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Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Ya !

sen Uni"e#si $

Lesson Notes Lesson 7 Merchandise Inventories and Cost of Sales Learning Objectives %& I'en if$ he i ems inclu'e' in me#chan'ise in"en o#$& (& I'en if$ he cos s of me#chan'ise in"en o#$& )& Com*u e he cos of +oo's sol' an' en'in+ me#chan'ise in"en o#$ in a *e#*e ual s$s em usin+ he cos in+ me ho's of s*ecific i'en ifica ion, mo"in+ ,ei+h e' a"e#a+e, FIFO, an' LIFO& -& Anal$.e he effec s of he choice /e ,een in"en o#$ cos in+ me ho's on financial #e*o# in+& 0& Com*u e he lo,e# of cos o# ma#ke "alue of in"en o#$& 1& Anal$.e he effec s of in"en o#$ e##o#s on cu##en an' fu u#e financial s a emen s& 2& A**l$ /o h he +#oss *#ofi an' #e ail me ho's o es ima e in"en o#$& Teaching Hours S u'en s ma3o# in accoun in+4 0 hou#s O he# s u'en s4 ) hou#s Teaching Contents 5hile sales an' *u#chases a#e he focus of o*e#a ions, in"en o#$ is no less im*o# an & In"en o#$ cos in+ an' e"alua ion me ho's can su/s an iall$ influence he /o om line& Since China6s lis e' com*anies ,e#e *e#mi e' o ,#i e 'o,n in"en o#ies in %778, in"en o#$ has lon+ /een c#i ici.e' as he 9income a'3us o#:& Besi'es, in"en o#$ cos in+ *olicies an' he sco*e of in"en o#$ can also si+nifican chan+e he cu##en an' fu u#e $ea#s6 income num/e#s& Items included in inventory Me#chan'ise in"en o#$ inclu'es +oo's hel' fo# #esale& Asse s no no#mall$ hel' fo# #esale a#e e;clu'e' f#om me#chan'ise in"en o#$& An im*o# an as*ec of in"en o#$ accoun in+ is 'e e#minin+ in"en o#$ o,ne#shi*& oods in transit a#e o /e inclu'e' in he /u$e#6s in"en o#$ ,hen o,ne#shi* has *asse' o he /u$e#& If he /u$e# is #es*onsi/le fo# f#ei+h cha#+es <FOB fac o#$ o# shi**in+ *oin =, o,ne#shi* *asses o he /u$e# as soon as +oo's a#e loa'e' a/oa#' he ca##ie#& If he selle# *a$s fo# he f#ei+h cha#+es <FOB 'es ina ion=, o,ne#shi* *asses o he /u$e# onl$ ,hen he +oo's a##i"e a he 'es ina ion& 5hen one com*an$ < he transferor o# consignor= #ansfe#s in"en o#$ o ano he# com*an$ < he transferee o# consignee= ,i hou #ansfe##in+ i le o ha in"en o#$, he a##an+emen is kno,n as a consignment& Goo's on consi+nmen /elon+ o he o,ne# <consi+no#= e"en hou+h he$ a#e *h$sicall$ loca e' a he consi+nee6s /usiness *lace& Consi+ne' +oo's shoul' /e omi e' f#om he consi+nee6s in"en o#$ coun & 5hen he +oo's a#e ul ima el$ sol', he consi+nee ,ill #emi o he consi+no# an amoun e>ual o he sellin+ *#ice of he +oo's, less an$ commissions an' #eim/u#sa/le e;*enses incu##e' /$ he consi+nee&

Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Ya !sen Uni"e#si $

!amaged" deteriorated" or obsolete goods shoul' /e omi e' f#om in"en o#$ if no salea/le& If salea/le a a #e'uce' *#ice an' /elo, cos , he$ shoul' /e inclu'e' in in"en o#$ a hei# net reali#able value <sales *#ice less he cos of makin+ he sale=& $lements of inventory cost The cost of inventory inclu'es all e;*en'i u#es ma'e in /#in+in+ he +oo's o# asse s o hei# e;is in+ con'i ion an' loca ion fo# sale& In"en o#$ cos he#efo#e e>uals in"oice *#ice less 'iscoun s, plus #ans*o# a ion, s o#a+e, im*o# 'u ies, insu#ance, an' o he# cos s of *#e*a#in+ he in"en o#$ fo# sale& These a''i ional o# inci'en al cos s a'' "alue o he in"en o#$ an' shoul' /e inclu'e' in he *u#chase cos & In ce# ain cases, ho,e"e#, he materiality principle allo,s fi#ms o cha#+e inci'en al cos s as e;*enses of he *e#io', an' no inclu'e hem in in"en o#$& Such a *#ac ice is 3us ifie' if he effo# of com*u in+ cos s on a *#ecise /asis ou ,ei+hs he /enefi f#om he e; #a accu#ac$& %our generally acce&ted methods of determining inventory costs Specific identification inventory costing method The s&ecific identification inventory costing method i'en ifies an' uses he *u#chase in"oice of each i em sol' o 'e e#mine he cos assi+ne' o cos of +oo's sol' an' o he en'in+ in"en o#$& E;ac ma chin+ is *ossi/le ,hen each i em in in"en o#$ can /e i'en ifie' ,i h a s*ecific *u#chase& S*ecific i'en ifica ion ,ill *#o'uce i'en ical #esul s un'e# ei he# a *e#*e ual o# a *e#io'ic in"en o#$ s$s em& First-in, first-out (FIFO) inventory costing method The first'in" first'out inventory costing method is /ase' on he assum* ion ha he fi#s i ems #ecei"e' ,e#e he fi#s i ems sol'& In o he# ,o#'s, i ems in he /e+innin+ in"en o#$ o# he ol'es i ems a#e assume' o /e sol' fi#s & The mos #ecen in"en o#$ *u#chase' is assume' o #emain in en'in+ in"en o#$& Fo# man$ /usinesses, his is he ac ual flo, of +oo's& FIFO ,ill *#o'uce i'en ical #esul s un'e# /o h he *e#*e ual an' *e#io'oic in"en o#$ s$s ems& Last-in, first-out (LIFO) inventory costing method The last'in" first'out inventory costing method is /ase' on he assum* ion ha he las i ems #ecei"e' ,e#e he fi#s i ems sol'& In o he# ,o#'s, he mos #ecen *u#chases a#e assume' o /e sol' fi#s an' he ol' +oo's #emain in in"en o#$& ?o,e"e#, he assume' flo, of +oo's can 'iffe# f#om he ac ual *h$sical flo,& <The #esul s un'e# LIFO *e#io'ic 'iffe# f#om LIFO *e#*e ual&=& Du#in+ infla iona#$ imes, #ecen cos s a#e hi+he# han ol' cos s, #esul in+ in hi+he# cos of +oo's sol', lo,e# ne income, an' lo,e# income a;es& Weighted-average inventory costing method The (eighted'average inventory costing method uses a ,ei+h e'!a"e#a+e cos *e# in"en o#$ uni in assi+nin+ cos o uni s sol' an' o in"en o#$& A ,ei+h e'!a"e#a+e cos of +oo's a"aila/le fo# sale is #ecalcula e' a he ime of each *u#chase& No ice ha he mos cu##en a"e#a+e cos is use' o calcula e he cos of each sale& 5ei+h e'!a"e#a+e ,ill *#o'uce 'iffe#en #esul s un'e# a *e#*e ual han un'e# a *e#io'ic in"en o#$ s$s em&

Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Ya !sen Uni"e#si $

Inventory errors @e"ie, he follo,in+ e>ua ions ha a**l$ un'e# /o h a *e#*e ual an' *e#io'ic in"en o#$ s$s em4

Cost of goods )urchase returns )urchase = )urchases + Trans&ortation' discounts &urchased and allo(ances
in
Cost of goods = *eginning inventory +Cost of goods &urchased available for sale

Cost of goods sold + Cost of goods available for sale , $nding inventory The#efo#e,

Cost of goods sold = *eginning inventory +

Cost of goods $nding inventory &urchased

The amoun of en'in+ in"en o#$ a**ea#s on he /alance shee , affec s cos of +oo's sol' on he cu##en income s a emen < h#ou+h en'in+ in"en o#$=, an' he follo,in+ $ea#6s income s a emen < h#ou+h /e+innin+ in"en o#$=& Conse>uen l$, an e##o# in 'e e#minin+ he amoun of in"en o#$ ,ill affec each of hese s a emen s& In"en o#$ e##o#s mi+h occu# as a #esul of miscoun in+ in"en o#$ i ems o# failu#e o *#ice in"en o#$ i ems co##ec l$& E##o#s also occu# 'ue o im*#o*e# #eco+ni ion /ein+ +i"en o in"en o#$ ha is s ill in #ansi & Fo# e;am*le, +oo's *u#chase' FOB shi**in+ *oin /elon+ o he /u$e# ,hen in #ansi an' shoul' /e inclu'e' in he /u$e#6s in"en o#$& In he cu##en $ea#, an o"e#s a emen of en'in+ in"en o#$ #esul s in4 cu##en asse s /ein+ o"e#s a e' cos of +oo's sol' /ein+ un'e#s a e' +#oss *#ofi /ein+ o"e#s a e' ne income /ein+ o"e#s a e' o,ne#6s e>ui $ /ein+ o"e#s a e' The effec on he follo,in+ $ea# is4 /e+innin+ in"en o#$ is o"e#s a e' cos of +oo's sol' is o"e#s a e' +#oss *#ofi is un'e#s a e' ne income is un'e#s a e' o,ne#6s e>ui $ is no, *#o*e#l$ s a e'

