1. Inventories and Cost of Goods Sold
Chapter 5
Inventories and Cost
of Goods Sold

2. Learning Objectives
LO1 Identify the forms of inventory held by different types of businesses and the types of costs incurred. LO2 Explain how wholesalers and retailers account for sales of merchandise. LO3 Show that you understand how wholesalers and retailers account for cost of goods sold. LO4 Use the gross profit ratio to analyze a company’s ability to cover its operating expenses and earn a profit. LO5 Explain the relationship between the valuation of inventory and the measurement of income. LO6 Apply the inventory costing methods of specific identification, weighted average, FIFO, and LIFO by using a periodic system.

3. Learning Objectives (continued)
LO7 Analyze the effects of the different costing methods on inventory, net income, income taxes, and cash flow.
LO8 Analyze the effects of an inventory error on various financial statement items.
LO9 Apply the lower-of-cost-or-market rule to the valuation of inventory.
LO10 Analyze the management of inventory.
LO11 Explain the effects that inventory transactions have on the statement of cash flows.
LO12 Explain the differences in the accounting for periodic and perpetual inventory systems and apply the inventory costing methods using a perpetual system (Appendix).

4. Module 1 Sales, Cost of Goods Sold, and Gross Profit
Inventory is an asset that is held for resale in the normal course of business
Types of inventory costs incurred and the form the inventory takes differs
The relationship between the company’s sales and the cost of those sales can be used to assess the company’s performance
Module 1

5. Three Types of Manufacturing Costs
Direct materials: also called raw materials
Ingredients used in making a product
Direct labor: amounts paid to workers to manufacture the product
Manufacturing overheads: all other costs that are related to the manufacturing process but cannot be directly matched to specific units of output
Example: depreciation of building and salary of supervisor
Module 1: LO 1

6. Three Forms of Inventory
Direct materials or raw materials
Work in process: product is not finished
Finished goods: inventory that is complete and ready for sale
Merchandise inventory for a retailer/wholesaler
Module 1: LO 1

7. Exhibit 5-1—Relationships between Types of Businesses and Inventory Costs
Module 1: LO 1

8. Net Sales of Merchandise
Gross profit: Net sales less cost of goods sold
Sales revenue: representation of the inflow of assets, either cash or accounts receivable, from the sale of a product during the period
Net sales: Sales revenue less sales returns and allowances and sales discounts
Module 1: LO 2

9. Exhibit 5-2—Condensed Income Statement for a Merchandiser
Module 1: LO 2

10. Sales Returns and Allowances
Sales returns and allowances: refunds to customers or an allowance for spoiled or damaged merchandise
Module 1: LO 2

11. Credit Terms and Sales Discounts
Credit terms: firm’s policy for granting credit
n/30: the net amount of the selling price is due within 30 days of the date of the invoice
Net, 10 EOM: the net amount is due anytime within ten days after the end of the month
1/10, n/30: the customer can deduct 1% from the selling price if the bill is paid within ten days
Sales discounts: discounts given to customers for early payment of their accounts
Module 1: LO 2

12. Cost of Goods Sold Model
Recognition of cost of goods sold as an expense is an excellent example of matching principle
Sales revenue: inflow of assets, cash or accounts receivable
Cost of goods sold: outflow of asset, inventory
Cost of goods available for sale
Cost of goods sold
Beginning inventory + Cost of goods purchased
Cost of goods available for sale − Ending inventory
Module 1: LO 3

13. Exhibit 5-3—Cost of Goods Sold Section of the Income Statement
Module 1: LO 3

14. Exhibit 5-4—Cost of Goods Sold Model
Module 1: LO 3

15. Example 5-2—Calculating Cost of Goods Sold
Module 1: LO 3

16. Inventory Systems: Perpetual and Periodic
Perpetual: inventory account is increased at the time of each purchase and decreased at the time of each sale
Periodic: inventory account is updated only at the end of the period
Module 1: LO 3

17. Example 5-3—Recording Cost of Goods Sold in a Perpetual System
Assume that Daisy’s sells a pair of running shoes that costs the company $70
In addition to the entry to record the sale, Daisy’s would also record this entry:
Module 1: LO 3

