Stice | Stice | Skousen
Intermediate Accounting,17E
Inventory and Cost
of Goods Sold
PowerPoint presented by: Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
© 2010 Cengage Learning
What Is Inventory?
• Inventory designates goods held for sale in
the normal course of business or, for a
manufacturer, also includes goods in
production.
• For a manufacturing firm, a broad array of
production costs is included as part of the
cost of inventory.
• The terms raw materials, work in process,
and finished goods refer to the inventories
of a manufacturing enterprise.
9-2
Work in Process
• Work in Process (WIP) consists
of materials partly processed
and requiring further work
before they can be sold.
• Work in Process includes three
cost elements.
1. Direct materials
2. Direct labor
3. Manufacturing overhead
9-3
Work in Process
1. Direct materials refers the cost of
materials directly identified with
goods in production.
2. Direct labor refers to the cost of
labor directly identified with goods
in production.
3. Manufacturing overhead refers to
the portion of factory overhead
assignable to goods in production.
9-4
Finished Goods
Finished goods are the manufactured
products awaiting sale.
9-5
Inventory Systems
Two types of inventory systems that keep
track of how much inventory has been sold
and at what price are:
• Periodic system—requires a physical
count of the inventory periodically,
and at the point of sale only records
the sale price.
• Perpetual system—at point of sale
records selling price and type of item
sold. Example: a bar code scanning
system.
9-6
Differences in Recording
The following transactions occurred
during the period for CyBorg, Inc.
Beginning inventory
Purchases during the period
Sales during the period
Ending inventory (physical)
50 units @ $10 $ 500
300 units @ $10 3,000
275 units @ $15 4,125
70 units @ $10
700
9-7
Differences in Recording
Periodic Inventory System
To record purchases during the period:
Purchases
Accounts Payable
3,000
3,000
To record sales during the period:
Accounts Receivable
Sales
4,125
4,125
9-8
Differences in Recording
Perpetual Inventory System
To record purchases during the period:
Inventory
Accounts Payable
3,000
3,000
To record sales during the period:
Accounts Receivable
Sales
Cost of Goods Sold
Inventory
4,125
4,125
2,750
2,750
275 units @ $10
9-9
Differences in Recording
The cost of goods sold in the CyBorg
example is computed as follows:
9-10
Whose Inventory Is It?
• Report inventory on the balance sheet
of the company that holds legal title.
• Legal title is not determined by who
has physical custody of the inventory
• Issues that develop:
• Goods in transit
• Goods on consignment
9-11
Goods in Transit
Whose inventory is it?
When terms of sale are FOB (free
on board) shipping point, title
passes to the buyer with the
loading of goods at the point of
shipment.
9-12
Goods in Transit
Whose inventory is it?
When terms of sale are FOB (free
on board) destination, legal title
does not pass until the goods are
received by the buyer.
9-13
Goods on Consignment
• Shipper retains title and includes the
goods in inventory until their sale or
use by the dealer or customer.
• Consigned goods are reported by the
shipper at the sum of:
• The cost of the goods
• The handling and shipping costs
9-14
Conditional Sales, Installment
Sales, and Repurchase Agreements
• Conditional sales and installment sales
contracts may provide for a retention of
title by the seller until the sales price is
fully recovered.
• Firms sometimes sell inventory to another
company but at the same time agree to
repurchase the inventory at some future
date. These repurchase agreements are,
in essence, allowing the selling company
to use the inventory to secure a shortterm loan.
9-15
Items Included in
Inventory Cost
Inventory costs are comprised of all
expenditures, both direct and
indirect, relating to acquisition,
preparation, and placement for sale.
• Expenditures that are relatively
small and difficult to allocate are
period costs. These are
recognized as expenses in the
current period.
9-16
Items Included in
Inventory Cost
Inventory costs are comprised of all
expenditures, both direct and
indirect, relating to acquisition,
preparation, and placement for sale.
• Costs that can be identified with
the product being manufactured
are called product or
inventoriable costs.
