Financial Accounting
Sixth Edition
Inventory and Cost
of Goods Sold
6
CHAPTER
Spiceland • Thomas • Herrmann
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6-1
Part A
UNDERSTANDING INVENTORY AND COST
OF GOODS SOLD
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6-2
Learning Objective 1
LO6–1 Understand that inventory flows from
manufacturing companies to merchandising
companies and is reported as an asset on the
balance sheet.
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6-3
Inventory***
Inventory is a current asset reported in the
balance sheet and represents the cost of
inventory not yet sold at the end of the period.
Cost of goods sold (COGS) is an expense
reported in the income statement and
represents the cost of inventory sold.
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6-4
Illustration 6–2
Types of
Companies
and Flow of
Inventory Costs
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6-5
Manufacturing and Merchandising
Companies***
Inventory
Merchandising
company
Manufacturing
company
Raw
materials
Work in
Process
Finished
goods
Wholesaler
Retailer
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6-6
Illustration 6–1
Manufacturing Company (Intel) vs.
Merchandising Company (Best Buy)
INVENTORY
(from balance sheets)
Inventory accounts ($ in millions)
Raw materials
Work in process
Finished goods
Merchandise inventories
Total inventories
Intel
$ 695
3,190
1,668
$5,553
Best Buy
$4,864
$4,864
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6-7
Key Point
Service companies record revenues when
providing services to customers.
Merchandising and manufacturing companies
record revenues when selling inventory to
customers.
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6-8
Learning Objective 2
LO6–2 Understand how cost of goods sold is reported
in a multiple-step income statement.
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6-9
Illustration 6–3
Relationship between Inventory
and Cost of Goods Sold ***
Beginning Inventory
(asset)
$20,000
Purchases During the Year
+
(asset)
$90,000
Total Inventory
Available for Sale
$110,000
Not Sold
Ending Inventory
Asset in the
balance sheet
$30,000
Sold
+
Cost of Goods Sold
Expense in the
income statement
$80,000
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6-10
Illustration 6–4
Multiple-Step Income Statement for Best Buy***
Best Buy Co., Inc.
Multiple-Step Income Statement
For the year ended January 31, 2017
($in millions)
Revenues (net of returns, allowances, and discounts)
Cost of goods sold
Gross profit
$39,403
29,963
9,440
Selling, general, and administrative expenses
(includes advertising, salaries, rent, utilities, supplies,
depreciation, and other operating expenses)
Operating income
7,586
1,854
Other income (expense):
Gain on sale of investment
Investment income and other
Interest expense
Income before income taxes
3
31
(72)
1,816
Income tax expense
Net income*
Multiple
levels
of
profit
609
$ 1,207
*Amounts include those from Best Buy’s actual income statement excluding small adjustments for discontinued operations and noncontrolling interest.
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6-11
Key Point ***
A multiple-step income statement reports
multiple levels of profitability.
Gross profit = Net Sales - Cost of Goods Sold
Operating income = GP - Operating Expenses
Net income = Revenues - Expenses
6-12
Concept Check 6–3
Which level of profitability is considered
profit from normal operations?
a. Gross profit
b. Operating income
c. Income before taxes
d. Net income
Operating income is measured as gross profit (sales
revenue minus cost of goods sold) minus operating
expenses. Income before taxes and net income include
nonoperating items, which are not considered part of
normal operations.
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6-13
Learning Objective 3
LO6–3 Determine the cost of goods sold and ending
inventory using different inventory cost
methods.***
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6-14
Inventory Cost Methods***
• Specific identification

Matches each unit of inventory with its actual cost
• First-in, first-out (FIFO)

Assumes first units purchased are first ones sold
• Last-in, first-out (LIFO)

Assumes last units purchased are first ones sold
• Weighted-average cost

Assumes each unit of inventory has a cost equal to the
weighted-average unit cost of all inventory items.
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6-15
Key Point
Companies are allowed to report inventory costs
by assuming which specific units of inventory
are sold and not sold, even if this does not
match the actual flow.
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6-16
Illustration 6–5
Inventory Transactions for Mario’s
Game Shop
Date
Jan. 1
Apr. 25
Oct. 19
Transaction
Beginning inventory
Purchase
Purchase
Total available
for sale
Number
of Units
Unit
Cost
100
300
600
$ 7
9
11
1,000
Jul. 17
Dec. 15
Sale
Sale
Total units sold
300
500
800
Dec. 31
Ending inventory
200
Total
Cost$
$
700
2,700
6,600
$10,000
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6-17
Illustration 6–6
Inventory Calculation – FIFO Method***
Inventory Transactions for Mario’s Game Shop—FIFO METHOD
Cost of
Ending
+
Goods Sold Inventory
Cost of Goods Available for Sale =
Beginning
Inventory and
Purchases
Jan. 1
Apr. 25
Oct. 19
Number
of Units
100
300
400
200
1,000
×
Unit
Cost
$ 7
9
11
11
=
Total
Cost
$
700
2,700
4,400
2,200
$10,000
Sold first
800 units
$ 700
2,700
4,400
Not sold
=
$7,800
+
$2,200
$2,200
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6-18
Illustration 6–7
Inventory Calculation – LIFO Method***
Inventory Transactions for Mario’s Game Shop—LIFO METHOD
Cost of
Ending
+
Goods Sold Inventory
Cost of Goods Available for Sale =
Beginning
Inventory and
Purchases
Jan. 1
Apr. 25
Oct. 19
Number
of Units
100
100
200
600
1,000
×
Unit
Cost
$ 7
9
9
11
=
Total
Cost
$
700
900
1,800
6,600
$10,000
$ 700
900
Not sold
Sold last
800 units
$1,800
6,600
$8,400
+
$1,600
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6-19
Weighted-Average Cost***
• Under this method, we assume:



