1. Chapter 5 Inventories and Cost of Goods Sold
Using Financial Accounting Information:
The Alternative to Debits and Credits , 6/e by
Gary A. Porter and Curtis L. Norton
Copyright © 2009 South-Western, a part of Cengage Learning.

2. Inventory of Wholesalers and Retailers
Purchased in finished form
Resold without transformation
Classified as “Merchandise Inventory” on balance sheet
LO1

3. Gap, Inc. Consolidated Balance Sheets [Partial]
ASSETS (in millions)
February 3, Janurary 28,
CURRENT ASSETS:
Cash and cash equivalents $ 2,030 $ 2,035
Marketable securities
Accounts receivable
Merchandise inventory , ,696
Other
TOTAL CURRENT ASSETS , ,239
More
than
1/3 of
current
assets

4. Inventory of Manufacturers
Costs Included in Inventory
Direct
materials
Direct
labor
Manufacturing
overhead

5. Inventory of Manufacturers
Balance Sheet
Classifications
Costs Included
in Inventory
Direct
materials
Raw
materials
Manufacture
products
Direct
labor
Work in
process
Manufacturing
overhead
Finished
goods

6. Caterpillar, Inc. Consolidated Balance Sheets [Partial]
ASSETS (in millions)
2006
Current assets:
Inventories:
Raw materials $ 2,182
Work in progress
Finished goods ,915
Supplies
Total inventories $ 6,351

7. Condensed Income Statement for a Merchandiser
Net sales $100,000
Cost of goods sold ,000
Gross profit $ 40,000
Selling and administrative expenses ,300
Net income before tax $ 10,700
Income tax expense ,280
Net income $ 6,420
LO2

8. Net Sales and Contra-Sales Accounts
Sales revenue
The inflow of either cash or accounts receivable
from the sale of a product
Normal
balance
Two deductions from sales:
sales returns and allowances
sales discounts
normal
debit
balance
normal
debit
balance

9. Sales Returns and Allowances
records inventory returned by customers
who are not completely satisfied
a customer may be given an allowance for
spoiled or damaged merchandise
single account used to record both returns
and allowances
Normal
balance
normal
debit
balance

10. 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

11. Net Sales Sales revenue $103,500 Less: Sales returns and
allowances ,000
Sales discounts ,500
Net sales $100,000

12. The Cost of Goods Sold Model
Beginning
inventory
Purchases of
merchandise + =
Goods Available
for Sale
Less: Ending inventory
Cost
of goods
sold =
LO3

13. The Cost of Goods Sold Model
Beginning inventory $ 15,000
+ Cost of goods purchased ,000
= Cost of goods available for sale 78,000
– Ending inventory (18,000)
= Cost of goods sold $ 60,000
An increase in ending
inventory means more
was bought than sold
“Pool” of goods
available to sell
during the period

14. 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

15. 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

16. Cost of Goods Purchased
Includes invoice price:
Less:
Purchase returns and allowances
Purchase discounts
Plus:
Transportation-in

17. To record purchase of inventory.
Recording Purchases
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ Revenues -- Expenses
Equity
Accounts Purchases
Payable 4, (4,000)
To record purchase of inventory.

18. Recording Purchase Returns and Allowances
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ Revenues -- Expenses
Equity
Accounts Purchase Returns and Payable (850) Allowances
To record inventory returned to supplier.

19. Recording Purchase Discounts
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ + Revenues -- Expenses
Equity
Cash (495) Accounts Purchase
Payable (500) Discounts 5
($ 500 × 1% = $5 discount)
To record payment within discount period to supplier who offers 1% purchase discount.

