StIce | StIce |Skousen
Inventory and Cost of
Goods Sold
Chapter 9
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Inventory Time Line
BUY
Raw
Materials
or Goods
for Resale
ADD
Value
SELL
COMPUTE
Finished
Inventory
Cost of
Goods
Ending
Sold
Inventory
What is Inventory?
• Items held for resale in the normal
course of business.
• 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.
Inventory Systems
•
Two types of inventory systems which
keep track of how much inventory has
been sold and at what price.
1. Periodic system- requires a physical count
of the inventory periodically, and at the
point of sale only records the sale price.
2. Perpetual system- at point of sale records
selling price and type of item sold.
Example: a bar code scanning system.
Differences in Recording
Purchases of Inventory- Periodic
Purchases
3,000
Accounts Payable
Sales During the Period- Periodic
Accounts Receivable
Sales
3,000
4,125
4,125
Purchases of Inventory- Perpetual
Inventory
Accounts Payable
Sales During the Period- Perpetual
Accounts Receivable
Sales
Cost of Goods Sold
Inventory
3,000
3,000
4,125
4,125
2,750
2,750
Differences in Valuing
Cost of Goods Sold
* From count
** From records
Beginning Inventory
+ Purchases
= Cost of Goods available for
sale
- Ending Inventory
Periodic
System
$ 500
Perpetual
System
$ 500
3,000
3,000
$3,500
$3,500
700*
750**
= Preliminary cost of goods sold $2,800
(COGS)
+ Cost of missing inventory
Unknown
$2,750
Reported cost of goods sold
$2,800
$2,800
50
Stop and Think
If perpetual inventory
systems have so
many clear
advantages, why
aren’t they used by
all companies?
Whose Inventory Is It?
• Report on the balance sheet inventory
to which the company holds legal title.
• Legal title is not determined by who
has physical custody of the inventory
• Issues that develop:
– Goods that are in transit.
– Goods that are on consignment.
Goods in Transit
FOB Shipping Point
Buyer
Seller
Quality
Produce
Goods being shipped are included in
inventory of buyer while in transit.
Goods in Transit
FOB Destination
Buyer
Seller
Quality
Produce
Goods being shipped are included in
inventory of seller until received by buyer.
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 costs
– The shipping costs incurred in their
transfer to the dealer or customer.
What Is Inventory Cost?
•
•
Inventory costs comprise of all
expenditures both direct and indirect,
relating to acquisition, preparation, and
placement for sale.
Discounts can change the total inventory
costs.
1. Trade Discounts
•
•
Convert the catalog price to the actual price.
Record inventory at discounted price.
2. Cash Discounts
•
•
Granted for payment of invoices within a limited time
period.
Record inventory using the net method or gross
method.
Cash Discounts- Net Method
• Records inventory net of any purchase
(cash) discounts.
Example:
June 1
Purchased merchandise for $10,000;
Terms of payment: 2/10, n/30;
Assuming a perpetual inventory method,
record the purchase of the inventory and
payment on June 8.
Cash Discounts
$10,000
Owed
$9,800
Owed
10 Days
20 Days
Supplier “Loan” Period
Purchase
Date
End of
Discount
Period
Final
Payment
Date
Cash Discounts- Net Method
June 1
Inventory
9,800
Accounts Payable (A/P) 9,800
June 8
A/P
Cash
June 28
A/P
Discounts Lost
Cash
June 30
Discounts Lost
A/P
Assume that
payment was
not made until
June 28.
9,800
9,800
9,800
200
10,000
200
200
Assume no
payment till
end of the
month (the
discount period
has lapsed)
here is the
adjustment:
Cash Discounts- Gross Method
• Records inventory gross cost;
discounts are recorded only if taken.
Example:
June 1
Purchased merchandise for $10,000;
Terms of payment: 2/10, n/30;
Assuming a perpetual inventory method,
record the purchase of the inventory and
payment on June 8.
Cash Discounts- Gross Method
June 1
Inventory
10,000
Accounts Payable (A/P) 10,000
June 8
A/P
Inventory
Cash
June 28
A/P
Cash
10,000
200
9,800
10,000
10,000
Assume that
payment was
not made until
June 28.
Purchase Returns and
Allowances
• Adjustments
Periodic Inventory System
are also made
Accounts Payable
400
when goods
are damaged
Purchase Returns &
or not lesser
Allowances
in quality than
400
ordered.
Perpetual Inventory System
• Sometimes the
Accounts Payable
400
customer
returns the
Inventory
goods.
