Reporting and
Interpreting
Cost of Goods
Sold and
Inventory
Chapter 7
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
7-2
Understanding the Business
Provide sufficient
quantities of highquality inventory.
Primary Goals of
Inventory
Management
Minimize the costs of
carrying inventory.
7-3
Learning Objectives
Apply the cost principle to identify the amounts
that should be included in inventory and the
matching principle to determine cost of goods
sold for typical retailers, wholesalers, and
manufacturers.
7-4
Items Included in Inventory
Inventory
Tangible
Held for Sale
Merchandise Inventory
Raw Materials Inventory
Work in Process Inventory
Finished Goods Inventory
Used to
Produce Goods
or Services
7-5
Costs Included in Inventory Purchases
The cost principle requires that inventory
be recorded at the price paid or the
consideration given.
Invoice
Price
Freight
Inspection
Costs
Preparation
Costs
7-6
Nature of Cost of Goods Sold
Beginning
Inventory
Purchases
for the Period
Goods available
for Sale
Ending Inventory
Cost of Goods Sold
(Balance Sheet)
(Income Statement)
Beginning inventory + Purchases = Goods Available for Sale
Goods Available for Sale – Ending inventory = Cost of goods sold
7-7
Inventory Costing Methods
Specific
Identification
FIFO
LIFO
Weighted
Average
7-8
Specific Identification
When units are
sold, the
specific cost
of the unit sold
is added to
cost of goods
sold.
7-9
First-In, First-Out Method
Oldest Costs
Cost of
Goods Sold
Recent Costs
Ending
Inventory
7-10
First-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale
Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200
$
Total
5.25
$ 5,250.00
5.30
5.60
5.80
5.90
2,650.00
1,680.00
1,450.00
1,180.00
2,250
$ 12,210.00
Ending
Inventory
1,200
?
Cost of
Goods Sold
1,050
?
Remember:
The costs of
most recent
purchases are
in ending
inventory.
Start with
11/29 and add
units
purchased
until you reach
the number in
ending
inventory.
7-11
First-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
Jan. 3
500 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
200 @ $5.90
200 Units
Cost of Goods
Sold
Units
7-12
First-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
Jan. 3
500 @ 5.30
450 @ $5.30
June 20
300 @ 5.60
300 @ $5.60
Sept. 15
250 @ 5.80
250 @ $5.80
Nov. 29
200 @ 5.90
200 @ $5.90
1,200 Units
Cost of Goods
Sold
Units
$ 6,695 Cost
Now, we have allocated the cost to all
1,200 units in ending inventory.
7-13
First-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
Jan. 3
500 @ 5.30
450 @ $5.30
June 20
300 @ 5.60
300 @ $5.60
Sept. 15
250 @ 5.80
250 @ $5.80
Nov. 29
200 @ 5.90
200 @ $5.90
1,200 Units
$ 6,695 Cost
Cost of Goods
Sold
1,000 @ $ 5.25
50 @ 5.30
1,050 Units
$ 5,515 Cost
Now, we have allocated the cost to all
1,050 units sold.
7-14
First-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale
Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200
$
5.25
5.30
5.60
5.80
5.90
Total
$
5,250.00
2,650.00
1,680.00
1,450.00
1,180.00
2,250
$ 12,210.00
Ending
Inventory
1,200
$ 6,695.00
Cost of
Goods Sold
1,050
$ 5,515.00
Here is the
cost of
ending
inventory
and cost
of goods
sold using
FIFO.
7-15
Last-In, First-Out Method
Oldest Costs
Ending
Inventory
Recent Costs
Cost of
Goods Sold
7-16
Last-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale
Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200
$
Total
5.25
$ 5,250.00
5.30
5.60
5.80
5.90
2,650.00
1,680.00
1,450.00
1,180.00
2,250
$ 12,210.00
Ending
Inventory
1,200
?
Cost of
Goods Sold
1,050
?
Remember:
The costs of the
oldest
purchases are
in ending
inventory. Start
with beginning
inventory and
add units
purchased until
you reach the
number in
ending
inventory.
7-17
Last-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
1,000 @ $5.25
Jan. 3
500 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
1,000 Units
Cost of Goods
Sold
Units
7-18
Last-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
1,000 @ $5.25
Jan. 3
500 @ 5.30
200 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
1,200 Units
Cost of Goods
Sold
Units
$ 6,310 Cost
Now, we have allocated the cost to all
1,200 units in ending inventory.
7-19
Last-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
1,000 @ $5.25
Jan. 3
500 @ 5.30
200 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
1,200 Units
$ 6,310 Cost
Cost of Goods
Sold
300
300
250
200
1,050
@ $ 5.30
@ 5.60
@ 5.80
@ 5.90
Units
$ 5,900 Cost
Now, we have allocated the cost to all
1,050 units sold.
