1. Inventory and Cost of Goods Sold
S t I c e | S t I c e | S k o u s e n
Inventory and Cost of Goods Sold
Chapter 9
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

2. Learning Objectives
Define inventory for a merchandising business and identify the different types of inventory for a manufacturing business.
Explain the advantages and disadvantages of both periodic and perpetual inventory systems.
Determine when ownership of goods in transit changes hands and what circumstances require shipped inventory to be kept on the books.

3. Learning Objectives Compute total inventory acquisition cost.
Use the four basic inventory valuation methods: specific identification, average cost, FIFO, and LIFO.
Explain how LIFO inventory layers are created, and describe the significance of the LIFO reserve.

4. Learning Objectives
Choose an inventory valuation method based on the trade-offs among income tax effects, book-keeping costs, and the impact on the financial statements.
Apply the lower-of-cost-or-market (LCM) rule to reflect declines in the market value of inventory.

5. Learning Objectives
Use the gross profit method to estimate ending inventory.
Determine the financial statement impact of inventory recording errors.
Analyze inventory using financial ratios, and properly compare ratios of different firms after adjusting for differences in inventory valuation methods.

6. Learning Objectives Expanded Material
Compute estimates of FIFO, LIFO, average cost, and lower-or-cost-or market inventory using the retail inventory method.
Use LIFO pools, dollar-value LIFO, and dollar-value LIFO retail to compute ending inventory.
Account for the impact of changing prices on purchase commitments.
Record inventory purchase transactions denominated in foreign currencies.

7. What is Inventory?
Items held for resale in the normal course of business.
For a manufacturing firm, a broad array of production costs is included as part of the cost of inventory.
The terms raw materials, work in process, and finished goods refer to the inventories of a manufacturing enterprise.

8. Summary Income Statement Items Balance Sheet Items Merchandise
Cost of Goods Sold
Sale
Retailer
Manufacturer
Raw Materials
Work in Process
Finished Goods
Cost of Goods Sold
Sale
Overhead
Direct
Labor

9. Inventory Systems
Two types of inventory systems which keep track of how much inventory has been sold and at what price.
Periodic system- requires a physical count of the inventory periodically, and at the point of sale only records the sale price.
Perpetual system- at point of sale records selling price and type of item sold. Example: a bar code scanning system.

10. Differences in Recording
Purchases of Inventory- Periodic
Purchases 3,000
Accounts Payable 3,000
Sales During the Period- Periodic
Accounts Receivable 4,125
Sales 4,125
Purchases of Inventory- Perpetual
Inventory 3,000
Accounts Payable 3,000
Sales During the Period- Perpetual
Accounts Receivable 4,125
Sales 4,125
Cost of Goods Sold 2,750
Inventory 2,750

11. Whose Inventory Is It?
Report on the balance sheet inventory to which the company holds legal title.
Legal title is not determined by who has physical custody of the inventory
Issues that develop:
Goods that are in transit.
Goods that are on consignment.

12. Goods on Consignment
Shipper retains title and includes the goods in inventory until their sale or use by the dealer or customer.
Consigned goods are reported by the shipper at the sum of:
The cost of the goods
The handling costs
The shipping costs incurred in their transfer to the dealer or customer.

13. What Is Inventory Cost?
Inventory costs comprise of all expenditures both direct and indirect, relating to acquisition, preparation, and placement for sale.
Discounts can change the total inventory costs.
Trade Discounts
Convert the catalog price to the actual price.
Record inventory at discounted price.
Cash Discounts
Granted for payment of invoices within a limited time period.
Record inventory using the net method or gross method.

14. Specific Identification Method
Assigns the actual cost of the asset to Inventory and Cost of Goods Sold.
Provides a highly objective method of matching costs because cost flow exactly matches physical goods flow.
Is almost impossible to implement cost effectively.

15. Average Cost Method
Assigns the same average cost to each unit sold and each item in inventory.
For periodic inventory, the unit cost is the weighted average for the entire period.
For perpetual inventory, the unit cost is computed as a moving average, which changes with each new purchase of goods.

16. First-In-First-Out (FIFO) Method
Assigns historical unit cost to Cost of Goods Sold in the order the costs are incurred.
Provides a close match between physical product flow and product cost flow.
Results in the same inventory valuation and Cost of Goods Sold regardless of whether perpetual or periodic inventory is used.

17. Last-In-First-Out (LIFO) Method
Assigns the most recent historical costs to Cost of Goods Sold and the oldest costs to Inventory.
Is used primarily to minimize taxable income.
Results in differences between Cost of Goods Sold and Inventory for perpetual inventory versus periodic inventory.

