copyright © 2011 mcgraw-hill ryerson limited 8-1 powerpoint author: robert g. ducharme, macc, ca...

Copyright © 2011 McGraw-Hill Ryerson Limited

8-1

PowerPoint Author:

Robert G. Ducharme, MAcc, CAUniversity of Waterloo, School of Accounting and Finance

FINANCIALACCOUNTINGFourth Canadian Edition LIBBY, LIBBY, SHORT, KANAAN, GOWING

FINANCIALACCOUNTINGFourth Canadian Edition LIBBY, LIBBY, SHORT, KANAAN, GOWING

Reporting and Interpreting Cost of Sales and Inventory

Chapter 8

8-2


Understanding the Business

Provide sufficient quantities of high-quality inventory.

Provide sufficient quantities of high-quality inventory.

Minimize the costs of carrying inventory.

Minimize the costs of carrying inventory.

Primary Goals of Inventory

Management

Primary Goals of Inventory

Management

Provides accurate information

Provides accurate information

Provides up-to-date information

Provides up-to-date information

Provides information to help protect assets

Provides information to help protect assets

Roles of the Accounting

System

Roles of the Accounting

System

LO 1

8-3


Items Included in Inventory

Inventorytangible property held for sale in the normal course of business

or used in producing goods or services for sale

Tangible Held for Sale

Used to Produce Goods or Services

Merchandise InventoryRaw Materials Inventory

Work in Process InventoryFinished Goods Inventory

LO 1

8-4


Costs Included in Inventory Purchases

The cost principlecost principle requires that inventory be recorded at the price paid or the

consideration given.

Include all costsall costs incurred to bring the asset to useable or saleable condition.

Invoice Price

Freight

Inspection Costs

Preparation Costs

LO 1

8-5


Flow of Inventory Costs

MerchandisePurchases

MerchandisePurchases

Cost ofSales

Cost ofSales

MerchandiseInventory

MerchandiseInventory

Merchandiser

RawMaterials

RawMaterials

Raw MaterialsInventory

Raw MaterialsInventory

Work in ProcessInventory

Work in ProcessInventory

Finished GoodsInventory

Finished GoodsInventory

Cost ofSales

Cost ofSales

Manufacturer

DirectLabourDirectLabour

FactoryOverheadFactory

OverheadLO 1

8-6


Nature of Cost of Sales

BeginningBeginningInventoryInventory

BeginningBeginningInventoryInventory

PurchasesPurchasesfor the Periodfor the PeriodPurchasesPurchases

for the Periodfor the Period

Ending InventoryEnding Inventory(Statement of (Statement of

Financial Position)Financial Position)

Ending InventoryEnding Inventory(Statement of (Statement of

Financial Position)Financial Position)

Goods AvailableGoods Availablefor Salefor Sale

Goods AvailableGoods Availablefor Salefor Sale

Cost of SalesCost of Sales(Income Statement)(Income Statement)

Cost of SalesCost of Sales(Income Statement)(Income Statement)

Beginning inventory + Purchases = Goods Available for Sale

Goods Available for Sale – Ending inventory = Cost of sales

Beginning inventory + Purchases = Goods Available for Sale

Goods Available for Sale – Ending inventory = Cost of salesLO 1

8-7


Internal Control of Inventory

Separation of inventory accounting and physical

handling of inventory.

Storage in a manner that protects from theft and

damage.

Limiting access to authorized employees.

Maintaining perpetual inventory records.

Comparing perpetual records to periodic

physical counts.

LO 2

8-8


Perpetual and Periodic Inventory Systems

Provides Provides up-to-dateup-to-date inventory records.inventory records.

Provides Provides up-to-dateup-to-date inventory records.inventory records.

Provides Provides up-to-date up-to-date cost of sales records. cost of sales records. Provides Provides up-to-date up-to-date

cost of sales records. cost of sales records.

