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Merchandise
Inventory and
Cost of Sales
CHAPTER 7
Learning Objectives
1.
2.
3.
Identify the components and costs included in
merchandise inventory.
Calculate the cost of goods sold and
merchandise inventory using specific
identification, moving weighted average, FIFO,
and LIFO-perpetual.
Analyze the effects of the costing methods on
financial reporting.
Learning Objectives
4.
5.
6.
Calculate the lower of cost or market value of
inventory.
Analyze the effects of inventory errors on
current and future financial statementsperpetual.
Apply both the gross profit and retail methods
to estimate inventory.
Learning Objectives
7.
8.
9.
Calculate cost of goods sold and merchandise
inventory using specific identification, weighted
average, FIFO, and LIFO-periodic. (Appendix
7A).
Analyze the effects of inventory errors on
current and future financial statements-periodic.
(Appendix 7A).
Assess inventory management using both
merchandise turnover and days’ sales in
inventory. (Appendix 7B)
Assigning Costs to Inventory
Accounting for inventory requires several
decisions which include:


Items to include in cost.
Inventory System.


Costing Method.


Perpetual or Periodic
FIFO, LIFO, Moving Weighted Average, Specific ID
Use of estimates.

Gross profit method, Retail inventory method
Items in Merchandise Inventory
Inventory includes all goods owned by a
company and held for sale.
Items requiring special attention:
 Goods in Transit
 Goods on consignment
 Obsolete or damaged goods
Costs of Merchandise Inventory
All expenditures necessary to bring an
item to a saleable condition and location.
 This includes:
 Invoice
price less discounts
 Import duties
 Transportation-in
 Storage
 Insurance
Assigning Costs to Inventory


