Chapter Six Page 222
Inventories and Cost of Sales
Objective: To have students demonstrate their knowledge of the four different types of inventory and cost of sales, systems; Specific Invoice, FIFO, LIFO, & Weighted Average. They will record and analyze inventory purchases using theses four systems to determine the most profitable method as it applies to net income for reporting and tax purposes. They will also asses the inventory levels by using Inventory Turnover and Days Sales in Inventory Ratios.
Topics to be covered:
Inventories And Cost of Sales
Use dollars and units to calculate inventory and sales
- Determine the inventory items and their cost at time of purchase
- Determine the inventory cost at time of sale
- Determine the value of the remaining inventory
Inventory Cost using a Perpetual or Periodic system
- Specific Invoice
- Weighted Average
- Four Methods
- Financial Statement Effects for Reporting and Tax purposes
- Inventory errors effects on financial statements
Inventory amount valuations
- Inventory Turnover Ratio
- Day’s Sales in Inventory Ratio
Determining Inventory Items
- Inventory – All goods that a company owns and holds for sale at a future point in time.
A. Goods in Transit – Determine when ownership is passed based on taking possession; two time frames: FOB Destination & FOB Shipping Point
B. Goods on Consignment – Who actually owns the product or is responsible for it
- Owner is the Consignor
- Seller is the Consignee
(ie. Book stores)
C. Goods Damaged or Obsolete – Not counted in inventory if it can’t be sold. Included in inventory if it can be sold at a reduced price.
Determining Inventory Costs
- Costs necessary and directly (or indirectly) related to bringing an item to a saleable condition. Included in the cost could be:
Import Duties, Freight, Storage, Insurance, Testing, Construction
- Matching Principle – Inventory costs are expensed in the period that their revenue is recorded and inventory is relieved.
Internal Controls for Inventory
- Take a physical count of what is on hand
- Pre-numbered inventory tickets
- Counters are not responsible for the inventory
- Second count is done by a different also noninvolved person
- Manager confirms final count and the remaining tickets at the same time
Management Decisions made in Accounting for Inventory involve the following:
- The inventory is at cost
- The inventory uses an approved and consistent costing method ( Specific Invoice, FIFO, LIFO, or Weighted Average)
- The inventory system is based on Perpetual or Periodic Methods
- They use market values or other approved estimates.
- There are four methods that are used to determine the value of the inventory and the value of what was sold. They are:
Specific Identification – This uses the invoice to identify exactly what was sold. This is used for expensive high end products. About 4% of companies use it.
FIFO – First-in-first-out. – This refers to the way inventory is moved. My first or oldest purchases are the first part of the inventory that is sold. What you are left with in inventory is your most recent purchases. 46% of the companies use this method.
LIFO – Last-in-first-out – This also refers to the way inventory is moved. My most recent purchases are the ones that I sell first. This leaves an ending inventory of my oldest purchases. This method comes the closest to the matching principle due to the timing of the inventory. 40% of the companies use this one.
Weighted Average - Here you first calculate the cost of a unit based on all of the remaining inventories purchased using their original cost, divided by the total remaining units in inventory to get a per unit cost. You then apply that unit cost to how much inventory was sold and how much inventory remains. This method is used 20% of the time.
- Tracks units & dollars of a product with how much was purchased and how much was sold.
Different methods report different results:
Specific Identification – This depends on the cost of the product
FIFO - assigns lowest amount to COGS, highest to G/P & N/I
LIFO – assigns highest amount to COGS, lowest to G/P & N/I, tax advantage
Weighted Average – produces somewhere between FIFO & LIFO
In reporting inventory valuation and cogs the Consistency Concept must be followed. It states that a company must use the same accounting methods from year to year in order to have meaningful comparisons across accounting periods. Different methods can be used for different categories across an inventory.
One exception is the use of the Full Disclosure Principle which allows you to tell of items that can potentially affect a future period’s net income.
LCM – Lower of cost or market. – Inventory is reported at the market value (cost) of replacing it when the market value is lower than its original cost. When the recorded cost of inventory is lower than market value no adjustment is needed.
There are three ways to apply LCM:
- To each item separately
- To major categories
- To inventory as a whole
The J/E is: Dr. COGS, Cr. Merchandise Inventory
Inventory errors will eventually fix themselves over a period of time. The current year of the error will be wrong and the following year as well. COGS and N/I will be affected. When averaged over time there will be no effect.
Inventory Turnover – How many times an inventory will turnover. (completely sells out) A high ratio is good. The formula is: COGS / Average Inventory
(Average is only the current year and last year divided by two)
Days in Sales in Inventory – How many days it would take to sell entire inventory without adding to it. The formula is: Ending Inventory/ COGS x 365
Demo Problem pg 238-242