9-17
Items Included in
Inventory Cost
Activity-based cost (ABC)
systems strive to allocate overhead
based on clearly identified cost
drivers—characteristics of the
production process that are known
to create overhead costs.
9-18
Discounts as
Reductions in Cost
• Cash discounts are discounts
granted for payment of invoices
within a limited time period.
• Example: A purchase of $10,000
provides for payment on a 2/10,
n/30 basis. If the buyer pays by
the 10th day, $9,800 settles the
invoice. After that, the full
$10,000 is required.
9-19
Purchases Reported
Net Method
To record the purchase of merchandise priced
at $10,000 with a cash discount of 2%:
Inventory
Accounts Payable
9,800
9,800
To record the payment of the invoice
within discount period:
Accounts Payable
Cash
9,800
9,800
(continues)
9-20
Purchases Reported
Net Method
To record payment of the invoice after the
discount period:
Accounts Payable
9,800
Discounts Lost
200
Cash
10,000
To record adjustment at the end of the
period if invoice has not been paid and the
discount period has lapsed:
Discounts Lost
Accounts Payable
200
200
9-21
Purchases Reported
Gross Method
To record the purchase of merchandise priced
at $10,000 with a cash discount of 2%:
Inventory
Accounts Payable
10,000
10,000
To record the payment of the invoice
within discount period:
Accounts Payable
Inventory
Cash
10,000
200
9,800
(continues)
9-22
Purchases Reported
Gross Method
To record payment of the invoice after the
discount period:
Accounts Payable
10,000
Cash
10,000
To record adjustment at the end of the
period if invoice has not been paid and the
discount period has lapsed:
No entry required
9-23
Purchase Returns and
Allowances
• Adjustments
Periodic Inventory System
are also made
when goods
Accounts Payable
400
Purchase Returns
are damaged
and Allowances
400
or are lesser in
quality than
Perpetual Inventory System
ordered.
400
• Sometimes the Accounts Payable
Inventory
400
customer
returns the
goods.
9-24
Inventory Valuation Methods
Specific
Identification
Cost
Allocation
Methods
Average
Cost
FIFO
LIFO
9-25
Inventory Valuation Methods
The four methods will be illustrated
using the following simple example for
Dalton Company.
Note: No beginning inventory
9-26
Specific Identification Method
• Assigns the actual cost of the asset to
inventory and cost of goods sold.
• Provides a highly objective method of
matching costs because cost flow
exactly matches physical goods flow.
• Is almost impossible to implement
cost effectively.
9-27
Specific Identification Method
Purchases:
Jan. 1
Mar. 23
200 units @ $10 per unit
300 units @ $12 per unit
July 15
500 units @ $11 per unit
Nov. 6
100 units @ $13 per unit
1,100 units
Sold 200 units from the
January 1 and 500 from
the July 15 purchase.
9-28
Specific Identification Method
Jan. 1
200 units @ $10 per unit
= $2,000
July 15
500 units @ $11 per unit
= 5,500
Total cost of goods sold
$7,500
9-29
Specific Identification Method
Mar. 23
300 units @ $12 per unit
= $3,600
Nov. 6
100 units @ $13 per unit
= 1,300
Ending inventory
$4,900
9-30
Average Cost Method
• The average cost method assigns
the same average cost to each unit
sold and each item in inventory.
• For periodic inventory, the unit cost
is the weighted average for the
entire period.
9-31
Average Cost Method
Jan. 1
200 units @ $10 per unit
= $ 2,000
Mar. 23
July 15
300 units @ $12 per unit
500 units @ $11 per unit
=
3,600
=
5,500
Nov. 6
100 units @ $13 per unit
=
1,300
1,100 units
$12,400
$12,400  1,100 units = $11.27 per unit (rounded)
Cost of goods sold = $11.27  700 = $7,890
Ending inventory = $11.27  400 = $4,510
9-32
First-In, First-Out
(FIFO) Method
• FIFO assigns historical unit cost to
cost of goods sold in the order the
costs are incurred.