7-20
Last-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale
Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200
$
5.25
Total
$
5.30
5.60
5.80
5.90
5,250.00
2,650.00
1,680.00
1,450.00
1,180.00
2,250
$ 12,210.00
Ending
Inventory
1,200
$
6,310.00
Cost of
Goods Sold
1,050
$
5,900.00
Here is the
cost of
ending
inventory
and cost of
goods sold
using LIFO.
7-21
Average Cost Method
When a unit is sold, the
average cost of each unit in
inventory is assigned to cost
of goods sold.
Cost of Goods
Available for ÷
Sale
Number of
Units
Available for
Sale
7-22
Average Cost Method
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale
Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200
$
5.25
5.30
5.60
5.80
5.90
Total
$
5,250.00
2,650.00
1,680.00
1,450.00
1,180.00
Weighted Average Cost
2,250
Ending
Inventory
1,200
Cost of
Goods Sold
1,050
$ 12,210.00
$ 12,210
= $5.42667
2,250
7-23
Average Cost Method
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale
Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200
$
5.25
Total
$
5.30
5.60
5.80
5.90
5,250.00
2,650.00
1,680.00
1,450.00
1,180.00
Weighted Average Cost
$ 12,210
= $5.42667
2,250
2,250
$ 12,210.00
Ending
Inventory
1,200
$
6,512.00
1,200 × $ 5.42667
Cost of
Goods Sold
1,050
$
5,698.00
1,050 × $ 5.42667
7-24
Comparison of Methods
Computers, Inc.
Income Statement
For Year Ended December 31, 2006
Net sales
Cost of goods sold:
Merchandise inventory, beginning
Net purchases
Goods available for sale
Merchandise inventory, ending
Cost of goods sold
Gross profit
Operating expenses
Income before taxes
Income taxes expense (30%)*
Net income
FIFO
$ 25,000
LIFO
$ 25,000
Weighted
Average
$ 25,000
$ 5,250
6,960
$ 12,210
6,695
$ 5,515
$ 19,485
750
$ 18,735
5,621
$ 13,114
$
$
* Tax expense amounts were rounded.
$
$
$
$
$
5,250
6,960
12,210
6,310
5,900
19,100
750
18,350
5,505
12,845
$
$
$
$
$
5,250
6,960
12,210
6,512
5,698
19,302
750
18,552
5,566
12,986
7-25
Financial Statement Effects of Costing
Methods
Advantages of Methods
First-In,
First-Out
Last-In,
First-Out
Weighted
Average
Ending inventory
approximates
current
replacement cost.
Better matches
current costs in cost
of goods sold with
revenues.
Smoothes out
price changes.
7-26
Learning Objectives
Decide when the use of different inventory
costing methods is beneficial to a company.
7-27
Managers Choice of Inventory Methods
Net Income Effects
Managers prefer to report
higher earnings for their
companies.
Income Tax Effects
Managers prefer to pay
the least amount of taxes
allowed by law as late as
possible.
7-28
Choosing Inventory Costing Methods
If . . .
LIFO for
taxes
LIFO
Conformity
Rule
Then . . .
LIFO for
books
7-29
Learning Objectives
Report inventory at the lower of cost or market
(LCM).
7-30
Valuation at Lower of Cost or Market
Ending inventory is reported at the
lower of cost or market (LCM).
Replacement Cost
The current purchase price
for identical goods.
The company will recognize a “holding” loss in the
current period rather than the period in which the
item is sold.
This practice is conservative.
7-31
Valuation at Lower of Cost or Market
Item
Pentium chips
Disk drives
Quantity
1,000
400
Cost
$ 250
100
Replacement
Cost
$
200
110
LCM
$ 200
100
Total LCM
$ 200,000
40,000
GENERAL JOURNAL
Date
Description
Cost of goods sold
Inventory
Debit
50,000
Credit
50,000
7-32
Learning Objectives
Evaluate inventory management using the
inventory turnover ratio and the effects of
inventory on cash flows.
7-33
Effect on Cash Flows








Inventory Decrease =
(more sales….)
Inventory Increase =
(more purchases….)
Increase + to Cash
Decrease - to Cash
Accounts Payable Increase = + to Cash
( Paying bills later….)
Accounts Payable Decrease = - to Cash
(Paid more bills……)
7-34
Inventory Turnover
Inventory =
Turnover
Cost of Goods Sold
Average Inventory
Average Inventory is . . .
(Beginning Inventory + Ending Inventory) ÷ 2
This ratio reflects how many times
average inventory was produced and
sold during the period. A higher ratio
indicates that inventory moves more
quickly thus reducing storage and
obsolescence costs.
7-35
Learning Objectives
Compare companies that use different
inventory costing methods.
7-36
Inventory Methods and Financial Statement
Analysis
U.S. public companies using LIFO also report beginning
and ending inventory on a FIFO basis if the FIFO values
are materially different.
