Chapter Inventories and Cost of Goods Sold Inventory Types Finished inventory: held by retailers and wholesalers  Merchandise inventory  Materials inventory: held by manufacturers  Raw materials  Work-in-progress  Finished goods  LO Types of Manufacturing Costs Direct materials: also called raw materials  Ingredients used in making a product  Direct labor: amounts paid to workers to manufacture the product  Manufacturing overheads: all other costs that are related to the manufacturing process but cannot be directly matched to specific units of output  Example: depreciation of building and salary of supervisor  Three Forms of Inventory Direct materials  The inventory of a manufacturer before the addition of any direct labor or manufacturing overhead  Work in process  Cost of unfinished products in a manufacturing company  Finished goods  A manufacturer’s inventory that is complete and ready for sale  Exhibit 5.1 Relationships between Types of Businesses and Inventory Costs Account for Sales of Merchandise  Sales revenue: representation of the inflow of assets, either cash or accounts receivable, from the sale of a product during the period Sales Return and Net Sales = Sales − − Sales Discount Allowances Gross Profit = Net Sales − Cost of Goods Sold LO Exhibit 5.3—Net Sales Section of the Income Statement Sales Returns and Allowances Sales returns and allowances: contra-revenue account used to record refunds to customers and reductions of their accounts  Sales discounts: contra-revenue account used to record discounts given to customers for early payment of their accounts  Credit terms: firm’s policy for granting credit  Example: n/30; Net, 10 EOM; 1/10, n/30  Credit Terms and Sales Discounts  Credit terms: firm’s policy for granting credit  n/30: the net amount of the selling price is due within 30 days of the date of the invoice  Net, 10 EOM: the net amount is due anytime within ten days after the end of the month  1/10, n/30: the customer can deduct 1% from the selling price if the bill is paid within ten days  Sales discounts: contra-revenue account used to record discounts given to customers for early payment of their accounts Cost of Goods Sold Recognition of cost of goods sold as an expense is an excellent example of matching principle  Sales revenue: inflow of assets, cash or accounts receivable  Cost of goods sold: outflow of asset, inventory  Cost of goods available for sale  Beginning inventory + Cost of goods purchased  Cost of goods sold Cost of goods available for sale − Ending inventory LO Exhibit 5.8—Summary of the Effects of Inventory Errors Lower-of-Cost-or Market Rule A conservative inventory valuation approach  Require that inventory be written down at the end of the period if the market value of the inventory is less than its cost  Can be applied to:  Entire inventory  Individual items  Groups of items  LO Lower-of-Cost-or-Market under International Standards Required under both U.S GAAP and IFRS  Difference:  U.S.GAAP  • Define market value as replacement cost, subject to a maximum and a minimum amount • New amount becomes basis for future adjustments  IFRS • Uses net realizable value with no upper or lower limits • Write-downs of inventory can be reversed in later periods Lower-of-Cost-or-Market under International Standards( Continued )  For example, if cost is $100,000 and market value is $85,000, the adjustment that can be identified and analyzed as follows: Inventory Turnover Ratio Measures company’s ability to sell its inventory quickly  Number of times inventory is sold during a period  Inventory Turnover Ratio = Cost of Goods Sold Average Inventory LO 10 Number of Days’ Sales in Inventory  Measures of how long it takes to sell inventory Number of Days in the Period Number of Days’ Sales = in Inventory Inventory Turnover Ratio The Ratio Analysis Model How liquid the company is? Gather cost of goods sold from the income statement and average inventory from balance sheet at the end of the two most recent years Calculate the inventory turnover ratio Compare the ratio with other ratios Interpret the ratios—measure of how long it takes to sell inventory The Business Decision Model If you were an investor, would you buy stock in the company? Gather information from the financial statements and other sources Compare trends in inventory turnover ratios, net income with industry averages Buy stock or find an alternative Monitor your decision periodically Exhibit 5.10—Inventories and the Statement of Cash Flows LO 11 Inventory Costing Methods with the Use of a Perpetual Inventory System LO 12 Example 5.20—Determining Ending Inventory Using FIFO with a Perpetual System Example 5.21—Determining Ending Inventory Using LIFO with a Perpetual System Moving Average  An average cost method when a weighted average cost assumption is used with a perpetual inventory system Example 5.22—Determining Ending Inventory Using Moving Average with a Perpetual System End of Chapter [...]