18. Cost of Goods Purchased
Purchases: temporary account to record acquisitions of inventory
Purchase Discounts: cash discount that results in a reduction of the cost to purchase merchandise
Purchase Returns and Allowances: reductions in the cost to purchase merchandise
Module 1: LO 3

19. Example 5-4—Recording Purchases in a Periodic System
Assume that Daisy’s buys shoes on account from Nike at a cost of $4,000
The journal entry to record the purchase is as follows:
Module 1: LO 3

20. Example 5-5—Recording Purchase Discounts in a Periodic System
Assume Daisy’s purchases merchandise on March 13 for $500 and takes advantage of the discount for early payment
Record the purchase at the net amount, that is the estimated amount it expects to pay: $500 ($ ), or $495
The entry at the time of the purchase is as follows:
Module 1: LO 3

21. Example 5-5—Recording Purchase Discounts in a Periodic System (continued)
Assume that the company does pay its account on March 23, within the discount period
The following entry would be made:
Module 1: LO 3

22. Shipping Terms and Transportation Costs
Cost principle: All costs necessary to prepare an asset for its intended use should be included in its cost
FOB: ‘‘free on board’’
FOB destination point: seller pays for the cost of shipping the merchandise to the buyer
FOB shipping point: buyer pays for the shipping costs
Module 1: LO 3

23. Example 5-6—Recording Transportation-In in a Periodic System
Assume that on delivery of a shipment of goods, Daisy’s pays an invoice for $300 from Rocky Mountain Railroad
Terms of shipment are FOB shipping point
The entry on Daisy’s books follows:
Module 1: LO 3

24. The Gross Profit Ratio Important measure of profitability
Indicates a company’s ability to cover operating expenses and earn a profit
Gross Profit
Net Sales
Gross Profit Ratio =
Module 1: LO 4

25. The Ratio Analysis Model
How much of the sales revenue is used for the cost of the products, and thus, how much remains to cover other expenses and to earn net income?
Gather the information about net sales and cost of goods sold
Calculate the gross profit ratio
Compare the ratio with prior years and with competitors
Interpret the ratios—showing increase or decrease
Module 1: LO 4

26. Calculate the Ratio
Module 1: LO 4

27. The Business Decision Model
If you were an investor, would you buy stock in a company?
Gather information from the financial statements and other sources
Compare the company's gross profit ratio with industry averages and look at trends
Buy stock or find an alternative use for the money
Monitor the investment periodically
Module 1: LO 4

28. Module 2 Inventory Costing Methods
Inventory costing methods are used to assign costs to the products sold
Module 2

29. Valuation of Inventory and the Measurement of Income
Value assigned to inventory on balance sheet determines the amount eventually recognized as an expense on income statement
Incorrect ending inventory will affect cost of goods sold and net income
Module 2: LO 5

30. Inventory Costs
Cost: price paid or consideration given to acquire an asset
Includes expenditures directly or indirectly incurred in bringing to its existing condition and location
Examples:
Freight costs incurred to bring inventory to the place of business
Cost of insurance when inventory is in transit
Cost of storing inventory before it is ready to be sold
Taxes paid—excise and sales taxes
Module 2: LO 5

31. Inventory Costing Methods with a Periodic System
Specific Identification Method
Weighted Average Cost Method
First-In, First-Out Method (FIFO)
Last-In, First-Out Method (LIFO)
Module 2: LO 6

32. Specific Identification Method
An inventory costing method that relies on matching unit costs with the actual units sold
A problem with the specific identification method is that it allows management to manipulate income
For example, management may selectively sell units with the lowest possible unit cost to keep cost of goods sold down and net income up
Module 2: LO 6

33. Weighted Average Cost Method
An inventory costing method that assigns the same unit cost to all units available for sale during the period
Cost of Goods Available for Sale Units Available for Sale
Weighted Average Cost =
Weighted Average Cost
Number of Units in
Ending Inventory
Ending inventory = ×
Module 2: LO 6

