Lesson Notes
Lesson 7 Merchandise Inventories and Cost of Sales
Learning Objectives
Identify the items included in merchandise inventory.
Identify the costs of merchandise inventory.
Compute the cost of goods sold and ending merchandise inventory in a perpetual system using the costing methods of specific identification,moving weighted average,FIFO,and LIFO.
Analyze the effects of the choice between inventory costing methods on financial reporting.
Compute the lower of cost or market value of inventory.
Analyze the effects of inventory errors on current and future financial statements.
Apply both the gross profit and retail methods to estimate inventory.
Teaching Hours
Students major in accounting,5 hours
Other students,3 hours
Teaching Contents
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 China’s 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.
Items included in inventory
Merchandise inventory includes goods held for resale,Assets not normally held for resale are excluded from merchandise inventory,
An important aspect of inventory accounting is determining inventory ownership,Goods in transit are to be included in the buyer’s inventory when ownership has passed to the buyer,If the buyer is responsible for freight charges (FOB factory or shipping point),ownership passes to the buyer as soon as goods are loaded aboard the carrier,If the seller pays for the freight charges (FOB destination),ownership passes to the buyer only when the goods arrive at the destination.
When one company (the transferor or consignor) transfers inventory to another company (the transferee or consignee) without transferring title to that inventory,the arrangement is known as a consignment,Goods on consignment belong to the owner (consignor) even though they are physically located at the consignee’s business place,Consigned goods should be omitted from the consignee’s inventory count,When the goods are ultimately sold,the consignee will remit to the consignor an amount equal to the selling price of the goods,less any commissions and reimbursable expenses incurred by the consignee.
Damaged,deteriorated,or obsolete goods should be omitted from inventory if not saleable,If saleable at a reduced price and below cost,they should be included in inventory at their net realizable value (sales price less the cost of making the sale).
Elements of inventory cost
The cost of inventory includes all expenditures made in bringing the goods or assets to their existing condition and location for sale,Inventory cost therefore equals invoice price less discounts,plus transportation,storage,import duties,insurance,and other costs of preparing the inventory for sale,These additional or incidental costs add value to the inventory and should be included in the purchase cost,In certain cases,however,the materiality principle allows firms to charge incidental costs as expenses of the period,and not include them in inventory,Such a practice is justified if the effort of computing costs on a precise basis outweighs the benefit from the extra accuracy.
Four generally accepted methods of determining inventory costs
Specific identification inventory costing method
The specific identification inventory costing method identifies and uses the purchase invoice of each item sold to determine the cost assigned to cost of goods sold and to the ending inventory,Exact matching is possible when each item in inventory can be identified with a specific purchase,Specific identification will produce identical results under either a perpetual or a periodic inventory system.
First in,first out (FIFO) inventory costing method
The first in,first out inventory costing method is based on the assumption that the first items received were the first items sold,In other words,items in the beginning inventory or the oldest items are assumed to be sold first,The most recent inventory purchased is assumed to remain in ending inventory,For many businesses,this is the actual flow of goods,FIFO will produce identical results under both the perpetual and periodoic inventory systems.
Last in,first out (LIFO) inventory costing method
The last in,first out inventory costing method is based on the assumption that the last items received were the first items sold,In other words,the most recent purchases are assumed to be sold first and the old goods remain in inventory,However,the assumed flow of goods can differ from the actual physical flow,(The results under LIFO periodic differ from LIFO perpetual.),During inflationary times,recent costs are higher than old costs,resulting in higher cost of goods sold,lower net income,and lower income taxes,
Weighted average inventory costing method
The weighted average inventory costing method uses a weighted average cost per inventory unit in assigning cost to units sold and to inventory,A weighted average cost of goods available for sale is recalculated at the time of each purchase,Notice that the most current average cost is used to calculate the cost of each sale,Weighted-average will produce different results under a perpetual than under a periodic inventory system.
Inventory errors
Review the following equations that apply under both a perpetual and periodic inventory system:
Transportation-in
Cost of goods sold = Cost of goods available for sale – Ending inventory
Therefore,
The amount of ending inventory appears on the balance sheet,affects cost of goods sold on the current income statement (through ending inventory),and the following year’s income statement (through beginning inventory),Consequently,an error in determining the amount of inventory will affect each of these statements,Inventory errors might occur as a result of miscounting inventory items or failure to price inventory items correctly,Errors also occur due to improper recognition being given to inventory that is still in transit,For example,goods purchased FOB shipping point belong to the buyer when in transit and should be included in the buyer’s inventory.