18. Perpetual Inventory Assume: Beginning inventory 100 @ $10 $1,000
Purchases:
April @ $11 880
April 20 $12 840
Sales:
April @ $15
April 27 $16
FIFO periodic and FIFO perpetual provide identical results for cost of goods sold and inventory.

19. Average Cost Method- Perpetual
Apr. 1 Beginning Inventory 100 $10 $1,000
Apr. 10 Purchases 80 $
Apr. 10 Balance 180 $10.44 $1,880
Apr. 18 Sales (90) $ (940)
Apr. 18 Balance 90 $10.44 $ 940
Apr. 20 Purchases 70 $
Apr. 20 Balance 160 $ $1,780
$1,880  180
Apr. 27 Sales (50) $ (556)
Apr. 30 Balance 110 $ $1,224
$1,780  160
Ending inventory, $1,224

20. Average Cost Method- Perpetual
Apr. 18 Sales (90) $ (940)
Apr. 18 Balance 90 $10.44 $ 940
Apr. 20 Purchases 70 $
Apr. 20 Balance 160 $ $1,780
Apr. 1 Beginning Inventory 100 $10 $1,000
Apr. 10 Purchases 80 $
Apr. 10 Balance 180 $10.44 $1,880
Apr. 27 Sales (50) $ (556)
Apr. 30 Balance 110 $ $1,224
Cost of Goods Sold (140 units) $940 + $556 = $1,496

21. LIFO Method- Perpetual
Perpetual Inventory System
Beginning inventory
Apr. 1
100 $10 per unit
90 $10 per unit
Sold 10
Apr. 10
0 $11 per unit
80 $11 per unit
Sold 80
Purchased 80
80 $11 per unit
Apr. 20
20 $12 per unit
Sold 50
Purchased 70
70 $12 per unit

22. LIFO Method- Perpetual
Perpetual Inventory System
= $ 900
= 0 =
$1,140
Apr. 1
Apr. 10
Apr. 20
100 $10 per unit
90 $10 per unit
80 $11 per unit
70 $12 per unit
20 $12 per unit
0 $11 per unit
Ending inventory………………..
Beg. Inv. + Purchases – End. Inv. = Cost of Goods Sold
$1, $1,720 – $1,140 = $1,580

23. Unique Aspects of LIFO
LIFO liquidation- the effect of cost of goods sold and net income during periods of rising prices, when “old” inventory layers are sold.
Low cost prices are matched with higher sales prices resulting in a lower than usual cost of goods sold and a higher net income.
LIFO conformity rule- in the 1930s Congress specified that companies who use LIFO for financial reporting must use LIFO for income tax reporting as well.
Dollar-value LIFO- LIFO layers are determined based on total dollar changes rather than quantity changes.

24. FIFO Advantages and Disadvantages
Usually corresponds with physical flow of goods.
Ending inventory balance agrees closely with current replacement cost.
Disadvantages:
Can cause older costs to be matched with current revenues.
Inventory holding gains and losses are included as part of gross profit.
Yields higher taxable income in times of inflation if inventory levels are stable or increasing.

25. LIFO Advantages Advantages:
Matches current costs with current revenues.
Excludes inventory holding gains from gross profit.
Yields lower taxable income in times of inflation if inventory levels are stable or increasing.

26. LIFO Disadvantages Disadvantages:
Usually does not correspond with the physical flow of goods.
Potential LIFO liquidation means old cost in LIFO layers can be drawn in to cost of goods sold.
Ending inventory balance can be much lower than current replacement cost.
LIFO liquidation can result in greatly increased tax payments when inventory levels decline.

27. Lower of Cost or Market
The term “market” in lower of cost or market means replacement cost.
Ceiling: Also known as the net realizable value
Ceiling: Estimated selling price – normal selling costs
Replacement Cost
Market
compare
Floor: Net realizable value – a normal profit margin
Historical Cost

28. Inventory Turnover Ratio.
Appropriateness of inventory size and position can be measured by calculating the
Inventory Turnover Ratio.
Inventory Turnover:
Cost of Goods Sold ÷ Average Inventory

29. Retail Inventory Method
Used by retail firms to estimate inventory value.
Can be used to estimate inventory under any valuation assumption.
Cost amounts and retail amounts are tracked of the goods that have been purchased in the period.
Cost percentage = goods available for sale at cost/ending inventory at retail