Inventories and
Cost of Goods Sold
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ACCOUNTING FOR INVENTORIES
LINKAGE
 ENHANCE YOUR PREVIOUS KNOWLEDGE REGARDING COST
OF GOODS SOLD
 YOU WILL BE ABLE TO CALCULATE COST OF SALES FOR ANY
MERCHANDISING BUSINESS
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OUTCOME of THIS SESSION
 Two inventory recording methods--Perpetual and Periodic
 Different inventory valuation methods
 Calculation of Cost of Sales under
perpetual and periodic methods
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ACCOUNTING FOR INVENTORIES
STRUCTURE OF THIS SESSION
50:50
 Active participation is sought
PARTICIPATION MEANS
Contributing innovative and effective ideas
towards the current topic
Answering various questions
Following the mentor’s instructions
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ACCOUNTING FOR INVENTORIES
WIIFM
THIS SESSION WILL PROVIDE YOU A BASIC
UNDERSTANDING OF ACCOUNTING FOR
o INVENTORIES; AND
o COST OF SALES
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Gross Profit and Cost of Goods Sold
• Companies report products being held prior to
sale as inventory—a current asset on the
balance sheet
• When the products are sold, the cost of the
inventory becomes Cost of Goods Sold in the
income statement
• Net Sales less Cost of Goods Sold equals
Gross Profit
• Gross Profit less operating expenses equals Net
Income
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Gross Profit and Cost of Goods Sold
Balance Sheet
Income Statement
Sales
Minus
Merchandise
Purchases
Merchandise
Merchandise
Sales
Inventory
Cost of
Goods Sold
(an expense)
Equals Gross Profit
Minus
Operating
Expenses
Selling
Expenses and
Administrative
Expenses
Equals Net Income
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METHODS OF RECORDING
INVENTORY
PERPETUAL METHOD
• Continuous record of
Inventory & Cost of
Goods Sold
PERIODIC METHOD
• No daily record of
Inventory & Cost of
Goods Sold
• Sale and Cost of sales
are recorded
simultaneously
• Updated inventory and
Cost of sales balance is
available only at the end
of the period
• Physical inventory count
is done at the END OF
THE PERIOD
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• Physical inventory count
is done at the END OF
THE PERIOD
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Perpetual Inventory System
• In the perpetual inventory system, the journal
entries are:
– When inventory is purchased:
Inventory
Accounts payable
xxx
xxx
– When inventory is sold:
Accounts receivable
Sales
xxx
Cost of goods sold
Inventory
xxx
xxx
xxx
Note: Cost of goods sold is calculated as soon as the inventory is
sold
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Periodic Inventory System
• Under the periodic system, the calculation of
cost of goods sold is DELAYED UNTIL THERE
IS A PHYSICAL COUNT:
Beginning inventories (by physical count)
Add: Purchases
Cost of goods available for sale
Less: Ending inventories (by physical count)
Cost of goods sold
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XXX
XXX
XXX
XXX
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Physical Inventory
• Inventory control procedures require a physical
count of items held in inventory at least annually
in both periodic and perpetual inventory systems
• Firms often choose fiscal accounting periods so
that the year ends when inventories are low
• External auditors usually observe the client’s
physical count and confirm its accuracy
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Cost of Merchandise Acquired
• The cost of merchandise includes the invoice
price PLUS directly identifiable inbound
transportation charges LESS any offsetting
discounts
• The costs of purchasing and receiving
departments are PERIOD COSTS and are
charged on the income statement as they occur.
In simple terms all the Selling & Administration
costs are called PERIOD COSTS.
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Transportation Charges
• When the seller bears the transportation cost,
the sales invoice reads free onboard or F.O.B.
destination
• When the buyer bears the transportation cost, it
reads F.O.B. shipping point
• In practice, accountants frequently use a
separate transportation cost account, Freight-in
• Freight-in appears in the purchases section of
an income statement as an additional cost of the
goods acquired during the period
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COST OF MERCHANDISE
INVENTORY
Cost of Merchandise Inventory:
•
•
•
•
Original purchase price
F.O.B shipping point
Freight in
Other Directly Attributable Costs
XXX
XXX
XXX
XXX
TOTAL PURCHASE PRICE
(GROSS PURCHASES)
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Returns, Allowances, and Discounts
• Using the periodic inventory system, suppose a
company’s GROSS PURCHASES are $960,000
and purchase returns and allowances are
$75,000. The summary journal entries are:
Purchases
Accounts payable
960,000
Accounts payable
Purchase returns and allowances
75,000
Purchase returns and allowances
Purchases
75,000
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75,000
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Returns, Allowances, and Discounts
• Suppose also that the company takes cash discounts of $5,000 on
payment of the remaining $960,000 - $75,000 = $885,000 of
payables. The summary journal entry is:
Accounts payable
Cash discounts on purchases
Cash
885,000
Cash discount on purchases
Purchases
5,000
5,000
880,000
5,000
• To calculate cost of goods sold, Cash Discounts on Purchases and
Purchase Returns and Allowances are subtracted from Purchases
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GROSS AND NET PURCHASES
GROSS PURCHASES
XXX
• Purchase returns & allowances
XXX
• Cash discount on purchases
XXX
NET PURCHASES
XXX
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Detailed Gross Profit Calculation
($ in thousands)
Gross sales
$1,740
Deduct: Sales returns and allowances
$ 70
Cash discounts on sales
100
170
Net sales
$1,570
Deduct: Cost of goods sold
Merchandise inventory, December 31, 20X1
$ 100
Purchases (gross)
$ 960
Deduct: Purchase returns and allowances
$ 75
Cash discounts on purchases
5
80
Net purchases
$ 880
Add: Freight-in
30
Total cost of merchandise acquired
910
Cost of goods available for sale
$1,010
Deduct: Merchandise inventory, December 31, 20X2
140
Cost of goods sold
870
Gross profit
$ 700
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INVENTORY VALUATION METHODS
• In both systems, we must determine the costs of
individual items by some inventory valuation
method.
