1. Inventories and Cost of Goods Sold
Chapter 6
Inventories and
Cost of Goods Sold
Financial Accounting 4e by Porter and Norton

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

3. CIRCUIT CITY Consolidated Balance Sheets [Partial]
February 28,
ASSETS (in thousands)
CURRENT ASSETS:
Cash and cash equivalents $1,251,532 $ 446,131
Net accounts and notes receivable 726, ,761
Merchandise inventory 1,633,327 1,757,664
Prepaid expenses and other current assets , ,623
TOTAL CURRENT ASSETS 3,652,711 2,847,179
Property, plant and equipment, net , ,947
Other assets , ,207
TOTAL ASSETS $4,539, $3,871,333
More
than
1/3
of total
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. NIKE, INC. Consolidated Balance Sheets [Partial]
May 31,
ASSETS (in millions)
Current assets:
Cash and cash equivalents $ $
Accounts receivable less allowance for
doubtful accounts of $72.1 and $ , ,569.4
Inventories:
Finished goods 1, ,416.6
Work in progress
Raw materials
1, ,446.0
Deferred income taxes
Prepaid expenses
Total current assets 3, ,596.4
Property, plant and equipment, net , ,583.4
Identifiable intangible assets and goodwill
Deferred income taxes and other assets
TOTAL ASSETS $ 5,819.6 $ 5,856.9

7. Inventory Valuation and Income Measurement
Value
Assigned to
Inventory
on Balance
Sheet
Value
Expensed
as Cost of
Goods Sold
on Income
Statement
When Sold =

8. Calculating Cost of Goods Sold
Internal calculation
Beginning inventory $
+ Purchases ,200
= Cost of goods available for sale ,700
- Ending inventory (600)
= Cost of goods sold $ 1,100

9. Inventory costs include
Any freight costs incurred by buyer
Cost of insurance for inventory in transit
Cost of storing inventory before selling
Excise and sales taxes

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

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

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

13. 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 x Cost = Total cost

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

15. 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 x Cost = Total cost

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

17. 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

18. : 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. :

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

20. X Avg. Cost # Units Weighted Average Method
Step 3: Calculate ending inventory and COGS by multiplying the weighted average cost per unit by the # of units in ending inventory and the # of units sold. X
Avg.
Cost #
Units

21. Weighted Average Method
ALLOCATE TO
Ending Cost of
Inventory Goods Sold
Units on hand
Units sold
Weighted average cost X $ $ 11.40
Total cost of goods
available of $17,100 allocated: $6,840 $10,260

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

23. First-in, First-out (FIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $10 $5,000
1/ $11
4/ $12
9/ $13
12/ $14

24. First-in, First-out (FIFO) Method
Step 2: Continue to work forward until you assign the total # of units sold during the period to cost of goods sold. Allocate the remaining units to ending inventory.
etc.
3rd
2nd

25. First-in, First-out (FIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $10 $5,000
1/ $ ,300
4/ / $12 $3, ,200
9/ $13 2,600
12/ $14 1,400
TOTALS $7,600 $9,500

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

27. 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/ $14 $1,400

28. Last-in, First-out (LIFO) Method
Step 2: Work backward until you assign the total # of units sold during the period to cost of goods sold (allocate the remaining units to ending inventory).
1st in

29. Last-in, First-out (LIFO) Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/ $10 $5,000
1/ / $11 1,100 $2,200
4/ $ ,800
9/ $ ,600
12/ $ ,400
TOTALS $6, $11,000

30. 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
17,000
LIFO
6,100
11,000
17,100

31. Comparison of Costing Methods
Weighted
Avg. FIFO LIFO
In periods of rising
prices:
highest COGS?
lowest COGS?
highest gross margin?
lowest net income?
lowest income taxes? X

32. LIFO Issues LIFO Liquidation LIFO Conformity Rule LIFO Reserve
liquidation can result in high gross margin (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

33. Reasons for Inventory Errors
Mathematical mistakes
Physical inventory counting errors
Cut-off problems - in-transit
Goods on consignment

34. Effect of Inventory Errors on the Income Statement
Reported Corrected Effect
Sales $1,000,000 $1,000,000
Beginning inventory $ 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 , , OS
OS = overstatement
US = understatement

35. Effect of Inventory Errors on the Income Statement
Reported Corrected Effect
Sales $1,500,000 $1,500,000
Beginning inventory $ 300, ,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 , , US
OS = overstatement
US = understatement

36. Counterbalancing Errors
Assume ending inventory is overstated (+) by $50,000 in 2004:
2004
Beginning inventory $xxx,xxx
Add: Purchases xxx,xxx
= Goods available for sale xxx,xxx
Less: Ending inventory + 50,000
= Cost of goods sold ,000

37. Counterbalancing Errors
2004 ending inventory becomes 2005 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 ,000

38. Counterbalancing Errors
The 2004 error reverses in 2005 (but 2004 inventory and both 2004 and 2005 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 , xxx,xxx
= Cost of goods sold
- 50, ,000

39. Report loss in year market falls below cost…
Lower of Cost or Market
Before After
Price Price Change Change
Cost
Report loss in year market falls below cost… 39

40. Lower of Cost or Market Price Price Change Change
Before After
Price Price Change Change
Selling price $200 $160
Cost
Gross margin $ 50 $ 40
…to maintain
normal G.M.%
when sold
Gross margin % % % 40

41. Lower of Cost or Market Market = replacement cost (not retail value)
Cost determined under one of four methods
Justified on basis of conservatism
Can be applied to:
entire inventory
individual items
groups of items

42. Estimating Inventory Values
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

43. Use income statement model but
Gross Profit Method
Beginning inventory
2 + Purchases
3 = Cost of goods available for sale
Ending inventory
5 = Cost of goods sold
Use income statement model but
reverse steps 4 and 5

44. * Cost of goods sold is estimated as a percentage of sales
Gross Profit Method
Beginning inventory $ 100,000
+ Purchases ,000
= Cost of goods available for sale ,000
- Cost of goods sold (estimated) * ,000
= Ending inventory (estimated) $ 40,000
* Cost of goods sold is estimated
as a percentage of sales

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

46. Inventory Turnover Ratios
Example:
Circuit City times per year
Safeway times per year
Can you compare the two ratios?

47. Days’ Sales in Inventory
# of Days in Period
Inventory Turnover
Ratio
The average # of days
inventory is on hand
before its sold. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27

48. Days’ Sales in Inventory
Circuit City 365 = 61 days
Safeway = 39 days
Do these averages seem reasonable?

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

50. 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

51. Comparison of Periodic and Perpetual Inventory Systems
Purchased on account 500 units at $8 each.
Periodic:
Purchases 4,000
Accounts Payable ,000
Perpetual:
Inventory 4,000
Accounts Payable ,000

52. Comparison of Periodic and Perpetual Inventory Systems
Returned for credit 100 units damaged in transit.
Periodic:
Accounts Payable
Purchase Returns & Allowances
Perpetual:
Accounts Payable
Inventory

53. Comparison of Periodic and Perpetual Inventory Systems
Sold on account 200 units at $10 each.
Periodic:
Accounts Receivable 2,000
Sales Revenue ,000
Perpetual:
Accounts Receivable 2,000
Sales Revenue ,000
Cost of Goods Sold 1,600
Inventory ,600

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

55. 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

56. 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)

57. End of Chapter 6