An in"en o#$ e##o# ,ill self!co##ec in he follo,in+ *e#io', #esul in+ in o,ne#6s e>ui $ /ein+ *#o*e#l$ s a e' af e# he secon' *e#io'& To al ne income o"e# he ,o *e#io's is co##ec , al hou+h he alloca ion /e ,een *e#io's ,as in e##o#& If +#oss *#ofi is o"e#s a e' in $ea# % /u un'e#s a e' in $ea# ( /$ he same amoun , hen o,ne#6s e>ui $ ,ill ha"e he co##ec /alance af e# $ea# (& Al hou+h in"en o#$ e##o#s self!co##ec , he$ 'is o# mana+emen 6s in e#*#e a ion of he ea#nin+s #en'& This ma$ conse>uen l$ lea' mana+emen o make *oo# 'ecisions&

Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Ya !sen Uni"e#si $

Lo(er of cost or mar-et GAAA #e>ui#e ha in"en o#$ /e #e*o# e' a ma#ke "alue ,hene"e# ma#ke "alue is lo,e# han cos & This is he lo(er'of'cost'or'mar-et <LCM= #ule& The follo,in+ *oin s a#e essen ial o un'e#s an' LCM4 The cos of en'in+ in"en o#$ is 'e e#mine' /$ usin+ one of he fou# in"en o#$ *#icin+ me ho's& On he /alance shee , in"en o#$ is #e*o# e' a ma#ke "alue ,hene"e# ma#ke is lo,e# han he cos #e*o# e' un'e# he chosen *#icin+ me ho'& Cost is he *#ice *ai' fo# an i em& Mar-et value is 'efine' as net reali#able value .N/01, ,hich is sales *#ice less a''i ional cos s o sell, o# as re&lacement cost, ,hich is he *#ice ha ,oul' ha"e o /e *ai' o *u#chase <#e*lace= he i em on he in"en o#$ 'a e& If he ma#ke "alue of in"en o#$ falls /elo, i s o#i+inal cos , a holding loss occu#s& I is likel$ ha he sales *#ice of in"en o#$ ,ill also 'ec#ease& The hol'in+ loss shoul' /e #eco#'e' in he *e#io' 'u#in+ ,hich he *#ice 'ecline'& This is he /asic conce* of LCM& LCM alloca es hol'in+ losses o he *e#io' 'u#in+ ,hich a fi#m hol's in"en o#$, an' all #emainin+ income o he *e#io' 'u#in+ ,hich me#chan'ise is sol'& LCM ma$ /e a**lie' o he in"en o#$ as a ,hole, /$ ma3o# ca e+o#$, o# se*a#a el$ o each *#o'uc in he in"en o#$& $stimating inventories Inventory estimation can /e use' in *#e*a#in+ in e#im financial s a emen s o 'e e#mine if he *h$sical in"en o#$ coun is #easona/le o# in 'e e#minin+ he amoun of in"en o#$ los in a floo', 'es #o$e' in a fi#e, o# s olen& The ,o common me ho's of in"en o#$ es ima ion a#e he +#oss *#ofi me ho' an' he #e ail in"en o#$ me ho'& /etail inventory method The retail inventory method is use' o es ima e he amoun of en'in+ in"en o#$ /ase' on a cost ratio, acco#'in+ o he follo,in+ fo#mula4
2mount of goods for sale at cost 2mount of goods for sale at mar-ed selling &rice

Cost ratio +

Usin+ he #e ail me ho' of in"en o#$ es ima ion, in e#im financial s a emen s can /e *#e*a#e' mon hl$ o# >ua# e#l$ ,i hou a *h$sical in"en o#$ coun & The en'in+ in"en o#$ is es ima e' /$ con"e# in+ #e ail *#ices <o# he ma#ke' sellin+ *#ice= o cos amoun s& @eco#'s mus /e ke* a /o h cos an' #e ail as follo,s4 A cos 4 oods available for sale + *eginning inventory 3 Net &urchases A #e ail4 $nding inventory + *eginning inventory 3 Net &urchases , Net sales

Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Ya !sen Uni"e#si $

The cos #a io is a**lie' o en'in+ in"en o#$ a #e ail *#ices o es ima e en'in+ in"en o#$ a cos & The #e ail me ho' me#el$ *#o"i'es an in"en o#$ es ima e& The *h$sical in"en o#$ can hen /e com*a#e' o he es ima e' in"en o#$& An$ 'iffe#ence ,ill /e an es ima e of sho# a+es 'ue o /#eaka+e, loss, o# hef & A leas once a $ea#, a com*an$ shoul' ake a *h$sical in"en o#$ o co##ec an$ e##o#s o# sho# a+es& ross &rofit method The gross &rofit method is use' o es ima e in"en o#$ fo# insu#ance *u#*oses af e# a /#eak!in, fi#e, o# floo', o# fo# checkin+ he accu#ac$ of a *h$sical in"en o#$ coun & The +#oss *#ofi me ho' uses he *as +#oss *#ofi #a e o es ima e he en'in+ in"en o#$ as he 'iffe#ence /e ,een +oo's a"aila/le fo# sale an' cos of +oo's sol'& I is an a**#o;ima ion echni>ue ha a**lies an es ima e' +#oss *#ofi #a e o ne sales&

Sales COGS Sales The +#oss *#ofi #a io is a**lie' o es ima e he en'in+ in"en o#$ usin+ he follo,in+ fo#mulas4 Net sale at retail 4 .5'gross &rofit ratio1 + $stimated cost of goods sold oods available for sale at cost , $stimated cost of goods sold + $stimated ending inventory at cost
ross &rofit ratio + The +#oss *#ofi #a e is an a"e#a+e of he *e#cen a+es fo# man$ *#o'uc s& As a #esul , es ima e' in"en o#$ #e*#esen s an a**#o;ima ion& If *#ices 'u#in+ he cu##en *e#io' 'iffe# f#om no#mal con'i ions, he +#oss *#ofi me ho' ,ill $iel' less! han!accu#a e #esul s& !iscussion Case6 No# heas Aha#maceu ical 5hen *#e*a#in+ financial s a emen of %771, No# heas Aha#maceu ical #eco#'e' @MB (%,(8B,BBB e;*enses as in"en o#$ cos , ,hich ca##ies o ne; $ea#6s /e+innin+ in"en o#$& As a #esul , he /o om line is @MB %7,70B,BBB *#ofi s, ins ea' of a /i+ loss& This ,as 'isco"e#e' an' ,as fine' /$ CS@C as secu#i ies f#au'& @e>ui#e'4 % 5ha 6s he 'iffe#ence /e ,een e;*enses an' in"en o#$ cos sC ( 5ha a#e he im*ac s of in"en o#$ e##o#s on financial s a emen sC ) 5h$ No# heas Aha#maceu ical chose o #e*o# false income num/e#sC - ?o, o *#e"en he occu##ence of such kin' of cases&

Summary % In"en o#$ inclu'es all +oo's o,ne' /$ a com*an$ an' hel' fo# sale& ( Cos s of me#chan'ise in"en o#$ inclu'e all e;*en'i u#es necessa#$ o /#in+ an i em o a salea/le con'i ion an' loca ion& ) The#e a#e fou# me ho's o assi+nin+ cos s o in"en o#$4 s*ecific i'en ifica ion, FIFO, LIFO an' a"e#a+e cos & The a"e#a+e cos me ho' smoo hes ou *u#chase *#ice chan+es&
0

Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Ya !sen Uni"e#si $

En'in+ in"en o#$ un'e# FIFO a**#o;ima es cu##en #e*lacemen cos & LIFO /e e# ma ches cu##en cos in cos of +oo's sol' ,i h #e"enue& - In"en o#$ mus /e #e*o# e' a ma#ke "alue ,hen ma#ke is lo,e# han cos & 0 @e ail in"en o#$ me ho' an' +#oss *#ofi me ho' can /e use' o es ima e en'in+ in"en o#$& 7ey )oints %& i ems inclu'e' in me#chan'ise in"en o#$ (& cos s of me#chan'ise in"en o#$ )& in"en o#$ cos in+ me ho's -& lo,e# of cos o# ma#ke 0& in"en o#$ e##o#s 1& in"en o#$ es ima ions

/eading material %& La#son, D&D&, T& Eensen, an' @& Ca##oll, (BB(, Fundamental Accounting Principles, McG#a,! ?ill @$e#son& (& Li//$, @&, A&A& Li//$, D&G& Sho# , G& Danaan, an' M& Go,in+, (BB), Financial Accounting, McGraw-Hill Ryerson& )& A/'el!Dhalik, A&@&, The effec of LIFO!S,i chin+ an' Fi#m O,ne#shi* on E;ecu i"e Aa$, Eou#nal of Accoun in+ @esea#ch <Au umn %780=, -(2!-22& -& Cushin+, B&E& an' M&E& Lecle#e, E"i'ence on he De e#minan s of In"en o#$ Accoun in+ Aolic$ Choice, The Accoun in+ @e"ie, <A*#il %77(=, )00!)11& 0& Do*uch, N& an' M& Aincus, E"i'ence on he Choice of In"en o#$ Accoun in+ Me ho's4 LIFO "s& FIFO, Eou#nal of Accoun in+ @esea#ch <S*#in+ %788=, (8!07&