lower-of-Costor-Market $ 7,000 2 9,000 10,000 9,000 3 7,000 6,500 6,500 $24,000 $23,500 $22,500 #2 Applied to Each Item Each item is evaluated; the lowest amount is selected for each item

Item Recorded Purchase Cost End-of-Period Market Value 1 $ 8,000 $ 7,000 Lower-of-Costor-Market $ 7,000 2 9,000 10,000 9,000 3 7,000 6,500 6,500 $24,000 $23,500 $22,500 Let s assume it was applied to the total inventory. A journal entry is needed to reduce Merchandise Inventory to $23,500.

1 2 3 4 5 6 7 8 9 DATE DESCRIPTION PR DEBIT CREDIT Loss on Write-Down of Inventory 500 Merchandise Inventory 500 To recognize loss in value of inventory held Expense 10 11

4 Estimate the ending inventory and cost of goods sold by using the gross profit and retail inventory methods.

Estimating inventory is not a problem for businesses using the perpetual inventory method Unverified amounts are generally reliable estimates and can be used for interim monthly or quarterly financial statements Businesses using the periodic inventory method must use other methods to estimate ending inventory and cost of goods sold Two generally accepted methods: o Gross profit method o Retail inventory method

A business s normal gross profit (net sales cost of goods sold) is used to estimate the cost of goods sold and ending inventory. 3 STEPS

Example: Inventory, start of period $80,000 Net purchases, first month $70,000 Net sales, first month $110,000 Normal gross profit as a percentage of 40% sales Step #1: Compute the cost of goods available for sale. Inventory, start of period $80,000 Net purchases, first month 70,000 Cost of goods avail. for sale $150,000

Example: Inventory, start of period Net purchases, first month Net sales, first month Normal gross profit as a percentage of sales Step #2: Estimate cost of goods sold by deducting the normal gross profit from net sales. Net sales $110,000 Normal gross profit 44,000 $110,000 40% $80,000 $70,000 $110,000 40%

Example: Inventory, start of period Net purchases, first month Net sales, first month Normal gross profit as a percentage of $80,000 $70,000 $110,000 40% sales Step #2: Estimate cost of goods sold by deducting the normal gross profit from net sales. Net sales $110,000 Normal gross profit 44,000 Estimated cost of goods sold 66,000

Example: Inventory, start of period Net purchases, first month Net sales, first month Normal gross profit as a percentage of $80,000 $70,000 $110,000 40% sales Step #3: Estimate the ending inventory by deducting cost of goods sold from the cost of goods available for sale. Cost of goods available for sale $150,000 Estimated cost of goods sold 66,000 Estimated end-of-month inv. $ 84,000

Used by many retail businesses. Requires keeping records of both the cost and selling (retail) prices of all goods purchased. 5 STEPS

Step #1: Compute the cost of goods available for sale at cost and retail. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000

Step #2: Compute the ending inventory at retail by subtracting sales at retail from goods available for sale at retail. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000

Step #3: Compute the cost-to-retail ratio by dividing the cost of goods available for sale by the retail value of the goods available for sale. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Cost to Retail Ratio ($186,000 $248,000) 75%

Step #4: Estimate the cost of the ending inventory by multiplying the ending inventory at retail by the cost-toretail ratio. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Cost to Retail Ratio ($186,000 $248,000) 75% Inventory, end of period, at cost ($68,000 75%) $(51,000)

Step #5: Estimate cost of goods sold by subtracting the estimated ending inventory from the cost of goods available for sale. COST RETAIL Inventory, start of period $ 60,000 $ 85,000 Net purchases during period 126,000 163,000 Goods available for sale $186,000 $248,000 Less net sales for period 180,000 Inventory, end of period, at retail $ 68,000 Ratio ($186,000 $248,000) 75% Inventory, end of period, at cost ($68,000 75%) $(51,000) Estimated cost of goods sold $135,000