Accounting for Inventories
and Cost of Goods Sold
Chapter 4&5
Mugan-Akman 2007
Current Assets-Inventories
Service
Chapter 4&5
Merchandising
Wholesale
Retails
Manufacturing
Merchandise
Merchandise
Raw Material
Work-in Process
Finished Goods
Mugan-Akman 2007
How do we determine the Acquisition
Cost of Purchased Inventory?
–Determine purchase
price :
•ordering goods +
•receiving +
•inspecting +
•Recorded when title
passes to the firm.
–Adjust purchase price for:
–transportation ( add)
–handling (add)
–customs and duties (add)
–cash discounts (deduction)
–returns (deduction)
–to determine the
acquisition cost
Cost of inventory should include all costs incurred to acquire
goods and prepare them for sale.
Chapter 4&5
Mugan-Akman 2007
How do we record the transactions?
Depends on the recording system: Perpetual or Periodic
Perpetual Inventory System:
•A running record of purchases
are kept through “merchandise
inventory” account
•Purchases entries and
Adjustments are made to the
merchandise inventory account
•The amount of inventories at a
point in time can be determined
•Cost of Goods sold is known
during the period
Chapter 4&5
Periodic Inventory System:
•Purchases of inventory are
recorded in “Purchases” account
•Adjustments are made to
separate accounts“
•Amount of inventories at a point
can not be determined unless a
physical count is made
•Cost of goods sold can be
determined after physical count at
the end of the period
Mugan-Akman 2007
How do we determine the cost of
goods that are sold -COGS?
Perpetual
•Accumulated in cost of
goods sold account as
sales are made
•Known during the period
•Physical count made at
the end – helps to
determine inventory
shrinkage
Chapter 4&5
Periodic
•Cost of goods sold can
be determined after the
physical count
•Beginning Inventory
(from previous period) +
•Purchases (net) –
•Ending Inventory
(physical count) =
•Cost of goods sold
•Cannot determine
inventory shrinkage
Mugan-Akman 2007
Transaction
Perpetual Inventory System
Purchases Related
- Purchase of Merchandise
Merchandise Inventory
- Receive Cash Discount
Merchandise Inventory
- Return of merchandise and /or receipt Merchandise Inventory
of price allowance
- Transportation Costs-if born by the Merchandise Inventory
buyer
Sales Related
-Sale of Merchandise
Sales ; COGS and Merchandise
Inventory
Sales
Discounts
- Grant Cash Discount
- Return of merchandise by the
Sales Returns and Allowances / COGS
customer
and Merchandise Inventory
- Price allowance given to the customer Sales Returns and Allowances
- Transportation Costs-if born by the
Chapter 4&5
Freight-out (Delivery Expense)
Mugan-Akman 2007
Accounting for Sale of Merchandise- Perpetual Inventory System
TWO ENTRIES ARE NECESSARY TO RECORD A SALE
UNDER PERPETUAL INVENTORY SYSTEM
1.
To record the sale transaction
2.
To reflect the cost of the sales (cost of goods sold) made and
deduct the cost of sales from the inventory
1) Record sale
Date
Account Title and Description
Debit
12-Dec-04 Accounts Receivable
Sales
Sale of merchandise on credit
Credit
125
125
2) show the decrease in inventory and the
corresponding increase in COGS
Date
Account Title and Description
12-Dec-04 COGS
Merchandise Inventory
To record cost of goods sold
Chapter 4&5
Mugan-Akman 2007
Debit
Credit
50
50
Gross Profit
GROSS PROFIT =
NET SALES – COST OF GOODS SOLD
COST OF GOODS SOLD=
BEG INV + PURCHASES –END INV
GROSS PROFIT PERCENTAGE=
GROSS PROFIT/NET SALES
Chapter 4&5
Mugan-Akman 2007
COGS Computation
Beginning Inventory:
Plus: Purchases
Less: Pur.Disc
Pur.R&A
Net Purchases
Plus: Freight-in
Total Cost of Purh.
