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Inventories and Cost of Sales

Dr Winston Kwok

Learning Objectives

1. Identify the costs of inventory

2. Compute the inventory in a perpetual system

using the methods of specific identification,

FIFO, and weighted average cost

3. Analyze the effects of inventory methods for

both financial and tax reporting

4. Compute the lower of cost and net realizable value of inventory

5. Analyze the effects of inventory errors on

current and future financial statements

Identify the costs of inventory

Identify the costs of inventory

INVENTORIES

Products a company owns and expects to sell in its normal operations.

Merchandisers

Wholesaler

Wholesaler Retailer

Retailer

Manufacturer

a company owns and expects to sell in its normal operations. Merchandisers Wholesaler Retailer Manufacturer Consumers
a company owns and expects to sell in its normal operations. Merchandisers Wholesaler Retailer Manufacturer Consumers

Consumers

DETERMINING INVENTORY COSTS

Include all expenditures necessary to bring an item to a salable condition and location.

Minus Minus Discounts Discounts and and Allowances Allowances
Minus
Minus
Discounts
Discounts
and
and
Allowances
Allowances
Plus Import Plus Import Duties Duties
Plus Import
Plus Import
Duties
Duties
Invoice Invoice Cost Cost
Invoice
Invoice
Cost
Cost
Plus Plus Freight Freight
Plus
Plus
Freight
Freight
Plus Plus Storage Storage
Plus
Plus
Storage
Storage
Plus Plus Insurance Insurance
Plus
Plus
Insurance
Insurance

INVENTORIES

DefinedDefined accordingaccording toto typetype andand naturenature ofof thethe company.company.

Merchandiser:

Items to be resold. For a supermarket, food is

inventory, the shopping trolley is not.

company.company. Merchandiser: Items to be resold. For a supermarket, food is inventory, the shopping trolley is
company.company. Merchandiser: Items to be resold. For a supermarket, food is inventory, the shopping trolley is

INVENTORIES

DefinedDefined accordingaccording toto typetype andand naturenature ofof thethe company.company.

Manufacturer:

Raw materials

Goods acquired in a relatively undeveloped state.

Eventually will compose a major part of the finished product.

Work in process (WIP)

Partly finished products.

Manufacturing plant contains work in process inventory.

Finished goods

Completed products waiting for sale.

 Manufacturing plant contains work in process inventory.  Finished goods  Completed products waiting for

INVENTORIES AND COST OF SALES

Merchandise or

Merchandise or

cost of goods

cost of goods

available for sale

available for sale

Beginning

Beginning

inventory

inventory

=

for sale Beginning Beginning inventory inventory = Merchandise or Merchandise or cost of goods cost of

Merchandise or

Merchandise or

cost of goods

cost of goods

available for sale

available for sale

At end of period,

+

Net

Net

purchases

purchases

is allocated between

inventory still remaining (a current asset on

statement of financial position), and

inventory sold during the period (an operating expense called cost of sales or cost of goods sold

on the income statement).

COST OF GOODS SOLD (COST OF SALES)

Represents net purchase costs of inventory sold to

customers during accounting period.

Cost of goods sold = beginning inventory + net purchases ending inventory

Often the largest expense for a manufacturer or a merchandiser.

GROSS PROFIT (GROSS MARGIN)

Difference between net sales and

cost of sales.

Gross Profit = Net Sales Cost of Sales

Must keep this high as it must cover all other expenses to generate net profit.

= Net Sales – Cost of Sales  Must keep this high as it must cover

INCOME STATEMENTS

Service Company Income Statement For Year Ended December 31

Merchandising Company Income Statement For Year Ended December 31

Service revenue Expenses Salary expense

Depreciation expense

$200

80

25

Income tax expense Net income

 

10

$

85

Sales

$200

Cost of goods sold

55

Gross profit

145

Expenses Salary expense

80

Depreciation expense

25

Income tax expense

10

Net income

$ 30

145 Expenses Salary expense 80 Depreciation expense 25 Income tax expense 10 Net income $ 30
145 Expenses Salary expense 80 Depreciation expense 25 Income tax expense 10 Net income $ 30

STATEMENTS OF FINANCIAL POSITION

Service Company Statement of Financial Position December 31

Current assets Cash

$300

Accounts receivable

600

Prepaid expenses

80

Total current assets

$980

Merchandising Company Statement of Financial Position December 31

Current assets Cash

Accounts receivable

Current assets Cash Accounts receivable Inventories Prepaid expenses Total current assets $300 600 700 80 $1,680