20. Title passes at destination
FOB Destination Point
Title passes at destination
No sale or purchase until inventory reaches its destination
Seller responsible for inventory while in transit

21. Title passes when shipped
FOB Shipping Point
Both sale and purchase recorded upon shipment
Buyer responsible for inventory while in transit
Title passes when shipped

22. Analysis of Profitability
particular
interest
to current and
potential
investors
Gross
Profit %
LO4 14 14

23. Gross Profit Ratio = Gross Profit
Daisy’s Profitability
Net sales $100,000
Cost of goods sold ,000
Gross profit $ 40,000
Gross profit ratio = %
Gross Profit Ratio = Gross Profit
Net Sales
(How many cents on every $ of sales are left over after covering the cost of the product) 15 15

24. Inventory Valuation and Income Measurement
Value
assigned to
inventory
on balance
sheet
Value
expensed
as cost of
goods sold
on income
statement
When Sold =
LO5

25. 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

26. Inventory Costing Methods
Four costing methods available:
Specific
Identification
Weighted
Average
First-in, First-out
(FIFO)
Last-in, First-out
(LIFO)
LO6

27. Detailed Costing Method Example
Beginning inventory, Jan. 1: 500 units (unit cost $10)
Inventory purchases:
Date Units Unit Cost
1/ $ 11 4/ 9/
12/
Total purchases 1,000 units
Ending inventory, Dec. 31: 600 units
Calculate the cost of goods sold and ending inventory under each cost flow method

28. Specific Identification Method
Step 1: Identify the specific units in
inventory at the end of the year
and their costs.

29. Units × Cost = Total cost
Specific Identification Method
Units in ending inventory:
Date purchased Units Cost Total Cost
1/ $11 $ 1,100
4/ ,600
9/ ,600
Ending inventory $ 7,300
Units × Cost = Total cost

30. Specific Identification Method
Step 2: Identify the units sold and calculate the cost of goods sold.

31. Units × Cost = Total cost
Specific Identification Method
Date purchased Units Cost Total Cost
Beg. inventory $10 $5,000
1/ ,200
4/ ,200
12/ ,400
Cost of goods sold $9,800
Units × Cost = Total cost

32. Weighted Average Method
Step 1: Calculate the cost of goods
available for sale.

33. Weighted Average Method
Date purchased Units Cost Total cost
Beg. inventory $ $ 5,000
1/ ,300
4/ ,800
9/ ,600
12/ ,400
Cost of goods
available for sale 1, $17,100

34. Weighted Average Method
Step 2: Divide the cost of goods available
for sale by the total units to
determine the weighted average
cost per unit.

35. Cost of Goods Available for Sale Units Available for Sale
Weighted Average Method
Cost of Goods Available for Sale
Units Available for Sale
$17,100
1,500
= $11.40/unit

36. 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

37. Weighted Average Method
ALLOCATE TO
Ending Cost of
Inventory Goods Sold
Units on hand
Units sold
Weighted average cost × $ $ 11.40
Total cost of goods
available of $17,100 allocated: $6, $10,260

38. First-in, First-out (FIFO) Method
Step 1: Assign the cost of the beginning
inventory to cost of goods sold.

39. First-in, First-out (FIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $ $5,000
1/ $11
4/ $12
9/ $13
12/ $14

40. First-in, First-out (FIFO) Method
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.

41. First-in, First-out (FIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $ $5,000
1/ $ ,300
4/ / 100 $ $3, ,200
9/ $ ,600
12/ $ ,400
TOTALS $7, $9,500

42. Last-in, First-out (LIFO) Method
Step 1: Assign the cost of the last units purchased to cost of goods sold.

43. Last-in, First-out (LIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $10
1/ $11
4/ $12
9/ $13
12/ $ $1,400

44. Last-in, First-out (LIFO) Method
Step 2: Work backward until you assign the total number of units sold during the period to cost of goods sold (allocate the remaining costs to ending inventory).

45. Last-in, First-out (LIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $10 $5,000
1/ / 200 $ , $ 2,200
4/ $ ,800
9/ $ ,600
12/ $ ,400
TOTALS $6, $11,000

46. Comparison of Costing Methods
Cost of
Goods
Sold
Goods Available for Sale
Ending
Inventory
Specific Identification
$7,300
$ 9,800
$17,100
Weighted
Average
6,840
10,260
17,100
FIFO
7,600
9,500
17,100
LIFO
6,100
11,000
17,100
LO7

47. Comparison of Costing Methods
Weighted
Average FIFO LIFO
In periods of rising prices:
Highest cost of goods sold?
Lowest cost of goods sold?
Highest gross profit?
Lowest net income?
Lowest income taxes? X

48. 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

49. Reasons for Inventory Errors
Mathematical mistakes
Physical inventory counting errors
Cutoff problems – in-transit
Goods on consignment
LO8

