Chapter 6
Inventories and
Cost of Goods Sold
Gross Profit and
Cost of Goods Sold
• An initial step in assessing profitability is
gross profit (profit margin or gross margin),
which is the difference between sales
revenues and the costs of the goods sold.
• Products being held for resale are reported
as inventory, a current asset.
– When the goods are sold, the costs of the
inventory become an expense, Cost of Goods
Sold. This expense is deducted from Net Sales
to determine Gross Profit.
The Basic Concept of
Inventory Accounting
• The key to calculating cost of goods sold is
accounting for the remaining inventory at
the end of the year.
• Cost valuation - process of assigning
specific historical costs to items counted in
the physical inventory
– Multiply the number of items in ending
inventory times the cost of each item.
Perpetual and Periodic
Inventory Systems
• Two main systems for keeping merchandise
inventory records:
– Perpetual inventory system - a system that
keeps a running, continuous record that tracks
inventories and the cost of goods sold on a dayto-day basis
– Periodic inventory system - a system in which
the cost of good sold is computed periodically
by relying solely on physical counts without
keeping day-to-day records of units sold or on
Perpetual and Periodic
Inventory Systems
• A perpetual inventory system helps
managers control inventory levels and
prepare interim financial statements.
– The inventory amount can be found at any
given point in time.
• Inventory items must be counted at least
once a year to ensure correct valuation.
– Physical count - the process of counting all the
items in inventory at a moment in time
Perpetual and Periodic
Inventory Systems
• In a perpetual system, the journal entries
are:
When inventory is purchased:
Merchandise inventory
Accounts payable (or Cash)
When inventory is sold:
Accounts receivable (or Cash)
Sales revenue
Cost of goods sold
Merchandise inventory
xxx
xxx
xxx
xxx
xxx
xxx
Perpetual and Periodic
Inventory Systems
• In a periodic system, no day-to-day
inventory records are maintained.
• The physical count allows management to
delete damaged or obsolete items and thus
helps to reveal inventory shrinkage inventory reductions from theft, breakage,
or losses of inventory.
Perpetual and Periodic
Inventory Systems
• Under the periodic system, calculations for
cost of goods sold start with cost of goods
available for sale, which is the sum of the
beginning inventory plus current year
purchases.
• Under the perpetual system, cost of goods
sold is kept on a day-to-day basis.
Perpetual and Periodic
Inventory Systems
• Both methods produce the same cost of
goods sold figure.
– The perpetual system is more timely, but it is
more costly to administer.
– The perpetual system is less costly to
administer because there is no day-to-day
processing regarding inventory costs or cost of
goods sold.
Comparing Accounting Procedures for
Periodic and Perpetual Inventory Systems
• In the perpetual system, purchases of
merchandise directly increase the Inventory
account, and purchase returns and
allowances and sales directly decrease the
Inventory account.
• In the periodic system, purchases of
merchandise increase the Purchases
account, and purchase returns and
allowances are placed in separate accounts
that are deducted from Purchases.
Comparing Accounting Procedures for
Periodic and Perpetual Inventory Systems
• Under the perpetual system, inventory
amounts are updated each time an inventory
transaction is processed.
• Under a periodic system, the Inventory
account does not change until the end of the
accounting period.
– At that time, a physical inventory is taken to
determine the amount of inventory on hand, and
an entry is made to adjust the Inventory account
to that amount.
Principal Inventory
Valuation Methods
• Four inventory valuation systems have been
generally accepted.
–
–
–
–
Specific identification
First in, first out (FIFO)
Last in, first out (LIFO)
Weighted average
Principal Inventory
Valuation Methods
• If unit prices and costs did not change, all
four inventory valuation methods would
show identical results.
• Because prices change, cost of goods sold
(income measurement) and inventories
(asset measurement) are affected.
– The choice of the inventory valuation method
can significantly affect the amount reported as
net income and ending inventory.
FIFO
• FIFO (first in, first out) method - assigns the
cost of the earliest acquired units to cost of
goods sold
– This might not be the actual physical flow of
goods within the company.
– Under FIFO, the oldest units are deemed to be
sold, regardless of which units are actually
given to the customer.
– The costs of the newer units in stock are
included in ending inventory.
FIFO
• FIFO includes the most recent costs in
ending inventory, so the inventory tends to
closely approximate that actual market
value of the inventory at the balance sheet
date.
• Also, in periods when prices are rising,
FIFO leads to higher net income because
the costs of the older, lower costing items
are included in cost of goods sold.
LIFO
• LIFO (last in, first out) method - assigns the
most recent costs to cost of goods sold
– This might not be the actual physical flow of
goods within the company.
– Under LIFO, the newest units are deemed to be
sold, regardless of which units are actually
given to the customer.
– The costs of the older units in stock are
included in ending inventory.
LIFO
• LIFO uses the oldest costs to value ending
inventory, so that value may be significantly
different from the actual market value of the
inventory at the balance sheet date.
• In periods when prices are rising, LIFO
yields lower net income because the higher
costs of more recent purchases are put into
cost of goods sold first.
LIFO
• Because LIFO results in reduced net
income, it also results in lower income
taxes.
– The Internal Revenue Code requires that if a
company uses LIFO to compute its taxable
income, the company must also use LIFO to
compute its financial net income.
– The result is lower income taxes and lower
reported earnings figures to investors.
LIFO
• If LIFO is such a good deal, why
do some companies still use FIFO?
• For several reasons:
– The costs of changing methods can be
significant.
– Management may be reluctant to decrease
earnings and possibly salaries and bonuses.
– Management might fear that lower income
would hurt in loan negotiations with banks.
– Lower earnings will often lower stock prices.