Perpetual Perpetual SystemSystem

Perpetual Perpetual SystemSystem

In a periodic inventory system, ending inventory and cost of sales are determined at the end of the accounting period

based on a physical count.

LO 2

8-9


Perpetual and Periodic Inventory Systems

Inventory System

Item Periodic System Perpetual System

Beginning InventoryCarried over from

prior periodCarried over from

prior period

Add: PurchasesAccumulated in the Purchases account

Accumulated in the Inventory account

Equals:

Less: Ending InventoryMeasured at end of period by physical

inventory count

Perpetual record updated at every

sale

Cost of SalesComputed as a

residual amount at end of period

Measured at every sale based on

perpetual record

Cost of Goods Available for Sale

LO 2

8-10


Comparison of Periodic and Perpetual Systems

Now, let’s compare the

various entries that are made

when using the periodic and

perpetual inventory systems.

LO 2

8-11



LO 2

Transaction Periodic PerpetualMerchandise purchased from supplier on account. Purchases (T) XX Inventory (A) XX

Trade Payables (L) XX Trade Payables (L) XXMerchandise returned to supplier. Trade Payables (L) XX Trade Payables (L) XX

Purchases Returns & All. (T) XX Inventory (A) XXMerchandise sold to customer on account. Trade Receivables (A) XX Trade Receivables (A) XX

Sales (R) XX Sales (R) XX

Cost of Sales (E) XX Inventory (A) XX

Purchases Returns and Allowances is subtracted from Purchases on the income statement.

Purchases Returns and Allowances is subtracted from Purchases on the income statement.

8-12



LO 2

Transaction Periodic PerpetualMerchandise purchased from supplier Purchases (T) XX Inventory (A) XX

on account. Trade Payables (L) XX Trade Payables (L) XXMerchandise returned to Trade Payables (L) XX Trade Payables (L) XX

supplier. Purchases Returns & Allow.(T) XX Inventory (A) XX

Merchandise sold to Trade Receivables (A) XX Trade Receivables (A) XX

customer on Sales (R) XX Sales (R) XXaccount.

Cost of Sales (E) XX

Inventory (A) XX

This entry is recorded at retail.

This entry is recorded at cost.

8-13



LO 2

Transaction Periodic PerpetualMerchandise returned by customer. Sales Returns and Allow. (XR) XX Sales Returns and Allow. (XR) XX

Trade Receivables (A) XX Trade Receivables (A) XX

Inventory (A) XX Cost of Sales (E) XXThis is recorded at

retail.

This entry is recorded at cost.

8-14



LO 2

Transaction Periodic PerpetualMerchandise returned by customer. Sales Returns and Allow. (XR) XX Sales Returns and Allow. (XR) XX

Trade Receivables (A) XX Trade Receivables (A) XX

Inventory (A) XX Cost of Sales (E) XX

At end of accounting period. Cost of Sales (E) XX No entry.

Inventory (A) (beginning) XX Purchases (T) XX

Inventory (A) (ending) XX Cost of Sales (E) XX

8-15


Methods for Estimating Inventory

LO 2

I use the periodicinventory method.Can you help me

estimate inventory?

I sure can, if you can give

me some information.

8-16



LO 2

I know sales,beginning inventory,

purchases, and my gross margin

is 30%.

Let’s constructan income

statement using your gross

margin.

8-17



LO 2

Sales 100%Cost of sales 70%Gross margin 30%

You told me that your sales are $200,000, beginning inventory is $4,500, and purchases are $150,000, so your income statement looks like this . . .

Sales 200,000$ Beginning inventory 4,500$ Purchases 150,000

Cost of goods available for sale 154,500 Ending inventory ?

Cost of sales 140,000

Gross margin 60,000$

8-18



LO 2

Estimated ending inventory must be $14,500 ($154,500 – $140,000).