Beginning inventory FIFO
- Beginning inventory LIFO
Beginning LIFO Reserve
(Excess of FIFO over LIFO)
Ending inventory FIFO
- Ending inventory LIFO
Ending LIFO Reserve
(Excess of FIFO over LIFO)
Beginning LIFO Reserve
- Ending LIFO Reserve
Difference in COGS Under FIFO
7-37
LIFO and International Comparisons
LIFO Permitted?
No
Yes
Singapore
China
Canada
Australia
Great Britain
7-38
Learning Objectives
Understand methods for controlling and
keeping track of inventory and analyze the
effects of inventory errors on financial
statements.
7-39
Internal Control of Inventory
Separation of inventory
accounting and physical
handling of inventory.
Storage in a manner that
protects from theft and
damage.
Limiting access to
authorized employees.
Maintaining perpetual
inventory records.
Comparing perpetual
records to periodic
physical counts.
7-40
Perpetual and Periodic Inventory Systems
Provides up-to-date
inventory records.
Perpetual
System
Provides up-to-date
cost of sales records.
In a periodic inventory system, ending inventory and cost of
goods sold are determined at the end of the accounting
period based on a physical count.
7-41
Perpetual and Periodic Inventory Systems
Inventory System
Periodic System
Carried over
Beginning Inventory
from prior period
Accumulated in
Add: Purchases
the Purchases
account
Measured at end
of period by
Less: Ending Inventory
physical
inventory count
Computed as a
residual amount
Cost of Goods Sold
at end of period
Item
Perpetual System
Carried over from
prior period
Accumulated in
the Inventory
account
Perpetual record
updated at every
sale
Measured at
every sale based
on perpetual
record
7-42
Errors in Measuring Ending Inventory
Errors in Measuring Inventory
Ending Inventory
Beginning Inventory
Overstated Understated Overstated Understated
Effect on Current Period's Balance Sheet
Ending Inventory
Retained Earnings
+
+
-
N/A
N/A
-
+
N/A
N/A
+
+
+
-
+
+
-
+
+
Effect on n Current Period's Income Statement
Goods Available for Sale
Cost of Goods Sold
Gross Profit
Net Income
7-43
Chapter Supplement A
LIFO Liquidations
7-44
LIFO Liquidations
When a LIFO company sells more inventory than it
purchases or manufactures, items from beginning
inventory become part of cost of goods sold. This is
called a LIFO liquidation.
When inventory costs are rising,
these lower cost items in
beginning inventory produce a
higher gross profit, higher
taxable income, and higher
taxes when they are sold.
7-45
LIFO Liquidations
Companies must disclose the effects of LIFO
liquidations in the notes when they are material.
Many companies avoid LIFO
liquidations and the accompanying
increase in tax expense by
purchasing sufficient quantities of
inventory at year-end to ensure that
ending inventory quantities are
greater than or equal to beginning
inventory quantities.
7-46
Chapter Supplement B
Additional Issues in Measuring
Purchases
7-47
Purchase Returns and Allowances
Purchase returns and allowances are a reduction in
the cost of purchases associated with unsatisfactory
goods.
Returned goods require a
reduction in the cost of
inventory purchases and the
recording of a cash refund or a
reduction in the liability to the
vendor.
7-48
Purchase Discounts
A purchase discount is a cash discount received for
prompt payment of an account.
Terms
Discount Period
Credit Period
Full amount
less discount
Full amount due
Time
Due
Purchase or Sale
7-49
Purchase Discounts
2/10,n/30
Discount
Percent
Number of
Days
Discount Is
Available
Otherwise,
Net (or All)
Is Due
Credit
Period
7-50
Purchase Discounts
Purchases paid for
within the discount
period reduce the
Inventory account for
the amount of the cash
discount received.
7-51
Chapter Supplement C
Comparison of Perpetual and
Periodic Inventory Systems
7-52
Perpetual Inventory System
Jan. 1
Apr. 14
Nov. 30
Dec. 31
Had beginning inventory of 800 units at a unit cost of
$50.
Purchased 1,100 units at a unit cost of $50.
Inventory
55,000
Accounts payable
55,000
Sold 1,300 units at a sales price of $83.
Accounts receivable
107,900
Sales revenue
107,900
Cost of goods sold
65,000
Inventory
65,000
Use cost of goods sold and inventory amounts.
7-53
Periodic Inventory System
Jan. 1
Apr. 14
Nov. 30
Dec. 31
Had beginning inventory of 800 units at a unit cost of $50.
Purchased 1,100 units at a unit cost of $50.
Purchases
55,000
Accounts payable
55,000
Sold 1,300 units at a sales price of $83.
Accounts receivable
107,900
Sales revenue
107,900
Count the number of units on hand.
Compute the dollar valuation of the ending inventory.
Compute and record the cost of goods sold.
Cost of goods sold
95,000
Inventory (beginning)
40,000
Purchases
55,000
Inventory (ending)
30,000
Cost of goods sold
30,000
7-54
End of Chapter 7