• Four principal inventory valuation methods are
generally accepted:
–
–
–
–
Specific identification
First-in, first-out (FIF0)
Last-in, first out (LIFO)
Weighted-average
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Specific Identification
• The specific identification method concentrates on the physical
linking of the particular items sold with the cost of goods sold that is
reported
• This method is relatively easy to use for EXPENSIVE LOWVOLUME MERCHANDISE
• The use of bar cods and scanning equipment makes specific
identification economically feasible for many companies
• EXAMPLES:
–
–
–
–
Custom artwork-----paintings etc
Diamond jewelry
Antiques
Automobiles
NOTE : This method uses ACTUAL PHYSICAL FLOW COSTING of
goods
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FIRST IN FIRST OUT-FIFO
• FIFO assigns the cost of the earliest acquired
units to cost of goods sold
• The costs of the newer units is assigned to the
units in ending inventory
• FIFO provides inventory valuations that closely
approximate the actual market value of the
inventory at the balance sheet date
• In periods of rising prices, FIFO leads to higher
net income
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LAST IN FIRST OUT-LIFO
• LIFO assigns the most recent cost to cost of goods sold
• LIFO provides an income statement perspective in that
net income measured using LIFO combines current
sales prices and current acquisition costs
• In a period of rising prices and constant or growing
inventories, LIFO yields lower net income
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Weighted Average
• The weighted-average method computes a
unit cost by dividing the total acquisition cost of
all items available for sale by the number of units
available for sale
• The weighted-average method produces gross
profit somewhere between that obtained under
FIFO and LIFO
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INVENTORY VALUATION METHODS
http://www.principlesofaccounting.com/chapter8/ch
apter8.html#Inventory
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Inventory Valuation Methods Example
• Assume a vendor of soft drinks starts out the
week with no inventory
• He buys and sells cola as follows:
–
–
–
–
Buys one can on Monday for 30 cents
Buys one can on Tuesday for 40 cents
Buys one can on Wednesday for 56 cents
Sells one can on Thursday for 90 cents
• The next slide shows the vendor’s cost of goods
sold and ending inventory under the four
methods
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Inventory Valuation Methods Example
(1)
Specific
Identification
(1A) (1B) (1C)
Income Statement for the Period Monday
through Thursday:
Sales
Deduct cost of goods sold:
1 30 cents (Monday) unit
1 40 cents (Tuesday) unit
1 56 cents (Wednesday) unit
1 weighted-average unit
[(30+40+56) / 3 = 42]
Gross profit for Monday through Thursday
Thursday's ending inventory, 2 units
Monday unit @ 30 cents
Tuesday unit @ 40 cents
Wednesday unit @ 56 cents
Weighted-average units @ 42 cents
Total ending inventory on Thursday
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90
90
90
30
(2)
FIFO
90
(3)
(4)
Weighted
LIFO Average
90
90
30
40
56
60
40
56
96
50
34
30
30
40
56
86
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56
60
40
56
96
34
42
48
30
40
70
84
84
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Cost Flow Assumptions
• Companies may choose any of the four methods
to record cost of goods sold
• Three out of the four methods are NOT linked to
the physical flow of merchandise
• First or the Last item sold is not physically the
first or the last BUT only the COST of the First
and Last item is used-----Cost Flow Assumption
• Accountants often refer to inventory methods as
COST FLOW ASSUMPTIONS
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Inventory Cost Relationships
• The difference in the four methods centers
on how inventory costs are allocated
between inventory and cost of sales
• The difference between FIFO and LIFO is:
Inventory Method
Period of Rising Prices
Period of Falling Prices
FIFO
Higher ending inventory
Lower cost of goods sold
Higher net income
Lower ending inventory
Higher cost of goods sold
Lower net income
LIFO
Lower ending inventory
Higher cost of goods sold
Lower net income
Higher ending inventory
Lower cost of goods sold
Higher net income
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The Consistency Convention
• Companies can choose any inventory cost flow
assumption, but they must be consistent over
time with the method they choose
• Consistency is defined as “conformity from
period to period with unchanging policies and
procedures”
• A change in market conditions may justify a
change in inventory method
• The firm must note the change in its financial
statements
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Characteristics and
Consequences of LIFO
• LIFO
– Is widely used in the United States
– Has strong tax benefits for companies
– Has some unusual features
• Few companies outside the U. S. use LIFO
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Holding Gains and Inventory Profits
• LIFO matches the most recent acquisition cost
with sales revenues
• LIFO cost of goods sold typically offers a close
approximation to the replacement cost
• Reported net income rarely contains significant
holding gains
• FIFO reports a profit which includes an
economic profit plus the holding gain because