50. Effect of Inventory Errors on the Income Statement, 2008
Reported Corrected Effect
Sales $1,000,000 $1,000,000
Beginning inventory $ 200, $ 200,000
Add: Purchases , ,000
Goods available for sale $ 900,000 $ 900,000
Less: Ending inventory , ,000 $50 OS
Cost of goods sold $ 600,000 $ 650, US
Gross margin $ 400,000 $ 350, OS
Operating expenses , ,000
Net income $ 300,000 $ 250, OS
OS = overstatement
US = understatement

51. Effect of Inventory Errors on the Income Statement, 2009
Reported Corrected Effect
Sales $1,500,000 $1,500,000
Beginning inventory $ 300, $ 250,000 $50 OS
Add: Purchases 1,100, ,100,000
Goods available for sale $1,400,000 $1,350, OS
Less: Ending inventory , ,000
Cost of goods sold $1,050,000 $1,000, OS
Gross margin $ 450,000 $ 500, US
Operating expenses , ,000
Net income $ 330,000 $ 380, US
OS = overstatement
US = understatement

52. Counterbalancing Errors
Assume ending inventory is overstated (+) by
$50,000 in 2008:
2008
Beginning inventory xxx,xxx
Add: Purchases xxx,xxx
= Goods available for sale xxx,xxx
Less: Ending inventory ,000
= Cost of goods sold –50,000

53. Counterbalancing Errors
2008 ending inventory becomes 2009 beginning
inventory:
Beginning inventory $xxx,xxx +50,000
Add: Purchases xxx,xxx
= Goods available for sale xxx,xxx
Less: Ending inventory ,000
= Cost of goods sold –50,000

54. Counterbalancing Errors
The 2008 error reverses in 2009 (but 2008 inventory
both 2008 and 2009 profits are misstated by 50,000):
Beginning inventory $xxx,xxx $+50,000
Add: Purchases xxx,xxx xxx,xxx
= Goods available for sale xxx,xxx +50,000
Less: Ending inventory ,000 xxx,xxx
= Cost of goods sold
–50, ,000

55. Report loss in year market falls below cost…
Lower of Cost or Market
Before After
Price Price Change Change
Cost $ $80
Report loss in year market falls below cost…
LO9

56. normal gross profit % when sold
Lower of Cost or Market
Before After
Price Price Change Change
Selling price $ $ 80
Cost
Gross profit $ $ 20
…to maintain
normal gross profit % when sold
Gross profit % % %

57. 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

58. Estimating Inventory Value
Sometimes impossible or impractical to measure inventory at cost
Estimation is necessary
Two methods used to estimate ending inventory values:
Gross profit method
Retail inventory method
LO10

59. Use income statement model but
Gross Profit Method
Beginning Inventory
+ Purchases
= Cost of Goods Available for Sale
– Ending Inventory
= Cost of Goods Sold
Use income statement model but
reverse last two steps

60. *Cost of goods sold is estimated as a percentage of sales
Gross Profit Method
Beginning inventory $1,200
+ Purchases ,500
= Cost of goods available for sale ,700
– Cost of goods sold (estimated)* ,200
= Ending inventory (estimated) $ 500
*Cost of goods sold is estimated
as a percentage of sales

61. Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
The number of times per period inventory is turned over (i.e., sold)
LO11

62. 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 it’s sold

63. Statement of Cash Flows
Cash Flows from Operating Activities:
Net income xxx
Increase in inventory –
Decrease in inventory
Increase in accounts payable
Decrease in accounts payable –
- OR -
Cash paid for inventory purchases –
Indirect
Method
Direct
Method
LO12

64. Inventory Costing Methods with the Use of a Perpetual Inventory System
Appendix
Accounting Tools:
Inventory Costing Methods with the Use of a Perpetual Inventory System

65. FIFO Costing with a Perpetual System
FIFO applied at time of sale
Same FIFO inventory total under periodic
and perpetual systems

66. LIFO Costing with a Perpetual System
LIFO applied at time of sale
Different LIFO inventory total under periodic and perpetual systems because of pricing gap

67. Moving Average with a Perpetual System
New weighted average cost is computed for each purchase
Different inventory total under weighted average (periodic) and moving average (perpetual)

68. End of Chapter 5