... Model 1 2 3 4 5 How much of the sales revenue is used for the cost of the products, and thus, how much remains to cover other expenses and to earn net income? Gather the information about net sales and cost of goods sold Calculate the gross profit ratio Compare the ratio with prior years and with competitors Interpret the ratios—showing increase or decrease The Business Decision Model 1 2 3 4 5 If you were... company? Gather information from the financial statements and other sources Compare the company's gross profit ratio with industry averages and look at trends Buy stock or find an alternative use for the money Monitor the investment periodically Inventory Valuation and the Measurement of Income Value assigned to inventory on balance sheet determines the amount eventually recognized as an expense on income... destination point: seller incurs the transportation costs  FOB shipping point: buyer incurs the transportation costs  FOB stands for ‘‘free on board’’  Example 5. 7—Recording Transportation-In in a Periodic System  Assume that on delivery of a shipment of goods, Daisy’s pays an invoice for $300 from Rocky Mountain Railroad The terms of shipment are FOB shipping point Example 5. 8—Determining the Effect...Exhibit 5. 4—Cost of Goods Sold Section of the Income Statement Exhibit 5. 5—Cost of Goods Sold Model Inventory Systems: Perpetual and Periodic Example 5. 3—Recording Cost of Goods Sold in a Perpetual System  Daisy’s sells a pair of running shoes that costs $70 In addition to the entry to record the sale, Daisy’s would also record an adjustment as follows: Exhibit 5. 6—Cost of Goods Purchased Example 5. 4—Recording... equity Example 5. 6—Recording Purchase Discounts in a Periodic System  On March 13,there is a purchase of merchandise for $50 0, with credit terms of 1/10, n/30 Example 5. 6—Recording Purchase Discounts in a Periodic System (continued) Purchase Discounts  A contra-purchases account used to record reductions in purchase price for early payment to a supplier Shipping Terms and Transportation Costs Cost... Specific Identification Weighted Average First-in, First-out (FIFO) Last-in, First-out (LIFO) LO 6 Specific Identification Method Relies on matching unit costs with the actual units sold  Example 5. 10—Determining Ending Inventory and Cost of Goods Sold Using Specific Identification  Example 5. 10—Determining Ending Inventory and Cost of Goods Sold Using Specific Identification (continued) Weighted Average... Shipping Terms on Purchases and Sales The Gross Profit Ratio Important measure of profitability  Indicates a company’s ability to cover operating expenses and earn a profit  Relationship between gross profit and net sales— measured by the gross profit ratio—one of the most important measures to assess the performance of a company  Gross Profit Ratio = Gross Profit Net Sales LO 4 The Ratio Analysis... Incorrect ending inventory will affect cost of goods sold and net income  LO 5 Inventory Costs Cost: price paid or consideration given to acquire an asset  Includes expenditures directly or indirectly incurred in bringing to its existing condition and location  Examples:  Freight costs incurred to bring inventory to the place of business  Cost of insurance when inventory is in transit  Cost of... buys shoes from Nike at a cost of $4,000 The effect is to increase liabilities and increase cost of goods sold, which is an expense Example 5. 5—Recording Purchase Returns in a Periodic System  Daisy’s returns $ 850 of merchandise to Nike for credit on Daisy’s account The return decreases both liabilities and purchases Because a return reduces purchases, it has the effect of reducing expenses and increasing... Method (FIFO) Assigns the most recent costs to ending inventory  Example 5. 12—Determining Ending Inventory and Cost of Goods Sold Using FIFO  Example 5. 12—Determining Ending Inventory and Cost of Goods Sold Using FIFO (continued) Last-In, First-Out Method (LIFO) Assigns the most recent costs to cost of goods sold  Example 5. 13—Determining Ending Inventory and Cost of Goods Sold Using LIFO  ... n/30: the net amount of the selling price is due within 30 days of the date of the invoice  Net, 10 EOM: the net amount is due anytime within ten days after the end of the month  1/10, n/30: the. .. destination point: seller incurs the transportation costs  FOB shipping point: buyer incurs the transportation costs  FOB stands for ‘‘free on board’’  Example 5. 7—Recording Transportation-In... information from the financial statements and other sources Compare the company's gross profit ratio with industry averages and look at trends Buy stock or find an alternative use for the money Monitor