Sales 200,000$ Beginning inventory 4,500$ Purchases 150,000 Cost of goods available for sale 154,500 Ending inventory 14,500 Cost of sales 140,000 Gross margin 60,000$

8-19


Errors in Measuring Ending Inventory

Errors in Measuring InventoryEnding Inventory Beginning Inventory

Overstated Understated Overstated Understated

Ending Inventory + - N/A N/A

Retained Earnings + - - +

Goods Available for Sale N/A N/A + -Cost of Sales - + + -Gross Profit + - - +Profit + - - +

Effect on Current Period's Statement of Financial Position

Effect on Current Period's Income Statement

LO 2

Beginning inventory + Purchases – Ending inventory = Cost of sales

8-20


Exhibit 8.4: Inventory Error:Understatement of Ending Inventory

LO 2

ERROR: UNDERSTATEMENT OF ENDING INVENTORY

Year of the error Following YearBeginning inventory NE U*Ending inventory U NECost of sales O UGross profit U OProfit before income tax U OIncome tax expense U OProfit U ORetained earnings, end of year U NE

*U = Understated; O = Overstated; NE = No Effect

8-21


If the 2011 ending inventory is understated by $3,000, which of the following is true for

2011?

a. Beginning Inventory was understated.b. Cost of Sales will be understated.c. Gross Profit will be overstated.d. Profit will be understated.

Question

LO 2

8-22



2011?



2011?


Errors in Measuring InventoryBeginning Inventory Ending Inventory



Ending Inventory N/A N/A + -Retained Earnings - + + -Effect on Current Period's Income Statement

Goods Available for Sale + - N/A N/A

Cost of Sales + - - +Gross Profit - + + -Profit - + + -


Question

LO 2

8-23



2012?

a. Beginning Inventory was understated.b. Cost of Sales will be understated.c. Gross Profit will be overstated.d. All of the above.

Question

LO 2

8-24


Question


2012?



2012?


Remember: The ending inventory for 2011 becomes the beginning inventory for 2012.

Errors in Measuring InventoryBeginning Inventory Ending Inventory



Ending Inventory N/A N/A + -Retained Earnings - + + -Effect on Current Period's Income Statement

Goods Available for Sale + - N/A N/A

Cost of Sales + - - +Gross Profit - + + -Net Income - + + -


LO 2

8-25


Inventory Costing Methods

Total Dollar Amount of Goods Total Dollar Amount of Goods Available for SaleAvailable for Sale

Total Dollar Amount of Goods Total Dollar Amount of Goods Available for SaleAvailable for Sale

Ending InventoryEnding Inventory

Inventory Costing Method

Cost of SalesCost of Sales

Inventory Costing Methods1.Specific Identification2.First-in, First-out (FIFO)3.Weighted Average

LO 3

8-26


Specific Identification

When units are sold, the

specific cost of the unit sold is

added to cost of sales.

When units are sold, the

specific cost of the unit sold is

added to cost of sales.

LO 3

8-27


Cost Flow Assumptions

The choice of an inventory costing method is not based on the physical flow of goods

on and off the shelves.

FIFO WeightedAverage

LO 3

8-28


First-In, First-Out Method

Cost of SalesCost of SalesCost of SalesCost of SalesOldest CostsOldest CostsOldest CostsOldest Costs

Ending Ending InventoryInventoryEnding Ending

InventoryInventoryRecent CostsRecent CostsRecent CostsRecent Costs

LO 3

8-29


First-In, First-Out

Remember: Remember: The costs of The costs of most most recent recent

purchasespurchases are are in ending in ending inventory. inventory. Start with Start with

11/29 and add 11/29 and add units units

purchased purchased until you reach until you reach the number in the number in

ending ending inventory.inventory.

Computers, Inc.Mouse Pad Inventory

Date Units $/Unit TotalBeginning Inventory 1,000 5.25$ 5,250.00$ Purchases:Jan. 3 500 5.30 2,650.00 June 20 300 5.60 1,680.00 Sept. 15 250 5.80 1,450.00 Nov. 29 200 5.90 1,180.00 Goods Available for Sale 2,250 12,210.00$

Ending Inventory 1,200 ?