34. Example 5-10—Determining Ending Inventory and Cost of Goods Sold Using Weighted Average
Module 2: LO 6

35. Example 5-10—Determining Ending Inventory and Cost of Goods Sold Using Weighted Average (continued)
Ending inventory is found by multiplying the weighted average unit cost by the number of units on hand:
Weighted Average Cost x Number of Units in Ending Inventory = Ending Inventory
$11.40 x 600 = $6,840
Module 2: LO 6

36. Weighted Average Cost x Number of Units Sold = Cost of Goods Sold
Example 5-10—Determining Ending Inventory and Cost of Goods Sold Using Weighted Average (continued)
Cost of goods sold can be calculated in one of two ways:
Weighted Average Cost x Number of Units Sold = Cost of Goods Sold
$11.40 x 900 = $10,260 or
Module 2: LO 6

37. First-In, First-Out Method (FIFO)
An inventory costing method that assigns the most recent costs to ending inventory
Module 2: LO 6

38. Example 5-11—Determining Ending Inventory and Cost of Goods Sold Using FIFO
To calculate Russell Company’s ending inventory using FIFO, we start with the most recent inventory acquired and work backward as follows:
Module 2: LO 6

39. Example 5-11—Determining Ending Inventory and Cost of Goods Sold Using FIFO (continued)
Cost of goods sold can then be found as follows:
Module 2: LO 6

40. Example 5-11—Determining Ending Inventory and Cost of Goods Sold Using FIFO (continued)
Or because the FIFO method assumes that the first units purchased are the first ones sold, cost of goods sold can be calculated by starting with the beginning inventory and working forward as follows:
Module 2: LO 6

41. Last-In, First-Out Method (LIFO)
An inventory costing method that assigns earlier (not recent) costs to ending inventory
Module 2: LO 6

42. Example 5-12—Determining Ending Inventory and Cost of Goods Sold Using LIFO
To calculate Russell Company’s ending inventory using LIFO, we start with the beginning inventory acquired and work forward as follows:
Module 2: LO 6

43. Example 5-12—Determining Ending Inventory and Cost of Goods Sold Using LIFO (continuing)
Cost of goods sold can then be found as follows:
Module 2: LO 6

44. Example 5-12—Determining Ending Inventory and Cost of Goods Sold Using LIFO (continuing)
Or because the LIFO method assumes that the last units purchased are the first ones sold, cost of goods sold can be calculated by starting with the most recent inventory acquired and working backward
Module 2: LO 6

45. Selecting an Inventory Costing Method
The choice of an inventory method will impact cost of goods sold and thus net income
A company should choose the method that results in the most accurate measure of net income for the period
Module 2: LO 7

46. Exhibit 5-5—Income Statements for the Inventory Costing Methods
Module 2: LO 7

47. Exhibit 5-5—Income Statements for the Inventory Costing Methods (continued)
The weighted average method normally yields results between LIFO and FIFO
The lower gross profit under LIFO results in lower income before tax, which in turn leads to lower taxes
Module 2: LO 7

48. Result of FIFO and LIFO during a Period of Rising Prices
Module 2: LO 7

49. LIFO Issues LIFO liquidation LIFO conformity rule LIFO reserve
Negative tax consequences
LIFO conformity rule
If LIFO is used on a tax return, it must also be used in reporting income to stockholders
LIFO reserve
The excess of the value of a company’s inventory stated at FIFO over the value stated at LIFO
Module 2: LO 7

50. Costing Methods and Inventory Profits
Replacement cost: the current cost of a unit of inventory
Inventory profit: the portion of the gross profit that results from holding inventory during a period of rising prices
Module 2: LO 7

51. Inventory Valuation in Other Countries
The valuation of inventory differs around the world
GAAP in the United States allows LIFO
IASB strictly prohibits the use of LIFO
Survival of LIFO is not only a matter of convergence with international standards
LIFO allows companies with rising inventory costs to report lower income
Module 2: LO 7

52. Module 3 Other Inventory Issues
Inventory errors affect the financial statements.
The lower-of-cost-or market rule is applied to value inventory
Module 3

53. Inventory Errors Mathematical errors
Physical count of inventory at year-end
Cutoff problems—in-transit—at year-end
Module 3: LO 8

