Chapter 05 - Inventories and Cost of Sales
Chapter Outline
I.
Notes
Inventory Basics
A. Determining Inventory Items
Merchandise inventory includes all goods that a company owns and
holds for sale. The following inventory items require special
attention:
1. Goods in Transit
If ownership has passed to the purchaser, the goods are included
in the purchaser’s inventory. Ownership is determined by
reviewing the shipping terms.
2. Goods on Consignment—goods shipped by the owner, called the
consignor, to another party, the consignee.
a. A consignee sells goods for the owner.
b. The consignor continues to own the consigned goods and
reports them in its inventory.
3. Goods Damaged or Obsolete
a. Damaged and obsolete (and deteriorated) goods are not
counted in inventory if they cannot be sold.
b. If these goods can be sold at a reduced price, they are
included in inventory at their net realizable value, the sales
price minus the cost of making the sale.
B. Determining Inventory Costs
1. The cost of an inventory item includes its invoice cost minus any
discount, plus any incidental costs (such as import duties,
freight, storage, and insurance necessary to put it in place and
condition for sale).
2. The expense recognition or matching principle states that
inventory costs should be recorded against revenue in the period
when inventory is sold. Some companies use the materiality
constraint (cost-to-benefit constraint) to avoid assigning those
incidental costs to inventory. Instead, they expense them when
incurred.
C. Internal Controls and Taking a Physical Count
1. The Inventory account under a perpetual system is updated for
each purchase and sale, but events (such as theft, loss, damage,
and errors) can cause the inventory account balance to differ
from the actual inventory on hand.
2. Nearly all companies take a physical count of inventory at least
once a year; the physical count is used to adjust the Inventory
account balance to the actual inventory on hand.
3. Internal controls when taking a physical count of inventory
include:
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Chapter 05 - Inventories and Cost of Sales
Chapter Outline
II.
Notes
a. Prenumbered inventory tickets; each ticket must be
accounted for.
b. Those responsible for the inventory do not count the
inventory.
c. Counters confirm the validity of inventory, including its
existence, amount, and quality.
d. A second count is taken by a different counter.
e. A manager confirms that all inventories are ticketed once,
and only once.
Inventory Costing under a Perpetual System
Major goal is to properly match costs with sales. The matching
principle is used to decide how much of the cost of goods available for
sale is deducted from sales (on the income statement) and how much is
carried forward as inventory (on the balance sheet). One of the most
important issues in accounting for inventory is determining the per
unit cost assigned to inventory items.
A. Inventory Cost Flow Assumptions
Four methods are commonly used to assign costs to inventory and
cost of goods sold. Each method assumes a particular pattern for
how costs flow through inventory. Physical flow and cost flow
need not be the same.
1. First-in, first-out (FIFO)—assumes costs flow in the order
incurred.
2. Last-in, first-out (LIFO)—assumes costs flow in the reverse
order occurred.
3. Weighted average—assumes costs flow in an average of the
costs available.
4. Specific identification—each item can be identified with a
specific purchase and invoice. Specific identification is
usually only practical for companies with expensive, custommade inventory.
Note: The following sections assume the use of a perpetual system,
the assignment of costs to inventory using a periodic system is
described in Appendix 5A.
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Chapter 05 - Inventories and Cost of Sales
Chapter Outline
Notes
B. Inventory Costing Illustration
1. Specific identification—As sales occur, cost of goods sold is
charged with the actual or invoice cost, leaving actual costs of
inventory on hand in the inventory account.
2. First-in, first-out (FIFO)—As sales occur, FIFO charges costs
of the earliest units acquired to cost of goods sold, leaving
costs of the most recent purchases in inventory.
3. Last-in, first-out (LIFO)—As sales occur, LIFO charges costs
of the most recent purchase to cost of goods sold, leaving
costs of the earliest purchases in inventory.
4. Weighted average—As sales occur, weighted average
computes the average cost per unit of inventory at the time of
sale and charges this cost per unit sold to cost of goods sold
leaving average cost per unit on hand in inventory. Weighted
average equals cost of goods available for sale divided by the
units available.
C. Financial Statement Effects of Costing Methods
1. When purchase prices do not change, each inventory costing
method assigns the same amounts to inventory and to cost of
goods sold. When purchase prices are different, the methods
assign different cost amounts. When purchase costs regularly
rise:
a. FIFO assigns the lowest amount to cost of goods sold
resulting in the highest gross profit and the highest net
income. Advantage: Inventory on the balance sheet
approximates its current replacement cost; it also mimics
the actual flow of goods for most businesses.
b. LIFO assigns the highest amount to cost of goods sold
resulting in the lowest gross profit and the lowest net
income. Advantage: Better match of current costs with
revenues in computing gross margin.
c. Weighted average method yields results between FIFO
and LIFO. Advantage: Smoothing out of price changes.
d. Specific identification always yields results that depend on
which units are sold. Advantage: Exactly matches costs
and revenues.
