Chapter 6: Inventory and Cost of Goods Sold Learning Objective 1: Show how to account for inventory 1. How is the income statement of a service company different from the income statement of a merchandising company? 2. Comstock Company purchased 1,000 units of its product for $6 per unit. Comstock sold 800 units for $10 per unit. a. What is Comstock?s sales revenue? Sales revenue based on sales price of inventory sold =$6 per unit b. What is Comstock?s cost of goods sold? Cost of goods sold based on cost of inventory sold = $10 per unit c. What is Comstock?s inventory? Inventory based on cost of inventory on hand= $10 per unit d. What is the difference between inventory and cost of goods sold? Cost of goods sold and sales revenue? e. What is Comstock?s gross profit? Is gross profit an account? Gross profit, also called gross margin, is the excess of Sales revenue minus cost of goods sold. It is called gross profit because operating expenses have not yet been subtracted. 6000 ? 8000 = - 2000 3. Comstock Company counted their inventory at the end of the year and had 220 units. Included in that amount were 20 units Comstock held on consignment from Davidson Inc. Comstock purchased 50 units of inventory on December 27, FOB shipping point. How many units of inventory should Comstock report on its year-end balance sheet? 4. If a customer wants to know if Comstock Company has a particular item on hand, Comstock can look at their records to determine if the item is in stock. Does Comstock use a periodic or perpetual inventory system? How can you tell? If a customer wants to know if Comstock Company has a particular item on hand, Comstock can go into its warehouse and look to see if that item is on hand. Does Comstock use a periodic or perpetual inventory system? How can you tell? 5. Prepare journal entries for the following transactions as illustrated on pages 343-344 in the text. Post the transactions to the Inventory T-account. a. Purchase of inventory on account, $1,000, terms FOB shipping point, 2/10 n/30. Freight on the purchase was $10. b. Sale of inventory on account, $1,500; cost, $750: Inventory Beg. Bal. 10 c. What is the net cost of purchases? What is the basic rule in determining which items are included as a part of the inventory cost (pg. 345)? Learning Objective 2: Apply and compare various inventory cost methods 1. Comstock Company had 2 units ($5 unit cost) in inventory. Comstock purchased 10 units ($8 unit cost) in January and purchased another 3 units ($10 unit cost) in July. Comstock ended up with 3 units in its ending inventory (1 unit with a unit cost of $8 and 2 with a unit cost of $10). a. If Comstock used the specific unit cost method, what is the cost of the ending inventory? b. If Comstock used the average cost method, what is the cost of the ending inventory? c. If Comstock used the FIFO method, what is the cost of the ending inventory? d. If Comstock used the LIFO method, what is the cost of the ending inventory? IN-CLASS EXAMPLE A summary of the purchases of Draper Sales, Inc. during 2011 is given in the following table Cost/unit Purchases Beg. Inventory $30 600 units Mar. 6 32 1,400 June 1 34 1,000 Nov. 30 36 500 3,500 units Assume Draper sold 2,500 units during the year. First, compute the number of units in the ending inventory. Next, compute the ending inventory and COGS under each of the four methods below. A. Specific Unit cost--Assume that 200 units in the ending inventory were from the Nov 30 purchase and the remainder was from the June 1 purchase. B. FIFO C. LIFO D. Average cost 2. Indicate which inventory methods apply to the following statements In a period of rising prices? Specific-Unit-Cost FIFO LIFO Average Cost a. This method results in the highest ending inventory. b. This method results in the highest COGS. c. This method results in the lowest income taxes. d. This method results in the highest cash flow. e. This method allows a company to manipulate income by the timing of inventory purchases. f. This method is acceptable under IFRS. g. When the quantity of inventory falls, income under this method is higher. Learning Objective 3: Explain and apply underlying GAAP for inventory 1. Refer to the link below for the Nike annual report. Scroll down to Note 1 on page 41 on the annual report. What inventory method does Nike use? How does this relate to the disclosure principle? http://investors.nikeinc.com/Theme/Nike/files/doc_financials/AnnualReports/2011/docs/Nike_2011_10-K.pdf How does Nike apply the consistency principle to inventory? 