Management must decide on method of
determining unit cost.
This will affect both the income statement
and the balance sheet.
Methods:
1.
2.
3.
4.
Specific Identification
FIFO
LIFO
Average Cost
Merchandising Cost Flows
Beginning
Inventory
Balance Sheet
Ending
Inventory
Net Cost
of Purchases
Merchandise
Available
for Sale
Income Statement
Cost of
Goods Sold
Use of Inventory Methods in
Practice
FIFO
47%
Other
4%
LIFO
4%
Average
Cost
45%
Specific Identification
This method is used when items:
 Are unique.
 Can be directly identified with a specific
purchase and its invoice.
Examples:
Automobiles, art
custom furniture.
Specific Identification — Example
Date
8/1
8/3
Specific Identificaton Computations - Perpetual Inventory System
Purchases
Sales
Balance
Units
Cost
Total
Units
Cost
Total
Units
Cost
Total
10 $
91 $
910
10 $
91 $
910
10 $
91 $
910
15 $
106 $ 1,590
15 $
106 $ 1,590
25
2 $
3 $
$ 2,500
91 $
182
106 $
318
$ 2,300
2 $
3 $
20 $
$
500
91 $
182
106 $
318
115 $ 2,300
$ 4,800
25
3 $
8 $
11
$ 2,800
106 $
318
115 $
920
$ 1,238
8/14
8 $
12 $
91 $
728
106 $ 1,272
The opening inventory consists of 10 units @ $91/unit.
5
8/17
20 $
115
8/28
Totals
45
2 $
12 $
34
91 $
182
115 $ 1,380
$ 3,562
Specific Identification — Example
Date
8/1
8/3
Specific Identificaton Computations - Perpetual Inventory System
Purchases
Sales
Balance
Units
Cost
Total
Units
Cost
Total
Units
Cost
Total
10 $
91 $
910
10 $
91 $
910
10 $
91 $
910
15 $
106 $ 1,590
15 $
106 $ 1,590
25
2 $
3 $
$ 2,500
91 $
182
106 $
318
$ 2,300
20 $
$
500
$
182
$
318
115 $ 2,300
$ 4,800
25
3 $
8 $
11
$ 2,800
106 $
318
115 $
920
$ 1,238
8/14
Additional units are
purchased @ $106/unit.
8/17
20 $
115
8/28
Totals
45
8 $
12 $
91 $
728
106 $ 1,272
This results in two layers
of
5
2 $
91
inventory.
3 $
106
2 $
12 $
34
91 $
182
115 $ 1,380
$ 3,562
Specific Identification — Example
Date
8/1
8/3
Specific Identificaton Computations - Perpetual Inventory System
Purchases
Sales
Balance
Units
Cost
Total
Units
Cost
Total
Units
Cost
Total
10 $
91 $
910
10 $
91 $
910
10 $
91 $
910
15 $
106 $ 1,590
15 $
106 $ 1,590
8/14
8 $
12 $
91 $
728
106 $ 1,272
25
2 $
3 $
$ 2,500
91 $
182
106 $
318
5
2 $
3 $
20 $
$
500
91 $
182
106 $
318
115 $ 2,300
11
$ 2,800
106 $
318
115 $
920
$ 1,238
On 8/17
August 20
14,$ 20115units
are sold. Eight of these units
$ 2,300
25
came from the opening inventory and the remaining 12
8/28
2 $
91 $
182
3 $
units came from the August
3
purchase.
12 $
115 $ 1,380
8 $
Totals
45
$ 4,800
34
$ 3,562
Specific Identification — Example
Date
8/1
8/3
8/14
8/17
8/28
Totals
Specific Identificaton Computations - Perpetual Inventory System
Purchases
Sales
Balance
Units
Cost
Total
Units
Cost
Total
Units
Cost
Total
10 $
91 $
910
10 $
91 $
910
10 $
91 $
910
15 $
106 $ 1,590
15 $
106 $ 1,590
8 $
12 $
91 $
728
106 $ 1,272
$
115 $ 2,300
This20 leaves
2 units remaining from the
2 $
91 $
182
original inventory and 3 units
remaining
12 $
115 $ 1,380
3 34purchase.$ 3,562
45 from the
$ August
4,800
25
2 $
3 $
$ 2,500
91 $
182
106 $
318
5
2 $
3 $
20 $
$
500
91 $
182
106 $
318
115 $ 2,300
25
3 $
8 $
11
$ 2,800
106 $
318
115 $
920
$ 1,238
Moving Weighted Average Method
Under this method, the cost of all units are
averaged together.
Average cost per unit
=
Cost of goods available for sale
Number of units available for sale
Moving Weighted Average - Example
Date
8/1
8/3
Moving Weighted Average Computations - Perpetual Inventory System
Purchases
Sales
Balance
Units
Cost
Total
Units
Cost
Total
Units
Cost
Total
10 $
91 $
910
10 $
91 $
910
15 $
106 $ 1,590
25 $
100 $ 2,500
8/14
8/17
20 $
20 $
100 $ 2,000
115 $ 2,300
5 $
100 $
500
25 $
112 $ 2,800
11 $
112 $ 1,232