In the current year,an overstatement of ending inventory results in:
current assets being overstated
cost of goods sold being understated
gross profit being overstated
net income being overstated
owner’s equity being overstated
The effect on the following year is:
beginning inventory is overstated
cost of goods sold is overstated
gross profit is understated
net income is understated
owner’s equity is now properly stated
An inventory error will self-correct in the following period,resulting in owner’s equity being properly stated after the second period,Total net income over the two periods is correct,although the allocation between periods was in error,If gross profit is overstated in year 1 but understated in year 2 by the same amount,then owner’s equity will have the correct balance after year 2,Although inventory errors self-correct,they distort management’s interpretation of the earnings trend,This may consequently lead management to make poor decisions,
Lower of cost or market
GAAP require that inventory be reported at market value whenever market value is lower than cost,This is the lower of cost or market (LCM) rule.
The following points are essential to understand LCM:
The cost of ending inventory is determined by using one of the four inventory pricing methods,On the balance sheet,inventory is reported at market value whenever market is lower than the cost reported under the chosen pricing method.
Cost is the price paid for an item,Market value is defined as net realizable value (NRV),which is sales price less additional costs to sell,or as replacement cost,which is the price that would have to be paid to purchase (replace) the item on the inventory date,
If the market value of inventory falls below its original cost,a holding loss occurs,It is likely that the sales price of inventory will also decrease,The holding loss should be recorded in the period during which the price declined,This is the basic concept of LCM.
LCM allocates holding losses to the period during which a firm holds inventory,and all remaining income to the period during which merchandise is sold.
LCM may be applied to the inventory as a whole,by major category,or separately to each product in the inventory,
Estimating inventories
Inventory estimation can be used in preparing interim financial statements to determine if the physical inventory count is reasonable or in determining the amount of inventory lost in a flood,destroyed in a fire,or stolen,The two common methods of inventory estimation are the gross profit method and the retail inventory method.
Retail inventory method
The retail inventory method is used to estimate the amount of ending inventory based on a cost ratio,according to the following formula:
Cost ratio =
Using the retail method of inventory estimation,interim financial statements can be prepared monthly or quarterly without a physical inventory count,The ending inventory is estimated by converting retail prices (or the marked selling price) to cost amounts,Records must be kept at both cost and retail as follows:
At cost:
Goods available for sale = Beginning inventory + Net purchases
At retail:
Ending inventory = Beginning inventory + Net purchases – Net sales
The cost ratio is applied to ending inventory at retail prices to estimate ending inventory at cost,
The retail method merely provides an inventory estimate,The physical inventory can then be compared to the estimated inventory,Any difference will be an estimate of shortages due to breakage,loss,or theft,At least once a year,a company should take a physical inventory to correct any errors or shortages.
Gross profit method
The gross profit method is used to estimate inventory for insurance purposes after a break-in,fire,or flood,or for checking the accuracy of a physical inventory count,The gross profit method uses the past gross profit rate to estimate the ending inventory as the difference between goods available for sale and cost of goods sold,It is an approximation technique that applies an estimated gross profit rate to net sales,
Gross profit ratio =
The gross profit ratio is applied to estimate the ending inventory using the following formulas:
Net sale at retail X (1-gross profit ratio) = Estimated cost of goods sold
Goods available for sale at cost – Estimated cost of goods sold = Estimated ending inventory at cost
The gross profit rate is an average of the percentages for many products,As a result,estimated inventory represents an approximation,If prices during the current period differ from normal conditions,the gross profit method will yield less-than-accurate results.
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 year’s 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.
Required:
What’s 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.
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 methods 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.
Key Points
items included in merchandise inventory
costs of merchandise inventory
inventory costing methods
lower of cost or market
inventory errors
inventory estimations
Reading material
Larson,K.D.,T,Jensen,and R,Carroll,2002,Fundamental Accounting Principles,McGraw-Hill Ryerson.
Libby,R.,P.A,Libby,D.G,Short,G,Kanaan,and M,Gowing,2003,Financial Accounting,McGraw-Hill Ryerson.
Abdel-Khalik,A.R.,The effect of LIFO-Switching and Firm Ownership on Executive Pay,Journal of Accounting Research (Autumn 1985),427-477,
Cushing,B.E,and M.J,Leclere,Evidence on the Determinants of Inventory Accounting Policy Choice,The Accounting Review (April 1992),355-366.
Dopuch,N,and M,Pincus,Evidence on the Choice of Inventory Accounting Methods,LIFO vs,FIFO,Journal of Accounting Research (Spring 1988),28-59.
