8-1
FINANCIAL
ACCOUNTING
Fourth Canadian Edition
LIBBY, LIBBY, SHORT, KANAAN, GOWING
Reporting and Interpreting Cost of Sales
and Inventory
Chapter 8
PowerPoint Author:
Robert G. Ducharme, MAcc, CA
University of Waterloo, School of Accounting and Finance
Copyright © 2011 McGraw-Hill Ryerson Limited
8-2
Understanding the Business
Provides accurate
information
Roles of the
Accounting
System
Provides up-to-date
information
Provides information
to help protect assets
Primary Goals of
Inventory
Management
Copyright © 2011 McGraw-Hill Ryerson Limited
Provide sufficient
quantities of highquality inventory.
Minimize the costs of
carrying inventory.
LO 1
8-3
Items Included in Inventory
Inventory
tangible property held for sale in the normal course of business
or used in producing goods or services for sale
Tangible
Held for Sale
Used to
Produce
Goods or
Services
Merchandise Inventory
Raw Materials Inventory
Work in Process Inventory
Finished Goods Inventory
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 1
8-4
Costs Included in Inventory Purchases
The cost principle requires that inventory
be recorded at the price paid or the
consideration given.
Include all costs incurred to bring the asset
to useable or saleable condition.
Invoice
Price
Freight
Inspection
Costs
Preparation
Costs
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 1
8-5
Flow of Inventory Costs
Merchandiser
Merchandise
Purchases
Manufacturer
Raw
Materials
Merchandise
Inventory
Raw Materials
Inventory
Direct
Labour
Factory
Overhead
Copyright © 2011 McGraw-Hill Ryerson Limited
Work in Process
Inventory
Cost of
Sales
Finished Goods
Inventory
Cost of
Sales
LO 1
8-6
Nature of Cost of Sales
Beginning
Inventory
Purchases
for the Period
Goods Available
for Sale
Ending Inventory
(Statement of
Financial Position)
Cost of Sales
(Income Statement)
Beginning inventory + Purchases = Goods Available for Sale
Goods Available for Sale – Ending inventory = Cost of sales
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 1
8-7
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.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-8
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
sales are determined at the end of the accounting period
based on a physical count.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-9
Perpetual and Periodic Inventory Systems
Inventory System
Periodic System Perpetual System
Carried over from
Carried over from
Beginning Inventory
prior period
prior period
Accumulated in the Accumulated in the
Add: Purchases
Purchases account Inventory account
Equals:
Cost of Goods Available for Sale
Measured at end of Perpetual record
Less: Ending Inventory period by physical
updated at every
inventory count
sale
Measured at every
Computed as a
sale based on
Cost of Sales
residual amount at
perpetual record
end of period
Item
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-10
Comparison of Periodic and Perpetual Systems
Now, let’s
compare the
various entries
that are made
when using the
periodic and
perpetual
inventory
systems.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-11
Comparison of Periodic and Perpetual Systems
Transaction
Periodic
Perpetual
Merchandise
purchased from
supplier on
account.
Purchases (T)
XX
Inventory (A)
Trade Payables (L)
XX Trade Payables (L)
Merchandise
returned to
supplier.
Trade Payables (L)
XX
Trade Payables (L)
Purchases Returns & All. (T)
XX Inventory (A)
Merchandise
Purchases Returns and Allowances is subtracted
sold to
Purchases on the income statement.
customer on
account.
Trade Receivables (A)
XX
Trade Receivables (A)
Sales (R)
XX Sales (R)
Cost of Sales (E)
Inventory (A)
Copyright © 2011 McGraw-Hill Ryerson Limited
XX
XX
XX
XX
from
XX
XX
XX
XX
LO 2
8-12
Comparison of Periodic and Perpetual Systems
Transaction
Merchandise
purchased from
supplier
on account.
Merchandise
returned to
supplier.
Merchandise
sold to
customer on
account.
Periodic
Perpetual
Purchases (T)
Trade Payables (L)
XX
Trade
Payables
(L) &
Purchases
Returns
Allow.(T)
XX
Trade Receivables (A)
Sales (R)
XX
This entry is recorded
at cost.
