Place yourself in the position of an upper-level manager in the corporate office of The Home Depot.You are in a meeting, the purpose of which is to discuss the inventory cost-flow method that is most appropriate for the company. You realize that the method you recommend would have important implications to the calculation of "ending inventory" of your company's balance sheet and "cost of goods sold" on the income statement. You are further aware of the tax implications of a given method.For this Discussion:
In your opinion, which inventory cost-flow method is most appropriate? Why?Chapter 8 © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* INVENTORIES AND COST OF GOODS SOLD Chapter 8 2 Chapter 8: Inventories and cost of goods sold. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* Inventory Inventory Defined Goods owned and held for sale to customers Current asset Inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Inventory is reported as a current asset on the balance sheet. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* Purchase costs (or manufacturing costs) as goods are sold The Flow of Inventory Costs INCOME STATEMENT Revenue Cost of goods sold Gross profit Expenses Net income BALANCE SHEET Asset Inventory Companies that sell inventory report the value of the inventory they have in stock at the end of the period as a current asset on the balance sheet. Companies that sell inventory also have an additional expense item called Cost of Goods Sold on their income statements. The Cost of Goods Sold account represents the cost of the inventory sold during the period to help earn revenue. Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of inventory sold, to cover all other expenses and a profit. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* In a perpetual inventory system, inventory entries parallel the flow of costs. The Flow of Inventory Costs Remember that in a perpetual inventory system, inventory purchases are recorded by a debit to Inventory and a credit to Accounts Payable. This entry is similar to the entry made when any asset is purchased, such as a truck or land. The cost entry on the sale date requires a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* When identical units of inventory have different unit costs, a question naturally arises as to which of these costs should be used in recording a sale of inventory. Which Unit Did We Sell? On the sale date, a natural question arises: What is the unit cost of the inventory being sold? If all the inventory has the same unit cost, then this is not a difficult question to answer. However, in most cases, companies will have identical units of inventory in stock that have different unit costs. Let’s see how to determine the cost of a unit of inventory sold. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* A separate subsidiary account is maintained for each item in inventory. How can we determine the unit cost for the Sept. 10 sale? Inventory Subsidiary Ledger In this example, ten laser lights are sold. There are one hundred seventy-five laser lights in stock. Of those in stock, thirty dollars each for one hundred units and fifty dollars each for seventy five units was paid. So, how is the exact cost of the ten units we are selling on September 10th determined? © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* Learning Objective LO1 In a perpetual inventory system, you are to determine the cost of goods sold using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. You should be able to discuss the advantages and shortcomings of each method. Learning objective number 1 is to determine cost of goods sold in a perpetual inventory system using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. You should be able to discuss the advantages and shortcomings of each method. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* We use one of these inventory valuation methods to determine cost of inventory sold. Inventory Cost Flows Specific Identification Average Cost LIFO FIFO There are four ways to determine the cost of inventory sold: Specific Identification First-in, First-out -- also known as FIFO Last-in, First-out -- also known a LIFO, and Average Cost Now, let’s see how these methods work. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* The Bike Company (TBC) Data for an Illustration Take a minute and review this chart for The Bike Company. This data will be used throughout the perpetual inventory examples to compare results. