# PART Understanding Inventory and Cost of Goods Sold

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```					                   Chapter 6 Outline (pages 260 – 273; 282 – 295 and 564 - 565)
Inventory and Cost of Goods Sold

PART A: Understanding Inventory and Cost of Goods Sold

Inventory: Inventory is tangible goods HELD FOR SALE IN THE NORMAL COURSE OF BUSINESS or
that will be used in producing goods (manufacturer) for sale.

Merchandisers
-Buy inventory for resale
-Wholesalers sell to other stores (retailers)
-Retailers sell to consumers (end users)

Merchandise Inventory (Inventory)
-cost to acquire including shipping & handling

Manufacturers
-create inventory from raw materials to sell to others
-three inventory accounts:                                                    Manufacturing
-raw material                                                     inventory is covered in
-work in process                                                     detail in Intro to
-finished goods                                                   Managerial Accounting
-sell unit only after they are finished (finished goods)

Cost of Goods Sold (COGS)
BI
+ Purchases
-Matching principle in action                                                               GAFS
-COGS is an Expense                                                                          - EI
COGS
-COGS is the cost to the seller of INVENTORY sold to the customer
-Goods available for sale (GAFS) are made up of Beginning inventory and Purchases
-The Goods available for sale (GAFS) will either be sold (cost of goods sold) or will remain at the end
of the period (ending inventory)

Gross Profit
Sales
-contra revenues
-profit from the sale of inventory                                               Net sales
-Cost of goods sold
-a subtotal that shows the amount sales exceed the cost of inventory sold        Gross profit

Chapter 6                                       Fall 2012                                      Page 6-1
Practice
At the beginning of 20C, Ayers Inc. reports inventory of \$6,000. During 20C, the company
purchases additional inventory for \$29,000. At the end of 20C, the cost of inventory remaining is
\$8,000. The company’s sales revenue for the year was \$45,000 and they had \$500 of sales
discounts.

Calculate Net sales:

Calculate Goods available for sale:

Calculate cost of goods sold:

Calculate gross profit:

INVENTORY COST METHODS

Specific Identification Inventory Costing Method

First-In, First-Out (FIFO)          Most closely represents the actual flow of inventory

Purchases occur

P2 units x cost

P1 units x cost

BI units x cost

Costs assigned to units sold

Last-In, First-Out (LIFO)

Purchases occur                            Costs assigned to units sold

P2 units x cost

P1 units x cost

BI units x cost

Chapter 6                                          Fall 2012                               Page 6-2
Weighted Average Cost

Weighted Average cost per unit =       Goods Available for Sale
# of Units Available for Sale
Purchases occur

1000 units @
Weighted Ave cost        Cost assigned to units sold (WA cost per unit x units sold)

Note: Inventory costing method used DOES NOT CHANGE the real economic value of
inventories…in all cases, the same units were sold; however, depending on the inventory valuation
method COGS and EI would be different.

Practice

SL Company uses a periodic inventory system. At the end of the annual accounting period the
accounting records provided the following information for product 1:

Units              Cost per unit      Total Amount
Beginning Inventory               100                    \$7                \$700
Purchase, January 20              300                    \$8                2,400
Purchase, October 6               600                    \$9                5,400
Available for sale:   1,000                                    \$8,500

SL Company Sold 950 units for \$14,250 (Total Sales Revenue).

Determine the cost remaining in ending inventory and the cost of good sold using FIFO, LIFO and
weighted average:

First in first out (FIFO)

Last in First out (LIFO)

Chapter 6                                      Fall 2012                                            Page 6-3
Weighted Average cost

Prepare the income statement for the company for each inventory valuation method assuming
operating expenses are \$5,000 and income taxes are 30%.

FIFO                   LIFO                    WA
Net Sales                            \$14,250                \$14,250                 \$14,250
COGS
Gross profit
Operating expenses                    5,000                  5,000                   5,000
Operating income (pretax)
Income tax expense
Net income

Comparison of the Inventory Costing Methods and CASH FLOW
Which of the above methods had the lowest income tax expense amount?

LIFO Conformity Rule

Impact on Valuation Methods with changes in the price level (inflation/deflation)

FIFO assigns the old inventory costs to COGS (New costs are assigned to Ending Inventory; Balance
Sheet approach)

LIFO assigns the new inventory costs to COGS (Old costs are assigned to Ending Inventory; Income
Statement approach)

LIFO not allowed by IFRS (International Financial Reporting Standards)

Appendix A: (Periodic) Recording Inventory Transactions
Gross Purchases: is a temporary account used in the periodic inventory system to keep track of
purchases of inventory. It is NOT an asset account; it is part of the calculation of COGS. (BI + Cost of
Purchases = GAFS – EI = COGS).

Purchase returns: reduces the Cost of Purchases.

Chapter 6                                      Fall 2012                                       Page 6-4
Purchase discounts: reduces the Cost of Purchases (it is when a buyer takes advantage of a sales
discount offered to them by the seller).

FOB shipping point: shipping is paid by the buyer and adds to the Cost of Purchases and is called
Transportation-In (aka Freight-in)…Freight-out is NOT added to the Cost of Purchases.