Inventories Prepaid expenses Total current assets

$300

600

700

80

$1,680

SAMSUNGS INVENTORIES

Inventories 3rd largest current asset
Inventories 3rd largest current asset

SAMSUNGS INVENTORIES

S AMSUNG ’ S I NVENTORIES Breakdown of inventories

Breakdown of inventories

SAMSUNGS INVENTORIES

Gross profit as

a percent of revenue = 38%

COMPETITORS’ COMPARISON

C OMPETITORS ’ C OMPARISON Source: www.gurufocus.com
C OMPETITORS ’ C OMPARISON Source: www.gurufocus.com

Source: www.gurufocus.com

Compute the inventory in a perpetual system using the methods of specific identification, FIFO, and

Compute the inventory in a perpetual system

using the methods of specific identification,

FIFO, and weighted average cost

OPERATING CYCLE FOR A MERCHANDISER

Begins with the purchase of merchandise

and ends with the collection of cash from the sale of merchandise.

M ERCHANDISER Begins with the purchase of merchandise and ends with the collection of cash from

INVENTORY SYSTEMS

Perpetual systems

continually update

accounting records for inventory transactions

Periodic systems

accounting records

relating to inventory transactions are

updated only at the end

of the accounting period

(not covered in ACC1002)

Most companies take a physical count of inventory at

least once each year.

INVENTORY COSTING UNDER A PERPETUAL SYSTEM

I NVENTORY C OSTING UNDER A P ERPETUAL S YSTEM Income Income Statement Statement Inventory affects
Income Income Statement Statement
Income
Income
Statement
Statement

Inventory

affects

YSTEM Income Income Statement Statement Inventory affects Statement Statement of of Financial Financial Position
Statement Statement of of Financial Financial Position Position
Statement
Statement
of
of
Financial
Financial
Position
Position
Statement of of Financial Financial Position Position The matching principle requires matching costs with sales.

The matching

principle requires

matching costs

with sales.

MERCHANDISE PURCHASES

On November 2, Z-Mart purchased $1,200 of

On November 2, Z-Mart purchased $1,200 of

merchandise inventory for cash.

merchandise inventory for cash.

$1,200 of On November 2, Z-Mart purchased $1,200 of merchandise inventory for cash. merchandise inventory for

SALES OF MERCHANDISE

Each sales transaction for a seller of

merchandise involves two parts:

for a seller of merchandise involves two parts: Revenue received in the form of an asset

Revenue received in

the form of an asset

from a customer.

Recognition of the

cost of merchandise

sold to a customer.

SALES OF MERCHANDISE

On November 3, Z-Mart sold $2,400 of

merchandise on credit. The merchandise has a cost basis to Z-Mart of $1,600.

On November 3, Z-Mart sold $2,400 of merchandise on credit. The merchandise has a cost basis
On November 3, Z-Mart sold $2,400 of merchandise on credit. The merchandise has a cost basis

INVENTORY COST METHODS

When inventory items are purchased at different

costs, a question arises as to which amounts to

record in COGS and which amounts remain in

inventory.

Cost methods assume particular patterns for how

costs flow through inventory.

Physical flow and cost flow need not be the same.

Methods allowed under IFRS (IAS 2 Inventories):

specific identification, FIFO, and weighted average cost.

INVENTORY COSTING ILLUSTRATION

Here is information about the mountain bike inventory of Trekking for the month of August.

C OSTING I LLUSTRATION Here is information about the mountain bike inventory of Trekking for the

SPECIFIC IDENTIFICATION

Can be used when each item in inventory can be identified

with a specific purchase and invoice.

Specific identification is usually practical only for companies with expensive, custom-made inventory.

and invoice.  Specific identification is usually practical only for companies with expensive, custom-made inventory.

SPECIFIC IDENTIFICATION

S PECIFIC I DENTIFICATION * Identification of items sold (and their costs) is obtained from internal

* Identification of items sold (and their costs) is obtained from internal documents

that track each unit from its purchase to its sale.

SPECIFIC IDENTIFICATION

Income Statement Income Statement Cost of Goods Sold Cost of Goods Sold Statement of Financial
Income Statement
Income Statement
Cost of Goods Sold
Cost of Goods Sold
Statement of Financial Position
Statement of Financial Position
Inventory
Inventory

SPECIFIC IDENTIFICATION

Here are the entries to record the purchases and sales. The COGS (numbers in red) are determined by the cost method used.