400
Practice time
• 9-66
• 9-1, 2, 3, 5
• 9- 28, 29, 31, 32, 33
Inventory Valuation Methods
Specific
Identification
Cost
Allocation
Methods
FIFO
Average
Cost
LIFO
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.
Inventory Valuation Method
Assume:
Purchases:
January 1
March 23
July 15
November 6
Total purchases
Sales
200
300
500
100
1,100
700
@
@
@
@
$10
$12
$11
$13
@ $15
$ 2,000
3,600
5,500
1,300
$12,400
Specific Identification Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
300 units @ $12 per unit
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.
Specific Identification Method
Jan. 1
200 units @ $10 per unit
July 15
500 units @ $11 per unit
SOLD 700
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
Specific Identification Method
Goods Not Sold
Mar. 23
300 units @ $12 per unit
= $3,600
Nov. 6
100 units @ $13 per unit
= 1,300
Ending inventory
$4,900
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.
• For perpetual inventory, the unit cost
is computed as a moving average,
which changes with each new
purchase of goods.
Average Cost Method
Periodic
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
300 units @ $12 per unit
500 units @ $11 per unit
Nov. 6
100 units @ $13 per unit
1,100 units
= $ 2,000
=
3,600
=
5,500
=
1,300
$12,400
$12,400 1,100 units = $11.27 per unit (rounded)
Cost of goods sold = $11.27 x 700 = $7,890
Ending inventory = $11.27 x 400 = $4,510
First-In-First-Out
(FIFO) Method
• 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.
FIFO Method--Periodic
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
300 units @ $12 per unit
500 units @ $11 per unit
Nov. 6
100 units @ $13 per unit
Total cost of goods sold
Sold 200
= $2,000
= 3,600
Sold 300
Sold 200
= 2,200
$7,800
FIFO Method--Periodic
Goods Not Sold
Mar. 23
300 units @ $11 per unit
= 3,300
Nov. 6
100 units @ $13 per unit
= 1,300
Ending Inventory
$4,600
Last-In-First-Out
(LIFO) Method
• 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 inventory versus periodic
inventory.
LIFO Method--Periodic
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
300 units @ $12 per unit
500 units @ $11 per unit
= $1,200
Sold 100
= $5,500
Sold 500
Nov. 6
100 units @ $13 per unit
= $1,300
Sold 100
Total cost of goods sold
$8,000
LIFO Method--Periodic
Goods Not Sold
Jan. 1
200 units @ $10 per unit
= 2,000
Mar. 23
200 units @ $12 per unit
= 2,400
Ending Inventory
$4,400
Comparison of Inventory
Methods (Periodic)
Ending
Cost of Goods
Inventory
Sold
Specific identification
$7,500
$4,900
Average cost
$7,890
$4,510
FIFO
$7,800
$4,600
LIFO
$8,000
$4,400
Practice
• Exercise 9-34
Perpetual Inventory
Assume:
Beginning inventory
Purchases:
April 10
April 20
Sales:
April 18
April 27
100
@ $10
$1,000
80
70
@ $11
@ $12
880
840
90
50
@ $15
@ $16
FIFO periodic and FIFO perpetual provide
identical results for cost of goods sold and
inventory.
Average Cost MethodPerpetual
Apr. 1
Apr. 10
Apr. 10
Beginning Inventory 100 units @ $10
$1,000
Purchases
80 units @ $11
880
Balance
180 units @ $10.44 $1,880
Apr.
Apr.
Apr.
Apr.
Sales
Balance
Purchases
Balance
18
18
20
20
Apr. 27
Apr. 30
Sales
Balance
(90)
90
70
160
units @ $10.44
(940)
units @ $10.44 $ 940
units @ $12
840
units @ $11.125 $1,780
$1,880  180
(50) units @ $11.125
(556)
110 units @ $11.125 $1,224
$1,780  160
Ending inventory, $1,224
Average Cost Method- Perpetual
Apr. 1
Apr. 10
Apr. 10
Beginning Inventory 100 units @ $10
$1,000
Purchases
80 units @ $11
880
Balance
180 units @ $10.44 $1,880
Apr.
Apr.
Apr.
Apr.
