Chapter 5 inventory

Gross Profit and Cost of Goods SoldSales Cost of Goods Sold an expense Selling and Administrative Expenses Merchandise Inventory Balance Sheet Income Statement... Perpetual and PeriodicI

Principles of Financial Accounting

OPEN UNIVERSITY HCMC

MBA PREPARATORY COURSE

Chapter 5

Inventories and Cost of Goods Sold

Learning Objectives

After studying this chapter, you should be able to:

 Link inventory valuation to gross profit.

 Use both perpetual and periodic inventory systems.

 Calculate the cost of merchandise acquired.

 Choose one of the four principal inventory valuation methods.

 Calculate the impact on net income of LIFO

liquidations.

Learning Objectives

After studying this chapter, you should be able to:

 Use the lower-of-cost-or-market method to value inventories.

 Show the effects of inventory errors on financial statements.

 Evaluate the gross profit percentage and

inventory turnover.

Gross Profit and Cost of Goods Sold

 An initial step in assessing profitability is gross profit

(profit margin or gross margin), which is the difference

between sales revenues and the costs of the goods sold

 Products being held for resale are reported as inventory, a current asset

 When the goods are sold, the costs of the

inventory become an expense, Cost of Goods Sold This expense is deducted from Net Sales

to determine Gross Profit.

Gross Profit and Cost of Goods Sold

Sales

Cost of Goods Sold (an expense)

Selling and Administrative Expenses

Merchandise Inventory

Balance Sheet Income Statement

The Basic Concept of Inventory Accounting

 The key to calculating cost of goods sold is accounting for the remaining inventory at the end of the year

 Cost valuation - process of assigning specific historical costs to items counted in the physical inventory

 Multiply the number of items in ending

inventory times the cost of each item.

Perpetual and Periodic

Inventory Systems

 Two main systems for keeping merchandise inventory records:

 Perpetual inventory system - a system that keeps a running, continuous record that tracks inventories and the cost of goods sold on a day-to-day basis

 Periodic inventory system - a system in which the cost of good sold is computed periodically by

relying solely on physical counts without keeping day-to-day records of units sold or on hand

Perpetual and Periodic

Inventory Systems

 A perpetual inventory system helps managers control

inventory levels and prepare interim financial statements

 The inventory amount can be found at any

given point in time.

 Inventory items must be counted at least once a year to ensure correct valuation

 Physical count - the process of counting all the items in inventory at a moment in time

Perpetual and Periodic

Inventory Systems

 In a perpetual system, the journal entries are:

When inventory is purchased:

Merchandise inventory xxx

Accounts payable (or Cash) xxx

When inventory is sold:

Accounts receivable (or Cash) xxx

Sales revenue xxx

Cost of goods sold xxx

Merchandise inventory xxx

Physical Inventory

 In both periodic and perpetual inventory systems, a

physical count of each item being held in inventory is

Cost of Merchandise Acquired

 Regardless of the inventory system used, the basis of inventory accounting is the cost of the merchandise a company purchases for resale

 What costs are included in the cost of the merchandise?

 The cost of merchandise usually includes the invoice price plus any directly identifiable

transportation charges less any offsetting

discounts.

Detailed Gross Profit Calculation

Deduct: Sales returns and allowances $ 2,000

Cash discounts on sales 1,500 3,500

Deduct: Cost of goods sold:

Merchandise inventory, 1/1/2002 $ 7,500

Deduct: Purchase returns and allowances $3,000

Cash discounts on purchase 1,000 4,000

Add: Freight in 10,000

Total cost of merchandise acquired 126,000 Cost of good available for sale $133,500

Deduct: Merchandise inventory, 12/31/2002 9,000

Principal Inventory Valuation Methods

 Four inventory valuation systems have been generally accepted

 Specific identification

 First in, first out (FIFO)

 Last in, first out (LIFO)

 Weighted average

Principal Inventory Valuation Methods

 If unit prices and costs did not change, all four inventory valuation methods would show identical results

 Because prices change, cost of goods sold (income

measurement) and inventories (asset measurement) are affected

 The choice of the inventory valuation method can significantly affect the amount reported as net income and ending inventory.

Specific Identification

 Specific identification method - concentrates on the

physical tracing of the particular items sold

 Used mostly when the physical flow of goods

is easy to track

 Works best for relatively expensive

low-volume merchandise, such as automobiles or jewelry

 Under FIFO, the oldest units are deemed to

be sold, regardless of which units are actually given to the customer.

 The costs of the newer units in stock are

included in ending inventory.