The opening inventory consists of 10 units @ $91/unit.
8/28
Totals
14 $
45
$ 4,800
34
112 $ 1,568
$ 3,568
11
$ 1,232
Moving Weighted Average- Example
Date
8/1
8/3
Moving Weighted Average Computations - Perpetual Inventory System
Purchases
Sales
Balance
Units
Cost
Total
Units
Cost
Total
Units
Cost
Total
10 $
91 $
910
10 $
91 $
910
15 $
106 $ 1,590
25 $
100 $ 2,500
8/14
20 $
100 $ 2,000
5 $
100 $
Additional
units
8/17
20 $ are
115 $ 2,300
25 $
112
This results in an average cost of
purchased
@ $106/unit.
8/28
14 $
112 $ 1,568
11 $
112
$100/unit.
Totals
45
$ 4,800
34
$ 3,568
11
(10 x $91) + (15 x $106)
25 units
500
$ 2,800
$ 1,232
$ 1,232
Moving Weighted Average- Example
Date
8/1
8/3
Moving Weighted Average Computations - Perpetual Inventory System
Purchases
Sales
Balance
Units
Cost
Total
Units
Cost
Total
Units
Cost
Total
10 $
91 $
910
10 $
91 $
910
15 $
106 $ 1,590
25 $
100 $ 2,500
8/14
8/17
20 $
20 $
100 $ 2,000
115 $ 2,300
These
20 units are sold at the14
8/28
Totals average45cost of $100/unit.
$ 4,800
34
$
112 $ 1,568
$ 3,568
5 $
100 $
500
25 $
112 $ 2,800
11 $
112 $ 1,232
11
$ 1,232
Moving Weighted Average- Example
Date
8/1
8/3
Moving Weighted Average Computations - Perpetual Inventory System
Purchases
Sales
Balance
Units
Cost
Total
Units
Cost
Total
Units
Cost
Total
10 $
91 $
910
10 $
91 $
910
15 $
106 $ 1,590
25 $
100 $ 2,500
8/14
8/17
8/28
Totals
20 $
20 $
100 $ 2,000
115 $ 2,300
14 $
112 at
$
This leaves 5 units remaining
45 average
$ cost
4,800 of $100/unit.
34
$
an
5 $
100 $
500
25 $
112 $ 2,800
1,568
11 $
112 $ 1,232
3,568
11
$ 1,232
Mini-Quiz
A company that uses a perpetual inventory system made
the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a
Moving Weighted Average system is used.
Cash
Sales (40x16)
Cost of goods sold 430
Inventory
(100x10 + 60x12)/160 x 40
640
640
430
First-In, First-Out (FIFO)
Based on the assumption that the items are
sold in the order acquired.
When a sale occurs:
 The earliest units purchased are
charged to Cost of Goods Sold.
 The cost of the most recent purchases
remain in inventory.
FIFO — Example
Date
8/1
8/3
FIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
10 $
10 $
91 $
910
106 $ 1,060
5 $
106 $
530
$
530
115 $ 2,300
The opening inventory consists of 10 units @ $91/unit.
5 $
106
8/17
20 $
115
$ 2,300
20 $
25
8/28
Totals
45
$ 4,800
5 $
9 $
34
106 $
530
115 $ 1,035
$ 3,535
11 $
11
$ 2,830
115 $ 1,265
$ 1,265
FIFO — Example
Date
8/1
8/3
FIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
Additionalunits
unitsreare
Additional
8/17
20 $
115 $ 2,300
purchased
@
$106/unit.
purchased @ $106/unit.
8/28
Totals
45
$ 4,800
10 $
10 $
91 $
910
106 $ 1,060
5 $
106
This results in two layers
of
5 $
106
20 $
115
inventory.
25
5 $
9 $
34
106 $
530
115 $ 1,035
$ 3,535
11 $
11
$
530
$
530
$ 2,300
$ 2,830
115 $ 1,265
$ 1,265
FIFO — Example
Date
8/1
8/3
FIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
8/17
10 $
10 $
20 $
115
$ 2,300
91 $
910
106 $ 1,060
5 $
5 $
20 $
106 $
530
106 $
530
115 $ 2,300
25 acquired.
$ 2,830
Under FIFO, units are assumed to be sold in the order
8/28
5 $
106 $
530
Therefore, of the 20 units sold on August
the first 11
10$units
9 $
115 14,
$ 1,035
115 come
$ 1,265
Totals
45
$ 4,800
34
$ 3,535
$ 1,265
from
beginning
inventory.
Therefore,
those
10 units 11
are removed
from the inventory record based on the cost of those units of $91.
FIFO — Example
Date
8/1
8/3
FIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
8/17
10 $
10 $
20 $
115
91 $
910
106 $ 1,060
$ 2,300
5 $
106 14
$ th 530
on August
come
5 $
5 $
20 $
25
106 $
530
106 $
530
115 $ 2,300
$ 2,830
The8/28
remaining 10 units sold
from the next
9
$
115
$
1,035
11 $
115 $ 1,265
rd
purchase,
made
