Introduction to Using
Financial Accounting
Information, 7/e
5
Inventories
and Cost of Goods Sold
PowerPoint Author: Catherine Lumbattis
COPYRIGHT © 2011 South-Western/Cengage Learning
Inventory of Wholesalers
and Retailers
 Purchased in finished form
 Resold without transformation
 Classified as “Merchandise
Inventory” on balance sheet
LO1
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
Condensed Income Statement
for a Merchandiser
Net sales
Cost of goods sold
Gross profit
Selling and administrative expenses
Net income before tax
Income tax expense
Net income
$100,000
60,000
$ 40,000
29,300
$ 10,700
4,280
$ 6,420
LO2
Net Sales and
Contra-Sales Accounts
Normal
Sales revenue
 The inflow of either cash or accounts
balance
receivable from the sale of a product
Two deductions from sales:
 normal
sales returns and allowances
normal
debit discounts
debit
 sales
balance
balance
Sales Returns and Allowances
Normal
 records inventory returned by customers
who are balance
not completely satisfied
 a customer may be given an allowance for
spoiled or damaged merchandise
 normal
single account used to record both
debit
returns
and allowances
balance
Credit Terms and Sales Discounts
n/30
Payment due 30 days from invoice
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
The Cost of Goods Sold Model
Beginning
inventory
+
Purchases of
merchandise
=
Goods Available
for Sale
Less: Ending inventory
=
Cost
of goods
sold
LO3
The Cost of Goods Sold Model
Beginning inventory
+ Cost of goods purchased
= Cost of goods available for sale
– 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
Perpetual Inventory Systems
Inventory records are updated
after each purchase or sale
 Point-of-sale terminals have improved the
ability of mass merchandisers to maintain
perpetual systems
Periodic Inventory Systems
Inventory records are updated
periodically based on physical
inventory counts
 Reduces record keeping but also decreases the
ability to track theft, breakage, etc., and prepare
interim financial statements
Cost of Goods Purchased
 Cost of inventory purchased (invoice price):
Less:
Purchase returns and
allowances
Purchase discounts
Plus:
Transportation-in
FOB Destination Point
Title passes at destination
 No sale or purchase until inventory reaches its
destination
 Seller responsible for inventory while in transit
FOB Shipping Point
 Both sale and purchase recorded upon shipment
 Buyer responsible for inventory while in transit
Title passes when shipped
Analysis of Profitability
Of
particular
interest
to current and
potential
investors
Gross
Profit %
LO4
Inventory Valuation and
Income Measurement
Value
assigned to When Sold =
inventory
on balance
sheet
Value
expensed
as cost of
goods sold
on income
statement
LO5
Inventory Costs Included
 Any freight costs incurred by buyer
 Cost of insurance for inventory in transit
 Cost of storing inventory before selling
 Excise and sales taxes
Inventory Costing Methods
Four costing methods available:
Specific
Identification
Weighted
Average
First-in, First-out
(FIFO)
Last-in, First-out
(LIFO)
LO6
Detailed Costing Method Example
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 units
Unit Cost
$ 11
12
13
14
Ending inventory, Dec. 31: 600 units
Calculate the Cost of Goods Sold and Ending
Inventory under each cost flow method
Specific Identification Method
Step 1: Identify the specific units in
inventory at the end of the year
and their costs.
Step 2: Identify the units sold and
calculate the cost of goods
sold.
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
Units × Cost = Total cost
$9,800
Weighted Average Method
Step 1: Calculate the cost of goods
available for sale.
Step 2:
Divide the cost of goods available
for sale by the total units to
determine the weighted average
cost per unit.
Weighted Average Method
Cost of Goods Available for Sale
Units Available for Sale
$17,100
= $11.40/unit
1,500
Weighted Average Method
Step 3: Calculate ending inventory and
cost of goods sold by multiplying
the weighted average cost per unit
by the number of units in ending
inventory and the number of units
sold.
Avg.
Cost
×
# of
Units
Weighted Average Method
ALLOCATE TO
Ending
Cost of
Inventory Goods Sold
600
900
$11.40
$ 11.40
Units on hand
Units sold
Weighted average cost
×
Total cost of goods
available of $17,100 allocated: $6,840
$10,260
First-in, First-out
(FIFO) Method
Step 1:
Assign the cost of the beginning
inventory to cost of goods sold.
