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.
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.
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.
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
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
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 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.
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.
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.
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.
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.
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.
• Dollar-value LIFO- LIFO layers are
determined based on total dollar changes
rather than quantity changes.
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.
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
Floor: Net realizable value –
a normal profit margin
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
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