54. Exhibit 5-6—Summary of the Effects of Inventory Errors
Module 3: LO 8

55. Valuing Inventory at Lower of Cost or Market
A conservative inventory valuation approach
Require that inventory be written down at the end of the period if the market value of the inventory is less than its cost
Can be applied to:
Entire inventory
Individual items
Groups of items
Module 3: LO 8

56. Valuing Inventory at Lower of Cost or Market (continued)
Module 3: LO 8

57. Exhibit 5-7—Gross Profit Percentage Before and After Price Change
Module 3: LO 8

58. Lower-of-Cost-or-Market under International Standards
Required under both U.S. GAAP and IFRS
Difference:
U.S. GAAP
Define market value as replacement cost, subject to a maximum and a minimum amount
New amount becomes basis for future adjustments
IFRS
Uses net realizable value with no upper or lower limits
Write-downs of inventory can be reversed in later periods
Module 3: LO 9

59. Module 4 Inventory Management and Cash Flow Issues
The relationship between sales on the income statement and inventory on the balance sheet is used to assess how well a company is managing its inventory
Inventory transactions affect cash flows
Module 4

60. Inventory Turnover Ratio
Measures company’s ability to sell its inventory quickly
Number of times inventory is sold during a period
Cost of Goods Sold Average Inventory
Inventory Turnover Ratio =
Module 4: LO 10

61. Number of Days’ Sales in Inventory
Measures of how long it takes to sell inventory
Number of Days’ Sales in Inventory
Number of Days in the Period
Inventory Turnover Ratio =
Module 4: LO 10

62. The Ratio Analysis Model
How many times a year does a company turn over its inventory?
Gather cost of goods sold from the income statement and average inventory from balance sheet at the end of the two most recent years
Calculate the inventory turnover ratio
Compare the ratio with other ratios
Interpret the ratios—measure of how long it takes to sell inventory
Module 4: LO 10

63. Calculate the Ratio
Module 4: LO 10

64. The Business Decision Model
If you were an investor, would you buy stock in the company?
Gather information from the financial statements and other sources
Compare trends in inventory turnover ratios, net income with industry averages
Buy stock or find an alternative
Monitor your decision periodically
Module 4: LO 10

65. Exhibit 5-8—Inventories and the Statement of Cash Flows
Module 4: LO 11

66. Exhibit 5-9—Partial Consolidated Statement of Cash Flows
Module 4: LO 11

67. Exhibit 5-9—Partial Consolidated Statement of Cash Flows (continued)
Module 4: LO 11

68. Module 5 Inventory Costing Methods with a Perpetual System (Appendix)
Inventory costing methods are applied with a perpetual system
Module 5

69. Inventory Costing Methods with the Use of a Perpetual Inventory System
Module 5: LO 12

70. Example 5-19—FIFO Costing Methods with a Perpetual Inventory System
Module 5: LO 12

71. Example 5-20—LIFO Costing Methods with a Perpetual Inventory System
Module 5: LO 12

72. Moving Average
An average cost method when a weighted average cost assumption is used with a perpetual inventory system
Each time a purchase is made, a new weighted average cost must be computed, thus the name moving average
For example, the goods available for sale after the January 20 purchase consist of 500 units at $10 and 300 units at $11, which results in an average cost of $10.38
Module 5: LO 12

73. Review
LO1 Identify the forms of inventory held by different types of businesses and the types of costs incurred.
Inventory is a current asset held for resale in the normal course of business. The nature of inventory held depends on whether a business is a reseller of goods (wholesaler or retailer) or a manufacturer.
Resellers incur a single cost to purchase inventory held for sale.
Manufacturers incur costs that can be classified as raw materials, direct labor, and manufacturing overhead.
LO2 Explain how wholesalers and retailers account for sales of merchandise.
Net sales represents sales less deductions for discounts and merchandise returned (returns and allowances) and is a key figure on the income statement.
Sales discounts are given to customers who pay their bills promptly.
Returns and allowances have the same effect on sales that sales discounts do; that is, they reduce sales.