Copyright © 2011 McGraw-Hill Ryerson Limited
Inventory (A)
XX Trade Payables (L)
XX
XX
This entry is recorded
Trade Payables (L)
XX
at retail.
XX Inventory (A)
XX
Trade Receivables (A)
XX Sales (R)
Cost of Sales (E)
Inventory (A)
XX
XX
XX
XX
LO 2
8-13
Comparison of Periodic and Perpetual Systems
Transaction
Merchandise
returned by
customer.
Periodic
Perpetual
Sales Returns and Allow. (XR) XX
Sales Returns and Allow. (XR) XX
Trade Receivables (A)
XX Trade Receivables (A)
XX
This is recorded at
retail.
Inventory (A)
Cost of Sales (E)
XX
XX
This entry is recorded
at cost.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-14
Comparison of Periodic and Perpetual Systems
Transaction
Merchandise
returned by
customer.
At end of
accounting
period.
Periodic
Sales Returns and Allow. (XR)
Trade Receivables (A)
Perpetual
XX
XX
Cost of Sales (E)
Inventory (A) (beginning)
Purchases (T)
XX
Inventory (A) (ending)
Cost of Sales (E)
XX
Copyright © 2011 McGraw-Hill Ryerson Limited
Sales Returns and Allow. (XR)
Trade Receivables (A)
XX
Inventory (A)
Cost of Sales (E)
XX
XX
XX
No entry.
XX
XX
XX
LO 2
8-15
Methods for Estimating Inventory
I use the periodic
inventory method.
Can you help me
estimate inventory?
Copyright © 2011 McGraw-Hill Ryerson Limited
I sure can, if
you can give
me some
information.
LO 2
8-16
Methods for Estimating Inventory
I know sales,
beginning inventory,
purchases, and
my gross margin
is 30%.
Copyright © 2011 McGraw-Hill Ryerson Limited
Let’s construct
an income
statement using
your gross
margin.
LO 2
8-17
Methods for Estimating Inventory
Sales
Cost of sales
Gross margin
100%
70%
30%
You told me that your sales
are $200,000, beginning
inventory is $4,500, and
purchases are $150,000, so
your income statement looks
like this . . .
Sales
Beginning inventory
Purchases
Cost of goods available for sale
Ending inventory
Cost of sales
Gross margin
Copyright © 2011 McGraw-Hill Ryerson Limited
$ 200,000
$
4,500
150,000
154,500
?
140,000
$ 60,000
LO 2
8-18
Methods for Estimating Inventory
Estimated ending inventory must be $14,500
($154,500 – $140,000).
Sales
Beginning inventory
Purchases
Cost of goods available for sale
Ending inventory
Cost of sales
Gross margin
Copyright © 2011 McGraw-Hill Ryerson Limited
$ 200,000
$
4,500
150,000
154,500
14,500
140,000
$ 60,000
LO 2
8-19
Errors in Measuring Ending Inventory
Beginning inventory + Purchases – Ending inventory = Cost of sales
Errors in Measuring Inventory
Ending Inventory
Beginning Inventory
Overstated Understated Overstated Understated
Effect on Current Period's Statement of Financial Position
Ending Inventory
Retained Earnings
+
+
-
N/A
N/A
-
+
N/A
N/A
+
+
+
-
+
+
-
+
+
Effect on Current Period's Income Statement
Goods Available for Sale
Cost of Sales
Gross Profit
Profit
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
Exhibit 8.4: Inventory Error:
Understatement of Ending Inventory
8-20
ERROR: UNDERSTATEMENT OF ENDING INVENTORY
Beginning inventory
Ending inventory
Cost of sales
Gross profit
Profit before income tax
Income tax expense
Profit
Retained earnings, end of year
Year of the error Following Year
NE
U*
U
NE
O
U
U
O
U
O
U
O
U
O
U
NE
*U = Understated; O = Overstated; NE = No Effect
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-21
Question
If the 2011 ending inventory is understated by
$3,000, which of the following is true for
2011?
a. Beginning Inventory was understated.
b. Cost of Sales will be understated.
c. Gross Profit will be overstated.
d. Profit will be understated.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-22
Question
Beginning inventory + Purchases – Ending inventory = Cost of sales
Errors ininventory
Measuring Inventory
If the 2011 ending
is
understated
by
Beginning Inventory
Ending Inventory
$3,000, whichOverstated
of the
following
is true for
Understated
Overstated Understated
Effect on Current Period's Statement of Financial Position
2011?