2. Assume Nike has 100,000 pairs of shoes on hand at the end of the year that have a cost of $25 per pair. To replace these shoes, Nike would have to spend $22 per pair. What value for inventory should Nike report on its balance sheet? What is this called? How would your answer change if Nike would have to spend $27 per pair to replace the shoes in its inventory? CLASS EXAMPLE: Detailed Income Statement An example of a detailed income statement is presented below. Using the information presented below the income statement, fill in the missing information on the next page. Sales $106,000 Less: Sales returns and allowances $1,000 Sales discounts 5,000 (6,000) Net sales 100,000 COGS: Beginning inventory $10,000 Purchases $50,000 Less: Purchases returns and allowances (4,000) Purchase discounts (2,000) Add: Freight-in 1,000 Net purchases 45,000 Cost of goods available for sale (GAFS) 55,000 Less: Ending inventory 12,000 Cost of Goods Sold (COGS) 43,000 Gross profit 57,000 Operating Expenses: Selling expenses $10,000 Administrative expenses 12,000 22,000 Income before income tax 35,000 Income tax expense 10,000 Net income $25s000 Sales $ 102,000 Sales returns/allowances 4,000 Sales discounts 3,000 Net sales ? Beginning inventory 18,600 Purchases 66,000 Purchase returns/allowances 1,000 Purchase discounts 2,000 Freight-in 400 Ending inventory 22,000 COGS ? Selling expense 10,000 Administrative expenses 8,000 Income tax expense 5,000 Sales Less: Sales returns and allowances Sales discounts Net Sales Beginning inventory Purchases Less: Purchases returns and allowances Purchase discounts Add: Freight-in Net purchases Cost of goods available for sale (GAFS) Less: Ending inventory Cost of goods sold Gross profit Operating expenses: Selling expenses Administrative expenses Income before tax Income tax expense Net income Learning Objective 4: Compute and evaluate gross profit (margin) and inventory turnover 1. Refer to Target Corporation at Yahoo Finance or click on the following link: http://finance.yahoo.com/q?s=TGT Look for the following information for the most recent year and write it in the space provided. You can find this information by choosing the link from the box on the left for the income statement and/or balance sheet. a. Revenue b. Cost of revenue (COGS) c. Gross profit d. Beginning Inventory (earlier year) e. Ending Inventory (most recent year) Next, click on competitors (under Company). Click on WMT and look up the same information for this company as you did for Target. f. Which company has more Revenue? Does the same company that has more Revenue also have more inventory? g. Revenue h. Cost of revenue (COGS) i. Gross profit j. Beginning Inventory (earlier year) k. Ending Inventory (most recent year) 2. Compute the following for TGT: For WMT a. Gross profit % b. Inventory Turnover Inventory turnover in days 3. If the inventory turnover in days increased, would this be a good sign? What could Target do to improve the inventory turnover? Learning Objective 5: Use the COGS model to make management decisions 1. Comstock Company budgets the following information for 2012. How much inventory should the manager of Comstock purchase? Use the COGS model. Beginning inventory Ending inventory Net purchases $ 10,000 35,000 110,000 Sales Cost of goods sold 175,000 85,000 2. Assume Comstock was unable to count its ending inventory because it was destroyed in a fire. Use the gross profit method to estimate the ending inventory. The gross profit rate is 52%. Beginning inventory Ending inventory Net purchases Net sales $ 10,000 ? 110,000 175,000 Learning Objective 6: Analyze effects of inventory errors 1. In 2011, Comstock overstated its ending inventory $10,000 by accidentally double-counting some inventory stored in a warehouse. Net income for 2011 and 2012 was $126,000 and $132,000, respectively. Was 2011 net income overstated, understated, or correctly stated? What amount should have been reported for net income in 2011? Was 2012 net income overstated, understated, or correctly stated? What amount should have been reported for net income in 2012?

Chapter 6: Inventory and Cost of Goods Sold Learning Objective 1: Show how to account for inventory 1. How is the income statement of a service company different from the income statement of a merchandising company? 2. Comstock Company purchased 1,000 units of its product for $6 per unit. Comstock sold 800 units for $10 per unit. a. What is Comstock's sales revenue? Sales revenue based on sales price of inventory sold =$6 per unit b. What is Comstock's cost of goods sold? Cost of goods sold based on cost of inventory sold = $10 per unit c. What is Comstock's inventory? Inventory based on cost of inventory on hand = $10 per unit d. What is the difference between inventory and cost of goods sold? Cost of goods sold and sales revenue? e. What is Comstock's gross profit? Is gross profit an account? Gross profit, also called gross margin, is the excess of Sales revenue minus cost of goods sold. It is called gross profit because operating expenses have not yet been subtracted. 6000 - 8000 = - 2000 3. Comstock Company counted their inventory at the end of the year and had 220 units. Included in that amount were 20 units Comstock held on consignment from Davidson Chapter 6 Inventory and Cost of Goods Sold 6-1 Inc. Comstock purchased 50 units of inventory on December 27, FOB shipping point. How many units of inventory should Comstock report on its year-end balance sheet? 