on August
are removed
Totals
45
$ 4,8003 . Therefore,
34
$these
3,535 units 11
$ 1,265
from the inventory record based on their cost of $106.
FIFO — Example
Date
8/1
8/3
FIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
8/17
10 $
10 $
20 $
115
91 $
910
106 $ 1,060
$ 2,300
5 $
5 $
20 $
25
5 $
106 $
530
The ending inventory consists
of
the
5
9 $
115 $ 1,035
Totals
$ 4,800
34
$ 3,535
remaining45 units from
the August
3 purchase.
106 $
530
106 $
530
115 $ 2,300
$ 2,830
8/28
11 $
11
115 $ 1,265
$ 1,265
Mini-Quiz
A company that uses a perpetual inventory system made
the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a FIFO
system is used.
Cash
Sales (40x16)
Cost of goods sold 400
Inventory (40x10)
640
640
400
Last-In, First-Out (LIFO)
Based on the assumption that the most
recently purchased items are sold first.
When a sale occurs:
 The latest units purchased are charged to
Cost of Goods Sold.
 The cost of the earliest purchases remain
in inventory.
LIFO — Example
Date
8/1
8/3
LIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
15 $
5 $
106 $ 1,590
91 $
455
5 $
91 $
455
$
455
115 $ 2,300
The opening inventory consists of 10 units @ $91/unit.
5 $
91
8/17
20 $
115
$ 2,300
8/28
Totals
20 $
14 $
45
$ 4,800
34
115 $ 1,610
$ 3,655
25
5 $
11
$ 2,755
91
$ 1,145
LIFO — Example
Date
8/1
8/3
LIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
Additional units are
8/17
$
115 $ 2,300
purchased
@ 20$106/unit.
8/28
Totals
15 $
5 $
$ 4,800
5 $
5 $
20 $
91 $
455
91 $
455
115 $ 2,300
This results in two layers of
inventory.
25
14 $
45
106 $ 1,590
91 $
455
34
115 $ 1,610
$ 3,655
5 $
11
$ 2,755
91
$ 1,145
LIFO — Example
Date
8/1
LIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/3
Of the
20 units sold, these
units8/14
are assumed to be sold
first.
8/17
20 $
115
14 $
45
106 $ 1,590
91 $
455
$ 2,300
8/28
Totals
15 $
5 $
$ 4,800
34
115 $ 1,610
$ 3,655
5 $
5 $
20 $
91 $
455
91 $
455
115 $ 2,300
25
5 $
$ 2,755
11
91
$ 1,145
LIFO — Example
Date
8/1
8/3
LIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
8/17
8/28
Totals
15 $
5 $
20 $
115
106 $ 1,590
91 $
455
$ 2,300
Once the latest units purchased
14 $
115 $ 1,610
are sold, units are sold from the
45
$ 4,800
34
$ 3,655
previous
purchase.
5 $
5 $
20 $
91 $
455
91 $
455
115 $ 2,300
25
5 $
$ 2,755
11
91
$ 1,145
LIFO — Example
Date
8/1
8/3
LIFO Computations - Perpetual Inventory System
Purchases
Sales
Units
Cost
Total
Units
Cost
Total
Units
10 $
91 $
910
10
10
15 $
106 $ 1,590
15
Balance
Cost
Total
$
91 $
910
$
91 $
910
$
106 $ 1,590
25
$ 2,500
8/14
8/17
15 $
5 $
20 $
115
$ 2,300
This leaves 5 units remaining
8/28
from the first purchase.14 $
Totals
45
106 $ 1,590
91 $
455
$ 4,800
34
115 $ 1,610
$ 3,655
5 $
5 $
20 $
91 $
455
91 $
455
115 $ 2,300
25
5 $
$ 2,755
11
91
$ 1,145
Mini-Quiz
A company that uses a perpetual inventory system made
the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a LIFO
system is used.
Cash
Sales (40x16)
Cost of goods sold 480
Inventory (40x12)
640
640
480
Financial Reporting
Because prices change, the choice of an inventory
method is important.
Moving
Specific
Weighted
Units Identification Average
FIFO
LIFO
Cost of Goods Sold
34
$
3,562 $ 3,568 $ 3,535 $ 3,655
Ending Inventory
11
$
1,238 $ 1,232 $ 1,265 $ 1,145
Goods Available for Sale
45
$
4,800 $ 4,800 $ 4,800 $ 4,800
Financial Reporting
Advantages of Each Method
Weighted
Average
First-In,
First-In,
First-Out
First-Out
Last-In,
First-Out
Smoothes out
purchase price
changes.
Ending inventory
inventory
Ending
approximates
approximates
current
current
replacement cost.
cost.
replacement
Better matches
current costs in
cost of goods sold
with revenues.
Financial Reporting



