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Chapter 7

Chapter 7. Inventories and Cost of Goods Sold. PowerPoint Authors: Brandy Mackintosh Lindsay Heiser. Learning Objective 7-1. Describe the issues in managing different types of inventory. Inventory Management Decisions. The primary goals of inventory managers are to:

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Chapter 7

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  1. Chapter 7 Inventories and Cost of Goods Sold PowerPoint Authors: Brandy Mackintosh Lindsay Heiser

  2. Learning Objective 7-1 Describe the issues in managing different types of inventory.

  3. Inventory Management Decisions The primary goals of inventory managers are to: 1. Maintain a sufficient quantity to meet customers’ needs 2. Ensure quality meets customers’ expectations and company standards 3. Minimize the costs of acquiring and carrying the inventory

  4. Types of Inventory Merchandisers . . . • Buy finished goods. • Sell finished goods. Manufacturers . . . • Buy raw materials. • Produce and sell finished goods. Merchandise inventory Raw Materials Work in Process Finished goods Completed products awaiting sale Materials waiting tobe processed Partially complete products

  5. Learning Objective 7-2 Explain how to report Inventory and Cost of Goods Sold.

  6. Balance Sheet and Income Statement Reporting

  7. Cost of Goods Sold Equation BI + P – CGS = EI National Outfitters’ beginning inventory was $4,800. During the period, the company purchased inventory for $10,200. The cost of goods sold for the period is $9,000. Compute the ending inventory. Beginning Inventory Purchases Cost of Goods Available for Sale Cost of Goods sold Ending Inventory $ 4,800 10,200 15,000 9,000 $ 6,000 + = - = Cost of Goods Sold Calculation

  8. Cost of Goods Sold Equation beginningInventory$4,800 purchases$10,000 + goods availablefor sale$15,000 StillHere Sold endingInventory$6,000 Cost ofGoods Sold$9,000 (Balance Sheet) (Income Statement)

  9. Learning Objective 7-3 Compute costs using four inventory costing methods.

  10. Inventory Costing Methods Specificidentification First-in, first-out(FIFO) Last-in, first-out(LIFO) Weighted average

  11. Inventory Costing Methods Consider the following information May 6$95 cost May 3 May 5 May 6 May 8 Purchased 1 unit for $70 Purchased 1 more unit for $75 Purchased 1 more unit for $95 Sold 2 units for $125 each May 5$75 cost May 3$70 cost Specific Identification This method individually identifies and records the cost of each item sold as part of cost of goods sold. If the items sold were identified as the ones that cost $70 and $95, the total cost of those items ($70 + 95 = $165) would be reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance sheet at the end of the period.

  12. Inventory Costing Methods FIFO LIFO Weighted average Balance Sheet Inventory Balance Sheet Inventory Balance Sheet Inventory $80 $95 $70 May 6$95 cost May 6$95 cost May 6$95 cost $80per unit $2403 = May 5$75 cost May 5$75 cost May 5$75 cost May 3$70 cost May 3$70 cost May 3$70 cost Income Statement Income Statement Income Statement Net Sales Cost of Goods Sold Gross Profit Net Sales Cost of Goods Sold Gross Profit Net Sales Cost of Goods Sold Gross Profit $250 145 $105 $250 160 $ 90 $250 170 $ 80 Still there Sold Sold Still there Sold Still there

  13. Inventory Costing Methods Cost of Goods sold (Income Statement) Inventory (Balance sheet) FIFO Oldest cost Newest cost LIFO Newest cost Oldest cost Weighted Average Average cost Average cost Description Beginning Inventory Purchase Purchase Sales Ending Inventory # of Units 10 30 10 (35) 15 Cost per Unit $ 7 $ 8 $10 To calculate To calculate Total Cost $ 70 240 100 To calculate To calculate Date Oct 1 Oct 3 Oct 5 Oct 6 Summary Let’s consider a more complex example.