4. If a customer wants to know if Comstock Company has a particular item on hand, Comstock can look at their records to determine if the item is in stock. Does Comstock use a periodic or perpetual inventory system? How can you tell? If a customer wants to know if Comstock Company has a particular item on hand, Comstock can go into its warehouse and look to see if that item is on hand. Does Comstock use a periodic or perpetual inventory system? How can you tell? 5. Prepare journal entries for the following transactions as illustrated on pages 343-344 in the text. Post the transactions to the Inventory T-account. a. Purchase of inventory on account, $1,000, terms FOB shipping point, 2/10 n/30. Freight on the purchase was $10. b. Sale of inventory on account, $1,500; cost, $750: Beg. Bal. Inventory 10 c. What is the net cost of purchases? What is the basic rule in determining which items are included as a part of the inventory cost (pg. 345)? Learning Objective 2: Apply and compare various inventory cost methods 6-2 Chapter 6 - Inventory and cost of goods sold 1. Comstock Company had 2 units ($5 unit cost) in inventory. Comstock purchased 10 units ($8 unit cost) in January and purchased another 3 units ($10 unit cost) in July. Comstock ended up with 3 units in its ending inventory (1 unit with a unit cost of $8 and 2 with a unit cost of $10). a. If Comstock used the specific unit cost method, what is the cost of the ending inventory? b. If Comstock used the average cost method, what is the cost of the ending inventory? c. If Comstock used the FIFO method, what is the cost of the ending inventory? d. If Comstock used the LIFO method, what is the cost of the ending inventory? IN-CLASS EXAMPLE A summary of the purchases of Draper Sales, Inc. during 2011 is given in the following table Cost/unit Purchases Beg. Inventory $30 600 units Mar. 6 32 1,400 June 1 34 1,000 Nov. 30 36 500 3,500 units Assume Draper sold 2,500 units during the year. First, compute the number of units in the ending inventory. Next, compute the ending inventory and COGS under each of the four methods below. A. B. Specific Unit cost--Assume that 200 units in the ending inventory were from the Nov 30 purchase and the remainder was from the June 1 purchase. FIFO Chapter 6 Inventory and Cost of Goods Sold 6-3 C. LIFO D. Average cost 2. Indicate which inventory methods apply to the following statements In a period of rising prices... Specific -UnitCost FIF O LIF O Average Cost a. This method results in the highest ending inventory. b. This method results in the highest COGS. c. This method results in the lowest income taxes. d. This method results in the highest cash flow. e. This method allows a company to manipulate income by the timing of inventory purchases. f. This method is acceptable under IFRS. g. When the quantity of inventory falls, income under this method is higher. Learning Objective 3: Explain and apply underlying GAAP for inventory 1. Refer to the link below for the Nike annual report. Scroll down to Note 1 on page 41 on the annual report. What inventory method does Nike use? How does this relate to the disclosure principle? http://investors.nikeinc.com/Theme/Nike/files/doc_financials/AnnualReports/2011/doc s/Nike_2011_10-K.pdf How does Nike apply the consistency principle to inventory? 6-4 Chapter 6 - Inventory and cost of goods sold 2. Assume Nike has 100,000 pairs of shoes on hand at the end of the year that have a cost of $25 per pair. To replace these shoes, Nike would have to spend $22 per pair. What value for inventory should Nike report on its balance sheet? What is this called? How would your answer change if Nike would have to spend $27 per pair to replace the shoes in its inventory? CLASS EXAMPLE: Detailed Income Statement An example of a detailed income statement is presented below. Using the information presented below the income statement, fill in the missing information on the next page. Sales ........................................................................................................$106,000 Less: Sales returns and allowances........................................................$1,000 Sales discounts................................................................................5,000 (6,000) Net sales ..........................................................................................................100,000 COGS: Beginning inventory.................................................................................$10,000 Purchases .................................................................$50,000 Less: Purchases returns and allowances........................(4,000) Purchase discounts...............................................(2,000) Add: Freight-in............................................................................. 1,000 Net purchases............................................................................................45,000 Cost of goods available for sale (GAFS)...................................................55,000 Less: Ending inventory..............................................................................12,000 Cost of Goods Sold (COGS)......................................................................................43,000 Gross profit ............................................................................................................57,000 Operating Expenses: Selling expenses..........................................................................