Sales
Balance
Purchases
Balance
(90)
90
70
160
Sales
Balance
(50) units @ $11.125 (556)
110 units @ $11.125 $1,224
18
18
20
20
Apr. 27
Apr. 30
units
units
units
units
@
@
@
@
$10.44
(940)
$10.44 $ 940
$12
840
$11.125 $1,780
Cost of Goods Sold (140 units) $940 + $556 =
$1,496
LIFO Method- Perpetual
Perpetual Inventory System
Apr. 1
100
units @
90 units
@$10
$10per
perunit
unit
Apr. 10
0 units
units @@$11
$11per
perunit
unit
80
Beginning
Sold 10
inventory
Purchased
Sold
80
80
Apr. 20
70 units
units @
20
@$12
$12per
perunit
unit
Purchased
Sold 50
70
LIFO Method- Perpetual
Perpetual Inventory System
90 units @ $10 per unit
Apr. 1 100
Apr. 10
Apr. 20
=
=
=
80
0 units @ $11 per unit
20
70 units @ $12 per unit
Ending inventory………………..
$ 900
0
240
$1,140
Beg. Inv. + Purchases – End. Inv. = Cost of Goods
Sold
$1,000 + $1,720 – $1,140 = $1,580
Unique Aspects of LIFO
• LIFO liquidation- the effect of cost of goods
sold and net income during periods of rising
prices, when “old” inventory layers are sold.
• Low cost prices are matched with higher
sales prices resulting in a lower than usual
cost of goods sold and a higher net income.
• LIFO conformity rule- in the 1930s Congress
specified that companies who use LIFO for
financial reporting must use LIFO for
income tax reporting as well.
• LIFO Tax effect can be significant over time.
See Exhibit 9-14.
Special LIFO Concerns
• LIFO Layers are created each year when the
number of units purchased exceeds the
number of units sold; a new layer of inventory
is created
• LIFO Reserve is the difference between LIFO
ending inventory and FIFO or other inventory
value. LIFO Reserves should be disclosed with
the Balance Sheet
• Results are that older costs are associated
with Sales in succeeding years, usually
resulting in a lower matched COGS and
misrepresenting the Gross Profit as higher
Practice
• 9-35
• 9-7
• 9-8 & 9
FIFO Advantages and
Disadvantages
Advantages:
• Usually corresponds with physical flow of
goods.
• Ending inventory balance agrees closely
with current replacement cost.
Disadvantages:
• Can cause older costs to be matched with
current revenues.
• Inventory holding gains and losses are
included as part of gross profit.
• Yields higher taxable income in times of
inflation if inventory levels are stable or
increasing.
LIFO Advantages
Advantages:
• Matches current costs with current
revenues.
• Excludes inventory holding gains from
gross profit.
• Yields lower taxable income in times
of inflation if inventory levels are
stable or increasing.
LIFO Disadvantages
Disadvantages:
• Usually does not correspond with the
physical flow of goods.
• Potential LIFO liquidation means old cost in
LIFO layers can be drawn in to cost of
goods sold.
• Ending inventory balance can be much
lower than current replacement cost.
• LIFO liquidation can result in greatly
increased tax payments when inventory
levels decline.
FIFO and LIFO Comparison
Inventory Accounting Change
• If a company changes its method of valuing
inventory, the change is accounted for as a
change in accounting principle.
Average Cost
change to
FIFO
Report the effect of changing methods on the
financial statements.
Any Method
change to
LIFO
No adjustment to financial statements for
change to LIFO, but special disclosure required.
Review time
•Exercise 43
Lower of Cost or Market
• Accounting Principle of
“Conservatism” applies
• LCM recognizes unrealized decreases
in the value of assets, but not
unrealized increases
• Market Value represents current
replacement cost, constrained by a
ceiling and floor value
Lower of Cost or Market
• The term
Ceiling:
Ceiling:
“market”
Also
Estimated
known
in lower
asselling
ofthe
cost
net
or
marketprice
means
– normal
replacement
selling
cost.
costs
realizable
value
Replacement
Cost
Market
compare
Historical Cost
see p.
Floor: Net realizable value
– 472
a normal profit margin
Lower of Cost or Market
Lower of Cost or Market p 473
CASE A
Ceiling: $0.80
Market
$0.70
$0.70
$0.65
Floor: $0.55 Historical Cost
LCM = $0.65
Lower of Cost or Market
Lower of Cost or Market
CASE B
Ceiling: $0.80
Market
$0.60
$0.60
$0.65
Floor: $0.55
Historical Cost
LCM = $0.60
Lower of Cost or Market
Lower of Cost or Market
CASE C
Ceiling: $0.80
Market
$0.55
$0.50
$0.65
Floor: $0.55
Historical Cost
LCM = $0.55
Lower of Cost or Market
Lower of Cost or Market
CASE D
Ceiling: $0.80
Market
$0.55
$0.45
$0.50
Floor: $0.55
Historical Cost
LCM = $0.50
Lower of Cost or Market
Lower of Cost or Market
CASE E
Ceiling: $0.80
Market
$0.80
$0.85
$0.75
Floor: $0.55
Historical Cost
LCM = $0.75
Lower of Cost or Market
Lower of Cost or Market
CASE F
Ceiling: $0.80
Market
$0.80
$1.00
$0.90
Floor: $0.55
Historical Cost
LCM = $0.80
Problem Solving
•Let’s practice with
Exercise 11, 13, 14,
44, 47, 48
Gross Profit Inventory Method
• An estimation technique based on the
relationship between gross profit and
Sales
• Gross Profit percentage is applied to
sales to estimate the COGS
• COGS is then subtracted COGA to
arrive at the estimated inventory
• May be used to estimate missing
inventory, verify counts, or use for
interim statements
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 percentage
Last year
40 %
Two years ago
37
Three years ago
42
Last year’s 40% is considered a good
estimate.