Cost of Sales 1,050 ?



Ending Inventory 1,200 ?

Cost of Sales 1,050 ?

LO 3

8-30


First-In, First-Out

Now, we have allocated the cost to all Now, we have allocated the cost to all 1,200 units in ending inventory.1,200 units in ending inventory.

Now, we have allocated the cost to all Now, we have allocated the cost to all 1,200 units in ending inventory.1,200 units in ending inventory.

Beg. Inv. 1,000 @ 5.25$ Jan. 3 500 @ 5.30 450 @ $5.30June 20 300 @ 5.60 300 @ $5.60Sept. 15 250 @ 5.80 250 @ $5.80Nov. 29 200 @ 5.90 200 @ $5.90

1,200 Units Units

6,695$ Cost

Ending Inventory Cost of SalesGiven Information

LO 3

8-31


First-In, First-Out

Now, we have allocated the cost Now, we have allocated the cost to all 1,050 units sold.to all 1,050 units sold.

Now, we have allocated the cost Now, we have allocated the cost to all 1,050 units sold.to all 1,050 units sold.

Beg. Inv. 1,000 @ 5.25$ 1,000 @ 5.25$ Jan. 3 500 @ 5.30 450 @ $5.30 50 @ 5.30 June 20 300 @ 5.60 300 @ $5.60Sept. 15 250 @ 5.80 250 @ $5.80Nov. 29 200 @ 5.90 200 @ $5.90

1,200 Units 1,050 Units

6,695$ Cost 5,515$ Cost

Ending Inventory Cost of SalesGiven Information

LO 3

$12,210

8-32


First-In, First-Out

Here is the Here is the cost of cost of ending ending

inventory inventory and cost and cost of sales of sales using using FIFO.FIFO.



Ending Inventory 1,200 6,695.00$

Cost of Sales 1,050 5,515.00$




Cost of Sales 1,050 5,515.00$

LO 3

8-33


Average Cost Method

When a unit is sold, the average cost of each unit in inventory is assigned to

cost of sales.

When a unit is sold, the average cost of each unit in inventory is assigned to

cost of sales. Cost of Goods Available for

Sale

Number of Units

Available for Sale

÷

LO 3

Ending Inventory

Units in Ending Inventory x Average Cost per Unit

Cost of Good Sold

Units Sold x Average Cost per Unit

8-34


Average Cost Method

12,210$ 2,250

= $5.42667

Weighted Average Cost

1,200 × 5.42667$

1,050 × 5.42667$




Cost of Sales 1,050 5,698.00$




Cost of Sales 1,050 5,698.00$

LO 3

8-35


Comparison of Methods

FIFO

Weighted Average

Net sales 25,000$ 25,000$ Cost of sales: Merchandise inventory, beginning 5,250$ 5,250$ Net purchases 6,960 6,960 Goods available for sale 12,210$ 12,210$ Merchandise inventory, ending 6,695 6,512 Cost of sales 5,515$ 5,698$ Gross profit 19,485$ 19,302$ Operating expenses 750 750 Profit before taxes 18,735$ 18,552$ Income taxes expense (30%)* 5,621 5,566 Profit 13,114$ 12,986$

* Tax expense amounts were rounded.

Computers, Inc.Income Statement

For Year Ended December 31, 2011

LO 3

In periods of rising prices,

FIFO results in the highest

ending inventory,

gross profit, income tax

expense, and profit, and the lowest cost of

sales.

In periods of rising prices,

FIFO results in the highest

ending inventory,

gross profit, income tax

expense, and profit, and the lowest cost of

sales.

8-36


Financial Statement Effects of Costing Methods

Advantages of MethodsAdvantages of Methods

Ending inventory approximates

current replacement cost.

Ending inventory approximates

current replacement cost.

First-In, First-OutFirst-In, First-Out

LO 3

Weighted Average

Weighted Average

Smoothes out price changes.

