Chapter 7
Inventories and
Cost of Goods Sold
Financial Accounting, Alternate 4e by Porter and Norton
1
Inventory of Wholesalers and Retailers
 Purchased
in finished form
 Resold without transformation
 Classified as “Merchandise Inventory”
on balance sheet
2
CIRCUIT CITY
Consolidated Balance Sheets [Partial]
ASSETS (in thousands)
2003
2002
CURRENT ASSETS:
Cash and cash equivalents More
$ 884,670
Net accounts and notes receivable
775,339
than
Merchandise inventory
1,409,736
1/3 of
Prepaid expenses and other
current assets
33,165
current
Assets of discontinued operations
--assets
TOTAL CURRENT ASSETS
3,102,910
Property, plant and equipment, net
853,778
Deferred income taxes
22,362
Other assets
24,252
Assets of discontinued operations
--TOTAL ASSETS
$3,799,117
$1,248,246
553,273
1,234,243
39,246
577,703
3,652,711
988,947
2,647
11,354
142,519
$4,542,033
3
Inventory of Manufacturers
Costs Included in Inventory
Direct
Materials
Direct
Labor
Manufacturing
Overhead
4
Inventory of Manufacturers
Balance Sheet
Classifications
Costs Included
in Inventory
Direct
Materials
Direct
Labor
Manufacturing
Overhead
Raw
Materials
Manufacture
Products
Work in
Process
Finished
Goods
5
NIKE, INC.
Consolidated Balance Sheets [Partial]
May 31,
ASSETS (in millions)
Current assets:
Cash and cash equivalents
Accounts receivable less allowance for
doubtful accounts of $77.4 and $72.1
Inventories:
Finished goods
Work in progress
Raw materials
2001
2002
$
575.5
$
304.0
1,807.1
1,621.4
1,348.2
13.0
12.6
1,373.8
140.8
260.5
4,157.7
1,399.9
15.1
9.1
1,424.1
113.3
162.5
3,625.3
Property, plant and equipment, net
1,614.5
Identifiable intangible assets and goodwill
437.8
Deferred income taxes and other assets
233.0
TOTAL ASSETS
$ 6,443.0
1,618.8
397.3
178.2
$ 5,819.6
Deferred income taxes
Prepaid expenses
Total current assets
6
Income Statement of a Merchandiser
Cash sales
$ 350,000
Credit sales
124,000
Total
474,000
Less: Sales returns &
allowances ( 12,400)
Sales discounts
( 34,600)
Net sales
$ 427,000
Contra-accounts used for
control and analysis purposes
7
Credit Terms and Sales Discounts
n/30
Payment due 30 days from invoice
date
1/10, n/30
Deduct 1% of invoice amount if
paid within 10 days; otherwise
full invoice amount is due in 30 days
2/10, n/30
Deduct 2% of invoice amount if
paid within 10 days; otherwise full
invoice amount is due in 30 days
8
The Cost of Goods Sold Model
New
purchases
Beginning
inventory
Inventory
not sold appears on
balance
sheet
Ending inventory
Inventory sold appears on
income statement
Cost
of goods
sold
9
The Cost of Goods Sold Model
Beginning inventory
Plus: Cost of goods purchased
= Cost of goods available for sale
Less: Ending inventory
= Cost of goods sold
“Pool” of goods
available to sell
during the period
$ 15,000
63,000
78,000
( 18,000)
$ 60,000
An increase in ending
inventory means more
was bought than sold
10
Perpetual Inventory Systems
Inventory records are
updated after each
purchase or sale
 Point
of sale terminals have improved ability
of mass merchandisers to maintain perpetual
systems
11
Periodic Inventory Systems
Inventory records are
updated periodically
based on physical
inventory counts
 Reduces
record-keeping but also decreases ability
to track theft, breakage, etc. and prepare interim
financial statements
12
Cost of Goods Purchased

Includes invoice price:
Plus:
Transportation-in
Less:
Purchase returns and
allowances
Purchase discounts
13
Recording Purchase Discounts
Assets
Cash (495)
=
Liab. + O/E + Rev. – Exp.
Accts Pay. 500
Purch. Discounts 5
To record payment within discount period to
supplier who offers 1% purchase discount.
($ 500 x 1% = $5 discount)
14
FOB Destination Point
Seller
Buyer
Title
Passes at
Destination


No sale or purchase until inventory reaches its destination
Seller responsible for inventory while in transit
15
FOB Shipping Point
Seller
Buyer
Title
Passes when
Shipped


Both sale and purchase recorded upon shipment
Buyer responsible for inventory while in transit
16
Inventory Valuation and
Income Measurement
Value
Assigned to
Inventory
on Balance
Sheet
When Sold =
Value
Expensed
as Cost of
Goods Sold
on Income
Statement
17
Calculating Cost of Goods Sold