Lesson 7 Merchandise Inventories and Cost of Sales
Learning Objectives
Identify the items included in merchandise inventory.
Identify the costs of merchandise inventory.
Compute the cost of goods sold and ending merchandise inventory in a perpetual system using the costing methods of specific identification,moving weighted average,FIFO,and LIFO.
Analyze the effects of the choice between inventory costing methods on financial reporting.
Compute the lower of cost or market value of inventory.
Analyze the effects of inventory errors on current and future financial statements.
Apply both the gross profit and retail methods to estimate inventory.
Teaching Hours
Students major in accounting,5 hours
Other students,3 hours
Teaching Contents
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 China’s 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.
Items included in inventory
Merchandise inventory includes goods held for resale,Assets not normally held for resale are excluded from merchandise inventory,
An important aspect of inventory accounting is determining inventory ownership,Goods in transit are to be included in the buyer’s inventory when ownership has passed to the buyer,If the buyer is responsible for freight charges (FOB factory or shipping point),ownership passes to the buyer as soon as goods are loaded aboard the carrier,If the seller pays for the freight charges (FOB destination),ownership passes to the buyer only when the goods arrive at the destination.
When one company (the transferor or consignor) transfers inventory to another company (the transferee or consignee) without transferring title to that inventory,the arrangement is known as a consignment,Goods on consignment belong to the owner (consignor) even though they are physically located at the consignee’s business place,Consigned goods should be omitted from the consignee’s inventory count,When the goods are ultimately sold,the consignee will remit to the consignor an amount equal to the selling price of the goods,less any commissions and reimbursable expenses incurred by the consignee.
Damaged,deteriorated,or obsolete goods should be omitted from inventory if not saleable,If saleable at a reduced price and below cost,they should be included in inventory at their net realizable value (sales price less the cost of making the sale).
Elements of inventory cost
The cost of inventory includes all expenditures made in bringing the goods or assets to their existing condition and location for sale,Inventory cost therefore equals invoice price less discounts,plus transportation,storage,import duties,insurance,and other costs of preparing the inventory for sale,These additional or incidental costs add value to the inventory and should be included in the purchase cost,In certain cases,however,the materiality principle allows firms to charge incidental costs as expenses of the period,and not include them in inventory,Such a practice is justified if the effort of computing costs on a precise basis outweighs the benefit from the extra accuracy.
Four generally accepted methods of determining inventory costs
Specific identification inventory costing method
The specific identification inventory costing method identifies and uses the purchase invoice of each item sold to determine the cost assigned to cost of goods sold and to the ending inventory,Exact matching is possible when each item in inventory can be identified with a specific purchase,Specific identification will produce identical results under either a perpetual or a periodic inventory system.
First in,first out (FIFO) inventory costing method
The first in,first out inventory costing method is based on the assumption that the first items received were the first items sold,In other words,items in the beginning inventory or the oldest items are assumed to be sold first,The most recent inventory purchased is assumed to remain in ending inventory,For many businesses,this is the actual flow of goods,FIFO will produce identical results under both the perpetual and periodoic inventory systems.
Last in,first out (LIFO) inventory costing method
The last in,first out inventory costing method is based on the assumption that the last items received were the first items sold,In other words,the most recent purchases are assumed to be sold first and the old goods remain in inventory,However,the assumed flow of goods can differ from the actual physical flow,(The results under LIFO periodic differ from LIFO perpetual.),During inflationary times,recent costs are higher than old costs,resulting in higher cost of goods sold,lower net income,and lower income taxes,
Weighted average inventory costing method
The weighted average inventory costing method uses a weighted average cost per inventory unit in assigning cost to units sold and to inventory,A weighted average cost of goods available for sale is recalculated at the time of each purchase,Notice that the most current average cost is used to calculate the cost of each sale,Weighted-average will produce different results under a perpetual than under a periodic inventory system.
Inventory errors
Review the following equations that apply under both a perpetual and periodic inventory system:
Transportation-in
Cost of goods sold = Cost of goods available for sale – Ending inventory
Therefore,
The amount of ending inventory appears on the balance sheet,affects cost of goods sold on the current income statement (through ending inventory),and the following year’s income statement (through beginning inventory),Consequently,an error in determining the amount of inventory will affect each of these statements,Inventory errors might occur as a result of miscounting inventory items or failure to price inventory items correctly,Errors also occur due to improper recognition being given to inventory that is still in transit,For example,goods purchased FOB shipping point belong to the buyer when in transit and should be included in the buyer’s inventory.