Cost of Goods Available for Sale
Less: Ending Inventory
Cost of Goods Sold
Chapter 4&5
Mugan-Akman 2007
6.700
14.800
- 300
- 400
14.100
500
14.600
21.300
- 4.800
16.500
Single Step Income Statement
• Deduct all expenses from the total of
revenues without a distinction among the
different sources of revenues or the
causes of expenses
Chapter 4&5
Mugan-Akman 2007
Giysi Giyim A.S.
Income Statement
For the Year Ended 31 December 2004
Revenues
Net Sales
Interest Revenue
Gain on Sale of Equipment
Total Revenues
Expenses
Cost of Goods Sold
Operating Expenses
Interest Expense
Income Before Tax
Chapter 4&5
Mugan-Akman 2007
TL 30.000
400
200
30.600
TL 16.500
12.600
600
29.700
TL 900
Multiple Step Income Statement
• Discloses numerous parts or steps to
determine net income, showing income
from operating and non-operating activities
Chapter 4&5
Mugan-Akman 2007
Giysi Giyim A.Ş.
Income Statement
For the Year Ended 31
December 2007
Chapter 4&5
S ales
Les s : Sales Dis counts
Sales Returns and Allowances
Net S ales
Cos t of Goods Sold:
Merchandis e Inventory, 1 January
Purchas es
Les s : Purchas e Returns and Allowances
Purchas e Dis counts
Net Purchas es
Add: Freight-in
Cos t of Goods Purchas ed
Cos t of Goods Available for Sale
Les s : Inventory, 31 December
Cos t of Goods Sold
Gros s Profit
Operating Expens es :
Selling Expens es
Salaries Expens e
Advertis ing Expens e
Delivery Expens e
Total Selling Expens es
Adminis trative Expens es
Rent Expens e
Utilities Expens e
Depreciation Expens e
Ins urance Expens e
Total Adminis trative Expens es
Total Operating Expens es
Operating Income
Other Revenues and Gains
Interes t Revenue
Gain on Sale of Equipment
Other Expens
es and Los
s es
Mugan-Akman
2007
Interes t Expens e
Income Before Tax
-
-
-
30.700
500
200
30.000
6.700
14.800
300
400
14.100
500
14.600
21.300
4.800
16.500
13.500
6.100
1.300
700
8.100
1.500
1.100
1.000
900
4.500
12.600
900
400
200
-
600
900
Composition of Inventories
INVENTORY = Unit cost * Quantity
Quantity
• taking a physical count of inventories
• determining the ownership of goods.
Unit Cost
• Cost Flow Assumptions
Chapter 4&5
Mugan-Akman 2007
Taking Physical Count
During the physical count, a company should pay very
close attention to the following issues in order to have an
effective internal control and also to minimize the errors
and fraud:
1. the employees who are responsible from safekeeping of
inventory items should not count them,
2. it has to be made sure that the items are complete and what
they are supposed to be,
3. items should be re-counted by another independent employee
for verification,
4. counting process should be documented by tagging the
inventory items,
5. a supervisor should oversee that each item has only one tag,
and that each item is counted, and
6. there should be no inventory movements during the count
Chapter 4&5
Mugan-Akman 2007
Whose ?
Determination of the owner of goods:
• Consignment goods
– consignor (owner of the merchandise) and
the consignee (the holder of the goods)
• Goods in transit are goods that are on
the way to the company (purchases) or
goods that are on a carrier being shipped
to the customer
Chapter 4&5
Mugan-Akman 2007
Seller
F.O.B. SHIPPING
POINT
WHO OWNS THE
GOODS ON THE
WAY?
Buyer
Chapter 4&5
Mugan-Akman 2007
Seller
F.O.B. DESTINATION
WHO OWNS THE
GOODS ON THE
WAY?