Practice
GJM, Inc., begins the year with inventory of \$25,000 and ends the year with inventory of \$12,000.
During the year, the following amounts are recorded.

Gross Purchases              \$200,000
Purchase returns                  20,000
Purchase discounts                10,000
Freight-in                        15,000
Freight-out                       22,000

Calculate the Cost of Purchases:           \$

\$
Calculate Cost of Goods Sold:

More Practice
Beginning inventory       \$7,470
Ending inventory          3,150
Contra revenue            1,900
Net sales                 88,100
Purchases                 51,100

Calculate gross sales:
Calculate GAFS:
Calculate COGS:
Calculate gross profit:

Chapter 6                                      Fall 2012                                  Page 6-5
Part B: MULTIPLE STEP INCOME STATEMENT—(Page 282)

Sales Revenue (sometimes called “Gross sales” or “Sales”)
-     Sales Returns and Allowances
-     Sales discounts                                          BI
Net Sales                                            + Purchases
GAFS
- Cost of goods sold                                          - EI
Gross profit                                             COGS

- operating expenses (S&A expense)
Operating Income or Income from operations
+/- other revenue/expense or gains, losses
Income before income taxes*
- income tax expense**
Net income

Operating expenses—selling expenses, and general and administrative expenses

Shows Multiple Levels of Profit

Gross profit

Operating Income —a subtotal used when other income, other expenses, gains or losses are
present on the multiple step income statement. It is also known as Income from operations.

Other revenue: non-operating revenue: example, interest revenue
Other expense: non-operating expense: example, interest expense

Gains—peripheral

Losses—peripheral

* Income before income taxes
also known as:
 IBT
 pre tax income

** income tax expense (also known as “Provision for Income Taxes”)
 effective income tax rate x pretax income = income tax expense

Chapter 6                                        Fall 2012                               Page 6-6
PART C: Other Inventory Reporting Issues

Gross Profit Ratio (AKA Gross Profit Margin):

Gross Profit
Gross Profit Ratio =                   x 100 = GP%
Net Sales
Vertical Analysis (pages 564-565)
Common sized Income Statement

Practice
Mills Corp. is a merchandising company that uses the periodic inventory system. Selected account
balances are listed below:
Sales                             \$1035,000
Sales returns                         20,000
Sales discounts                       15,000
Purchases                           470,000
Inventory (beginning)                 25,000
Inventory (ending)                    30,000
Operating Expenses                  248,000
Effective Income Tax Rate               30%
Based on the above determine COGS:

Goods available for sale

Find the missing amounts
Sales (Total Sales)              \$1,035,000

Net Sales                                        100%

Gross Profit
24.8%
Operating income
Is there a difference between Operating income
Income tax expense                                        and Income before Income tax (IBT) in this
Net income                                                example? Why not?

Chapter 6                                      Fall 2012                                            Page 6-7
Lower-of-Cost-or-Market Method (LCM)
-conservatism
-costs versus replacement cost (market)
-write-down goes to cost of goods sold
Inventory Turnover Ratio

The inventory turnover ratio is a measure of the effectiveness in managing inventory.

Cost of Goods Sold
Inventory Turnover =
Average Inventory

“Average” is calculated as follows: (last year’s ending balance + this year’s ending balance)/2

Average days in Inventory = 365 days/Inventory turnover
Average length of time (in days) it takes to sell inventory

Practice:
Last year TLC showed ending inventory of \$25,000 on their December 31 balance sheet. This year
their ending inventory at December 31 is \$15,000. Sales for the year were \$400,000 and the cost of
goods sold for the year were \$300,000.

\$                    Calculate Average Inventory:

What is TLC’s inventory turnover ratio?

days. What is the average length of time it takes the company to sell its inventory?

\$                    What is TLC’s gross profit from the sale of their inventory?

What is TLC’s gross profit ratio?

APPENDIX B

Inventory Errors
-Last period’s EI equals the current period’s BI.                                               BI
+ Purchases
-EI is obtained by physical count (periodic system) or by referring to the                    GAFS
inventory account balance (perpetual system).                                                  - EI
COGS

Chapter 6                                          Fall 2012                                  Page 6-8
Understatement of Ending Inventory

Year 1    Year 2
Year Year                         Year Year
BRE
1    2                            1    2
+NI
BI                        SALES
-DIV
+P                         - COGS
ERE
GAFS                      Gross Profit
- EI                      - Operating Exp.                                Assets = L +        SE
COGS                      Op. Inc (NOI)                          Year 1
Year 2

The error will impact the Income statement, Statement of Stockholders’ Equity and Balance Sheet

Overstatement of Ending Inventory

Year 1    Year 2
Year Year                         Year Year
BRE
1    2                            1    2
+NI
BI                        SALES
-DIV
+P                         - COGS
ERE
GAFS                      Gross Profit
- EI                      - Operating Exp.                                Assets = L +        SE
COGS                      Op. Inc (NOI)                          Year 1
Year 2

Chapter 6                                    Fall 2012                                   Page 6-9
Chapter 6 Homework
Submit your answers in Angel before it is due