 FIFO includes the most recent costs in ending inventory,

so the inventory tends to closely approximate that actual market value of the inventory at the balance sheet date

 Also, in periods when prices are rising, FIFO leads to

higher net income because the costs of the older, lower costing items are included in cost of goods sold

 Under LIFO, the newest units are deemed to

be sold, regardless of which units are actually given to the customer.

 The costs of the older units in stock are

included in ending inventory.

 LIFO uses the oldest costs to value ending inventory, so that value may be significantly different from the actual market value of the inventory at the balance sheet date

 In periods when prices are rising, LIFO yields lower net income because the higher costs of more recent

purchases are put into cost of goods sold first

 Because LIFO results in reduced net income, it also

results in lower income taxes

 The Internal Revenue Code requires that if a company uses LIFO to compute its taxable income, the company must also use LIFO to compute its financial net income.

 The result is lower income taxes and lower reported earnings figures to investors.

 If LIFO is such a good deal, why do some companies still use FIFO?

 For several reasons:

 The costs of changing methods can be significant.

 Management may be reluctant to decrease

earnings and possibly salaries and bonuses.

 Management might fear that lower income would hurt in loan negotiations with banks.

 Lower earnings will often lower stock prices.

Weighted Average

 Weighted-average method - computes a unit cost by

dividing the total acquisition cost of all items available

for sale by the number of units available for sale

sale for

available Units

sale for

available goods

of

Cost average

Weighted Average

 The averaging in the weighted average must consider not only the price paid, but also the number of units purchased at each price

 The weighted-average method produces a gross profit somewhere between gross profit under FIFO and LIFO

Weighted Average

Smith Corporation purchased 5 units of Product

X for $4.00 on Monday and 7 units of Product X for $4.25 on Friday What is the weighted-

average cost per unit?

12

$4.25)

x (7

$4.00)

x

(5 average

12

75 49

$

=

= $4.15

Inventory Cost Relationships

 The four cost flow assumptions affect inventory only; they do not affect purchases and liabilities for those purchases

 Note that in the detailed computation of gross profit, ending inventory affects cost of goods sold

 The lower the ending inventory, the higher the cost of goods sold.

 The higher the ending inventory, the lower the cost of goods sold.

Holding Gains and Inventory Profits

 LIFO approximates a replacement cost view of

transactions, and measures profit relative to newer

costs

 Replacement cost - the cost at which an

inventory item could be acquired today

 In contrast, FIFO measures profit relative to older costs

Holding Gains and Inventory Profits

 The difference between profit measured under FIFO and LIFO is called a holding gain or an inventory profit

 The holding gain is also the difference between the historical cost under FIFO (older costs) and the historical cost under LIFO (newer costs).

 LIFO ending inventory rarely has holding gains.

 FIFO ending inventory often has holding gains.

LIFO Layers

 LIFO layer - a separately identifiable additional

segment of LIFO inventory

 Ending inventory under LIFO will have

one total value, but it may contain prices from many different points in time.

 As a company continues in business, the LIFO layers tend to pile on top of one

another over the years.

 LIFO presents an economic reality on the income

statement, but FIFO presents a more up-to-date

valuation on the balance sheet

LIFO Inventory Liquidations

 As stated before, in periods of rising prices, LIFO will produce a higher cost of goods sold and lower gross profit than FIFO

 Sometimes companies must “liquidate” some of their LIFO layers, that is, units in the older LIFO layers are sold

 In such a case, cost of goods sold decreases because very old costs are now included in cost of goods sold When cost of goods sold decreases, gross profit increases.

LIFO Inventory Liquidations

 Security analysts often like to keep track of the effect of choosing LIFO over FIFO because the effect on net income can be significant

 LIFO reserve - the difference between a company’s

inventory valued at LIFO and what it would be under FIFO

 The balance in the LIFO reserve indicates the cumulative effect on gross profit over all prior years due to LIFO.

The Importance of Gross Profit

 Management and investors are interested in gross profit and how it changes over time

 The inventory method chosen might have a significant affect on a company’s gross profit, so gross profit is

often expressed as a percentage of sales

Sales

profit

Gross

% Profit

Gross Profit Percentage

 Often the nature of the business of a company affects the gross profit as compared to other types of

companies

 Wholesaler - an intermediary that sells

inventory items to retailers and incurs few selling costs - often have

low gross profit percentages

 Retailer - a company that sells items to the

final users, individuals

Gross Profit Percentage

and Turnover

 Retailers often lower their gross profit margins and

selling prices and hope that the lower selling prices will

increase sales volume enough to compensate for the

lower gross profit

 One measure of sales level is inventory turnover, which

tells how fast inventory is sold

period the

during held

inventory Average

sold goods

Gross Profit Percentage

 A higher inventory turnover indicates an

ability to use smaller inventory levels to attain

a high sales level.

References:

Horngren, Introduction to financial accounting