(numbers in red) are determined by the cost method used. All purchases and sales are made

All purchases and sales are made on credit.

The selling price of inventory was as follows:

Aug. 14

$130

Aug. 31

150

INVENTORY COST METHODS

First-In, First-Out

(FIFO)

Assumes costs flow in the order

incurred.

(FIFO) Assumes costs flow in the order incurred. Weighted Average Cost Assumes costs flow at an

Weighted

Average Cost

Assumes costs flow at an

average of the costs available.

costs flow in the order incurred. Weighted Average Cost Assumes costs flow at an average of

FIRST-IN, FIRST-OUT (FIFO)

Oldest

Oldest

Costs

Costs

Cost of

Cost of

Goods Sold

Goods Sold

Costs Costs Cost of Cost of Goods Sold Goods Sold Recent Recent Costs Costs Ending Ending

Recent

Recent

Costs

Costs

Ending

Ending

Inventory

Inventory

Costs Cost of Cost of Goods Sold Goods Sold Recent Recent Costs Costs Ending Ending Inventory

FIRST-IN, FIRST-OUT (FIFO)

F IRST -I N , F IRST -O UT (FIFO) 20 units sold on Aug 14:

20 units sold on Aug 14: FIFO assumes 10 units from beginning balance and another 10 from Aug 3 purchase.

FIRST-IN, FIRST-OUT (FIFO)

F IRST -I N , F IRST -O UT (FIFO) 23 units sold on Aug 31:

23 units sold on Aug 31: FIFO assumes 5 units from Aug 3 purchase and

another 18 from Aug 17 purchase.

FIRST-IN, FIRST-OUT (FIFO)

Here are the entries to record the purchases and sales. The COGS (numbers in red) are determined by the cost method used.

(numbers in red) are determined by the cost method used. All purchases and sales are made

All purchases and sales are made on credit.

The selling price of inventory was as follows:

Aug. 14

$130

Aug. 31

150

LAST-IN, FIRST-OUT (LIFO)

Recent

Recent

Costs

Costs

Cost of

Cost of

Goods Sold

Goods Sold

Costs Costs Cost of Cost of Goods Sold Goods Sold Oldest Oldest Costs Costs Ending Ending

Oldest

Oldest

Costs

Costs

Ending

Ending

Inventory

Inventory

Costs Costs Ending Ending Inventory Inventory This method allowed under US GAAP but not under IFRS

This method allowed under US GAAP but not under IFRS

Not examinable in ACC1002

WEIGHTED AVERAGE COST

When a unit is sold, the average

cost of each unit in inventory is

assigned to cost of goods sold.

Cost of Goods Available for

Sale

Units on hand

÷ on the date of

sale

WEIGHTED AVERAGE COST

W EIGHTED A VERAGE C OST
W EIGHTED A VERAGE C OST
W EIGHTED A VERAGE C OST

WEIGHTED AVERAGE COST

W EIGHTED A VERAGE C OST
W EIGHTED A VERAGE C OST
W EIGHTED A VERAGE C OST

WEIGHTED AVERAGE COST

Here are the entries to record the purchases and sales. The COGS (numbers in red) are determined by the cost method used.

(numbers in red) are determined by the cost method used. All purchases and sales are made

All purchases and sales are made on credit.

The selling price of inventory was as follows:

Aug. 14

$130

Aug. 31

150

CONSISTENCY IN USING COSTING METHODS

Comparability is an enhancing qualitative characteristic in IASB’s Conceptual Framework.

Related to comparability is consistency, which requires

a company to use the same accounting methods period after period so that financial statements are

comparable across periods.

Change is allowed if that will improve financial reporting but company must disclose reasons and impact of

change.

Company can use different methods for different categories of inventory.

Analyze the effects of inventory methods for both financial and tax reporting

Analyze the effects of inventory methods for

both financial and tax reporting

INVENTORY COSTING ILLUSTRATION

Let’s revisit the information about the mountain bike inventory of Trekking for the month of August.

Costs are rising
Costs are rising

FINANCIAL STATEMENT EFFECTS OF COSTING METHODS

Because costs change, inventory methods nearly always assign different amounts.

inventory methods nearly always assign different amounts. In times of rising costs, FIFO yields higher gross

In times of rising costs, FIFO yields higher gross profit than WAC

FINANCIAL STATEMENT EFFECTS OF COSTING METHODS

F INANCIAL S TATEMENT E FFECTS OF C OSTING M ETHODS • • Since inventory costs

Since inventory costs affect income, they have potential tax effects.