When costs regularly decline, the reverse occurs for FIFO and
LIFO.
D. Tax Effects of Costing Methods
Since inventory costs affect net income, they have potential tax
effects.
1. Financial reporting often differs from the method used for tax
reporting.
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Chapter 05 - Inventories and Cost of Sales
Chapter Outline
III.
Notes
2. Exception: LIFO may only be used for tax purposes if it is
also used for financial reporting.
E. Consistency in Using Costing Methods
1. Consistency concept requires the use of the same accounting
methods period after period so the financial statements are
comparable across periods.
2. Method change is acceptable if it will improve financial
reporting. The full-disclosure principle requires statement
notes report type of change, its justification, and its effect on
income.
3. Different methods may be consistently applied to different
categories of inventory.
Valuating Inventory at LCM and the Effects of Inventory Errors
A. Lower of Cost or Market
Accounting principles require that inventory be reported on the
balance sheet at the lower of cost or market (LCM).
1. Market is the current replacement cost of purchasing the same
inventory items in the usual manner.
2. When the recorded cost of inventory is higher than the
replacement cost, a loss is recognized; when the recorded cost
is lower, no adjustment is made.
3. Lower of cost or market pricing is applied in one of three
ways to:
a. Each individual item separately,
b. Major categories of items, or
c. To the entire inventory.
4. Accounting rules require that inventory be adjusted to market
when market is less than cost, but inventory normally cannot
be written up to market when market exceeds cost. The
conservatism constraint prescribes the use of the less
optimistic amount when more than one estimate of the amount
to be received or paid exists and these estimates are about
equally likely.
B. Financial Statement Effects of Inventory Errors
An inventory error causes misstatements in cost of goods sold,
gross profit, net income, current assets, and equity. It also causes
misstatements in the next period’s financial statements because
ending inventory of one period is the beginning inventory of the
next.
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Chapter 05 - Inventories and Cost of Sales
Chapter Outline
Notes
1. Income statement effects:
a. If ending inventory is understated, cost of goods sold is
overstated and net income is understated.
b. If beginning inventory is understated, cost of goods sold is
understated and net income is overstated.
c. If ending inventory is overstated, cost of goods sold is
understated and net income is overstated.
d. If beginning inventory is overstated, cost of goods sold is
overstated and net income is understated.
2. Balance sheet effects:
a. If ending inventory is understated, assets and equity are
understated.
b. If ending inventory is overstated, assets and equity are
overstated.
c. Errors in beginning inventory do not yield misstatements
in the end-of-period balance sheet, but they do affect
current period’s income statement (see 1 above).
C. Global View
1. Items and Costs Making Up Inventory – Both GAAP and
IFRS include broad and similar guidance for the items and
costs making up merchandise inventory which includes all
items that a company owns and holds for sale, including the
costs of expenditures necessary to bring those items to a salable
condition and location.
2. Assigning Costs to Inventory – Both GAAP and IFRS allow
companies to use specific identification in assigning costs to
inventory and both systems allow companies to apply a cost
flow assumption (FIFO, Weighted Average and LIFO). IFRS
does not allow use of LIFO.
3. Estimating Inventory Costs – The value of inventory can
change while it awaits sale to customers and this value can
decrease or increase.
a. Decreases in Inventory Value – Both GAAP and IFRS
require companies to write down (reduce the recorded cost)
for inventory when its value falls below the cost presently
recorded. This is called the lower of cost or market method.
GAAP prohibits any later increase in the recorded value, but
IFRS allows reversals of those write downs up to the
original acquisition cost.
b. Increases in Inventory Value – GAAP and IFRS do not
allow inventory to be adjusted upward beyond original cost.
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Chapter 05 - Inventories and Cost of Sales
Chapter Outline
IV.
V.
VI.
Notes
Decision Analysis—Inventory Turnover and Days’ Sales in
Inventory
A. Inventory Turnover
1. Inventory turnover is used to measure a company’s ability to
pay short-term obligations can depend on how quickly
inventory is sold.
2. It is calculated by dividing cost of goods sold by average
inventory.