Internal calculation
Beginning inventory
+ Purchases
= Cost of goods available for sale
-
Ending inventory
= Cost of goods sold
$
500
1,200
1,700
(600)
$ 1,100
18
Inventory costs include
 Any
freight costs incurred by buyer
 Cost of insurance for inventory in transit
 Cost of storing inventory before selling
 Excise and sales taxes
19
Inventory Costing Methods
Four costing methods available:
Specific
Identification
Weighted
Average
First-in, First-out
(FIFO)
Last-in, First-out
(LIFO)
20
Detailed Costing Method Example
Calculate the cost of goods sold and ending inventory
under each method using the data below:
Beginning inventory, Jan. 1: 500 units (unit cost $10)
Inventory purchases:
Date
Units
1/20
300
4/8
400
9/5
200
12/12
100
Total purchases
1,000
Ending inventory, Dec. 31: 600 units
Unit Cost
$ 11
12
13
14
21
Specific Identification Method
Step 1:
Identify the specific units in
inventory at the end of the year
and their costs.
22
Specific Identification Method
Units in ending inventory:
Date purchased
Units Cost Total cost
1/20
100
$11
$1,100
4/8
300
12
3,600
9/5
200
13
2,600
Ending inventory
600
$7,300
Units x Cost = Total cost
23
Specific Identification Method
Step 2:
Identify the units sold and
calculate the cost of goods sold.
24
Specific Identification Method
Date purchased
Units Cost Total cost
Beg. Inventory
500
$10
$5,000
1/20
200
11
2,200
4/8
100
12
1,200
12/12
100
14
1,400
Cost of goods sold
900
$9,800
Units x Cost = Total cost
25
Weighted Average Method
Step 1:
Calculate the cost of goods
available for sale.
26
Weighted Average Cost Method
Date purchased
Units Cost Total cost
Beg. inventory
500
$10
$ 5,000
1/20
300
11
3,300
4/8
400
12
4,800
9/5
200
13
2,600
12/12
100
14
1,400
Cost of goods
available for sale
1,500
$17,100
27
Weighted Average Method
Step 2:
Divide the cost of goods available
for sale by the total units to
determine the weighted average
cost per unit.
:
28
Weighted Average Method
Cost of Goods Available
Units Available
$17,100
= $ 11.40/unit
1,500
29
Weighted Average Method
Step 3: Calculate ending inventory and
COGS by multiplying the
weighted average cost per unit by
the # of units in ending inventory
and the # of units sold.
Avg.
Cost
X
#
Units
30
Weighted Average Method
Units on hand
Units sold
Weighted average cost
X
Total cost of goods
available of $17,100 allocated:
ALLOCATE TO
Ending
Cost of
Inventory Goods Sold
600
900
$11.40
$ 11.40
$6,840
$10,260
31
First-in, First-out (FIFO) Method
Step 1:
Assign the cost of the beginning
inventory to cost of goods sold.
1st
in
32
First-in, First-out (FIFO) Method
Units
Cost
1/1
500
$10
1/20
300
$11
4/8
400
$12
9/5
200
$13
12/12
100
$14
ALLOCATE TO
Ending
Cost of
Inventory Goods Sold
$5,000
33
First-in, First-out (FIFO) Method
Step 2:
Continue to work forward until you
assign the total # of units sold during
the period to cost of goods sold. Allocate
the remaining units to ending inventory.
2nd
3rd
etc.
34
First-in, First-out (FIFO) Method
ALLOCATE TO
Ending
Cost of
Inventory Goods Sold
Units
Cost
1/1
500
$10
$5,000
1/20
300
$11
3,300
4/8
300 / 100
$12
$3,600
9/5
200
$13
2,600
12/12
100
$14
1,400
TOTALS
$7,600
1,200
$9,500
35
Last-in, First-out (LIFO) Method
Step 1:
Assign the cost of the last units
purchased to cost of goods sold.
1st
in
36
Last-in, First-out (LIFO) Method
Units
Cost
1/1
500
$10
1/20
300
$11
4/8
400
$12
9/5
200
$13
12/12
100
$14
ALLOCATE TO
Ending
Cost of
Inventory Goods Sold
$1,400
37
Last-in, First-out (LIFO) Method
Step 2:
Work backward until you assign the
total # of units sold during the period
to cost of goods sold (allocate the
remaining units to ending inventory).
1st
in
38
Last-in, First-out (LIFO) Method
Units
Cost
ALLOCATE TO
Ending
Cost of
Inventory Goods Sold
1/1
500
$10
$5,000
1/20
100 / 200
$11
1,100
4/8
400
$12
4,800
9/5
200
$13
2,600
12/12
100
$14
1,400
TOTALS
$6,100
$2,200
$11,000
39
Comparison of Costing Methods
Ending
Inventory
Specific
Identification
Cost of
Goods
Sold
Goods
Available
for Sale
$7,300
9,800
$17,100
Weighted
Average
6,840
10,260
17,100
FIFO
7,600
9,500
17,000
LIFO
6,100
11,000
17,100
40
Comparison of Costing Methods
Weighted
Avg.
FIFO LIFO
In periods of rising
prices:
highest COGS?
lowest COGS?
highest gross margin?
lowest net income?
lowest income taxes?
X
X
X
X
X
41
LIFO Issues
 LIFO Liquidation
 liquidation can result in high gross
margin (and large tax bill)
 LIFO Conformity Rule
 if used for tax, LIFO must
also be used for books
 LIFO Reserve
 difference between inventory value
stated at FIFO and value stated at LIFO
42
Reasons for Inventory Errors
 Mathematical
mistakes
 Physical inventory counting errors
 Cut-off problems - in-transit
 Goods on consignment
43
Effect of Inventory Errors on the
Income Statement
Reported
Sales
$1,000
Beginning inventory
$ 200
Add: Purchases
700
Goods available for sale $ 900
Less: Ending inventory
300
Cost of goods sold
$ 600
Gross margin
$ 400
Operating expenses
150
Net income
250
(In 000s)
Corrected Effect
$1,000
200
700
$ 900
250 $50 OS
$ 650
50 US
$ 350
50 OS
150
200
50 OS
OS = overstatement
US = understatement
44
Effect of Inventory Errors on the
Income Statement
Reported
Sales
$1,500
Beginning inventory
$ 300
Add: Purchases
1,100
Goods available for sale $1,400
Less: Ending inventory
350
Cost of goods sold
$1,050
Gross margin
$ 450
Operating expenses
120
Net income
330
(in 000s)
Corrected
$1,500
250
1,100
$1,350
350
$1,000
$ 500
120
380
Effect
$50 OS
50 OS
50 OS
50 US
50 US
OS = overstatement
US = understatement
45
Counterbalancing Errors
Assume ending inventory is overstated (+) by
$50,000 in 2004:
2004
Beginning inventory
$xxx,xxx
Add: Purchases
xxx,xxx
= Goods available for sale
xxx,xxx
Less: Ending inventory
+ 50,000
= Cost of goods sold
- 50,000
46
Counterbalancing Errors
2004 ending inventory becomes 2005 beginning
inventory:
2004
2005
Beginning inventory
$ xxx,xxx + 50,000
Add: Purchases
xxx,xxx
= Goods available for sale
xxx,xxx
Less: Ending inventory
+50,000
= Cost of goods sold
- 50,000
47
Counterbalancing Errors
The 2004 error reverses in 2005 (but 2004 inventory
and both 2004 and 2005 profits are misstated by
$50,000):
2004
2005
Beginning inventory
$xxx,xxx $+50,000
Add: Purchases
xxx,xxx
xxx,xxx
= Goods available for sale
xxx,xxx
+ 50,000
Less: Ending inventory
+ 50,000
xxx,xxx
= Cost of goods sold
- 50,000
+ 50,000
48
Lower of Cost or Market
Before
Price
Change
Cost
150
After
Price
Change
120
Report loss
in year
market falls
below cost…
49
Lower of Cost or Market
Selling price
Cost
Gross margin
Gross margin %
Before
Price
Change
$200
150
$ 50
25%
After
Price
Change
$160
120
$ 40
25%
50
Lower of Cost or Market
Market = replacement cost (not retail value)
 Cost determined under one of four methods
 Justified on basis of conservatism
 Can be applied to:
 entire inventory
 individual items
 groups of items