Trekking can gain a temporary tax advantage by using WAC. In some countries, companies can and often do use different costing methods for financial reporting and tax reporting.

FINANCIAL STATEMENT EFFECTS OF INVENTORY METHODS

AdvantagesAdvantages ofof MethodsMethods

Weighted

Weighted

Average

Average

Cost

Cost

Weighted Weighted Average Average Cost Cost Smoothes out Smoothes out cost changes. cost changes.

Smoothes out

Smoothes out

cost changes.

cost changes.

FIFOFIFO

out Smoothes out cost changes. cost changes. FIFOFIFO Ending inventory Ending inventory approximates

Ending inventory

Ending inventory

approximates

approximates

current cost.

current cost.

Profit Effects when Inventory Costs are Increasing

Ending inventory, gross profit, and net profit

Weighted

average

FIFO

Profit Effects when Inventory Costs are Decreasing

Ending inventory, gross profit, and net profit

Weighted average FIFO
Weighted
average
FIFO
Compute the lower of cost and net realizable value of inventory

Compute the lower of cost and

net realizable value of inventory

GOODS DAMAGED OR OBSOLETE

Damaged or obsolete goods are not counted in

inventory if they cannot be sold.

Cost should be reduced to net realizable value if they cannot be sold.

Net realizable value is the estimated selling price in the ordinary course of

business less the estimated costs of

completion and the estimated costs

necessary to make the sale.

LOWER OF COST AND NET REALIZABLE VALUE

IAS 2: Inventory must be reported at NRV

when NRV is lower than cost.

must be reported at NRV when NRV is lower than cost. NRV is the estimated NRV

NRV is the estimated

NRV is the estimated

selling price in the ordinary

selling price in the ordinary

course of business less the

course of business less the

estimated costs of

estimated costs of

completion and the

completion and the

estimated costs necessary

estimated costs necessary

to make the sale.

to make the sale.

Can be applied two ways:

Can be applied two ways:

(1)

(1)

(2)

(2)

separately to each

separately to each

individual item.

individual item.

to major categories of

to major categories of

assets.

assets.

LOWER OF COST AND NRV

A motor sports retailer has the following items in inventory:

Per Unit

Per Unit

Units on

Units on

Inventory Items

Inventory Items

Hand

Hand

Cost

Cost

NRV

NRV

Total Cost

Total Cost

Total NRV

Total NRV

Cycles: Cycles:

Roadster

Roadster

Sprint

Sprint

O

O

ff-R oa d

ff-R oa d

Trax-4

Trax-4

Blazer

Blazer

Totals

Totals

20

20

$

$

8,000

8,000

$

$

7,000

7,000

$

$

160,000

160,000

$

$

140,000

140,000

10

10

5,000

5,000

6,000

6,000

50,000

50,000

60,000

60,000

8

8

5,000

5,000

6,500

6,500

40,000

40,000

45,000

45,000

8 8 5,000 5,000 6,500 6,500 40,000 40,000 45,000 45,000 $ $ 295,000 295,000 52,000 52,000
8 8 5,000 5,000 6,500 6,500 40,000 40,000 45,000 45,000 $ $ 295,000 295,000 52,000 52,000

$

$

295,000

295,000

52,000

52,000

5

5

9,000

9,000

7,000

7,000

35,000

35,000

6,500 6,500 40,000 40,000 45,000 45,000 $ $ 295,000 295,000 52,000 52,000 5 5 9,000 9,000
6,500 6,500 40,000 40,000 45,000 45,000 $ $ 295,000 295,000 52,000 52,000 5 5 9,000 9,000

LOWER OF COST AND NRV

Here is how to compute lower of cost and

NRV for individual inventory items.