3. It measures the number of times a company's average
inventory was sold during an accounting period.
B. Days' Sales in Inventory
1. Day’s sales in inventory measures how much inventory is
available in terms of the number of days’ sales.
2. It is calculated by dividing ending inventory by cost of goods
sold, and then multiplying the result by 365.
3. It estimates how many days it will take to convert inventory at
the end of a period into accounts receivable or cash.
C. Analysis of Inventory Management
Inventory management is a major emphasis for most
merchandisers; they must both plan and control inventory
purchases and sales. We prefer a high inventory turnover.
Inventory Costing under a Periodic System (Appendix 5A)
Results of periodic vs. perpetual by method:
A. Specific identification—same results as perpetual.
B. First-in, first-out (FIFO)—same results as perpetual.
C. Last-in, first-out (LIFO)—results differ from perpetual because
timing of cost assignment changes what is identified as the last
cost.
D. Weighted average—results differ from perpetual because timing
of cost assignment changes what costs are averaged.
Inventory Estimation Methods (Appendix 5B)
Inventory sometimes requires estimation for two reasons. First,
companies often require interim financial statements, but only take an
annual physical count of inventory. Second, companies may require an
inventory estimate if some casualty makes taking a physical count
impossible. Estimates are usually only required for companies that use
the periodic system.
A. Retail Inventory Method
The retail inventory method estimates the cost of ending
inventory for interim statements in a periodic inventory when a
physical count is taken only annually. Steps include:
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Chapter 05 - Inventories and Cost of Sales
Chapter Outline
Notes
1. Subtract sales (general ledger amount) from goods available
measured at retail price (retail data in supplementary records)
to get ending inventory at retail.
2. Find cost ratio by dividing total of goods available at cost by
total of goods available at retail.
3. Apply cost ratio to ending inventory at retail to convert to
ending inventory at cost.
Note: The cost ratio is also used to convert a physical inventory
taken using retail price to cost. Shrinkage can be measured by
comparing converted to estimated inventory.
B. Gross Profit Method
The gross profit method estimates the cost of ending inventory
by applying the gross profit ratio to net sales (at retail). This type
of estimate is often used for insurance claims when inventory is
destroyed, lost or stolen. Steps include:
1. Determine the normal gross profit percentage from recent
years.
2. Find the cost of goods percentage (100% less gross profit
percentage).
3. Multiply actual sales by the cost of goods sold percentage to
get estimated cost of goods sold.
4. Subtract estimated cost of goods sold from the actual amount
of cost of goods available for sale to get estimated ending
inventory at cost.
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Chapter 05 - Inventories and Cost of Sales
VISUAL #5-1
Schedule of Cost of Goods Available
Units
Jan. 1
Mar. 27
Aug. 15
Nov. 6
Beginning Inventory
Purchase
Purchase
Purchase
60
90
100
50
300
Cost of goods available for sale
Cost
@
@
@
@
$10
11
13
16
Total
=
=
=
=
$ 600
990
1,300
800
$3,690
$3,690
Methods of Assigning Cost to Units in Ending Inventory
(1) Specific Identification - requires that each item in an inventory be
assigned its actual invoice cost.
(2) Weighted Average - a weighted average cost per unit is determined
based on total cost and units of goods available for sale. This cost is
assigned to units in the ending inventory.
(3) First-in, First-out (FIFO) - assumes the first units acquired
(beginning inventory) are the first to be sold and that additional sales
flow is in the order purchased. Therefore, the costs of the last items
received are assigned to the ending inventory.
(4) Last-in, First-out (LIFO) - assumes the last units acquired (most
recent purchase) are the first units sold. Therefore, the cost of the first
items acquired (starting with beginning inventory) are assigned to the
ending inventory.
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Chapter 05 - Inventories and Cost of Sales
VISUAL #5-2
Goods
O
Available
(COGA)
has 2 parts
Ending
Inventory
(EI)
Which costs
to assign to
each?
Cost of
Goods Sold
(COGS)
Varies by
method
highest
lowest
EI
most recent
costs
FIFO
out = sold
(first or earliest
costs)
COGS
earliest
costs
EI
earliest
costs
LIFO
out = sold
(last or most
recent costs)
COGS
most recent
costs
lowest
highest
In an inflationary
period
(rising prices)
OBSERVATIONS
COGA
- EI
COGS
Net Sales
- COGS
Gross Profit
(varies by method)
(affected by method)
(affected by method)
(affected by method)
Verbally identify the impact of LIFO & FIFO on net income in a period of rising
prices and a period of declining prices.
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