Buyer
Chapter 4&5
Mugan-Akman 2007
Inventory Costs
Beginning Inventory + Purchases - Ending Inventory = COGS
Available for Sale
Chapter 4&5
Mugan-Akman 2007
Inventory Cost Flows
•
•
•
•
Specific Identification Method
First-in First-out
Weighted Average
Last-in First-out – not allowed by IFRS or
CMB
Chapter 4&5
Mugan-Akman 2007
Specific Identification Method
• used when the actual cost of the item is
tracked
• closely follows the actual flow of goods
• whether a company uses a periodic or
perpetual inventory system does not make
any difference on cost of goods sold or the
amount of inventory
Chapter 4&5
Mugan-Akman 2007
Cost Flow vs. Physical Flow
• First-in First-out (FIFO), and weighted
average methods assume that flow of
costs may be unrelated to physical flow
of goods
• The accounting regulations do not
require that the physical flow of goods
and the related cost flow to be the
same
Chapter 4&5
Mugan-Akman 2007
Example-Cost Flow
Cacun Elektronik B55 Alpha Relay
Date
Explanation
1.1.2004
Beg. Inv.
100
TL 10
TL 1.000
15.5.2004
Purchase
200
11
2.200
20.5.2004
Sale
250
25.7.2004
Purchase
300
12
3.600
10.10.2004
Sale
300
1.12.2004
Purchase
400
13
5.200
Available for Sale
Chapter 4&5
Units
Unit Cost
1.000
Mugan-Akman 2007
Total Cost
TL12.000
First-in First-out Method
FIFO
• FIFO method assumes that the goods
purchased earlier will be sold first
• The cost of the first units on hand is
assigned to the units sold first
Chapter 4&5
Mugan-Akman 2007
FIFO – COGS and Ending Inventory : Perpetual Inventory System
Date
Purchased
Units
Sold
Unit
Cost
COGS
(units x
unit cost)
1.1.2004
15.5.2004
200@11
20.5.2004
25.7.2004
250 100 x 10
150 x 11
300@12
10.10.2004
1.12.2004
300
50 x 11
250 x 12
400@13
550
Chapter 4&5
TL 1.000
1.650
Mugan-Akman 2007
550
3.000
Balance
(units x
unit cost)
100 x 10 =1.000
100 x 10 = 1.000
200 x 11 = 2.200
50 x 11 = 650
50 x 11= 650
300 x 12 =3.600
50 x 12 = 600
50 x 12 =600
400 x 13 =5.200
TL 6.200
5.800
Weighted Average
• Goods available are homogeneous and
the cost to be assigned to each unit sold is
the same
Total Cost of Goods Available for Sale
Unit Cost 
Total Number of Units Available for Sale
Chapter 4&5
Mugan-Akman 2007
Weighted Average-Perpetual
Weighted Average– COGS and Ending Inventory : Perpetual Inventory System
Date
1.1.2004
15.5.2004
20.5.2004
25.7.2004
10.10.2004
1.12.2004
Purchased
Units Sold Unit Cost COGS
Assigned (units x
unit cost)
200@ 11
250 250*10,66
300@ 12
300 300*11,81
400 @ 13
550
Chapter 4&5
Mugan-Akman 2007
Balance
(total cost ÷
number of units = unit cost)
100 x 10 =1.000
3.200 ÷ 300= 10.66
2.667
50 x 10.66=533
(533+ 3600) ÷ 350= 11.81
3.543
50 x 11.81 = 590.50
(590.50 + 5.200) ÷ 450= 12.87
TL 6.210
TL 5.790
Summary
Perpetual Inventory System
Ending Inventory
COGS
Chapter 4&5
FIFO
5.800
6.200
Mugan-Akman 2007
LIFO
Weighted Ave.