  14. Inventory Cost Flow Computations FIFO + - = beginning Inventory purchases cost of goods available for sale ending Inventory Cost of Goods Sold 10 units x $ 7 = $ 70 30 units x $ 8 = 240 10 units x $ 10 = 100 $ 410 140 $ 270 (10 units @ $10) + (5 units @ $8) (10 units @ $7) + (25 units @ $8)

  15. Inventory Cost Flow Computations LIFO + - = beginning Inventory purchases cost of goods available for sale ending Inventory Cost of Goods Sold 10 units x $ 7 = $ 70 30 units x $ 8 = 240 10 units x $ 10 = 100 $ 410 110 $ 300 (10 units @ $7) + (5 units @ $8) (10 units @ $10) + (25 units @ $8)

  16. Inventory Cost Flow Computations Description beginning Inventory purchase purchase cost of goods available for sale # of Units 10 30 10 50 Cost per Unit $ 7 $ 8 $10 Total Cost $ 70 240 100$ 410 Weighted Average WeightedAverage Cost = Cost of goods Available for SaleNumber of Units Available for Sale WeightedAverage Cost $41050 units = = $8.20 per unit

  17. Inventory Cost Flow Computations Weighted Average + - = Beginning Inventory Purchases Cost of Goods Available for Sale Ending Inventory Cost of Goods Sold 10 units x $ 7 = $ 70 30 units x $ 8 = 240 10 units x $ 10 = 100 $ 410 123 $ 287 15 units @ $8.20 35 units @ $8.20

  18. Financial Statement Effects Effects on the Income Statement Sales Cost of Goods Sold Gross Profit Operating Expenses Income from Operations Other Revenue (Expenses) Income before Income Tax Expense Income Tax Expense (30%) Net Income Effects on the Balance Sheet Inventory FIFO $ 525 270 255 125 130 20 150 45 $ 105 $ 140 LIFO $ 525 300 225 125 100 20 120 36 $ 84 $ 110 Weighted Average $ 525 287 238 125 113 20 133 40 $ 93 $ 123

  19. Financial Statement Effects

  20. Smoothes out price changes. Ending inventory approximates current replacement cost. Better matches current costs in cost of goods sold with revenues. Financial Statement Effects Advantages of Methods Weighted Average First-In, First-Out Last-In, First-Out

  21. Tax Implications and Cash Flow Effects Effects on the Income Statement Sales Cost of Goods Sold Gross Profit Operating Expenses Income from Operations Other Revenue (Expenses) Income before Income Tax Expense Income Tax Expense (30%) Net Income Effects on the Balance Sheet Inventory FIFO $ 525 270 255 125 130 20 150 45 $ 105 $ 140 LIFO $ 525 300 225 125 100 20 120 36 $ 84 $ 110 Weighted Average $ 525 287 238 125 113 20 133 40 $ 93 $ 123

  22. Learning Objective 7-4 Reporting inventory at thelower of cost or market.

  23. Lower of Cost or Market • The value of inventory can fall below its recorded cost for two reasons: • it’s easily replaced by identical goods at a lower cost, or • it’s become outdated or damaged. When the value of inventory falls below its recorded cost, the amount recorded for inventory is written down to its lower market value. This is known as the lower of cost or market (LCM) rule.

  24. Stockholders’ Equity + Inventory -$15,000 Cost of Goods Sold (+E) -$15,000 Lower of Cost or Market 1,000 items @ $165 15,000 15,000 dr Cost of Goods Sold (+E, -SE) cr Inventory (-A) 400 items @ $20 Record Analyze Liabilities Assets = 1,000 items @ $150 1 Item Leather coats Vintage jeans Cost per Item $165 20 Market Value per Item $150 25 LCM per Item $150 20 Quantity 1,000 400 Total Lower of cost or Market $150,000 8,000 Total cost $165,000 8,000 Write- down $15,000 0 2

  25. Lower of Cost or Market

  26. Learning Objective 7-5 Analyze and record inventory purchases, transportation, returns and allowances, and discounts.

  27. Recording Inventory Transactions We will now look at the accounting for purchases, transportation costs, purchase returns and allowances, and purchase discounts. We will record all inventory-related transactions in the Inventory account.