Smoothes out price changes.

8-37


International PerspectiveLIFO and International Comparisons

While U.S. GAAP allows companies to choose between FIFO, LIFO, and weighted average inventory methods, International

Financial Reporting Standards (IFRS) and Canadian Accounting Standards for Private Enterprises (ASPE) prohibit

the use of LIFO.

These differences can create comparability problems when one attempts to compare companies across international

borders.

IFRS requires that the same method be used for all

inventory items that have a similar nature and use.

GAAP allows different inventory accounting methods to be used for different types

of inventory items.

LO 3

8-38


Managers Choice of Inventory Methods

Profit EffectsManagers prefer to report higher earnings for their

companies.

Profit EffectsManagers prefer to report higher earnings for their

companies.

Income Tax EffectsManagers prefer to pay the

least amount of taxes allowed by law as late as

possible.

Income Tax EffectsManagers prefer to pay the

least amount of taxes allowed by law as late as

possible.

LO 4

8-39


Valuation at Lower of Cost or Net Realizable Value

Ending inventory is reported at the lower of cost or net realizable value (LCNRV). Ending inventory is reported at the lower of cost or net realizable value (LCNRV).

Net Realizable Value (NRV)is the expected sales price less

estimated selling costs (e.g., repair and disposal costs).

Net Realizable Value (NRV)is the expected sales price less

estimated selling costs (e.g., repair and disposal costs).

The company will recognize a “holding” loss in the current period rather than the period in which the item is sold.

This practice is conservative.

The company will recognize a “holding” loss in the current period rather than the period in which the item is sold.

This practice is conservative.LO 5

8-40


Valuation at Lower of Cost or Net Realizable Value

Item Quantity Cost

Net Realizable

Value (NRV) LCNRV Total LCNRVIntel chips 1,000 250$ 200$ 200$ 200,000$ Disk drives 400 100 110 100 40,000

$ 290,000 $ 240,000

Item Quantity Cost

Net Realizable

Value (NRV) LCNRV Total LCNRVIntel chips 1,000 250$ 200$ 200$ 200,000$ Disk drives 400 100 110 100 40,000

$ 290,000 $ 240,000

(1,000 Intel chips × $50) = $50,000

LO 5

8-41


Inventory Turnover

Cost of Sales = Average Inventory

Inventory Turnover

Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2

Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2

This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more

quickly thus reducing storage and obsolescence costs.

This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more

quickly thus reducing storage and obsolescence costs.

LO 6

8-42


Inventory and Cash Flows

Add

Subtract

Cash Flows Cash Flows from from

OperationsOperations

Cash Flows Cash Flows from from

OperationsOperations

ProfitProfitProfitProfit

Decrease in InventoryDecrease in InventoryIncrease in Trade Increase in Trade

PayablesPayables

Decrease in InventoryDecrease in InventoryIncrease in Trade Increase in Trade

PayablesPayables

Increase in Inventory Increase in Inventory Decrease in Trade Decrease in Trade

PayablesPayables

Increase in Inventory Increase in Inventory Decrease in Trade Decrease in Trade

PayablesPayables

LO 6

8-43


Appendix 8A: Additional Issues in Measuring Purchases

Purchase returns and allowances are a reduction

in the cost of purchases associated with

unsatisfactory goods.

A purchase discount is a cash discount

received for prompt payment of an account.

Appendix 8A

8-44


Appendix 8B: Additional Issues in Measuring Purchases

Terms

Time

Due

Discount Period

Full amountless discount

Credit Period

Full amount due

Purchase or Sale

2/10,n/302/10,n/30Discount Percent

Discount Percent

Number of Days Discount

Is Available

Number of Days Discount

Is Available

CreditPeriod

CreditPeriod

Appendix 8A

8-45


End of Chapter 8

copyright © 2011 mcgraw-hill ryerson limited 8-1 powerpoint author: robert g. ducharme, macc, ca...

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