Lesson 7 Merchandise Inventories and Cost of Sales

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Lesson 7 Merchandise Inventories and Cost of
Sales

• Task Team of
• FUNDAMENTAL ACCOUNTING
• School of Business, Sun Yat-sen University

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Outline

• Flow of inventory cost
• Items and costs of merchandising inventory
• Assigning costs to inventory
• Lower of cost or market
• Errors in measuring inventory
• Inventory estimating method

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Introduction

• While sales and purchases are the focus of
  operations, inventory is no less important.
  Inventory costing and evaluation methods can
  substantially influence the bottom line. Since
  Chinas listed companies were permitted to write
  down inventories in 1998, inventory has long been
  criticized as the income adjustor. Besides,
  inventory costing policies and the scope of
  inventory can also significant change the current
  and future years income numbers.

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Nature of Inventory and Cost of Goods Sold
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Flow of Inventory Costs
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Accounting for Inventory

• Accounting for inventory requires several
  decisions which include
• Items to include in cost.
• Inventory System.
• Perpetual or Periodic
• Costing Method.
• FIFO, LIFO, Weighted Average, Specific ID
• Use of estimates.
• Gross profit method, Retail inventory method

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Items in Merchandise Inventory

• Inventory includes all goods owned by a company
  and held for sale.
• Items requiring special attention
• Goods in Transit
• Goods on consignment
• Obsolete or damaged goods

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Costs of Merchandise Inventory

• All expenditures necessary to bring an item to a
  saleable condition and location.
• This includes
• Invoice price less discounts
• Import duties
• Transportation-in
• Storage
• Insurance

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Assigning Costs to Inventory

• Management must decide on method of determining
  unit cost.
• This will affect both the income statement and
  the balance sheet.
• Methods
• Specific Identification
• FIFO
• LIFO
• Average Cost

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Specific Identification

• This method is used when items
• Are unique.
• Can be directly identified with a specific
  purchase and its invoice.

Examples Automobiles, custom furniture, art.
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Specific Identification-Example
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Specific Identification-Example
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Specific Identification-Example
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Specific Identification-Example
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First-In, First-Out (FIFO)

• Based on the assumption that the items are sold
  in the order acquired.
• When a sale occurs
• The earliest units purchased are charged to Cost
  of Goods Sold.
• The cost of the most recent purchases remain in
  inventory

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FIFO-Example
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FIFO-Example
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FIFO-Example
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Last-In, First-Out (LIFO)

• Based on the assumption that the most recently
  purchased items are sold first.
• When a sale occurs
• The latest units purchased are charged to Cost of
  Goods Sold.
• The cost of the earliest purchases remain in
  inventory.

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LIFO-Example
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LIFO-Example
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LIFO-Example
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Moving Weighted Average Method

• Under this method, the cost of all units are
  averaged together.

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Moving Weighted Average-Example
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Moving Weighted Average-Example
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Moving Weighted Average-Example
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Financial Reporting

• Because prices change, the choice of an inventory
  method influences both income statement and the
  balance sheet.

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Lower of Cost or Market

• Inventory must be reported at market value when
  market is lower than cost (conservatism
  principle).
• Market may be defined as
• Net realizable value
• Current replacement cost
• May be applied in one of three ways
• Separately to each item.
• To major categories of items.
• To the inventory as a whole.

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Lower of Cost or Market

• A motor retailer has the following items in
  inventory

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Lower of Cost or Market

• Compute lower of cost or market for individual
  inventory items.

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Lower of Cost or Market

• Compute lower of cost or market for the two
  groups of inventory items.

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Lower of Cost or Market

• Compute lower of cost or market for the entire
  inventory.

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Errors in Measuring Inventory
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Retail Inventory Method

• Occasionally used for interim period reporting.
• Needed information includes
• Beginning inventory at cost and retail.
• Net purchases at cost and retail.
• Net sales.

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Retail Inventory Method
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Retail Inventory Method
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Retail Inventory Method
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Retail Inventory Method
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Gross Profit Method

• Estimate ending inventory by applying the gross
  profit ratio to net sales at retail.
• Useful when inventories have been destroyed, lost
  or stolen.

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Gross Profit Method
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Gross Profit Method

• In March of 2002, CheTec Companys inventory was
  destroyed by fire. CheTecs normal gross profit
  ratio is 40 of net sales. At the time of the
  fire, CheTec showed the following balances

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Gross Profit Method
Step 1
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Gross Profit Method
Step 2
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Discussion Case

• Northeast Pharmaceutical
• When preparing financial statement of 1996,
  Northeast Pharmaceutical recorded RMB 21,280,000
  expenses as inventory cost, which carries to next
  years beginning inventory. As a result, the
  bottom line is RMB 19,950,000 profits, instead of
  a big loss. This was discovered and was fined by
  CSRC as securities fraud.

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Discussion Case

• Required
• Whats the difference between expenses and
  inventory costs?
• What are the impacts of inventory errors on
  financial statements?
• Why Northeast Pharmaceutical chose to report
  false income numbers?
• How to prevent the occurrence of such kind of
  cases.

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Summary

• Inventory includes all goods owned by a company
  and held for sale.
• Costs of merchandise inventory include all
  expenditures necessary to bring an item to a
  saleable condition and location.
• There are four method to assigning costs to
  inventory specific identification, FIFO, LIFO
  and average cost. The average cost method
  smoothes out purchase price changes. Ending
  inventory under FIFO approximates current
  replacement cost. LIFO better matches current
  cost in cost of goods sold with revenue.
• Inventory must be reported at market value when
  market is lower than cost.
• Retail inventory method and gross profit method
  can be used to estimate ending inventory.

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The End of Lesson 7