• Provides a close match between
physical product flow and product
cost flow.
• Results in the same inventory
valuation and cost of goods sold
regardless of whether perpetual or
periodic inventory is used.
9-33
FIFO Method
Jan. 1
200 units @ $10 per unit
= $2,000
Sold 200
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
= 3,600
Sold 300
Sold 200
= 2,200
100 units @ $13 per unit
Total cost of goods sold
$7,800
9-34
FIFO Method
Mar. 23
300 units @ $11 per unit
= $3,300
Nov. 6
100 units @ $13 per unit
= 1,300
Ending inventory
$4,600
9-35
Last-In, First-Out
(LIFO) Method
• LIFO assigns the most recent
historical costs to cost of goods sold
and the oldest costs to inventory.
• Is used primarily to minimize taxable
income.
• Results in differences between cost of
goods sold and inventory for perpetual
versus periodic methods.
9-36
LIFO Method
Jan. 1
Mar. 23
July 15
Nov. 6
200 units @ $10 per unit
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
Total cost of goods sold
Sold 100
= $1,200
Sold 500
= $5,500
Sold 100
= $1,300
$8,000
9-37
LIFO Method
Jan. 1
200 units @ $10 per unit
= $2,000
Mar. 23
200 units @ $12 per unit
=
Ending Inventory
2,400
$4,400
9-38
9-39
(continued)
(continues)
9-40
9-41
LIFO Layers
The following data are for Ryanes Company
for the first three years of its existence:
9-42
LIFO Layers
• Each year in which the number of
units purchased exceeds the number
of units sold, a new LIFO layer is
created in ending inventory.
• Many companies that use LIFO
report the amount of their LIFO
reserve, either as a parenthetical
note in the balance or the notes to
the financial statements.
9-43
Calculating FIFO Cost of Goods
for Ryanes for 2010
The FIFO calculation can be done as follows:
9-44
LIFO Liquidation
Ryanes Company’s purchases and
sales for 2011 are as follows:
Purchases
Sales
60 units @ $20
150 units @ $25
Because the number of units
purchased does not exceed the
number sold, no new LIFO layer is
added in 2011.
(continues)
9-45
LIFO Liquidation
LIFO liquidation causes old LIFO
layer costs to flow through cost of
goods sold, sometimes with bizarre
results.
9-46
(continues)
9-47
(concluded)
9-48
Income Tax Effects
If a company has large inventory
levels, is experiencing significant
inventory cost increases, and does not
anticipate reducing inventory levels in
the future, LIFO gives substantial
cash flow benefits in terms of tax
deferrals.
9-49
Bookkeeping Costs
• The bookkeeping associated with
LIFO is a bit more complicated than
with FIFO or average costs.
• In dollars and cents, a LIFO system
costs more to operate.
• Until information technology is
improved, small businesses will
continue to lean toward not using
LIFO.
9-50
Impact on Financial Statements
While LIFO gives tax benefits, it also
gives reduced reported income and
reduced reported inventory.
9-51
International Accounting and
Inventory Valuation
• In 1992, the IASB decided to
officially endorse FIFO and average
cost, to kill the base stock method,
and to let LIFO live on as a secondclass “allowed alternative
treatment.”
• In 2003, the IASB adopted a revised
version of IAS 2 and did away with
LIFO.
9-52
Inventory Accounting Change
If a company changes its method of valuing
inventory, the change is accounted for as a
change in accounting principle.
LIFO
change to
Average Cost
or FIFO
Report the effect of changing methods
on the financial statements.
9-53
Inventory Accounting
Change
Any Method
change to
LIFO
No adjustment to financial statements for change to
LIFO, but special disclosure required.
9-54
Lower of Cost or Market
• The term
Ceiling:
market
Also in
known
loweras
of the
costnet
or market
means replacement
cost.
realizable value
(NRV)
Replacement
Range
Cost
Market
compare to
Historical Cost
Floor: Net realizable value
less a normal profit margin
9-55
9-56
Gross Profit Method
Beginning inventory, January 1
$25,000
Sales, January 1–January 31
50,000
Purchases, January 1–January 31
40,000
Historical gross profit percentages:
Last year
40%
Two years ago
37%
Three years ago
42%
Last year’s 40% is
considered a good estimate.