5.700
5.790
6.300
6.210
Lower of Cost or Net Realizable
Value
• as time passes the value of the inventories might decline
in the market because of the obsolescence factor
• IFRS specify that the companies should use the lowerof-cost-or net realizable (LCNRV) valuation basis
• Net realizable value is the expected sales price less
costs to sell
• LCNRV rule can be applied with any of the cost flow
methods, or the specific identification method
• LCNRV may be applied to individual items or major
categories of inventory
• the decline in value is not expected to increase in the
very near future
Chapter 4&5
Mugan-Akman 2007
Example-LCM-1
Item by item
Item
Quantity
W
75
X
48
Y
101
Z
64
Chapter 4&5
Unit Cost
(TL)
Unit
Market Inventory Value
Item(TL)
at Cost (TL)
W 130
X 151
Y
87
Z 110
Total
125
9.750
164
7.248
81
8.787
115
Mugan-Akman 2007
7.040
32.825
Example-LCM-1
Item by item
Item
Quantity
W
75
X
48
Y
101
Z
64
Date
Unit Cost
(TL)
Unit
Market
Inventory Value
(TL)
Item
130
125
X 151
164
87
Z 110
Total
W
Y
at Cost (TL)
Inventory
Value at LCM
(TL)
9.750
9.375
9.375
7.248
7.872
7.248
81
8.787
8.181
8.181
115
7.040
7.360
7.040
32.825
32.788
31.844
Account Title and Description
31-Dec-07 Loss from Decline in Value of Inventory
Allowance for Decline in Value of
To record the decline in value.
Chapter 4&5
Inventory
Value at
Market (TL)
Mugan-Akman 2007
Debit Credit
981
981
Example-LCM-2
on 15 August 2008, the company sold 15 units of
Item W at TL 126 per unit
Date
Account Title and Description
Debit Credit
15-Aug-08 Cash
1.890
Sales
1.890
To recognize the sale of 15 units of item W
15-Aug-08 COGS (*)
1.875
Allowance for Decline in Inventory
75
Inventories
1.950
To record COGS of the sale of 15 units of item W
Chapter 4&5
Mugan-Akman 2007
Example-LCM-3
Item
Inventory
Inventory
Inventory
Value at Cost
Value at
Value at
(TL)
Market (TL) LCM (TL)
7.800
7.500
7.500
7.248
7.872
7.248
8.787
8.383
8.383
7.040
7.360
7.040
30.875
31.115
30.171
W
X
Y
Z
Total
Using item-by-item basis
31 December 2008
Decline in value of inventories as 31 December 2008
T L 704 CR balance
Balance of Allowance for Decline in Inventory before adjustment
T L 906 CR balance
Difference
T
L 981 CR balance
202
Date
Account Title and Description
31-Ara-08 Allowance for Decline in Value of Inventory
COGS
To record the recovery of the decline in the
value of inventories
Chapter 4&5
Mugan-Akman 2007
Debit
Credit
202
202
Chapter 4&5
Mugan-Akman 2007
Allowance for decline in
value of inventory
Chapter 4&5
Mugan-Akman 2007
Inventory Errors
Ending Inventory Year 1
Understated by
Overstated by
TL 1.000
TL 1.000
Year 1
Beginning Inventory
Cost of goods sold
Gross margin
Net Income
Retained Earnings at year end
Chapter 4&5
No effect/ correct
No Effect/correct
Overstated + 1,000 Understated – 1,000
Understated – 1,000 Overstated + 1,000
Understated – 1,000 Overstated + 1,000
Understated – 1.000 Overstated + 1,000
Mugan-Akman 2007
Inventory Errors
Ending Inventory Year 1
Understated by
Overstated by
TL 1.000
TL 1.000
Year 1
Beginning Inventory
Cost of goods sold
Gross margin
Net Income
No effect/ correct
No Effect/correct
Overstated + 1,000 Understated – 1,000
Understated – 1,000 Overstated + 1,000
Understated – 1,000 Overstated + 1,000
Understated – 1.000 Overstated + 1,000
Retained Earnings at year end
Year 2
Beginning Inventory
Cost of goods sold
Gross margin
Net Income
Retained Earnings at year
end
Sum of two years income or
ending
equity
ending shareholders’