Use the following to answer questions 1 – 6

Case 1          Case 2             Case 3            Case 4
Beginning inventory              \$7,520          \$12,540             \$6,650              ?
Ending inventory                    ?             9,850              11,750            6,660
Purchases                        225,310            ?                298,540         345,260
Cost of goods sold               218,790         311,450               ?             351,790

1. \$____________ For case 1, determine goods available for sale
2. \$____________For case 1, determine ending inventory
3. \$____________For case 2, determine goods available for sale
4. \$____________ For case 2, determine Purchases
5. \$____________For case 3, determine cost of goods sold
6. \$____________ For case 4, determine beginning inventory

Use the following to answer questions 7 – 17
During January, G Company sells 890 remote control airplanes for \$46 each. The company has the following inventory
purchase transactions for 2011:

Date                Transaction                 # of Units         Unit cost            Total Cost
1-Jan          Beginning Inventory                 125                 \$22               \$2,750
7-Jan                Purchase                      625                 26                16,250
21-Jan                Purchase                      250                 28                 7,000
1000                                  \$26,000

7. \$____________What were G’s sales revenue for the period?
For questions 8 - 10 assume the company uses First-in, First-out (FIFO) inventory valuation.

Chapter 6                                             Fall 2012                                               Page 6-10
8. \$_____________Calculate ending inventory (FIFO)
9. \$_____________Calculate cost of goods sold (FIFO)

10. \$_____________ Calculate gross profit (FIFO)

For questions 11 - 13 assume the company uses Last-in, First-out (LIFO) inventory valuation.

11. \$_____________Calculate ending inventory (LIFO)

12. \$_____________Calculate cost of goods sold (LIFO)

13. \$_____________ Calculate gross profit (LIFO)

For questions 14 - 16 assume the company uses Weighted Average cost inventory valuation.

14. \$_____________Calculate ending inventory (WA)

15. \$_____________Calculate cost of goods sold (WA)

16. \$_____________Calculate gross profit (WA)

17. Based on the above, which method would show a larger net income number? (FIFO, LIFO or WA)

Use the following to answer questions 18 – 19
MegaLo-Mart begins the year with inventory of \$24,500 and ends the year with inventory of \$16,980. During the year,
the following amounts are recorded:

Purchases                          \$598,200
Purchase returns                     18,200
Purchase discounts                   11,800
Freight-in                            7,650
Freight-out                           9,500

18. \$_____________Calculate cost of purchases

19. \$_____________Calculate cost of goods sold

Chapter 6                                            Fall 2012                                          Page 6-11
Use the following to answer questions 20 – 32
RL Corporation reports the following amounts in its December 31, 20D income statement:

Net sales                         \$500,000    Cost of goods sold             268,000
Interest expense                      2,200   Advertising expense              36,000
Salaries expense                   168,500    Sales discounts                   6,200
Utilities expense                     4,500   Effective income tax rate          30%

20. \$____________Determine Sales

21. \$____________Determine gross profit

22. \$____________Determine operating expenses

23. \$____________Determine Income before income taxes (IBT)

24. \$____________Determine Income tax expense

25. \$____________Determine net income

26. ___ ___.___% Calculate gross profit ratio (one decimal place).

27. _____________Comparing RL’s common sized income statement with its competitor. The competitor’s gross
margin is 42.5%, which company is doing better?

28. ___ ___.___% Calculate RL’s operating expenses as a percentage of their sales (one decimal place).

29. _____________The competitor’s operating expenses are 36.2% which company is doing better controlling their
operating expenses?

RL’s beginning inventory was \$12,450 and their ending inventory was \$9,760.

30. ___ ___.___ Calculate RL’s inventory turnover ratio (one decimal place)

31. ______ days. Calculate RL’s average days in inventory (round to nearest day)

32. _____________The competitor’s average days in inventory are 17 days. Which company is more effective in
managing their inventory?

Chapter 6                                            Fall 2012                                           Page 6-12
Use the following to answer questions 33 - 38
Find the missing amounts:

Case 1             Case 2         Case 3
Net Sales                           \$654,300         \$456,900              ?
COGS                                     ?               284,500        245,600
Gross profit                         265,400                ?           198,700
Operating expense                    184,300             78,500            ?
Operating income                         ?                  ?           64,750

33. \$____________For case 1, determine cost of goods sold

34. \$____________For case 1, determine operating income

35. \$____________For case 2, determine gross profit

36. \$____________For case 2, determine operating income

37. \$____________For case 3, determine net sales

38. \$____________For case 3, determine operating expense

Use the following to answer questions 39 –40

MATCH… For each of the following independent situations, fill in the blanks to indicate the effect of the error on each
of the various financial statement items. Assume that each of the companies uses a periodic inventory system.
Indicate:
(A) an understatement
(B) an overstatement or
(C) no effect, correct

Balance Sheet         Income Statement
Ending     Retained    Cost of   Net Income
Error
Inventory    Earnings Goods Sold
39. Understated EI in year 1, affect on items in year 1.     a.             b.        c.          d.
40. Understated EI in year 1, affect on items in year 2.     a.             b.        c.          d.

Chapter 6                                                 Fall 2012                                           Page 6-13

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