Gross Profit Method
Sales (actual)
$50,000
Cost of goods sold (estimate) 30,000
Gross profit (estimate)
$20,000
Beginning inventory (actual)
100 %
60 %
40 %
$25,000
Gross Profit Method
Sales (actual)
$50,000
Cost of goods sold (estimate) 30,000
Gross profit (estimate)
$20,000
Beginning inventory (actual)
+ Purchases (actual)
100 %
60 %
40 %
$25,000
40,000
Gross Profit Method
Sales (actual)
$50,000
Cost of goods sold (estimate) 30,000
Gross profit (estimate)
$20,000
Beginning inventory (actual)
+ Purchases (actual)
– Cost of goods available for
sale (actual)
100 %
60 %
40 %
$25,000
40,000
$65,000
Gross Profit Method
Sales (actual)
$50,000
Cost of goods sold (estimate) 30,000
Gross profit (estimate)
$20,000
Beginning inventory (actual)
+ Purchases (actual)
– Cost of goods available for
sale (actual)
– Cost of goods sold (estimate)
100 %
60 %
40 %
$25,000
40,000
$65,000
30,000
Gross Profit Method
Sales (actual)
$50,000
Cost of goods sold (estimate) 30,000
Gross profit (estimate)
$20,000
Beginning inventory (actual)
+ Purchases (actual)
– Cost of goods available for
sale (actual)
– Cost of goods sold (estimate)
=Ending inventory (estimate)
100 %
60 %
40 %
$25,000
40,000
$65,000
$30,000
35,000
Gross Profit Method
Sales (actual)
$50,000
Cost of goods sold (estimate) 29,000
Gross profit (estimate)
$21,000
Beginning inventory (actual)
+ Purchases (actual)
– Cost of goods available for
sale (actual)
– Ending inventory (estimate)
= Cost of goods sold (estimate)
100 %
58 %
42 %
$25,000
40,000
$65,000
36,000
$29,000
Effects of Errors
• Misstated inventory will result in
errors on both the Balance Sheet and
Income Statement
• Multiple amounts may be effected on
the Income Statement
• An error in one period effects the next
• Some errors may self-correct
• See p. 479
Effects of Errors in Recording
Inventory
Correction of Errors
• Depends on when error is detected
• If found in current period,
adjustments can be made to current
accounts and the reported net income
and balance sheet amounts will be
correct.
Cost of Goods Sold
1,000
Inventory
1,000
Correction of Errors
• If found in subsequent period and the
net income of the prior period was
misstated, the correcting entry
qualifies as a prior-period adjustment
and is made to beginning retained
earnings of the subsequent period in
which the error was discovered.
Retained Earnings 1000
Inventory
1000
Practice
• 9-15, 16, 49, 51, 52
Inventory Turnover
Appropriateness of inventory size and
position can be measured by
calculating the
Inventory Turnover Ratio.
Inventory Turnover:
Cost of Goods Sold ÷ Average Inventory
Inventory Turnover
• Cost of Goods Sold
• Beginning Inventory
• Ending Inventory
$1,000
$
90
$ 110
Determine the inventory turnover.
Inventory Turnover
• Cost of Goods Sold
• Beginning Inventory
• Ending Inventory
$1,000
$
90
$ 110
$1,000
($90 + $110)/2
= 10
Inventory Turnover
• The higher the Turnover, the faster a
company is using its inventory, thus
“turning a profit”
• The turnover ratio will be different
based on what inventory method is
used: Fifo vs. Lifo
• With an increased turnover, the
investment needed for a given volume
of business is smaller
Number of Days’ Sales in Inventory
• The average time it takes to turn over
the inventory
• The type of inventory and nature of
business determines what is
acceptable
• Days = 365/Inventory Turnover
Number of Days’ Sales in
Inventory
$1,000
($90 + $110)/2
= 10
365
10
Number of days’ sales in inventory is
36.5
Practice
• Exercise 9-17
Retail Inventory Method
• Used by retail firms to estimate
inventory value.