shareholders' equity
Chapter 4&5
Understated – 1,000 Overstated + 1,000
Understated –1,000 Overstated + 1,000
Overstated + 1,000 Understated – 1,000
Overstated + 1,000 Understated – 1,000
Overstated + 1,000 Understated – 1,000
No effect /correct
No effect/correct
Mugan-Akman 2007
Inventory Management and
Ethical Issues
• inventories are closely related with net income
and thus with the shareholders’ equity, and the
assets
• taking decisions that would affect the ending
inventory and cost of goods sold amount, the
management can manipulate income
• for example, management might decide to make
a large purchase at the end of the period, in
order to maximize profits in that period, and then
return the goods at the beginning of the
following period stating that they are not
according to specifications
Chapter 4&5
Mugan-Akman 2007
Manufacturing Operations
CLASSES OF INVENTORIES
Chapter 4&5
MANUFACTURING COSTS
Raw Materials
Direct Materials
Work-in-process
Direct Labor
Finished Goods
Mfg. Overhead
Mugan-Akman 2007
Raw materials
Purchases
Manufacturing Overhead
Work-in-process
Finished Goods
Cost of Goods Sold
Chapter 4&5
Mugan-Akman 2007
Purchases
Raw materials
Direct Materials Used
Manufacturing Overhead
Work-in-process
Direct Materials Used
Finished Goods
Cost of Goods Sold
Chapter 4&5
Mugan-Akman 2007
Purchases
Raw materials
Direct Materials Used
Indirect Materials Used
Manufacturing Overhead
Actual Overhead
(Indirect Materials)
Work-in-process
Direct Materials Used
Finished Goods
Cost of Goods Sold
Chapter 4&5
Mugan-Akman 2007
Purchases
Raw materials
Direct Materials Used
Indirect Materials Used
Manufacturing Overhead
Actual Overhead
Overhead Applied
(Indirect Materials)
(Indirect Labor)
(Other mfg costs)
Work-in-process
Direct Materials Used
Direct Labor
Overhead Applied
Finishedsalaries
Goods and
Accrued
wages of direct labor
Cost of Goods Sold
Chapter 4&5
Mugan-Akman 2007
Purchases
Raw materials
Direct Materials Used
Indirect Materials Used
Manufacturing Overhead
Actual Overhead
Overhead Applied
(Indirect Materials)
(Indirect Labor)
(Other mfg costs)
Work-in-process
Direct Materials Used
Cost of goods manufactured
Direct Labor
Overhead Applied
Finished Goods
Cost of goods manufactured
Cost of Goods Sold
Chapter 4&5
Mugan-Akman 2007
Purchases
Raw materials
Direct Materials Used
Indirect Materials Used
Manufacturing Overhead
Actual Overhead
Overhead Applied
(Indirect Materials)
(Indirect Labor)
(Other mfg costs)
Work-in-process
Direct Materials Used
Cost of goods manufactured
Direct Labor
Overhead Applied
Finished Goods
Cost of goods manufactured Cost of Goods Sold
Cost of Goods Sold
Cost of Goods Sold
Chapter 4&5
Mugan-Akman 2007
Analysis of Inventories
• To check whether adequate profits are
generated by the operations
• To check whether inventory is adequate or
more than adequate to meet future
demands
Chapter 4&5
Mugan-Akman 2007
Some Ratios
Gross Profit Ratio 
Gross Profit
Sales
very low ratio might point to some problems that are related to pricing
policies, and inefficiencies in the production process
Inventory Turnover Ratio 
Cost of Goods Sold
Average Inventory
a high turnover ratio usually shows that a company does not have
obsolete products that it cannot sell
Average Number of Days' Inventory on Hand =
365 days / Inventory Turnover Ratio
shows whether a company has adequate stock on hand; can be used
as an indicator of holding obsolete inventory
Chapter 4&5
Mugan-Akman 2007