A company is required to use the same
accounting methods from period to period
(consistency principle).
A change is only acceptable when it improves
financial reporting.
The costing method used must be disclosed in
the notes to the financial statements (fulldisclosure principle).
Lower of Cost or Market
Inventory must be reported at market value
when market is lower than cost
(conservatism principle).
 Market may be defined as:
 Net realizable value
 Current replacement cost

Lower of Cost or Market
May be applied in one of three ways:
1. Separately to each item.
2. To major categories of items.
3. To the inventory as a whole.
Inventory Errors
Errors in the computation of or physical count
of inventory will cause a misstatement of:





Cost of goods sold
Gross profit
Net income
Current assets
Owner’s equity
Inventory Errors- Effects on the
Income Statement
Inventory Error
Understate ending inventory
Understate beginning inventory
Overstate ending inventory
Overstate beginning inventory
Cost of Goods Sold
Overstated
Understated
Understated
Overstated
Net Income
Understated
Overstated
Overstated
Understated
Inventory Errors- Effects on the
Balance Sheet
Inventory Error
Understate ending inventory
Overstate ending inventory
Assets
Owner's Equity
Understated
Understated
Overstated
Overstated
Gross Profit Method
Ending inventory is estimated by
applying gross profit ratio to net sales.
It is used:
when inventory has been destroyed, lost, or
stolen.
 for testing the reasonableness of the
physical inventory count.

Retail Inventory Method
Occasionally used for interim period
reporting.
Information required:
1.
2.
3.
Beginning inventory at cost and retail.
Net purchases at cost and retail.
Net sales.
Review
Q Describe how management’s decisions can
affect the determination of the cost of inventory.
A Choice of method –FIFO,LIFO, Moving weighted
average, Specific item.
Choice of application of LCM -separate item,
categories, whole inventory. Definition of market.
Choice of periodic or perpetual system.
Items to include in cost. Other.
Periodic System-Appendix 7A
 The
periodic system also uses FIFO,
LIFO, specific identification, and
weighted average methods to assign
costs to inventory and cost of goods
sold.
 The results may be the same or
different under both systems.
Specific Identification- Appendix 7A
 Applied
in same manner as periodic
system.
 Yields same results as perpetual
system since units are specifically
identified.
Weighted Average-Appendix 7A
1.
Steps:
Calculate weighted average unit cost.
(# units
beg. Inv.
X unit cost) + (#units purchased x unit cost)
# units available for sale
= weighted average unit cost
2.
Use weighted average unit cost to assign
costs to cost of goods sold and ending
inventory.
FIFO-Appendix 7A
Yields same results as perpetual
system since most recent purchases
are in ending inventory under both
systems.
LIFO-Appendix 7A
Yields different results than perpetual
system since:


LIFO periodic assigns costs at the end of
period.
LIFO perpetual assigns most recent costs to
cost of goods sold.
Inventory Errors in a Periodic
System-Appendix 7A


An error in the ending inventory affects the
assets, net income, and owner’s equity of
that period.
The ending inventory of one period
becomes the opening inventory of the next
period.
The cost of goods sold
and net income of the next period are
affected as well.
Ratios-Appendix 7B
Inventory ratios may be used to assess:
1.
2.
Short-term liquidity.
Inventory management.
Ratios-Appendix 7B
Merchandise Turnover Ratio


Measures how many times a company
turns its inventory over each period.
The ratio will vary from industry to
industry.
Merchandise turnover
cost of goods sold
average inventory
Ratios-Appendix 7B
Days’ Sales in Inventory


Used to estimate how many days it will take to
convert inventory to cash or receivables.
Used to assess if inventory levels can meet sales
demand.
Days’ sales in inventory = Ending inventory x 365
Cost of goods sold
End of Chapter