Inventory Items

Inventory Items

Units on

Units on

Hand

Hand

Total Cost

Total Cost

Lower of Cost and

Lower of Cost and

NRV Applied to

NRV Applied to

of Cost and Lower of Cost and NRV Applied to NRV Applied to Total NRV Total

Total NRV

Total NRV

Items

Items

to NRV Applied to Total NRV Total NRV Items I t e m s Cycles: Cycles:

Cycles:

Cycles:

Roadster

Roadster

Sprint

Sprint

Off-R oad

Off-R oad

Trax-4

Trax-4

Blazer

Blazer

20

20

10

10

8

8

5

5

$

$

160,000

160,000

50,000

50,000

$

$

40,000

40,000

45,000

45,000

$

$

$

$

140,000

140,000

60,000

60,000

52,000

52,000

35,000

35,000

$

$

140,000

140,000

50,000

50,000

40,000

40,000

35,000

35,000

Totals

Totals

$

$

295,000

295,000

$

$

265,000

265,000

LOWER OF COST AND NRV

Lower of Cost and NRV Applied to Units on Inventory Items Hand Total Cost Items
Lower of Cost
and NRV Applied
to
Units on
Inventory Items
Hand
Total Cost
Items
$ 295,000 Totals $ 265,000
$ 295,000
Totals
$
265,000
Items Hand Total Cost Items $ 295,000 Totals $ 265,000 If this adjusting journal entry NOT

If this adjusting journal entry NOT recorded,

then both profit and asset overstated which

will mislead investors and creditors.

SAMSUNGS INVENTORIES

S AMSUNG ’ S I NVENTORIES
Analyze the effects of inventory errors on current and future financial statements

Analyze the effects of inventory errors on

current and future financial statements

FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS

How do errors in ending inventory affect

key financial numbers such as:

Cost of goods sold?

Gross profit?

Net income?

Current assets and total assets? Equity?

FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS

An error in inventory results in COGS being overstated or understated. The inventory error has
An error in inventory
results in COGS
being overstated or
understated.
The inventory error
has the opposite
effect on gross profit
and net income.
Any uncorrected error will affect the financial statements for two years.
Any uncorrected
error will affect the
financial statements
for two years.

FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS

Ending inventory errors impact TWO periods

financial statements.

Current period

Ending inventory

Next period

Beginning inventory

Error counterbalanced

by end of second period.

2010 2011
2010
2011

ENDING INVENTORY UNDERSTATED

Assume that this company errs in computing its 2010 ending inventory and

reports $16,000 instead of the correct amount of $20,000.

reports $16,000 instead of the correct amount of $20,000. Inventory Error Cost of Goods Sold Net
Inventory Error Cost of Goods Sold Net Income Understate ending inventory Overstated Understated
Inventory Error
Cost of Goods Sold
Net Income
Understate ending inventory
Overstated
Understated

ENDING INVENTORY UNDERSTATED

E NDING I NVENTORY U NDERSTATED Inventory Error Cost of Goods Sold Net Income Understate ending
Inventory Error Cost of Goods Sold Net Income
Inventory Error
Cost of Goods Sold
Net Income
Understate ending inventory Overstated Understated Understate beginning inventory Understated Overstated
Understate ending inventory
Overstated
Understated
Understate beginning inventory
Understated
Overstated

ENDING INVENTORY UNDERSTATED

E NDING I NVENTORY U NDERSTATED
E NDING I NVENTORY U NDERSTATED

FINANCIAL STATEMENT EFFECTS OF INVENTORY ERRORS

Income Statement Effects

Inventory Error Cost of Goods Sold Net Income
Inventory Error
Cost of Goods Sold
Net Income
Understate ending inventory Overstated Understated
Understate ending inventory
Overstated
Understated
Understate beginning inventory Understated Overstated
Understate beginning inventory
Understated
Overstated
Overstate ending inventory Understated Overstated
Overstate ending inventory
Understated
Overstated
Overstate beginning inventory Overstated Understated
Overstate beginning inventory
Overstated
Understated

Statement of Financial Position Effects

Inventory Error

Assets

Equity

Understate ending inventory

Understated

Understated

Overstate ending inventory

Overstated

Overstated

ETHICS IN BUSINESS

Pressure to report profits

Management’s bonuses linked to gross profit

or net income

Shareholders’ expectations Analysts’ forecasts

bonuses linked to gross profit or net income  Shareholders’ expectations  A nalysts’ forecasts

ETHICS IN BUSINESS

Management of companies which profits do not meet shareholders’ expectations

are sometimes tempted to cook the

booksto increase reported profit.

to “ cook the books ” to increase reported profit. 1. Creating fictitious sales revenue 2.

1. Creating fictitious sales revenue

2. Overstating ending inventory

ETHICS IN BUSINESS

Overstating ending inventory

E THICS IN B USINESS Overstating ending inventory
E THICS IN B USINESS Overstating ending inventory
E THICS IN B USINESS Overstating ending inventory
E THICS IN B USINESS Overstating ending inventory