51
Estimating Inventory Values
 Sometimes
impossible or impractical to
measure inventory at cost
– Estimation is necessary
 Two
methods used to estimate ending
inventory values:
–
–
gross profit method
retail inventory method
52
Gross Profit Method
1
2
3
4
5
Beginning inventory
+ Purchases
= Cost of goods available for sale
- Ending inventory
= Cost of goods sold
Use income statement model but
reverse steps 4 and 5
53
Gross Profit Method
Beginning inventory
+ Purchases
= Cost of goods available for sale
-
Cost of goods sold (estimated) *
= Ending inventory (estimated)
$ 100,000
30,000
130,000
90,000
$ 40,000
* Cost of goods sold is estimated
as a percentage of sales
54
Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
The number of times per
period inventory is
turned over (i.e., sold)
55
Inventory Turnover Ratios
Example:
Circuit City
Safeway
5.8 times per year
9.2 times per year
Can you compare the two ratios?
56
Number of Days’ Sales in Inventory
# of Days in Period
Inventory Turnover
Ratio
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
The average # of days
inventory is on hand
before it is sold.
57
Days’ Sales in Inventory
Circuit City
365 =
5.8
62 days
Safeway
365 =
9.2
39 days
Do these averages seem reasonable?
58
Statement of Cash Flows
Cash Flows from Operating Activities:
Net income
Increase in inventory
Decrease in inventory
Increase in accts. payable
Decrease in accts. payable
Indirect
Method
- OR -
Cash paid for inventory purchases
$ xxx
–
+
+
–
Direct
Method
–
59
Appendix
Accounting Tools:
Inventory Costing Methods with the
Use of a Perpetual Inventory System
60
FIFO Costing With a Perpetual System
Same FIFO inventory total under periodic
and perpetual systems
61
LIFO Costing With a Perpetual System
Different LIFO inventory total under periodic and
perpetual systems because of pricing gap
62
Moving Average With a Perpetual System
Different inventory total under weighted average
(periodic) and moving average (perpetual)
63
End of Chapter 7
64