In the current year,an overstatement of ending inventory results in:
current assets being overstated
cost of goods sold being understated
gross profit being overstated
net income being overstated
owner’s equity being overstated
The effect on the following year is:
beginning inventory is overstated
cost of goods sold is overstated
gross profit is understated
net income is understated
owner’s equity is now properly stated
An inventory error will self-correct in the following period,resulting in owner’s equity being properly stated after the second period,Total net income over the two periods is correct,although the allocation between periods was in error,If gross profit is overstated in year 1 but understated in year 2 by the same amount,then owner’s equity will have the correct balance after year 2,Although inventory errors self-correct,they distort management’s interpretation of the earnings trend,This may consequently lead management to make poor decisions,
Lower of cost or market
GAAP require that inventory be reported at market value whenever market value is lower than cost,This is the lower of cost or market (LCM) rule.
The following points are essential to understand LCM:
The cost of ending inventory is determined by using one of the four inventory pricing methods,On the balance sheet,inventory is reported at market value whenever market is lower than the cost reported under the chosen pricing method.
Cost is the price paid for an item,Market value is defined as net realizable value (NRV),which is sales price less additional costs to sell,or as replacement cost,which is the price that would have to be paid to purchase (replace) the item on the inventory date,
If the market value of inventory falls below its original cost,a holding loss occurs,It is likely that the sales price of inventory will also decrease,The holding loss should be recorded in the period during which the price declined,This is the basic concept of LCM.
LCM allocates holding losses to the period during which a firm holds inventory,and all remaining income to the period during which merchandise is sold.
LCM may be applied to the inventory as a whole,by major category,or separately to each product in the inventory,
Estimating inventories
Inventory estimation can be used in preparing interim financial statements to determine if the physical inventory count is reasonable or in determining the amount of inventory lost in a flood,destroyed in a fire,or stolen,The two common methods of inventory estimation are the gross profit method and the retail inventory method.
Retail inventory method
The retail inventory method is used to estimate the amount of ending inventory based on a cost ratio,according to the following formula:
Cost ratio =
Using the retail method of inventory estimation,interim financial statements can be prepared monthly or quarterly without a physical inventory count,The ending inventory is estimated by converting retail prices (or the marked selling price) to cost amounts,Records must be kept at both cost and retail as follows:
At cost:
Goods available for sale = Beginning inventory + Net purchases
At retail:
Ending inventory = Beginning inventory + Net purchases – Net sales
The cost ratio is applied to ending inventory at retail prices to estimate ending inventory at cost,
The retail method merely provides an inventory estimate,The physical inventory can then be compared to the estimated inventory,Any difference will be an estimate of shortages due to breakage,loss,or theft,At least once a year,a company should take a physical inventory to correct any errors or shortages.
Gross profit method
The gross profit method is used to estimate inventory for insurance purposes after a break-in,fire,or flood,or for checking the accuracy of a physical inventory count,The gross profit method uses the past gross profit rate to estimate the ending inventory as the difference between goods available for sale and cost of goods sold,It is an approximation technique that applies an estimated gross profit rate to net sales,
Gross profit ratio =
The gross profit ratio is applied to estimate the ending inventory using the following formulas:
Net sale at retail X (1-gross profit ratio) = Estimated cost of goods sold
Goods available for sale at cost – Estimated cost of goods sold = Estimated ending inventory at cost
The gross profit rate is an average of the percentages for many products,As a result,estimated inventory represents an approximation,If prices during the current period differ from normal conditions,the gross profit method will yield less-than-accurate results.
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 year’s 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.
Required:
What’s 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.
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 methods 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.
Key Points
items included in merchandise inventory
costs of merchandise inventory
inventory costing methods
lower of cost or market
inventory errors
inventory estimations
Reading material
Larson,K.D.,T,Jensen,and R,Carroll,2002,Fundamental Accounting Principles,McGraw-Hill Ryerson.
Libby,R.,P.A,Libby,D.G,Short,G,Kanaan,and M,Gowing,2003,Financial Accounting,McGraw-Hill Ryerson.
Abdel-Khalik,A.R.,The effect of LIFO-Switching and Firm Ownership on Executive Pay,Journal of Accounting Research (Autumn 1985),427-477,
Cushing,B.E,and M.J,Leclere,Evidence on the Determinants of Inventory Accounting Policy Choice,The Accounting Review (April 1992),355-366.
Dopuch,N,and M,Pincus,Evidence on the Choice of Inventory Accounting Methods,LIFO vs,FIFO,Journal of Accounting Research (Spring 1988),28-59.