  28. Stockholders’ Equity + Inventory (+A) +$10,500 Accounts Payable (+L) $10,500 Inventory Purchases American Eagle Outfitters purchases$10,500 of vintage jeans on credit. 10,500 10,500 dr Inventory (+A) cr Accounts Payable (+L) Record Analyze Liabilities Assets = 1 2

  29. Stockholders’ Equity + Cash (-A) -$400 Inventory (+A) +$400 Transportation Cost American Eagle pays $400 cash to a trucker whodelivers the $10,500 of vintage jeans to one of its stores. 400 400 dr Inventory (+A) cr Cash (-A) Record Analyze Liabilities Assets = 1 2

  30. Stockholders’ Equity + Inventory (-A) -$500 Accounts Payable (-L) -$500 Purchase Returns and Allowances American Eagle returned some of the vintage jeans to thesupplier and received a $500 reduction in the balance owed. 500 500 dr Accounts Payable (-L) cr Inventory (-A) Record Analyze Liabilities Assets = 1 2

  31. Stockholders’ Equity + Cash (-A) -$9,800 Inventory (-A) -$200 Accounts Payable (-L) -10,000 Purchase Discounts American Eagle’s vintage jeans purchase for $10,500 had terms of 2/10, n/30. Recall that American Eagle returned inventory costing $500 and received a $500 reduction in its Accounts Payable. American Eagle paid within the discount period. 10,000 9,800 200 dr Accounts Payable (-L) cr Cash (-A) cr Inventory (-A) Record Analyze Liabilities Assets = 1 2

  32. Summary of Inventory Transactions

  33. Learning Objective 7-6 Evaluate inventory management by computing and interpreting the inventory turnover ratio.

  34. Inventory Turnover Analysis

  35. Comparison to Benchmarks

  36. Supplement 7A FIFO, LIFO, and Weighted Average in a Perpetual Inventory System

  37. Perpetual Inventory System This is the same information that we used earlier in the chapter to illustrate a periodic inventory system. The only difference is that we have assumed the sales occurred on October 4, prior to the final inventory purchase.

  38. FIFO (First-in, First-Out)

  39. LIFO (Last-in, First-Out)

  40. Weighted Average Cost $310 ÷ 40 units = $7.75 per unit

  41. Financial Statement Effects Summary of Perpetual Inventory System Cost Flow Assumptions on Financial Statements

  42. Supplement 7B The Effects of Errors in Ending Inventory

  43. The Effects of Errors in Ending Inventory 2012 + - = Beginning Inventory Purchases Ending Inventory Cost of Goods Sold Accurate Accurate Overstated $10,000 Understated $10,000 Errors in EndingInventory will affectthe Balance Sheet andthe Income Statement. Cost of Goods Sold Equation BI + P – CGS = EI Assume that Ending Inventory was overstated in 2012 by$10,000 due to an error that was not discovered until 2013.

  44. The Effects of Errors in Ending Inventory 2013 + - = Beginning Inventory Purchases Ending Inventory Cost of Goods Sold Overstated $10,000 Accurate Accurate Overstated $10,000 Now let’s examine the effects of the2012 Ending Inventory Error on 2013. Assume that Ending Inventory was overstated in 2012 by$10,000 due to an error that was not discovered until 2013.

  45. Supplement 7C Recording Inventory Transactions in a Periodic System

  46. Recording Inventory Transactions in a Periodic System A local cell phone dealer stocks and sells one item. The following events occurred in the past year: We will record these events assuming the company usesa periodic inventory system and then compare theperiodic inventory system to a perpetual inventory system.

  47. Recording Inventory Transactions in a Periodic System Periodic Inventory System Perpetual Inventory System

  48. Recording Inventory Transactions in a Periodic System Periodic Inventory System BI + P – CGS = EI End-of-year adjustment entries are not required using a perpetual inventory system.

  49. Recording Inventory Transactions in a Periodic System Summary of the Effects on the Accounting Equation Periodic Inventory System Perpetual Inventory System

  50. Chapter 7Solved Exercises M7-6, M7-7, E7-2, E7-5, E7-10, E7-17

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