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* Specific Identification When a unit is sold, its specific cost is added to cost of goods sold. First, let’s look at the specific identification method. In this method, the specific cost of each unit that is sold is known. It is most commonly used in businesses that have low sales volume of high dollar items, like car dealerships, exclusive jewelry stores, and custom builders. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* On August 14, TBC sold 20 bikes for $130 each. Of the bikes sold 9 originally cost $91 and 11 cost $106. Specific Identification On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 9 bikes that cost $91 each and 11 bikes that cost $106 each. What is the total cost of goods sold on August 14th? Sheet1 DatePurchasesCost of Goods SoldInventory Balance Aug. 110@$ 91=$ 910$ 910 Aug. 315@$ 106=$ 1,590$ 2,500 &A Page &P © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* The Cost of Goods Sold for the August 14 sale is $1,985, leaving $515 and 5 units in inventory. Let’s look at the entries for the Aug. 14 sale. Specific Identification The Cost of Goods Sold for August 14th is $1,985. After this sale, TBC has 5 units in inventory: 1 unit that costs $91 and 3units that cost $106 each. Sheet1 DatePurchasesCost of Goods SoldInventory Balance Aug. 110@$ 91=$ 910$ 910 Aug. 315@$ 106=$ 1,590$ 2,500 Aug. 149@$ 91=$ 819 11@$ 106=$ 1,166$ 515 &A Page &P © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* A similar entry is made after each sale. Specific Identification Retail (20 × $103) Cost Part I Remember that in a perpetual inventory system, two entries are required to record a sale. Part II The first entry is to record the sale at retail and involves Cash or Accounts Receivable and Sales. In our example, we debit Cash for $2,600 ( 20 bikes at $130 each), and credit Sales for the same amount. Part III The second entry is to record Cost of Goods Sold at cost and remove the items sold from Inventory. In our case, we debit Cost of Goods Sold for $1,985 and credit Inventory for the same amount. We determined the Cost of Goods Sold amount on the previous screen. We will make a similar set of entries each time we have a sale. ]Sheet1 GENERAL JOURNAL DateAccount Titles and ExplanationPRDebitCredit Aug.14Cash2,600 Sales2,600 14Cost of Goods Sold1,985 Inventory1,985 &A Page &P ]Sheet1 GENERAL JOURNAL DateAccount Titles and ExplanationPRDebitCredit Aug.14Cash2,600 Sales2,600 14Cost of Goods Sold1,985 Inventory1,985 &A Page &P ]Sheet1 GENERAL JOURNAL DateAccount Titles and ExplanationPRDebitCredit Aug.14Cash2,600 Sales2,600 14Cost of Goods Sold1,985 Inventory1,985 &A Page &P © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* Additional purchases were made on August 17 and 28. Costs associated with sales on August 31 were as follows: 1 @ $91, 3 @ $106, 15 @ $115, & 4 @ $119. Specific Identification Cost of Goods Sold for August 31 = $2,610 Part I Next, TBC makes a purchase on August 17th and another on August 28th. Part II On August 31st, TBC sell 23 bikes: 1 that cost $91; 3 that cost $106 each; 15 that cost $115 each; and 4 that cost $119 each. How much is the cost of goods sold on August 31st? Part III The Cost of Goods Sold for the August 31st sale is $2,610. After the August 31st sale, TBC has 12 units in inventory: 1 unit that cost $106; 5 units that cost $115 each; and 6 units that cost $119 each. Sheet1 DatePurchasesCost of Goods SoldInventory Balance Aug. 110@$ 91=$ 910$ 910 Aug. 315@$ 106=$ 1,590$ 2,500 Aug. 149@$ 91=$ 819 11@$ 106=$ 1,166$ 515 Aug. 1720@$ 115=$ 2,300$ 2,815 Aug. 2810@$ 119=$ 1,190$ 4,005 &A Page &P Sheet1 DatePurchasesCost of Goods SoldInventory Balance Aug. 110@$ 91=$ 910$ 910 Aug. 315@$ 106=$ 1,590$ 2,500 Aug. 149@$ 91=$ 819 11@$ 106=$ 1,166$ 515 Aug. 1720@$ 115=$ 2,300$ 2,815 Aug. 2810@$ 119=$ 1,190$ 4,005 Aug. 311@$ 91=$ 91 3@$ 106=$ 318 15@$ 115=$ 1,725 4@$ 119=$ 476$ 1,395 &A Page &P © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 8-* Balance Sheet Inventory = $1,395 Income Statement COGS = $4,595 Specific Identification Using the specific identification method, TBC would report Cost of Goods Sold on their August income statement of $4,595 and they would report Ending Inventory on the balance sheet of $1,395. Sheet1 DatePurchasesCost of Goods SoldInventory Balance Aug. 110@$ 91=$ 910$ 910 Aug. 315@$ 106=$ 1,590$ 2,500 Aug. 149@$ 91=$ 819 11@$ 106=$ 1,166$ 515 Aug. 1720@$ 115=$ 2,300$ 2,815 Aug. 2810@$ 119=$ 1,190$ 4,005 Aug. 311@$ 91=$ 91 3@$ 106=$ 318 15@$ 115=$ 1,725 4@$