Step 2: Continue to work forward until you
assign the total number of units sold
during the period to cost of goods sold.
Allocate the remaining costs to ending
inventory.
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
Last-in, First-out (LIFO) Method
Step 1:
Assign the cost of the last units
purchased to cost of goods sold.
Step 2: Work backwards until you assign the
total number of units sold during the
period to cost of goods sold (allocate
the remaining costs to ending inventory).
Last-in, First-out (LIFO) Method
ALLOCATE TO
Ending
Cost of
Inventory
Goods Sold
Units
Cost
1/1
500
$10
1/20
100 /200 $11
4/8
400
$12
4,800
9/5
200
$13
2,600
12/12
100
$14
1,400
TOTALS
$5,000
1,100
$6,100
$ 2,200
$11,000
LIFO Issues
 LIFO liquidation
• Liquidation can result in high gross
profit (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
International Inventory
Valuation Methods
 Acceptable methods of costing inventory in the
United States may not be acceptable in other
countries
• LIFO is generally accepted in the United States
• IASB (international standards) prohibit the use
of LIFO by companies that follow international
standards
 It is uncertain whether LIFO will survive as an
acceptable inventory valuation method
Reasons for Inventory Errors
 Mathematical mistakes
 Physical inventory counting errors
 Cutoff problems – in-transit
 Goods on consignment
LO8
Effect of Inventory Errors on
the Income Statement, 2010
Sales
Beginning inventory
Add: Purchases
Goods available for sale
Less: Ending inventory
Cost of goods sold
Gross margin
Operating expenses
Net income
OS = overstatement
US = understatement
Reported
$1,000
$ 200
700
$ 900
300
$ 600
$ 400
100
$ 300
Corrected Effect
$1,000
$ 200
700
$ 900
250 $50 OS
$ 650
50 US
$ 350
50 OS
100
$ 250
50 OS
Effect of Inventory Errors on the
Income Statement, 2011
Sales
Beginning inventory
Add: Purchases
Goods available for sale
Less: Ending inventory
Cost of goods sold
Gross margin
Operating expenses
Net income
OS = overstatement
US = understatement
Reported
$1,500
$ 300
1,100
$1,400
350
$1,050
$ 450
120
$ 330
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
Counterbalancing Errors
The 2010 error reverses in 2011 (but 2010 inventory
both 2010 and 2011 profits are misstated by 50):
2010
2011
Beginning inventory
$xxx
$+50
Add: Purchases
xxx
xxx
= Goods available for sale
xxx
+50
Less: Ending inventory
+50
xxx
= Cost of goods sold
–50
+50
Lower of Cost or Market
Before
Price
Change
Cost
$100,000
After
Price
Change
$85,000
Report loss
in year
market falls
below cost…
LO9
Lower of Cost or Market
Selling price
Cost
Gross profit
Before
Price
Change
$100
75
$ 25
After
Price
Change
$ 80
60
$ 20
Gross profit %
25%
25%
Lower of Cost or Market
 Market = replacement cost (not retail
value)
 Cost determined under one of the costing
methods
 Justified on basis of conservatism
 Can be applied to:
• Entire inventory
• Individual items
• Groups of items
Lower of Cost or Market
under International Standards
 Both U.S. GAAP and international financial
reporting standards (IFRS) require lowerof-cost-or-market
 Differences between U.S. GAAP and IFRS
• How market value is defined
• Recording changes in market value in
future periods
Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
The number of times per period
inventory is turned over (i.e., sold)
LO10
Number of Days’ Sales in
Inventory
Number of Days in the Period
Inventory Turnover Ratio
The average number of days
inventory is on hand before its sold
Statement of Cash Flows
Cash Flows from Operating Activities:
Net income
Increase in inventory
Decrease in inventory
Increase in accounts payable
Decrease in accounts payable
xxx
–
+
+
–
Indirect
Method
LO11
Appendix
Accounting Tools:
Inventory Costing Methods with the Use of
a Perpetual Inventory System
FIFO Costing with a
Perpetual System
Same FIFO inventory total under periodic
and perpetual systems
LIFO Costing with a
Perpetual System
Different LIFO inventory total under periodic and
perpetual systems because of pricing gap
Moving Average with a
Perpetual System
Different inventory total under weighted average
(periodic) and moving average (perpetual)
End of Chapter 5