$10,000 Administrative expenses................................................................12,000 22,000 Income before income tax..................................................................................... 35,000 Income tax expense.............................................................................................. 10,000 Net income ....................................................................................................... $25s000 Sales Sales returns/allowances Sales discounts Net sales Beginning inventory Purchases Purchase returns/allowances $ 102,000 4,000 3,000 ? 18,600 66,000 1,000 Purchase discounts Freight-in Ending inventory COGS Selling expense Administrative expenses Income tax expense 2,000 400 22,000 ? 10,000 8,000 5,000 Sales .................................................................................................................. Chapter 6 Inventory and Cost of Goods Sold 6-5 Less: Sales returns and allowances................................................. Sales discounts...................................................................... Net Sales.............................................................................................................. Beginning inventory........................................................................... Purchases.............................................................. Less: Purchases returns and allowances............ Purchase discounts.................................... Add: Freight-in...................................................... Net purchases.................................................................................... Cost of goods available for sale (GAFS)........................................... Less: Ending inventory...................................................................... Cost of goods sold............................................................................. Gross profit......................................................................................... Operating expenses: Selling expenses....................................................................... Administrative expenses........................................................... Income before tax................................................................................................ Income tax expense............................................................................................. Net income........................................................................................................... Learning Objective 4: Compute and evaluate gross profit (margin) and inventory turnover 1. Refer to Target Corporation at Yahoo Finance or click on the following link: http://finance.yahoo.com/q?s=TGT Look for the following information for the most recent year and write it in the space provided. You can find this information by choosing the link from the box on the left for the income statement and/or balance sheet. a. Revenue b. Cost of revenue (COGS) c. Gross profit d. Beginning Inventory (earlier year) e. Ending Inventory (most recent year) Next, click on competitors (under Company). Click on WMT and look up the same information for this company as you did for Target. 6-6 Chapter 6 - Inventory and cost of goods sold f. Which company has more Revenue? Does the same company that has more Revenue also have more inventory? g. Revenue h. Cost of revenue (COGS) i. Gross profit j. Beginning Inventory (earlier year) k. Ending Inventory (most recent year) 2. Compute the following for TGT: a. Gross profit % b. For WMT Inventory Turnover Inventory turnover in days 3. If the inventory turnover in days increased, would this be a good sign? What could Target do to improve the inventory turnover? Learning Objective 5: Use the COGS model to make management decisions 1. Comstock Company budgets the following information for 2012. How much inventory should the manager of Comstock purchase? Use the COGS model. Beginning inventory $ 10,000 Ending inventory 35,000 Net purchases 110,000 Sales 175,000 Cost of goods sold 85,000 Chapter 6 Inventory and Cost of Goods Sold 6-7 2. Assume Comstock was unable to count its ending inventory because it was destroyed in a fire. Use the gross profit method to estimate the ending inventory. The gross profit rate is 52%. Beginning inventory Ending inventory Net purchases Net sales $ 10,000 ? 110,000 175,000 Learning Objective 6: Analyze effects of inventory errors 1. In 2011, Comstock overstated its ending inventory $10,000 by accidentally doublecounting some inventory stored in a warehouse. Net income for 2011 and 2012 was $126,000 and $132,000, respectively. Was 2011 net income overstated, understated, or correctly stated? What amount should have been reported for net income in 2011? Was 2012 net income overstated, understated, or correctly stated? What amount should have been reported for net income in 2012? 6-8 Chapter 6 - Inventory and cost of goods sold