9-57
Gross Profit Method
Sales (actual)
Cost of goods sold (estimate)
Gross profit (estimate)
Beginning inventory (actual)
+ Purchases (actual)
– Cost of goods available for
sale (actual)
– Ending inventory (estimate)
= Cost of goods sold (estimate)
$50,000
30,000
$20,000
100 %
60 %
40 %
$25,000
40,000
$65,000
35,000
$30,000
9-58
Gross Profit Method
Sales (actual)
Cost of goods sold (estimate)
Gross profit (estimate)
Beginning inventory (actual)
+ Purchases (actual)
– Cost of goods available for
sale (actual)
– Ending inventory (estimate)
= Cost of goods sold (estimate)
$50,000
31,500
$18,500
100 %
63 %
37 %
$25,000
40,000
$65,000
33,500
$31,500
9-59
Gross Profit Method
Sales (actual)
Cost of goods sold (estimate)
Gross profit (estimate)
Beginning inventory (actual)
+ Purchases (actual)
– Cost of goods available for
sale (actual)
– Ending inventory (estimate)
= Cost of goods sold (estimate)
$50,000
29,000
$21,000
100 %
58 %
42 %
$25,000
40,000
$65,000
36,000
$29,000
9-60
Effects of Errors in
Recording Inventory
Failure to correctly report inventory results
in misstatements on both the balance sheet
and the income statement. There are three
typical inventory errors:
1. Overstatement of ending inventory
through an improper physical count
2. Understatement of ending inventory
through an improper physical count
3. Understatement of ending inventory
through delay in recording a purchase
until the following year
9-61
9-62
Using Inventory Information
for Financial Analysis
Consider the financial information relating to
inventories for Deere & Co. provided below.
9-63
Inventory Turnover
Appropriateness of inventory size and
position can be measured by
calculating the inventory turnover
ratio.
Cost of Goods Sold
$16,252.8
=
Average Inventory
$2,147
($2,337 + $1,957)/2 = $2,147
= 7.57 times
9-64
Number of Days’
Sales in Inventory
($2,337 + $1,957)/2
Average Inventory
$2,147
=
Average Daily
$44.528
Cost of Goods Sold
$16,252.8/365
Number of days’ sales in inventory = 48.2
9-65
Number of Days’
Sales in Inventory
Deere’s number of days’ sales in
inventory results mean that, on
average, Deere & Co. has enough
inventory to continue operations for
48.2 days using just its existing
inventory.
9-66
Retail Inventory Method
• The retail inventory method is
widely employed by retail firms to
arrive at reliable estimates of
inventory position whenever desired.
• This method permits the estimation
of an inventory amount without the
time and expense of taking a
physical inventory or maintaining
detailed perpetual records.
9-67
Retail Inventory Method
One Cost Percentage
Inventory, Jan. 1
Purchases in January
Goods available for sale
Cost percentage ($60,000 ÷
$90,000) = 66.7%
Deduct sales for January
Inventory, January 31, at retail
Inventory, January 31, at estimated
cost ($25,000  66.7%)
Cost
$30,000
30,000
$60,000
Retail
$50,000
40,000
$90,000
65,000
$25,000
$16,675
9-68
Retail Inventory Method
Multiple Cost Percentages
Cost
$30,000
30,000
$60,000
Inventory, Jan. 1
Purchases in January
Goods available for sale
Cost percentage:
Beg. inventory ($30,000 + $50,000) = 60.0%
Purchases ($30,000 + $40,000) = 75.0%
Deduct sales for January
Inventory, January 31, at retail
Inventory, January 31, at estimated cost:
FIFO ($25,000  75.0%)
$18,750
LIFO ($25,000  60.0%)
$15,000
Retail
$50,000
40,000
$90,000
65,000
$25,000
9-69
Retail Inventory Method: Lower
of Cost or Market
9-70
LIFO Pools
To illustrate the formation of LIFO pools, the
following data are provided for Elohar Co., a seller
of fine neckties:
9-71
LIFO Pools
If two types of neckties are accounted
for separately, computations of LIFO
ending inventory are as follows:
9-72
LIFO Pools
LIFO cost of goods sold:
9-73
Dollar-Value LIFO
Under dollar-value LIFO, LIFO
layers are determined based on
total dollar changes rather than
quantity changes. With dollarvalue LIFO, the unit of
measurement is the dollar.