Both cost of goods sold and ending inventory
consist of a random mixture of all the goods
available for sale
Each unit of inventory has a cost equal to the
weighted-average unit cost of all inventory items
The unit weighted-average cost is calculated as:
Cost of goods available for sale $
Units available for sale #
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6-20
Illustration 6–8
Inventory Calculation Assuming the
Weighted-Average Cost Method***
Inventory Transactions for Mario’s Game Shop—
WEIGHTED-AVERAGE COST METHOD
Cost of Goods Available for Sale
Date
Jan. 1
Apr. 25
Oct. 19
Number
of Units
Transaction
Beginning inventory
Purchase
Purchase
Weighted-average unit cost
Cost of goods sold
Ending Inventory
×
100
300
600
1,000
=
=
=
Unit
Cost
$7
9
11
$10,000
1,000 units
= $10 per unit
800 sold
200 not sold
×
×
$10
10
=
Total
Cost
$ 700
2,700
6,600
$10,000
$ 8,000
2,000
$10,000
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6-21
Illustration 6–10
Comparison of Inventory Cost Methods,
When Costs Are Rising***
FIFO
LIFO
$ 2,200
$ 1,600
$ 2,000
Income statement:
Sales revenue (800 × $15) $12,000
Cost of goods sold
7,800
Gross profit
$ 4,200
$12,000
8,400
$ 3,600
$12,000
8,000
$ 4,000
Balance sheet:
Ending inventory
Weighted-Average
• The choice of inventory method affects:


Reported ending inventory (asset)
Reported cost of goods sold (and therefore profit)
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6-22
Key Point ***
Generally, FIFO more closely resembles the actual
physical flow of inventory.
When inventory costs are rising:
FIFO results in higher inventory and higher income.
LIFO results in a lower inventory and net income, reducing the
company’s income tax obligation.
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6-23
Learning Objective 4
LO6–4 Explain the financial statement effects and tax
effects of inventory cost methods.***
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6-24
Choice of Inventory Reporting
Methods***
• FIFO method


Matches physical flow for most companies
Ending inventory reflects current cost
• LIFO method

Cost of goods sold reflects current cost
• LIFO conformity rule***

Companies that use LIFO for tax reporting must
also use LIFO for financial reporting
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6-25
Illustration 6–11
Impact of the LIFO Difference on
Reported Inventory of Kroger
Company
KROGER COMPANY
Balance Sheet (partial)
($ in millions)
2017
Cash and temporary cash investments $ 322
Store deposits in transit
910
Receivables
1,649
FIFO inventory
7,852
LIFO reserve
(1,291)
Prepaid and other current assets
898
Total current assets
$10,340
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6-26
Part B
RECORDING INVENTORY TRANSACTIONS
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6-27
Perpetual Inventory System and
Periodic Inventory System
Perpetual Inventory
Periodic Inventory
System
System
• Maintains a continual
record of inventory
• Helps a company better
manage inventory levels
• Most often used in practice
• Does not maintain a
continual record of
inventory
• Periodically adjusts for
purchase and sale of
inventory
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6-28
Learning Objective 5
LO6–5 Record inventory transactions using a
perpetual inventory system.
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6-29
Illustration 6–12
Inventory Transactions for Mario’s
Game Shop
Date
Jan. 1
Apr. 25
Jul. 17
Oct. 19
Dec. 15
Transaction
Beginning inventory
Purchase
Sale
Purchase
Sale
Totals
Details
100 units for $7 each
300 units for $9 each
300 units for $15 each
600 units for $11 each
500 units for $15 each
Total
Cost
$ 700
2,700
Total
Revenue
$ 4,500
6,600
$10,000
7,500
$12,000
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6-30
Example
Inventory Purchases
• On April 25, Mario’s purchases inventory for
$2,700 on account (300 units @ $9 each)
April 25
Inventory ……………………………………….
Accounts Payable ……………..........
Debit
2,700
Credit
2,700
(Purchase inventory on account)
• The entry involves:


Increasing the balance of inventory (an asset)
Increasing the balance of accounts payable (a
liability)
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6-31
Example
Inventory Sales
• On July 17, Mario’s sells inventory on account
for $4,500 (300 units @ $15 each)
July 17
Debit
Accounts Receivable ………………………… 4,500
Sales Revenue ……………..................
Credit
4,500
(Sell inventory on account)
($4,500 = 300 units × $15)
Cost of Goods Sold …………………………… 2,500
Inventory ……………..........................
2,500
(Record cost of inventory sold)
($2,500 = [100 units × $7] + [200 units × $9])
• Sales Revenue = Selling price
• Cost of goods sold (expense) = Purchase cost (FIFO)
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6-32
Illustration 6–13
Inventory Account for Mario’s Game
Shop
Inventory
Jan. 1 Beginning
Apr. 25 Purchase
Oct. 19 Purchase
700
2,700
6,600
10,000
2,500
5,300
7,800
Jul. 17 Sale
Dec. 15 Sale
Dec. 31 Ending
FIFO amount Bal. 2,200
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6-33
LIFO Adjustment***
• Companies generally maintain their inventory records on a FIFO basis
• To report using LIFO, a year-end adjustment to inventory needs to be
made (LIFO adjustment)
• The difference in reported inventory when using LIFO instead of FIFO is
commonly referred to as the LIFO reserve
• Recall that Mario’s ending inventory using FIFO was $2,200 but would
have been $1,600 under LIFO.
• Let’s look at Mario’s year-end LIFO adjustment on the next slide
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6-34
Illustration 6–14
Inventory Account after LIFO Adjustment ***
December 31
Debit
Cost of Goods Sold …………………………… 600
Inventory ……………..........................
Credit
600
(Record the LIFO adjustment)
Inventory
Jan. 1 Beginning
Apr. 25 Purchase
Oct. 19 Purchase
Dec. 31 FIFO amount
700
2,700
6,600
10,000
2,200
2,500
5,300
7,800
600
Jul. 17
Dec. 15
Sale
Sale
Dec. 31 LIFO adjustment
Dec. 31 Ending
LIFO amount Bal. 1,600
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6-35
Additional Inventory Transactions
• Freight charges


Freight-in (shipments from suppliers)
Freight-out (shipments to customers)
• Purchase discounts

Discount offered by seller to buyer for quick
payment
• Purchase returns

Buyer returns unwanted or defective inventory
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6-36
Illustration 6–17
Gross Profit for Mario’s Game Shop
after Additional Inventory Transactions
Sales revenue
Cost of goods sold:
Beginning inventory
Purchase on April 25
Freight charges
Purchase discount
Purchase on October 19
Gross profit
Units Unit Price Total
800
$15
$12,000
Units Unit Cost Total
100
$ 7
$ 700
300
9
2,700
300
(54)
400
11
4,400
800
$ 8,046
$ 3,954
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6-37
Illustration 6–15
Shipping Terms
1. FOB Shipping Point. Title
Shipping 2. FOB Destination.
passes at shipping point (when
Terms Title passes at destination
(when inventory arrives at
inventory leaves the supplier’s
Mario’s). Mario would record
warehouse). Mario would record
the purchase on April 29.
the purchase on April 25..
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6-38
Learning Objective 7
LO6–7 Analyze management of inventory using the
inventory turnover ratio and gross profit ratio.
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6-39
Inventory Turnover Ratio
• Shows the number of times the firm sells its
average inventory balance during a reporting
period.
Cost of goods sold
Inventory turnover ratio =
Average inventory
Average Days in Inventory
• Indicates the approximate number of days the
average inventory is held.
365
Average days in inventory =
Inventory turnover ratio
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6-40
Illustration 6–21
Inventory Turnover Ratios for
Best Buy and Tiffany’s
Average Days in
Inventory Turnover Ratio
Inventory
Best Buy $29,963 ÷ $4,957.5 = 6.0 times 365 = 61 days
6.0
Tiffany’s
$1,512 ÷ $2,191.5 = 0.7 times
365 = 521 days
0.7
• Best Buy’s turnover ratio is much higher, and
its average days in inventory is much lower

Best Buy sells its inventory more quickly
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6-41
Gross Profit Ratio
• Indicator of the company’s successful
management of inventory
• Measures the amount by which the sale price
of inventory exceeds its cost per dollar of sales
Gross profit
Gross profit ratio =
Net sales
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6-42
Illustration 6–22
Gross Profit Ratios for Best Buy
and Tiffany’s
Gross Profit/Net Sales =
Best Buy
Tiffany’s
$9,440/$39,403
$2,490/$4,002
=
=
Gross
Profit Ratio
24%
62%
• Best Buy’s gross profit ratio is lower

Best Buy sells its inventory for less profit
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6-43
End of Chapter 6
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6-44