Ending Inventory
N/A
N/A
+
Retained Earnings
-
+
+
-
Effect on Current Period's Income Statement
a. Beginning
Inventory
was
understated.
Goods Available for Sale
N/A
N/A
+
Cost of
of Sales
+
b. Cost
Sales will +be understated.
Gross Profit
+
+
c. Gross
Profit Profit will be
- overstated.
+
+
d. Profit will be understated.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-23
Question
If the 2011 ending inventory is understated by
$3,000, which of the following is true for
2012?
a. Beginning Inventory was understated.
b. Cost of Sales will be understated.
c. Gross Profit will be overstated.
d. All of the above.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 2
8-24
Question
Remember: The ending
If the 2011 ending inventory is understated by
inventory for 2011 becomes the
$3,000,
which
the following is true for
beginning
inventory
forof
2012.
2012?
Beginning inventory + Purchases – Ending inventory = Cost of sales
Errors in Measuring Inventory
a. Beginning Inventory was understated.
b. Cost of Sales will be understated.
+
c. Gross Profit will be overstated.
+
+
d. All of the above.
Beginning Inventory
Ending Inventory
Overstated Understated Overstated Understated
Effect on Current Period's Statement of Financial Position
Ending Inventory
N/A
N/A
Retained Earnings
-
Effect on Current Period's Income Statement
Goods Available for Sale
Cost of Sales
Gross Profit
Net Income
Copyright © 2011 McGraw-Hill Ryerson Limited
+
+
-
+
+
N/A
N/A
+
+
+
LO 2
8-25
Inventory Costing Methods
Inventory Costing Methods
1. Specific Identification
2. First-in, First-out (FIFO)
3. Weighted Average
Total Dollar Amount of Goods
Available for Sale
Inventory Costing
Method
Ending Inventory
Copyright © 2011 McGraw-Hill Ryerson Limited
Cost of Sales
LO 3
8-26
Specific Identification
When units are
sold, the
specific cost of
the unit sold is
added to cost of
sales.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 3
8-27
Cost Flow Assumptions
The choice of an inventory
costing method is not based
on the physical flow of goods
on and off the shelves.
FIFO
Copyright © 2011 McGraw-Hill Ryerson Limited
Weighted
Average
LO 3
8-28
First-In, First-Out Method
Oldest Costs
Cost of Sales
Recent Costs
Ending
Inventory
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 3
8-29
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
Sales
1,050
?
Copyright © 2011 McGraw-Hill Ryerson Limited
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.
LO 3
8-30
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 Sales
Units
$ 6,695 Cost
Now, we have allocated the cost to all
1,200 units in ending inventory.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 3
8-31
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 Sales
1,000 @ $ 5.25
50 @
5.30
1,050 Units
$ 5,515 Cost
$12,210
Now, we have allocated the cost
to all 1,050 units sold.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 3
8-32
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
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
$
6,695.00
Cost of
Sales
1,050
$
5,515.00
Copyright © 2011 McGraw-Hill Ryerson Limited
Here is the
cost of
ending
inventory
and cost
of sales
using
FIFO.
LO 3
8-33
Average Cost Method
When a unit is sold, the
average cost of each unit
in inventory is assigned to
cost of sales.
Cost of Goods
Available for ÷
Sale
Number of
Units
Available for
Sale
Ending Inventory
Units in Ending Inventory x Average Cost per Unit
Cost of Good Sold
Units Sold x Average Cost per Unit
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 3
8-34
Average Cost Method
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale
Ending
Inventory
Cost of
Sales
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
1,200
$
$
12,210.00
6,512.00
$ 12,210
= $5.42667
2,250
1,200 × $ 5.42667
1,050 × $ 5.42667
1,050
Copyright © 2011 McGraw-Hill Ryerson Limited
$
5,698.00
LO 3
8-35
Comparison of Methods
Computers, Inc.
