Slide 1Chapter 6: Inventories and Cost of SalesSlide 2Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. We must pay special attention to include inventory that we own but that is in transit or on consignment. We should also consider the condition of inventory that is damaged or obsolete when determining a cost for the inventory.Slide 3Transportation costs are sometimes included in the cost of Merchandise Inventory. The FOB terms designate when title passes and who pays the transportation costs. FOB stands for “Free On Board.” So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means the buyer will pay all transportation costs. In this case, the transportation costs will be added to the merchandise inventory account.On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means the seller will pay the transportation costs.Slide 4Goods on consignment are goods that we own, but that are on display for sale at another place of business. Even though these goods are not in our physical possession, we still have ownershipof them and should include them in our inventory count.Slide 5Damaged and obsolete goods are not counted in inventory if they cannot be sold. If these goodscan be sold at a reduced price, they are included in inventory at a conservative estimate of their net realizable value. Net realizable value is the sales price minus the cost of making the sale.Slide 6The cost of inventory includes any cost that is necessary and reasonable to get the inventory to your place of business and to get it in a salable condition. We already know that the invoice price and transportation costs are included in the total cost ofinventory. Other costs to include are insurance, storage, and import duties. Any purchase discounts or allowances received reduce the cost of the inventory purchased.Slide 7Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in our inventory records. In reality, this is not the case. The physical count may not match our records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps us get our records up to date to reflect what we actually have on hand. A company has adequate internal controls over the inventory count if, (1) it uses pre-numbered inventory tags, (2) inventory counters have no responsibility for inventory, (3) the count confirms the existence, amount, and quality of inventory items counted,(4) a second count of the inventory is made, and (5) a count supervisor confirms that all items ininventory have been counted.Slide 8Inventory transactions impact both the balance sheet and the income statement. Ending Inventory is reported as a current asset on the balance sheet and cost of goods sold is reported on the income statement. The matching principle requires matching costs with sales.Slide 9Management decisions in accounting for inventory involve the following:• Items included in inventory and their costs.• Costing method (specific identification, FIFO, LIFO, or weighted average).• Inventory system (perpetual or periodic).• Use of market values or other estimates.Choices made concerning these four points affect the reported amounts for inventory, cost of goods sold, gross profit, income, current assets, and other accounts. Four methods are commonly used to assign costs to inventory and to cost of goods sold: (1) specific identification; (2) first-in, first-out; (3) last-in, first-out; and (4) weighted average. The graph on this slide shows the frequency in the use of these methods. Each method assumes a particular pattern for how costs flow through inventory. Each of these four methods is acceptable whether or not the actual physical flow of goods follows the cost flow assumption.Slide 10We must make assumptions about the inventory cost flow. First-in, first-out assumes costs flow in the order incurred. Last-in, first-out assumes costs flow in the reverse order incurred. Weighted average assumes costs flow at an average of the costs available.Slide 11Take a minute and review this chart. We will use these data throughout our inventory examples so we can compare our results at the end. The inventory information is provided by Trekking, a sporting goods retailer. Data for the month of August includes: 1) beginning inventory; 2) purchases; and 3) sales.Slide 12First, let’s look at the specific identification method. In this method, we know the specific cost ofeach unit that is sold. 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. On August 14th, Trekking sold 8 bikes that cost $91 each and 12 bikes that cost $106. The total cost of goods sold on this date is $2,000. That leaves in inventory 2 bikes that cost $91 each and 3 bikes that cost $106 each.Slide 13On August 31, Trekking sold 23 bikes with the cost per unit shown on your screen. The total costof good sold on this date is $2,582. Using the specific identification method, on August 31, there are 12 units in inventory at $1,408 (5 units at $115 each plus 7 units at $119 each). Trekking would report Cost of Goods Sold on its August income statement of $4,582, and report Inventory on its balance sheet of $1,408.Slide 14Here are the entries to record the purchases and sales discussed previously (the colored boldface numbers are those impacted by the cost flow assumption). All purchases and sales are made on credit. The selling price of inventory on August 14 was $130 per unit sold and the selling price for the August 31 sale was $150 per unit sold.Slide 15The first-in, first-out method is abbreviated as FIFO, and pronounced as Fifo. When using FIFO, we assign the older costs to the units sold. That leaves the more recent costs to be used to valueending inventory.Slide 16For the August 14 sale, the company first assigns the cost of the 10 oldest inventory items from beginning inventory on August 1 at $91 each. Now, we need 10 more units; so we move down to the next purchase on August 3 and include the cost of