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Chapter 7 Inventories 2009 The McGraw-Hill Companies, Inc. Slide 2 McGraw-Hill/Irwin Slide 2 Reporting Inventory and Cost of Goods Sold Merchandisers Usually hold merchandise inventory, which they acquire in finished condition, ready for sale without further processing. Manufacturers Often hold three types of inventory, each of which represents a different stage in the manufacturing process. AMERICAN EAGLE OUTFITTERS, INC. Partial Consolidated Balance Sheet At January 31, 2007 (in millions) Assets Current assets: Cash and cash equivalents $60 Short-term investments 767 Merchandise inventory 264 Accounts and note receivable 26 Prepaid expenses and other 34 AMERICAN EAGLE OUTFITTERS, INC. Partial Consolidated Income Statement For the Year Ended January 31, 2007 (in millions) Assets Net sales $2,794 Cost of goods sold 1,454 Gross profit 1,340 Slide 3 McGraw-Hill/Irwin Slide 3 Cost of Goods Sold Equation Beginning Inventory $40,000 Purchases $55,000 Cost of Goods Available for Sale $95,000 Cost of Goods Available for Sale $95,000 Ending Inventory $35,000 Ending Inventory $35,000 Cost of Goods Sold $60,000 Cost of Goods Sold $60,000 Still here Sold (Balance Sheet)(Income Statement) BI + P CGS = EI Slide 4 McGraw-Hill/Irwin Slide 4 Cost of Goods Sold Equation Cost of Goods Sold Calculation Beginning inventory $40,000 Plus: Purchases of merchandise during the year 55,000 Goods available for sale 95,000 Less: Cost of goods sold 60,000 Ending inventory $35,000 + Merchandise Inventory (A) - BI 40,000 P 55,000 60,000 CGS EI 35,000 Slide 5 McGraw-Hill/Irwin Slide 5 Inventory Costing Methods 5/3 Purchased 1 units of Product A for $70 5/5 Purchased 1 units of Product A for $75 5/6 Purchased 1 units of Product A for $95 5/8 Sold 2 units of Product A for $125 each. How do we determine cost of goods sold when the same inventory item is purchased at different prices? Generally accepted inventory costing methods provide four methods of dealing with this problem: 1.Specific identification, 2.First-in, first-out (FIFO), 3.Last-in, first-out (LIFO), and 4.Weighted average Slide 6 McGraw-Hill/Irwin Slide 6 May 3 $70 May 5 $75 Inventory Costing Methods May 6 $95 May 3 $70 May 5 $75 May 6 $95 May 3 $70 May 5 $75 May 6 $95 FIFOLIFOWeighted average Income Statement Net sales $250 Cost of goods sold 145 Gross profit $105 Balance Sheet Inventory $95 Income Statement Net sales $250 Cost of goods sold 170 Gross profit $80 Balance Sheet Inventory $70 Income Statement Net sales $250 Cost of goods sold 160 Gross profit $90 Balance Sheet Inventory $80 $240 3 = $80 2 $80 1 $80 Slide 7 McGraw-Hill/Irwin Slide 7 Cost-Flow Methods Under a Perpetual Inventory System In a perpetual inventory system all inventory purchases, and sales and cost of goods sold are recorded in sequence as they occur. Consider the following information provided by American Eagle for it AE Alpine Bomber Jacket, each selling for $150 per unit. DateDescriptionUnits Unit Cost Total Cost Balance in Units Jan. 1 Beginning inventory20 $70 $1,40020 Jan. 12 Purchase60 80 4,80080 Jan. 17 Sale50 30 Jan. 19 Purchase 20 100 2,00050 Jan. 26 Sale32 18 $8,200 Slide 8 McGraw-Hill/Irwin Slide 8 First-In, First-Out Method FIFO FIFO Perpetual Calculations PurchasesCost of Goods SoldInventory Balance Units Unit Cost Total CostUnits Unit Cost Total CostUnits Unit Cost Total Cost Jan. 1 Beginning inventory 20 $70 $1,400 Jan. 12 Purchase60 $80 $4,800 60 80 4,800 Jan. 17 Sale 20 $70 $1,400 30 80 2,40030 80 2,400 Jan. 19 Purchase20 100 2,000 20 100 2,000 Jan. 26 Sale 30 80 2,40018 100 1,800 2 100 200 Totals80 $6,80082 $6,40018 $1,800 Slide 9 McGraw-Hill/Irwin Slide 9 Last-In, First-Out Method (LIFO) LIFO Perpetual Calculations PurchasesCost of Goods SoldInventory Balance Units Unit Cost Total CostUnits Unit Cost Total CostUnits Unit Cost Total Cost Jan. 1 Beginning inventory 20 $70 $1,400 Jan. 12 Purchase60 $80 $4,800 60 80 4,800 Jan. 17 Sale 50 $80 $4,00020 70 1,400 10 80 800 Jan. 19 Purchase20 100 2,000 20 100 2,000 Jan. 26 Sale 20 100 2,00018 100 1,800 10 80 800 2 70 140 Totals80 $6,80082 $6,94018 $1,260 Slide 10 McGraw-Hill/Irwin Slide 10 Weighted Average Cost Method Weighted Average - Perpetual PurchasesCost of Goods SoldInventory Balance Units Unit CostTotal CostUnitsUnit CostTotal CostUnitsUnit CostTotal Cost Jan. 1 Beginning inventory 20 $70.00 $1,400 Jan. 12 Purchase60 $80 $4,800 60 80.00 4,800 Jan. 17 Sale 50 $77.50 $3,87530 77.50 2,325 Jan. 19 Purchase20 100 2,000 20 100.00 2,000 Jan. 26 Sale 32 86.50 2,76818 86.50 1,557 Totals80 $6,80082 $6,64318 $1,557 ($1,400 + $4,800) (20 + 60) = $77.50 per unit ($2,325 + $2,000) (30 + 20) = $86.50 per unit Slide 11 McGraw-Hill/Irwin Slide 11 Financial Statement Effects of Inventory Costing Methods FIFOLIFOWAC Effect on the Income Statement Sales $12,300 Cost of goods sold 6,400 6,940 6,643 Gross Profit 5,900 5,360 5,657 Effect on the Balance Sheet Inventory $1,800 $1,260 $1,557 Increasing Costs Effects of Increasing Costs on the Financial Statements FIFOLIFO Inventory on balance sheet Higher Lower Cost of goods sold on income statement Lower Higher Slide 12 McGraw-Hill/Irwin Slide 12 Financial Statement Effects of Inventory Costing Methods FIFOLIFOWAC DebitCreditDebitCreditDebitCredit Jan. 12 Inventory (+A) 4,800 Accounts Payable (+L) 4,800 Jan. 17 Cash (+A) 7,500 Sales Revenue (+R, +OE) 7,500 Cost of Goods Sold (+E, -OE) 3,800 4,000 3,875 Inventory (-A) 3,800 4,000 3,875 Jan. 19 Inventory (+A) 2,000 Accounts Payable (+L) 2,000 Jan. 26 Cash (+A) 4,800 Sales Revenue (+R, +OE) 4,800 Cost of Goods Sold (+E, -OE) 2,600 2,940 2,768 Inventory (-A) 2,600 2,940 2,768 Slide 13 McGraw-Hill/Irwin Slide 13 Do It The accounting records of Shumway AG Implement show the following data: Beginning Inventory4000 units @ $3 Purchases6000 units @ $4 Sales7000 units @ $12 Determine the Cost of Goods sold during the period using the a)FIFO Method b)LIFO Method c)Average method Slide 14 McGraw-Hill/Irwin Slide 14 Identifying the Effects of Inventory Errors Errors in inventory valuations can significantly affect both the balance sheet and the income statement. As the cost of goods sold equation indicates, there is a direct relationship between ending inventory and the cost of goods sold: items that are not in the ending inventory are assumed to have been sold. So, errors in ending inventory will affect both the balance sheet (current assets) and the income statement (cost of goods sold, gross profit, and net income). Slide 15 McGraw-Hill/Irwin Slide 15 Income Statement Effect Lets assume that ending inventory was overstated by $10,000 due to an error that was not discovered until the following year. Current Year Beginning inventoryAccurate +Purchases of merchandise during the yearAccurate Goods available for saleAccurate Ending inventory (balance sheet)Overstated $10,000 =Cost of goods sold (income statement)Understated $10,000 Next Year Beginning inventoryOverstated $10,000 +Purchases of merchandise during the yearAccurate Goods available for saleOverstated $10,000 Ending inventory (balance sheet)Accurate =Cost of goods sold (income statement)Overstated $10,000 Slide 16 McGraw-Hill/Irwin Slide 16 Income Statement Effect Current Year With the ErrorWithout the Error Sales $120,000 Beginning inventory $50,000 Purchases 75,000 Cost of goods available for sale 125,000 Ending inventory 45,000 35,000 Cost of goods sold 80,000 90,000 Gross profit 40,000 30,000 Operating expenses 10,000 Net income $30,000 $20,000 Next Year With the ErrorWithout the Error Sales $110,000 Beginning inventory $45,000 $35,000 Purchases 70,000 Cost of goods available for sale 115,000 105,000 Ending inventory 20,000 Cost of goods sold 95,000 85,000 Gross profit 15,000 25,000 Operating expenses 10,000 Net income $5,000 $15,000 Overstated $10,000 Understated $10,000 Lets assume that ending inventory was overstated by $10,000 due to an error that was not discovered until the following year. Slide 17 McGraw-Hill/Irwin Slide 17 Balance Sheet Effects Year Endng Inventory ErrorAssetsOwners' Equity CurrentOverstated $10,000 NextAccurate Slide 18 McGraw-Hill/Irwin Slide 18 Supplement A: Periodic Inventory System In a periodic inventory system the computations are made as if all purchases during the period take place before any sales or cost of goods sold are recorded. Consider the following information provided by American Eagle relating to its AE Alpine Bomber Jacket for the month of January. UnitTotal DateDescriptionUnitsCost Jan. 1Beginning inventory 20 $70 $1,400 Jan. 12Purchase 60 80 4,800 Jan. 19Purchase 20 100 2,000 Sales during the month (82) $8,200 BI + P EI = CGS Slide 19 McGraw-Hill/Irwin Slide 19 First-In, First-Out Method (FIFO) Cost of Goods Sold and Ending Inventory Calculation (FIFO) Beginning inventory(20 units at $70 each) $1,400 Add: Purchases(60 units at $80 each) 4,800 (20 units at $100 each) 2,000 Goods available for sale $8,200 Less: Ending Inventory(18 units at $100 each) 1,800 Cost of goods sold $6,400 Cost of Goods Sold (20 $70) $1,400 (60 $80) 4,800 (2 $100) 200 $6,400 Slide 20 McGraw-Hill/Irwin Slide 20 Last-In, First-Out Method (LIFO) Cost of Goods Sold and Ending Inventory Calculation (LIFO) Beginning inventory(20 units at $70 each) $1,400 Add: Purchases(60 units at $80 each) 4,800 (20 units at $100 each) 2,000 Goods available for sale $8,200 Less: Ending Inventory(18 units at $70 each) 1,260 Cost of goods sold $6,940 Cost of Goods Sold (2 $70) $140 (60 $80) 4,800 (20 $100) 2,000 $6,940 Slide 21 McGraw-Hill/Irwin Slide 21 Average Cost Method (WAC) Cost of Goods Sold and Ending Inventory Calculation (WAC) Beginning inventory(20 units at $70 each) $1,400 Add: Purchases(60 units at $80 each) 4,800 (20 units at $100 each) 2,000 Goods available for sale $8,200 Less: Ending Inventory(18 units at $82 each) 1,476 Cost of goods sold(82 units at $82 each) $6,724 $8,200 100 units = $82 Average Cost Slide 22 McGraw-Hill/Irwin Slide 22 Financial Statement Effects of Inventory Costing Methods FIFOLIFOWAC Effect on the Income Statement Sales $12,300 Cost of goods sold 6,400 6,940 6,724 Gross Profit 5,900 5,360 5,576 Effect on the Balance Sheet Inventory $1,800 $1,260 $1,476 Increasing Costs Effects of Increasing Costs on the Financial Statements FIFOLIFO Inventory on balance sheet Higher Lower Cost of goods sold on income statement Lower Higher