Income Statement
For Year Ended December 31, 2011
Net sales
Cost of sales:
Merchandise inventory, beginning
Net purchases
Goods available for sale
Merchandise inventory, ending
Cost of sales
Gross profit
Operating expenses
Profit before taxes
Income taxes expense (30%)*
Profit
FIFO
$ 25,000
Weighted
Average
$ 25,000
$
$
$
$
$
$
$
* Tax expense amounts were rounded.
Copyright © 2011 McGraw-Hill Ryerson Limited
5,250
6,960
12,210
6,695
5,515
19,485
750
18,735
5,621
13,114
$
$
$
$
$
5,250
6,960
12,210
6,512
5,698
19,302
750
18,552
5,566
12,986
In periods of
rising prices,
FIFO results in
the highest
ending
inventory,
gross profit,
income tax
expense, and
profit, and the
lowest cost of
sales.
LO 3
8-36
Financial Statement Effects of Costing Methods
Advantages of Methods
First-In,
First-Out
Weighted
Average
Ending inventory
approximates
current
replacement cost.
Smoothes out
price changes.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 3
8-37
International Perspective
LIFO and International Comparisons
While U.S. GAAP allows companies to choose between FIFO,
LIFO, and weighted average inventory methods, International
Financial Reporting Standards (IFRS) and Canadian
Accounting Standards for Private Enterprises (ASPE) prohibit
the use of LIFO.
GAAP allows different
inventory accounting methods
to be used for different types
of inventory items.
IFRS requires that the same
method be used for all
inventory items that have a
similar nature and use.
These differences can create comparability problems when
one attempts to compare companies across international
Copyright © 2011 McGraw-Hill Ryerson Limited
borders.
LO 3
8-38
Managers Choice of Inventory Methods
Profit Effects
Managers prefer to report
higher earnings for their
companies.
Copyright © 2011 McGraw-Hill Ryerson Limited
Income Tax Effects
Managers prefer to pay the
least amount of taxes
allowed by law as late as
possible.
LO 4
8-39
Valuation at Lower of Cost or Net Realizable Value
Ending inventory is reported at the lower
of cost or net realizable value (LCNRV).
Net Realizable Value (NRV)
is the expected sales price less
estimated selling costs (e.g., repair
and disposal costs).
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.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 5
8-40
Valuation at Lower of Cost or Net Realizable Value
Item
Intel chips
Disk drives
Quantity
1,000
400
Cost
$
250
100
$ 290,000
Net
Realizable
Value (NRV)
$
200
110
LCNRV Total LCNRV
$ 200
$ 200,000
100
40,000
$ 240,000
GENERAL JOURNAL
Date
Description
Cost of sales (+E, -SE)
Inventory (-A)
Debit
50,000
Credit
50,000
(1,000 Intel chips × $50) = $50,000
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 5
8-41
Inventory Turnover
Inventory =
Turnover
Cost of Sales
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.
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 6
8-42
Inventory and Cash Flows
Add Decrease in Inventory
Increase in Trade
Payables
Profit
Cash Flows
from
Operations
Increase in Inventory
Decrease in Trade
Subtract
Payables
Copyright © 2011 McGraw-Hill Ryerson Limited
LO 6
Appendix 8A: Additional Issues in Measuring
Purchases
8-43
Purchase returns and
allowances are a reduction
in the cost of purchases
associated with
unsatisfactory goods.
A purchase discount is
a cash discount
received for prompt
payment of an account.
Copyright © 2011 McGraw-Hill Ryerson Limited
Appendix 8A
Appendix 8B: Additional Issues in Measuring
Purchases
8-44
Credit Period
Terms
Discount Period
Time
Due
Full amount
less discount
Purchase or Sale
Copyright © 2011 McGraw-Hill Ryerson Limited
Full amount due
2/10,n/30
Discount
Percent
Number of
Days Discount
Is Available
Credit
Period
Appendix 8A
8-45
End of Chapter 8
Copyright © 2011 McGraw-Hill Ryerson Limited