9-74
Dollar-Value LIFO
First, the replacement cost of ending
inventory is computed using prices
prevailing at the end of the period.
The beginning inventory was
$22,000, so there was an increase in
inventory during the period.
9-75
Dollar-Value LIFO
To determine if a new LIFO layer was
added, we need to find out what the
value of the beginning inventory
would be at ending prices.
9-76
Dollar-Value LIFO
After adjusting for price increases
during the year, we can see that the
dollar value of inventory increased.
9-77
Dollar-Value LIFO
Finally, dollar-value LIFO ending
inventory is computed as follows:
9-78
Dollar-Value LIFO
Retail Method
The following is the LIFO retail layer
data for Miracle Max Department
Store as of December 31.
9-79
Dollar-Value LIFO
Retail Method
Assume that the 2011 year-end price
index is 1.08.
9-80
Dollar-Value LIFO
Retail Method
9-81
Purchase Commitments
• Extreme fluctuations in the price of
inventory purchases can expose a
company to excessive risk.
• Of the different ways to manage this
risk, the simplest is a purchase
commitment that locks in the
inventory purchase price in advance.
9-82
Purchase Commitments
Rollins Oat Company entered into a
purchase commitment on November 1,
2010, for 100,000 bushes of wheat at
$3.40 per bushel to be delivered on
March 2011. At the end of 2010, the
market price for wheat had dropped to
$3.20 per bushel.
9-83
Purchase Commitments
2010
Dec. 31 Loss on Purchase Commitments
Estimated Loss on Purchase
Commitments
20,000
20,000
(100,000 bushels  $0.20 per bushel)
2011
Mar. 31Estimated Loss on Purchase
Commitments
Purchases
Accounts Payable
20,000
320,000
340,000
9-84
Foreign Currency
Inventory Transactions
On November 1, 2010, Washington
Company purchased inventory from
Swiss Company and the invoice was
denominated in Swiss francs with a
purchase price of 50,000 francs. At the
time, the spot rate was 5 francs per
U.S. dollar.
9-85
Foreign Currency
Inventory Transactions
Washington Company would make the
following journal entry to record the
purchase.
2010
Nov.1 Inventory
Accounts Payable (fc)
10,000
10,000
(50,000 francs/5 = $10,000)
9-86
Foreign Currency
Inventory Transactions
Assume the spot rate is 4.7 francs per
U.S. dollar on February 1, 2011.
2011
Feb.1 Accounts Payable (fc)
Exchange Loss
Cash
10,000
638
10,638
$50,000/4.7
9-87
Foreign Currency
Inventory Transactions
Assume the spot rate is 5.1 francs per
U.S. dollar on February 1, 2011.
2011
Feb.1 Accounts Payable (fc)
Exchange Gain
Cash
10,000
196
9,804
$50,000/5.1
9-88
Foreign Currency
Inventory Transactions
If the spot rate on December 31, 2010
is 4.8 francs per dollar, the following
adjusting entry is needed:
2010
Dec. 31 Exchange Loss
Accounts Payable (fc)
417
417
($50,000/4.8)  $10,000
9-89
Foreign Currency
Inventory Transactions
On February 1, 2011, the spot rte is
4.7 francs per dollar.
2011
Feb.1 Accounts Payable (fc)
Exchange Loss
Cash
10,417
221
10,638
$50,000/4.7
9-90