74. Review
LO3 Show that you understand how wholesalers and retailers account for cost of goods sold.
The cost of goods sold represents goods sold, as opposed to the inventory purchased during the year. Cost of goods sold is matched with the sales of the period.
The cost of goods sold in any one period is equal to: Beginning inventory + Purchases –Ending inventory.
Under the perpetual method, the Inventory account is updated after each sale or purchase of merchandise.
In contrast, under the periodic method, the Inventory account is updated only at the end of the period.
The cost of goods purchased includes any costs necessary to acquire the goods less any purchase discounts, returns, and allowances.
Transportation-in is the cost to ship goods to a company and is typically classified as part of cost of goods purchased.

75. Review
LO4 Use the gross profit ratio to analyze a company’s ability to cover its operating expenses and earn a profit.
The gross profit ratio is the relationship between gross profit and net sales. Managers, investors, and creditors use this important ratio to measure one aspect of profitability.
The ratio is calculated as follows: Gross Profit
Net Sales
LO5 Explain the relationship between the valuation of inventory and the measurement of income.
Inventory costs ultimately become the cost of goods sold reflected in the income statement.
Since inventory is not expensed as the cost of goods sold until merchandise is sold, determining which costs belong in inventory affects the timing of when these expenses are reflected in net income.

76. Review
LO6 Apply the inventory costing methods of specific identification, weighted average, FIFO, and LIFO by using a periodic system.
The purchase price of inventory items may change frequently, and several alternatives are available to assign costs to the goods sold and those that remain in ending inventory.
Specific identification assigns the actual costs of acquisition to items of inventory. In some circumstances, it is not practical to do this.
Three other methods involve making assumptions about the cost of inventory.
Weighted average assigns the same unit cost to all units available for sale during the period.
The FIFO method assumes that the first units purchased are the first units sold.
The LIFO method assumes that the last units purchased are the first units sold.

77. Review
LO7 Analyze the effects of the different costing methods on inventory, net income, income taxes, and cash flow.
The ability to measure net income accurately for a period should be the driving force behind selecting an inventory costing method.
Inventory costing methods impact the cost of goods sold and, therefore, net income.
When a company uses LIFO for tax purposes, it must use it for financial reporting purposes as well.
LO8 Analyze the effects of an inventory error on various financial statement items.
The link between the balance sheet and the income statement can be seen through the effect of errors in inventory valuation.
Overstatement of ending inventory results in an understatement of the cost of goods sold and therefore an overstatement of net income.
The effects of errors in inventory may offset themselves over time. These are known as counterbalancing errors.

78. Review
LO9 Apply the lower-of-cost-or-market rule to the valuation of inventory.
The principle of conservatism in accounting may warrant a departure from historical cost. This departure is known as the lower-of-cost-or-market rule (LCM).
Under LCM, the historical cost of inventory is compared with its replacement cost. If the replacement cost is lower, the Inventory account is reduced and a loss is recognized.

79. Review LO10 Analyze the management of inventory.
Inventory turnover is a measure of how efficiently inventory is managed. The ratio measures how quickly inventory is sold and is calculated as follows:
Cost of Goods Sold
Average Inventory
The higher the ratio, the less time inventory resides in storage (i.e., the more quickly it turns over).
The average length of time that it takes to sell inventory can be derived from the inventory turnover ratio:
Number of Days’ Sales in Inventory = Number of Days in the Period
Inventory Turnover Ratio

80. Review
LO11 Explain the effects that inventory transactions have on the statement of cash flows.
Under the indirect method of calculating cash flows from operating activities, both the changes in the Inventory account and the Accounts Payable account must be taken into consideration.
LO12 Explain the differences in the accounting for periodic and perpetual inventory systems and apply the inventory costing methods using a perpetual system (Appendix).
The three inventory costing methods—FIFO, LIFO, and weighted average—may be used in combination with a perpetual inventory system.
The inventory costing method is applied after each sale of merchandise to update the Inventory account.
The results from using LIFO differ depending on whether a periodic or perpetual system is used. The same is true with weighted average, which is called moving average in a perpetual system.

81. End of Chapter 5