• Can be used to estimate inventory
under any valuation assumption.
• Cost amounts and retail amounts are
tracked of the goods that have been
purchased in the period.
• Cost percentage = goods available for
sale at cost/ending inventory at retail
Retail Inventory Method
Retail Inventory Method
Inventory, Jan 1
Purchases in Jan
Goods Available for Sale
COST
RETAIL
$30,000 $50,000
30,000 40,000
$60,000 $90,000
Cost Percentage:
Beginning inventory ($30,000/$50,000) = 60.0%
Purchases ($30,000/$40,000) =75.0%
–Sales for January
65,000
Inventory, Jan 31, at retail
$25,000
Inventory, Jan 31, at estimated cost:
FIFO ($25,000 x 75%)
$ 18,750
LIFO ($25,000 x 60%)
$ 15,000
Learning Objectives
1. Define inventory for a merchandising
business and identify the different
types of inventory for a manufacturing
business.
2. Explain the advantages and
disadvantages of both periodic and
perpetual inventory systems.
3. Determine when ownership of goods in
transit changes hands and what
circumstances require shipped
inventory to be kept on the books.
Learning Objectives
4. Compute total inventory acquisition
cost.
5. Use the four basic inventory
valuation methods: specific
identification, average cost, FIFO,
and LIFO.
6. Explain how LIFO inventory layers
are created, and describe the
significance of the LIFO reserve.
Learning Objectives
7. Choose an inventory valuation
method based on the trade-offs
among income tax effects, bookkeeping costs, and the impact on the
financial statements.
8. Apply the lower-of-cost-or-market
(LCM) rule to reflect declines in the
market value of inventory.
Learning Objectives
9. Use the gross profit method to
estimate ending inventory.
10.Determine the financial statement
impact of inventory recording errors.
11.Analyze inventory using financial
ratios, and properly compare ratios
of different firms after adjusting for
differences in inventory valuation
methods.
Learning Objectives
Expanded Material
12.Compute estimates of FIFO, LIFO,
average cost, and lower-or-cost-or
market inventory using the retail
inventory method.
13.Use LIFO pools, dollar-value LIFO, and
dollar-value LIFO retail to compute
ending inventory.
14.Account for the impact of changing
prices on purchase commitments.
15.Record inventory purchase
transactions denominated in foreign
currencies.
Raw Materials
Raw Materials are
Materials that are
goods acquired for
necessary in the
use
in
the
Materials that are
production process
production
process.
used directly in the
but are not directly
production of goods
incorporated into
are frequently
the product are
referred to as direct
referred to as
materials.
indirect materials.
Work in Process
Work in Process
(WIP) consists ofDirect labor refers
to the cost of labor
materials
partly
The three cost
directly identified
processed
and
elements
that make
Manufacturing
with goods in
requiring
further
up overhead
WIP are direct
refers
to
production.
work before
they can
materials,
direct of
the
proportion
be sold.
labor and
factory
overhead
manufacturing
assignable to goods
overhead.
in production.
Finished Goods
Finished goods are the manufactured
products awaiting sale.
Balance Sheet
Income Statement
Direct Labor
Raw
Materials
Work in
Process
Manufacturing
Overhead
Finished
Goods
Cost of
Goods
Sold
Summary
Income
Statement
Items
Balance Sheet Items
Retailer Merchandise
Sale
Cost of
Goods Sold
Finished
Goods
Cost of
Goods Sold
Manufacturer
Raw
Materials
Work in
Process
Direct Overhead
Labor
Sale
Schedule of Cost of Goods
Manufactured
Bartlett Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2005
Direct materials:
Raw materials
$ 21,350
Purchases
107,500
Cost of raw materials available for use 128,850
Less raw materials inventory, Dec. 31
22,350
Raw materials used in production
$106,500
Direct labor
96,850
Manufacturing overhead:
Schedule of Cost of Goods
Manufactured
Manufacturing overhead:
Indirect labor
Factory supervision
$ 40,000
29,000
Depr.—factory building and equipment 20,000
Light, heat, and power
18,000
Factory supplies
15,000
Miscellaneous manufacturing overhead 12,055
Total manufacturing costs
Add work in process inventory, January 1
Less work in process inventory, December 31
Cost of goods manufactured
134,055
$337,405
99,400
$366,805
26,500
$340,305