the value of the inventory rises over time
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Lower-of-Cost-or-Market Method
• The lower-of-cost-or-market value method
(LCM) requires a comparison of the current
market price of inventory with historical cost
derived under one of the four primary methods
used
• The lower of the two amounts is reported as the
inventory value
• CONSERVATISM principle
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Role of Replacement Cost
• Market price is generally considered to be the
replacement cost of the inventory item—what it
would cost to buy the inventory item today
• A write-down reduces the recorded historical
cost of an item in response to a decline in value
• The required journal entry for a write-down is:
Loss on write-down of inventory (or cost of goods sold) XX
Inventory
XX
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Effects of Inventory Errors
• An undiscovered inventory error usually affects
two reporting periods
• The error will cause misstated amounts in the
period in which the error occurred, but the
effects will then be counterbalanced by identical
offsetting amounts in the following period
• If ending inventory is understated, retained
earnings in understated
• If ending inventory is overstated, retained
earnings is overstated
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Cutoff Errors and
Inventory Valuation
• Cutoff errors are failures to record transactions
in the correct time period
• Legal transfer of ownership controls the
recording of purchases and sales near the yearend
• The pressure for profits may cause managers to
– Delay the recording of purchases
– Include sales orders in revenues
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The Importance of Gross Profits
• Management and investors are interested in
gross profit and how it changes over time
• Gross profit is often expressed as a percentage
of sales
Gross profit % = Gross profit
Sales
• Wholesalers have smaller gross profit
percentages than retailers
• R&D is treated as a period cost and not a
product cost; thus, pharmaceutical companies
have relatively high gross profit margins
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Estimating Intraperiod Gross Profit
and Inventory
• The gross profit percentage can be used to
estimate ending inventory balances for monthly
or quarterly reports
• Suppose a Home Depot Store has quarterly
sales of $10 million and usually has a gross
profit percentage of 30%. Cost of goods sold
can be estimated as:
Sales – Cost of goods sold = Gross profit
$10M – CGS = .30 x $10M
CGS = $7M
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Estimating Intraperiod Gross Profit
and Inventory
• Also assume the beginning inventory is $5
million and purchases are $7.1 million. Ending
inventory can be estimated as:
Beginning inventory + Purchases – Ending Inventory = CGS
$5M + $7.1M – EI = $7.0M
EI = $5.1M
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Gross Profit Percentage
and Turnover
• Inventory turnover relates sales levels to
inventory levels
• Inventory turnover in the previous Home Depot
example would be:
Turnover = Cost of goods sold / Average inventory
= $7M / $5.05M = 1.4
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Gross Profit Percentage
and Turnover
• Industries with higher gross profit percentages
tend to have lower inventory turnover
• Example: lower turnover for jewelers and drug
manufactures means that they need a higher
gross profit margin to cover the high costs of
selling or research
• Inventory turnover is especially effective in
assessing companies in the same industry
– Higher turnover is associated with greater efficiency
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Gross Profit Percentages and
Accuracy of Records
• The gross profit percentage can be used to
prove the accuracy of the accounting records
• An unusually low percentage may mean the
company has tried to avoid taxes by failing to
record all sales
• Some other factors that may cause a decline in
the percentage are
– Price wars that reduce selling prices
– Shifting of the product mix sold
– Increase in shoplifting or embezzlement
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Internal Control of Inventories
• Inventory shrinkage can result from customer
shoplifting or employee embezzlement
• The best deterrent for shoplifting is an alert
employee at the point of sale
• Retail stores also use:
– Sensitized tags on merchandise
– Surveillance cameras
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Shrinkage in
Perpetual Inventory Systems
• Shrinkage is the difference between the cost of
inventory from a physical count and the
inventory balance in the general ledger
• The journal entries to record shrinkage under a
perpetual inventory system would be:
Inventory shrinkage
Inventory
XXX
XXX
To adjust inventory to its balance per physical count
Cost of goods sold
Inventory shrinkage
XXX
XXX
To transfer inventory shrinkage to cost of goods sold
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Shrinkage in
Periodic Inventory Systems
• A periodic inventory system has no running
balance in the inventory account
• Cost of goods sold automatically includes
inventory shrinkage by virtue of the system
• Shrinkage is much more difficult to isolate in the
periodic system
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